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.
The company?s EV per share at Rs 362 can be broken down between (a) infrastructure, SPVs at Rs 150 per share, mix of DCF and P/E multiple approaches is used to derive the fair value, (b) Rs 100/ share for L&T international FZE and its subsidiaries based on P/E multiple, (c), Rs 51/share for holding in Ultratech Cement based on market value and (d) Rs 61/share for other subsidiaries, associates companies integrated JVs that are not consolidated in earnings currently.
To present a different business perspective, by employing the same valuation tool, let?s consider another large-cap: Delhi Land and Finance (DLF). It has been estimated that Rs 268 per share of EV is attached to the real estate major?s business, considering a 30% of EV from the new businesses of the company. And land bank accounts for 75% of the company?s EV.
The Gurgaon-based company?s business includes: (a) future development (b) hotel business (c) construction JV (d) Bidadi township (e) properties such as 7.2 million sq ft plots in Gurgaon and a hotel site. In the hotel space, DLF has indicated that it is in the process of acquiring 125 sites with a potential of 25,000 rooms. The potential capital outlay in these businesses is estimated to be $15 billion. Its hotel business is present in metropolitan cities like New Delhi, Chennai, and Hyderabad.
Overall, there are 39 projects of the companies under various stages design, development and execution. This along with its construction business, JVs with Laaing o?Rourke, Feedback Ventures and WSP Group Plc, and with the Karnataka government recently granting DLF to develop 9178 acres integrated township at Bidadi would give a thrust to the company?s stock when seen in the light of EV.
This appears reasonable and convincing. But all depends on the realisation of the assumptions. And considering this premise, the fairness of the tool is gauged and pondered over other valuations.
The unacknowledged factors
States Manish Sonthalia, vice-president, equity strategy, Motilal Oswal, ?Four important factors determine the accuracy of an EV. First, realisation of the value considered, secondly the success of the ?probability? assumed, thirdly, timeframe and fourthly, quantum, the amount of value that would be realised.? He says any inconsistence in these factors, the value of EV may be an unjustified one.
For instance, consider Cairn India. According to a leading brokerage, the market is currently ascribing $2-4.1bn for either higher reserves in Cairn?s Rajasthan block or new discoveries in its 15 exploration and development blocks. This is construed to be high in the context of the specifics of Cairn?s production sharing contract with the government of India for the key Rajasthan block and limited exploration success so far in any of the new exploration blocks.
The brokerage argues that even if it is assumed that crude prices rise, the valuation of the company is not that it is perceived to be currently. The reason being the nature of the production sharing contract (PSC) with the government, in which, the government is entitled 50% of the petroleum profit. Also, there is no clarity on recovery of cost of pipeline. The government is yet to take a decision on the inclusion of the crude pipeline cost in the upstream development cost of the project.
As of now, Cairn has received a proposal to construct a crude oil pipeline to transport crude oil to west coast refineries or to ports, has received ?Rights of Use? (RoU) acquisition approval from the government of India.
Also, there is no clarity on cess issue. The government is yet to take a decision on the contentious issue of cess on Cairn?s portion of crude oil. Cairn believes that ONGC, the 30% partner in the Rajasthan block, will bear the cess on the entire crude oil produced in the Rajasthan block. However, ONGC believes its liability is restricted to 30% share in the block.
Hence the accuracy of the embedded valuation cannot be assumed to get a clearer picture of a company and can be more of an amalgamation of assumptions and expectations.
Inconsistencies
Also, it is seen that in most of the ?embedded value? valuation calculations, quite a few subsidiaries of the valued companies, which are non-listed are taken into account, which most investors are oblivious of. However, differs Dharmesh Mansukhani, a research analyst with a broking firm, ?If the subsidiaries are listed, you can discount certain factors, however, if they are not listed it is prudent to follow the price to book value ratio.?
He advises that it is important to check the operating history of the companies. There are companies, which have no operating history but claim to do big in the future. Investors must do away with such companies irrespective of the promising future these companies may be projecting. Also, it is seen that the assumptions factored in may not materialise. For example, consider a pharmaceutical company A. A claims to bring out a drug that cures AIDS. Many an analyst re-rate A?s stock price and it gets a better valuation. Now, if the drug fails, then the stock plummets and gets corrected.
Analysing the cost structure of a company in a consistent fashion can be very different from the way the management has looked at the business in the past. By its very nature, an EV calculation cuts transversely across the entire organisation in order to capture the whole value chain, so the coordination of the needed activities must be at the highest level.
It is perceived that embedded assets take into account the announcement to a project due for completion, sometimes a second project based on the future cash flows of the first project, which is in a developing stage. Here it makes an EV quite subjective and fallible tool. Therefore, you as an investor need to employ a combination of tools to get a clearer and correct picture of the earnings of the company
Stick to the basics
Accentuates Anurag Tripathi, executive vice-president, Alomndz Securities, ?A decent book value, visible growth in revenues and earnings, consistent dividend track record and integrity of the management are some of the parameters that should be used by retail investors while evaluating investment opportunities in companies.?
Further, you should look at business model of the companies, which are easy to understand. And where future earnings are not clearly visible, you must lay emphasis on past performance of the management, dividend track record, book value, etc.
The management of the company should have clearly defined business plans for the subsidiaries and also the wherewithal to implement them. And lastly, the subsidiary should have a certainty of business and cash flows.
