No valuation parameter explains the price of a company in entirety

Updated: Dec 2 2007, 02:40am hrs
Anurag Tripathi, executive vice-president, Almondz Capital Markets, gives a perspective on the viability and the uniqueness of embedded value as a valuation tool and what differentiates it from other valuation tools. He interacted with Rajesh Naidu of The Financial Express. Excerpts:

In your view, how fair and rewarding is the embedded value valuation parameter in investment decisions

Embedded value is a measure of shareholder value embedded in the balance sheet of the company. This is associated with earnings/ cash flows arising from non-core businesses of the company that may not be completely captured in the balance sheet and thus not evaluated by usual valuation parameters such as book value, dividend discounting, DCF, earning multiples, etc. Unlocking of value could happen on account of the following factors:

* Profitable subsidiaries of the company.

* Substantial accretion in the value of assets appearing in the balance sheet of the company including investment portfolios. These assets are usually valued on historical cost basis and their current saleable value in the market may be very different from the value appearing in the balance sheet.

While using embedded value, it is important to differentiate between a company having separate independent lines of businesses such as ITC which has Tobacco, Paper, FMCG and Hotels and one which is merely backward integrated such as a chemical company with an internal power plant. SOTP could be easily applied to ITC by dividing its market price into different businesses to arrive at its valuation. However, the valuation of the chemical company is already enhanced due to cost savings resulting from the internal power plant. Therefore, if the internal power plant is separately valued, then the valuation of the chemical unit should be adequately discounted.

Do you concur that the surge in most large caps prices is due to the embedded value factor taken into account in the valuation of these companies than the core business fundamentals of these companies Your reasons.

Embedded value has its origin in the current bull-run and has been used extensively by financial analysts to explain spectacular run-ups in various large cap stocks. Similar terms have found use in prior bull-runs such as replacement cost in the early nineties and new economy during the dot com bubble. Retail investors should exercise caution as these concepts hold value only during euphoric markets and lose favour during bearish phases when even core businesses of companies do not get fully valued.

However, it would not be fair to completely discount embedded value as a concept. If used properly, it helps to explain valuation of conglomerates with a dominant business line such as ITC, Reliance Industries, etc. Embedded value is calculated by doing a sum of the parts (SOTP) valuation. This methodology should be used to understand the dynamics of current businesses with actual earnings. However, where embedded value is used to calculate future earning that is not clearly visible, this method might give rise to valuations that are far from the value assigned to the company by the stock markets. It is important that the embedded value is realised in the near future. A case in point is textile companies with underlying real estate assets. Unless these assets can be hived off from the main unit and sold in the near future to generate cash flows, it should not form part of embedded value.

Ideally, as an investor, in order to get a clearer picture of the companys position and its scrip movement, what must be the valuation parameters one needs to consider

While it is true that none of the valuation parameters explain the price of a company in entirety, it is advisable to use them in combination for greater comfort. A decent book value, visible growth in revenues and earnings, consistent dividend track record, integrity of the management are some of the parameters that should be used by retail investors while evaluating investment opportunities in companies. Further, the business model of the company should be easy to understand. Where the future earnings are not clearly visible, more emphasis should be laid on past performance of the management, dividend track record, book value, etc.

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. Your thoughts on this.

Where, private companies are merged in the listed entity on the grounds of adding intrinsic value, the retail investor should ensure that these private entities have visible earnings in the near future. Similarly, corporate actions such as mergers, de-mergers, etc, are not necessarily value accretive unless they give rise to visible cash flows.

Lastly, which are the subsidiary businesses you are bullish on, that have the potential to contribute to earnings of the companies in the long run

Management integrity and credibility should also be considered while using embedded value. The management of the company should have clearly defined business plans for the subsidiaries and also the wherewithal to implement them to completion. The subsidiary should have certainty of business and cash flows.