The equity markets have tanked and much value and wealth has been lost in this process. However, there are some industry leaders who are not perturbed and there are many who are indeed. And, it is not just the fall in share prices that is bothering managements, but it is also the ubiquitous price to earnings ratio or the PE ratio that is being looked at carefully.
And there are various reasons. For one, a strong or premium valuation would mean that the company is being looked at as an outperformer. And there are reasons for this premium to be attached to the company. Hence, in times when the management intends to raise funds, the chances of getting a better price with little equity dilution become very high. Even in the case of a merger and acquisition scenario, better valuation in the market place means that the management is in a position of strength.
With the markets tanking, the overall valuation numbers have shrunk, but there are several companies whose relative valuation as compared to their peers in the sector or even the sector itself has reversed. The real estate sector, the construction and capital goods sector and even the IT sector have seen a reversal of sorts. A sector that attracted premium valuations and therefore had seen deals being done at premium prices has now come a cropper. And again, there are companies in these sectors that command a premium. Companies like Infosys, TCS and Wipro will command some premium in the market place.
It, therefore, becomes important for corporates to look at their relative valuation against their peers and also in the market place overall. And, it can be noticed that the market place, over the long run, attaches premium based on strong operational and principle-led fundamentals as opposed to fancy fads.
Lessons learnt
?The growth from 2003 to 2006 was based purely on the growth of the Indian economy and was supported by strong fund inflows. Hence, earnings growth and expansion were the buzz words and these took precedence over tested valuation parameters,? says Hiten Rathod, an investment banker with a leading multinational firm.
Growth and just growth were the words that attracted investment bankers and market participants alike. ?All one had to do to get a higher valuation rating was to make a few announcements and tie-ups with global players and also vaguely mention plans of acquiring overseas companies, and bang you had a higher rating,? says Rathod.
So, several companies, many with reputed promoters, started announcing fabulous projects to be implemented over the next 10 years and the market started according them huge valuation premia. However, now, these valuations have been reworked. ?Earlier, companies would command an enterprise value 15 times of operating profits or EBITDA. And commercial viability considerations were thrown out of the window. How can you pay for something that will recover your money in 15 years and borrow at exorbitant costs? This had to correct,? says another investment banker, who does not want to be named.
Also, there were other excesses that have been corrected over the past couple of quarters, leading acquiring companies and investment bankers to take a closer look at the earnings quality. Studies point out that the pressure to maintain earnings growth, quarter after quarter, meant that certain numbers were fudged. Also, excess liquidity by raising funds meant that they were deployed gainfully in the capital and money markets to generate returns that boosted the bottomline. Till the last year, studies carried out by FE reveal that the other income factor was more than 30% of the profit before tax of Corporate India. This year the number has come down to single digits. ?Earnings from non-core areas decorate the books but also hide the real earnings from operations,? says Rathod.
The new old order
However, the meltdown has cut out these excesses and market forces are now looking at age old norms for attaching a premium to corporates. And savvy managers can pay attention to these so as to gain from the benefits that come.
Clearly, the message is to cut out the fluff and stick to the fabric. Unrelated investments and splurging of cash for acquisitions is being viewed suspiciously. And there have been several incidents of investor activism that have caused several leading corporates to put these ambitious plans on hold and in many cases completely shun them.
Investment bankers and analysts have got the buzz word ?earnings visibility? back to the fore. Not just having strong plans and order books, but the ability to convert these into earnings and then into free cash flows is being scrutinised. And companies that have managed these consistently will always get a premium rating.
And even here, the quality of earnings and its consistency gets rewarded. Recently the global CEO of Unilever Paul Polman, when in India, clearly mentioned about the mad rush amongst several corporates to have these strong quarter on quarter growth numbers and the strife to come up with strong performance. ?We would rather focus on getting value across to our customers and keep working on those lines,? Polman said. Little wonder then that Hindustan Unilever even today, gets a premium rating.
New valuation parameters like Sum of The Parts or SOTP, which were in vogue have been either shunned or used sparingly. This valuation technique carried out a systematic valuation of the subsidiaries and business lines within an organisation. All these values were then summed up to get a complete organisational value. So a telecom company could be valued on the basis of its tower properties, service centres, value-added services and so on. These would then be added up to arrive at an aggregate.
While the SOTP technique is a valid one, it was so often being misused that it prompted many companies to demerge and seemingly ?unlock value? for shareholders. Most of the companies that have resorted to such demergers are now eating crow. Several companies have in fact announced the merger of their subsidiaries to gain from, once again an old business principle, of economies of scale.
There are companies like ICICI Bank or State Bank of India, where an SOTP-like valuation model becomes applicable. Both these banks have strong and established subsidiaries in the insurance businesses (life & non-life) and have a host of other arms like an asset management company, a broking outfit and so on. But simply picking up the valuation model and applying it to corporate decision making can be fatal in the current scenario.
Corporate governance gambit
But truly the real essence of premium ratings is the corporate governance standard. But does strong corporate governance help in a ratings scenario? Anirudha Dutta & Anshu Govil of CLSA Asia Pacific Markets said in their report on valuation risks in India, ?Indian markets have in the last few years traded at a premium to other regional markets because of better corporate governance, superior disclosures, high management quality and better capital productivity, apart from superior and consistent earnings growth. In a scenario of rising risk aversion, investors will take a tougher view on companies that adopt ?aggressive? accounting policies, even if these are in line with prevailing accounting standards. This will reflect in the de-rating of such stocks, relative to peers that adopt ?conservative? accounting policies.? The report also listed out several companies, including the bluest of blue that have found their way around sound practices.
According to a model developed by Credit Suisse, they look at corporate governance based on structural risks, accounting risks, transactional risks and previous events or issues that have concerned investors.
Here factors like a company having several subsidiaries in the same line of business and then having inter-group transactions is seen with suspicion. Even the shareholding pattern is now being looked at carefully. While there is confusion here on the extent of shareholding by promoters, analysts are now looking at past friction between minority shareholders and the management. The need for having independent directors and an operational whistle blowing policy is also a positive factor. Importantly, even small measures like improving the liquidity in the market place and investor grievance handling allow companies to score brownie points.
The real test of character comes when the company on its own initiative takes steps towards improving transparency and communicates with its stakeholders, even when there is bad news to dispense. The current move by Infosys to announce its detailed cash and bank balances in their quarterly results is one such move that will go a long way in enhancing its premium valuations in the market place.
Simply coming out with a glossy tome of an annual report worded with exquisite power phrases is not enough. Talking about it, Morgan Stanley analysts Ridham Desai and Sheela Rathi say in a recent report on India and its premium valuation: ?This factor (corporate governance) drives the quality of earnings and hence equity risk premium. Historically, India has been a mixed bag on corporate governance. While India?s return on equity (ROE)-focused entrepreneurs provides interesting investment opportunities, the recent Satyam episode may have dented investor confidence.? This spells good news for Indian companies when compared with their global peers.
However, the need to maintain capital efficiency (ROE) and quality of earnings gets tremendous importance at a time when risk aversion is at a high. Desai and Rathi also mention, ?India could end up trading at a premium to emerging markets more often than not over the coming decade. We believe the level of this premium could be better than the average of the past 15 years (around 7%).?
Hence, all it requires is pulling up the socks and getting into action in the old fashioned manner of making money for shareholders on a consistent basis, in a clean manner and keeping all involved in clear communication.