PREDICTABILITY HOLDS PREMIUM

Valuing stocks is often a subjective exercise. We all have our ‘objective’ yardsticks, which could be related to PE, EPS, book value, RoCE, RoE or any other matrix or a combination thereof. Even among these, there is always a final element of ‘subjectivity’. We often fail to find a good reason and then simply say that a similar company trades at so many times earnings, and therefore this company deserves better. Often I have seen research reports give precise price targets as if they are a holy grail.

Common sense says that if we use a multiple, say Price to Earnings (PE) as one indicator, there should be some rationale. A company can have a high PE or low PE. It does not necessarily mean that the company with a low PE is undervalued or vice versa. All quantitative measures have an element of subjectivity when it comes to valuation.

One thing I like to look at is the ‘predictability’ of earnings of a company. I do not refer to the precise numbers, but to whether I can predict that under normal conditions, the company will keep making money. For instance, if I take a company like HUL or Marico, I know that their products will continue to sell with reasonable margins and there is a high level of predictability about their earnings. This is important.

On the other hand, if I take a company like L&T, a lot depends on the stage of completion, the revenue recognition methods, etc. Similarly, a construction company will always have work-in-progress. A completed contract is when the earnings can truly be recognised. However, some of their contracts will cross the financial year-end and some work is still left before revenue can be recognised. However, they use something called ‘stage of completion’ and recognize some revenue and profits.

To me, this is not high quality. Nor is it ‘predictable’. For instance, we know that in the year 201617, Bajaj Auto sold “X” no of two and three wheelers and made “Y” rupees. In 2017-18, I am sure that they will do the same or better both on the volume and on the profits. This company has predictable earnings.

I am willing to pay a higher multiple for a more predictable stream of revenue as compared to ‘probable’ or not so certain streams of revenue. A rupee earned by Bajaj Auto is valued higher than a rupee earned by L&T. In Bajaj Auto, the future is less volatile. So, one is willing to pay a higher ‘valuation’ — whether it is in terms of P/E multiple or P/B etc. It may be also incidental that Bajaj Auto earns a Return on Equity that is immensely superior to L&T.

Industries that have poor predictability of income include commodities, engineering, construction etc. They also could have ‘lumpiness’ in earnings.

One of the most ‘predictable’ industries should be banking and finance. However, while one can forecast numerical growth in lending, interest rates etc, the element of risk in lending vitiates the industry valuation. So we look for comfort in history. By now the market believes that HDFC Bank or Kotak Mahindra are great at managing loan recoveries. So, these banks command a premium in terms of measures like Price to Book or Price Earnings. On the other end of the spectrum, we have the PSU banks, where the predictability seems to be the recurrence of NPAs.

However, our markets are young and tiny. We have too much money chasing stocks and there is not enough depth or breadth in the market. So, we probably have no valuation rules except those decided by flow of funds rather than any yardstick. We tend to swing between extremes of optimism and pessimism. And our optimism is often based on who is buying, the recent price moves etc rather than any genuine exercise at studying the P&L, Balance Sheet and the management.

However, the earnings predictability is certainly anchored in to a lot of valuation, if we look at stocks in the FMCG or consumer spend sectors or in growing B2B spaces. If we want to look for big winners, we should try and evaluate: Will the products or service sell profitably? Can the company pass on cost increases? Will the demand grow in line with the economy? Is the cash flow and profits in line with each other? Is the RoE / RoCE attractive? If the answer is yes to all the above and the stock commands a low PE or low Price to Book, it is worth digging deeper. Sooner or later, the market will recognise this and give it a greater valuation. The writer is a veteran investment adviser. He can be reached at balakrishnanr@gmail.com