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Valuation Models

A private equity player of my acquaintance once confessed that he had a basic rule of thumb about investments: double estimated expenses and halve projected future profits!

A private equity player of my acquaintance once confessed that he had a basic rule of thumb about investments: double estimated expenses and halve projected future profits!

There are more systematic methods of valuation. Some valuation methods are themselves optimistic, others conservative. The multiples assigned to the valuation may also be conservative or optimistic. For example, the price to book value (PBV) ratio is a conservative valuation method. The underlying assumption: in bankruptcy, the investor will receive some portion of the original investment back. A cut-off PBV of 1 or less would be a conservative multiple.

But in an emerging market such as India with its high growth rates, a more optimistic PBV multiple can be assigned. In fact, if one examines average index PBV since 1991, the PBV has never dropped below 1.5.

A dividend yield-based valuation method is also conservative. It assumes no capital appreciation and treats the original investment like debt. Again, a high or low cut-off yield could be set depending on the risk-appetite.

Earnings growth-based valuations such as the PEG (Price-earnings to projected Earnings Growth) ratio are optimistic. A PEG valuation implies that a reliable projection of forward earnings and forward earnings growth is possible. A PEG multiple of less than 1 is conservative but the valuation method itself is optimistic.

Another, more conservative valuation method using earnings, is comparing earnings yield with the yield from a risk-free instrument. If the earnings yield is higher than the risk-free yield, the stock is worth investment. Again, conservative investors will keep greater margins of safety.

In a bull market, people give maximum weight to PEG ratios. In bear markets, more conservative methods come to the fore. At the peak of a business cycle, businesses will tend to be optimistically valued at high multiples. At the bottom, the same businesses will be available at low multiples.

In fact, historically, peaks and troughs in the same economy tend to be associated with similar levels of valuation. In India, bear market bottoms tend to be associated with conservative average multiples. Usually the Nifty will be available at an earnings yield that is higher than the 364-day T-Bill yield. The PEG will be well below 1. The Price-book-value ratio will be down to less than 2.5 and the Nifty's dividend yield will be over 2 per cent.

At the top of a bull market on the other hand, these multiples are all optimistic. The PEG will be 1 or higher. The earnings yield will be below the T-Bill yield. The PBV will be higher than 4 and the dividend yield will be below 1 per cent. Usually the PEG ratio is the last to go into the red zone by rising above 1. This is because the PEG is subjective and growth estimates tend to be optimistic during bull markets. There are minor variations but these average multiples have held good through the cycles of the last 15 years. This means that a conservative value-investor can buy when the multiples are in the bear-market range. And, it is time to sell when the multiples are in the range of a bull-market top.

Since January 2006, most of the valuation multiples have been high. However until late 2007, the PEG was below 1. It was only in early 2008 that the PEG rose beyond 1 and gave the final sell signal. By then, the market had already peaked.

The crash in October has pulled all the valuation multiples back close to the levels that would be expected at a bear market bottom. Right now, at a Nifty level of 2900, the PBV is at 2.42, while the dividend yield is 1.96 per cent and the PE ratio is 12.57, with an earnings yield of 7.9 per cent in comparison to the T-Bill yield of 7.4 per cent.

At the 2550 levels that prevailed for a while in late October, these multiples were even more attractive. The PEG ratio incidentally is close to 1. While the current PE ratios have dropped, so have the forward earnings growth estimates for 2008-09. But given the turmoil, there could be further EPS downgrades.

Is it worth buying into this market? Yes, it looks that way. Certainly systematic accumulation at these prices should work over the long-term.