In the previous article, we saw the most commonly used valuation ratios. If you have not read that, you can read it to understand the Basics of Market Valuation. In this article, lets look on how to interpret these ratios and the larger picture of how the fundamental analysis can be applied to build your own equity portfolio.
Value versus Growth Market commentators and participants are divided on the usage of valuation ratios, especially the P/E ratio. The topic contributes to a fascinating debate between “Value Investors” & “Growth Investors”. Value investors claim that a company having a low P/E ratio could be a hidden gem where it has not yet caught the market's eye. The company is undervalued because of past under-performance or due to unfavourable sectoral/business conditions. They could also be old darlings of the market which lost sheen due to varied causes. Whatever be the reason, value investors feel their potential is not yet discovered by the markets and is good low risk investment bet for the long term. Value investors shun stocks carrying high valuation due to the risk involved and has the opinion that the market has over-valued the stock as the current earnings do not justify the premium it is commanding. On the other hand, Growth investors argue that valuation chases performance. They believe that the market factors everything there is to value a stock and if a stock is not commanding a premium, it is because of the poor performance and sub-par expectations it has set. Growth investors believe in momentum and the company's current out performance puts it in pole position ahead of it's competitors by increasing the gap between peers. Due to this, they are willing to pay a high premium to take part in a business that is already winning despite the significant risk the investment carries. Basically, the 2 ways of looking at valuation is, betting on potential leaders versus betting on current leaders. Both types of evaluating valuation ratios have it's share of winners, but under certain conditions. As for as how I see it, we should mix both worlds of valuation interpretations to choose our portfolio with a combination of Value stocks and Growth stocks based on the conditions that I mentioned. This minimises risk all the while improving the chance of grabbing opportunities with following momentum. So, what are those conditions? Continue reading...
Impact of Business Cycles Business cycles can alter the valuation ratios such as P/E by crunching or expanding the EPS of companies. You can learn more about Business Cycles in my earlier article. Business cycles can affect a particular set of businesses too. For example, when COVID struck, Pharma sector was a huge beneficiary and earnings growth was expected. In lieu with the future EPS expansion, Price of equity sky rocketed. The stock price increased in advance based on the expectation of EPS growth, P/E shot upwards making it over-valued in theory. At the same time, the expected EPS expansion reduces the PEG ratio which is forward looking, confirming that the high valuation is justified. EPS would eventually catch up leading to P/E going back to normal levels after the company results are announced. Similarly, based on the length of the business cycle in consideration, under-performance or over-performance of a business can last longer due to underlying business condition, but valuations are bound to get re-rated once the business cycle reverses. Hence it is important to understand the current business cycle we are in, to look at P/E accordingly with a historical view in mind and how P/E is expected to change in future. Business cycle reversal can be spotted by keeping a tab on the change of supply/demand and Govt/Central Bank policies and adjust our valuation expectation.
Impact of Market Cycles Similar to business cycles, market cycles can also alter the valuation ratios by involving price as a measuring criteria. Market cycles refer to the cyclical nature of the financial markets, where every boom is followed by a bust that keeps repeating. The terms bullish and bearish refers to this boom-bust cycle. Business cycles affect Earnings Component, Market cycles affect the Price Component of the Valuation Ratios. When a market is in a bullish trend, the equity prices soar irrespective of whether the premium is justifiable or not. This causes P/E ratio to expand. If earnings follow through, the P/E ratio normalises to historical average, but if earnings disappoint, the stock is deemed to be over-valued and becomes risky, thereby paving a way for a correction. Likewise, for whatever reason a market is under the grip of a bearish trend, the P/E ratio contracts even though EPS remains steady. If the future earnings disappoint as expected by the investors, P/E normalises, else, the stock is deemed to be under-valued and attractive. In bullish cycle, a good company with a good track record can see its P/E contract due to external factors. This does not mean the company is not investment worthy (Growth POV), rather it provides attractive valuations. Similarly a poorly run company, could see its share prices surge without reason, thereby presenting a high P/E ratio. Again this does not mean that the company is investment worthy (Growth POV), rather it is over-valued and risky. Hence past performance is an important gauge while interpreting valuation ratios such as the P/E ratio. This brings us to an important observation about Value vs Growth Investing. "Value Investing is more suitable in a Bear Market, Growth Investing is more suitable in a Bull Market."
Forward P/E or PEG , which is better? When talking in terms of future valuation expectations, Brokerages, Financial Analysts, Credit Rating agencies etc, often provide valuation in terms of forward P/E. Forward P/E ratio is calculated with future estimate of EPS. . The forward P/E guidance provided by one analyst almost never matches with another, sometimes significantly different too. This is because, the future EPS estimation is one’s own guess work. For this reason, forward P/E is a metric I don’t give much importance as it is speculative and debatable. Moreover, if you had observed the valuation guidance of brokerages, they always provide a very optimistic number, which the company often fails to achieve at the end of the year (More on this in the next article). Brokerages and mutual fund agents are businesses that benefit by selling products, hence their forward P/E are mostly biased towards too much optimism to drive target based equity calls. Due to this bias, we need to look at alternatives. In that sense, PEG is better metric that can gauge future expected valuation based on average earning growth that a company has posted in the recent years. This ratio removes the bias of "setting targets". The expectation is that the company would grow at the same rate in future as well, thereby PEG is a much realistic estimation model than forward P/E where expectations are met more often than not. Forward P/E is subjective, whereas PEG is objective. Objectivity helps you avoid volatility.
Sectoral Valuation & Peer Valuation The valuation ratios can be extended to sectoral indices as well by calculating the index constituent’s valuation ratios. When we are unable to plug the valuation as reasonable or not, leaving us confused, sectoral comparison can guide in our decision making. Sectoral valuation can be used as a reference to compare the valuation of a company with the sectoral average. Such a comparison gives a good insight on how the company fares relative to the industry under which the company operates. Valuation ratios can differ vastly between sectors. For example P/E ratio of the FMCG sector commands a higher valuation than that of a PSU dominated sector. This is because, the business model, the industry specific performance parameters and the end consumer demand could lead to varied benchmarks. Due to this, one could be easily confused on how to weigh these ratios across the market. Sectoral comparison of ratios helps in such cases. In addition, the valuation ratios can be compared with immediate peers operating in the same business area to help you choose a stock while adding to your portfolio. This can give an edge to your portfolio’s performance.
This list of interpretations are by no means the only ones in the art of direct equity investment. More such interpretations and insights are possible as we progress with our investment journey. If you have come across any such valuation tit-bits, do share with the larger community by commenting on this post. Also, you could share this your circle of investors to pool in knowledge.
Now, with this understanding in place, we can extrapolate this learning, to apply the valuation ratios on Indian Index such as Nifty 50, Nifty 500 to see how the Indian markets have been valued historically and the current trend. Since the markets have rallied phenomenally in the recent days, it is worth to objectively re-assess, to understand the market commentary from experts. This can help in our own decision-making process. Until the next article is published, stay safe and happy investing!
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