Stock valuations are not about earnings alone


Listing of subsidiaries, re-rating of peers within a sector and news of private equity deals are among the factors that can transform the valuation picture.



Srividhya Sivakumar

Healthy growth in corporate earnings, rising institutional interest and ample liquidity have been the main drivers of high stock prices over the past three years. Conventional parameters apart, the recent re-rating of stocks has also been driven by other factors. Companies are valued not just for their core businesses but also for other strengths that have the potential to add value to core operations. Here are a few such triggers investors need to take note of:

Listing of subsidiaries

With the primary market in spate, companies seeking to hive off a new business for subsequent listing stand to receive an attractive valuation for the new business that isn't captured in the company's books. The listing of a subsidiary by an existing company has more often than not delivered value to the holding company. Consider Reliance Energy.

Since the filing of the draft prospectus of Reliance Power (early October-07), Reliance Energy has returned about 76 per cent, while the Sensex appreciated by only 10 per cent. Pantaloon Retail, following the announcement of the listing of Future Capital Holding (late September-07), its 78 per cent subsidiary, spurted 40 per cent between the date of announcement and that of the IPO, outpacing the 20-per cent rise in the Sensex.

The price surge in HEG and Rajasthan Spinning and Weaving Mills (RSWM) can be traced to similar factors. Given their rather indifferent valuations, news of the potential listing of Bhilwara Energy, their commonly-held subsidiary, drove their stock prices to new heights.

HEG more than doubled and RSWM appreciated more than 150 per cent in just two months while the Sensex managed a piffling 6 percent rise only!

Going by these trends, investors looking for potential upsides should watch for proposed listings of subsidiaries by companies such as ICICI Bank (planned listing of ICICI Securities and ICICI Ventures), M&M (Club Mahindra) and L&T (L&T Infotech).

Tracking the draft prospectuses of these arms on the SEBI site and looking into the potential valuations of these new companies may help investors time their investments in these stocks. One caveat here is that valuations would hinge on the sector leanings of the subsidiaries concerned.

Peer re-rating

Had you invested in Tata Power three months ago, you would now be sitting on profits of over 70 per cent on the investment, thanks to the high-profile Reliance Power IPO. In the same three-month window, other power stocks such as Torrent Power, JP Hydro, NTPC and CESC have turned in double-digit returns, a rare phenomenon in the sedate power sector. This bout of re-rating was prompted by the Reliance ADAG group's decision to list Reliance Power.

The spate of new listings in the brokerage/financial space in recent times — Motilal Oswal Financial Services, Religare Enterprises and Edelweiss Capital has had a trickle-down effect on listed brokerage firms, such as India Infoline and Geojit Securities, IL&FS Investment Managers, and so on. The price investors were willing to pay for Motilal's offer also pegged up the valuations for holding companies with unlisted broking businesses — such as Kotak Mahindra Bank and Indiabulls.

The mega public offer of DLF also had a similar impact on its realty peers. Given that most IPOs today enjoy strong investor appetite, a new listing usually contributes to a fresh discovery of the prices investors are willing to pay for the growth prospects of the business.

In this context, the price action in peer group companies of Emaar MGF (DLF), Oil India (ONGC), Wockhardt Hospitals (Apollo Hospitals and Fortis Healthcare) and Titagarh Wagons (Texmaco), among the many in line for initial offers, bear close watching in the weeks ahead.

Private equity deals

The private equity party in India has just begun; nonetheless, PE deals have altered the price discovery mechanism of our markets. For instance, Eton Park Capital's acquisition of a 5 per cent stake in Reliance Capital for Rs 500 crore had valued the latter at about 13 per cent of its assets under management. This valuation was quite liberal when compared to the values earlier accorded to Reliance Capital's asset business and thus drove a re-rating of comparable AMCs, such as Birla Sun Life.

Birla's AMC business is housed with Aditya Birla Nuvo, the flagship company of this group. The Aditya Birla Nuvo stock gained 30 per cent from the time of this deal.

Similar benchmarking was also used to drive an expansion in price-earnings numbers of several listed broking companies, which attracted private equity deals in good number over the past year or so.

Valuation 'gaps' between two firms in a similar business have been swiftly bridged. This underlines the fact that investors are increasingly willing to bet on businesses and stocks if they are available at cheaper valuations in a bull market, rather than try and justify standalone absolute valuations for a business.

Nonetheless, it might not be such a great idea to invest blindly in companies that have attracted PE money. While most such companies have generated profits for shareholders, investors may be better off tracking the company fundamentals before taking the plunge.

For instance, while Nagarjuna Constructions returned about 85 per cent after the Blackstone deal, Gokaldas Exports, despite a similar private equity deal, has delivered only about 7 per cent.

Investment books

Prolonged bull markets, such as the current one, tend to soak up the supply of stock candidates that are available at good "value". This may explain the trend among market participants to unearth hidden sources of "value" in a company's asset base or balance-sheet that could add a few rupees to the company's intrinsic worth.

The market value of investment books of companies (the value of securities/stakes held by the company as a part of its trade or non-trade investments) have been drivers of re-rating for stocks such as Tata Investment Corporation, Ramco Industries, Rallis India, IDFC, and many others. Consider Ramco Industries. The stock price shot up by a whopping 33 per cent in the last one month on discovery of a valuation mismatch; its investment book value per share was higher than the market price.

Arguments on similar lines may partly explain the surge in stock prices of companies such as Tata Investment Corporation, LMW, Dewan Housing and IDFC, to name a few. For instance, in Tata Investment Corporation, the value of its investment book would stand at about Rs 841 per share at current market prices; LMW's investment book would be valued at about Rs.64 per share.

However, the caveat here is that though the market value of the investment book may be much higher than the book value, it must be capable of value unlocking through a sale of those shares at market price. Companies that do not actively manage their equity portfolios and cross-holdings between group companies may not lend themselves to such unlocking. Moreover, the market value of the investment book too is directly related to the state of the stock market and any meltdown could lead to a swift mark-down in values.

Beware the black swan

More often than not, while such triggers have made stocks outperform the broad market till now, they may not continue to do so. Investors should primarily base their investment decisions on a company's core business fundamentals.

The Bajaj Auto demerger is a case in point. Contrary to the general market sentiment that demergers are good for shareholders, the stock crashed by about 13 per cent after the terms of the demerger were announced; the stock continues to languish despite a bull market. Investors expecting value discovery for Bajaj's insurance business were caught off-guard on disclosure of a call option at a nominal price with its insurance partner, Allianz.

This came as an unpleasant surprise to market participants who were pegging up Bajaj's insurance business at about Rs 600-1000 per share. Such damp-squib occurrences are rare but they prove that investors may be better off going by stock fundamentals for long-term investments