Embedded Value Counting The Future In The Present

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: That the large-caps are on the verge of losing their sheen would be too hard a guess to hazard. But considering the mammoth upward trend demonstrated in the prices of these companies in the last several sessions of the markets, it appeared that the trend would continue at least till the end of December.

However, in these dynamics, two developments played a paramount role. One, the end of the bouts of buying by the FIIs, partly, blessings of Sebi by introducing the participatory notes-related norms adherence and partly, due to the advent of the Holiday season, where it is profit booking that assumes significance than over-indulgence. And two, the in-vogue phrase of the stock markets: ‘Embedded Value.’

It has been estimated that embedded valuations account for 17% of the large-caps i.e. the Sensex 30. More so, embedded value of the large-caps has expanded to a staggering 220%. In fact, one of the contributory factors to the positive story of the markets has been ‘embedded value’.

Hence, it becomes indispensable to understand, as to what this valuation tool entails, what is it that differentiates it from the often used valuation tool: price to earnings, things that one ignores while applying it and the impact it has created and more importantly, does one get a clearer picture of the company’s position and its scrip movement, when the tool is employed.

The essentials

Embedded value is a non-GAAP measure and does not have a standard definition. It is a construct from the field of actuarial science, which allows (uncertain) future cash flows to be valued, so that a more realistic picture of the company’s financial position is possible. It is calculated by doing a sum of the parts (SOTP) valuation - the stock price takes into account different businesses to reach at valuations. In this, subsidiaries of a company are valued and their future cash flows are factored in the present value of the stock price.

The symphony effect

To take it further, let’s consider the large-cap Larson & Toubro. It is estimated that L&T has an EV of Rs 362 per share out of its total SOTP fair valuation of Rs 4,050. The EV comprises infrastructure special purpose vehicles (SPVs), L&T’s international business, it’s holding in Ultratech Cement and investments in other associates and subsidiary companies that are currently not consolidated in the earnings.