Valuation: Understanding the Concepts and Numbers

Valuation isn’t as simple as it is made out to be via the ratios like P/E, EV/EBITDA, Price/Sales, and methods like Reverse DCF. It isn’t safe to create a right portfolio using these metrics. Your individual stocks may do well — but overall portfolio must do well — hence valuation methodology matters immensely.

We value a company to make educated estimates about what is expected return in X years. Valuation mandates fully grasping all these three somewhat complex but important concepts.

• Accrual and cashflow accounting
• Time series analysis of intrinsic value
• Concept of enterprise value

There is a lot of material on each of these so here I would highlight only the conceptual part that impacts your returns.

Accrual and cashflow accounting

Investors care about (free) cash flow and not profits. So do smart businesses. The reason profit and loss metrics are popular is because they are less volatile and hence simple to make sense of and forecast. Novice investors fall in this simplistic trap.

Even shorthands like “cashflow will eventually follow profits” is mostly wrong. There are several businesses that show profit but don’t show positive free cash for many many years.

Why cashflows? Because you invest money to get money back. Profit is not money. It is an accounting concept. Profit hides the fact that your money is actually stuck in inventory and receivables. If I am going to receive the money after X years then I should value that money by discounting it to today.

Time series analysis of intrinsic value

In simple terms the intrinsic value of a stock is a discounted sum of future in-hand cash flows + terminal value.

I come across suggestions — buy below intrinsic value. But there are serious problems with this idea. Let us see how.

The discount rate commonly suggested is about 8–10%. If you buy at intrinsic value and the growth in business is 10% then you should expect to make <10% in return. What went wrong even after buying at intrinsic value? It is the fact that such a stock has to be bought much below intrinsic value. How much below? You cannot know without doing maths (i.e. a good DCF).

Secondly, if my return expectation is 20% — what discount rate should I use? 20%? At 20% most stocks will seem pricey — try it out. So what gives?

One can assume that the market may be using index like returns as the discount rate. But then should I expect to make only market returns (e.g. Nifty 50)? So what should one do?

There is an interplay between return expectations, discount rate used by market, and duration of your holding. Investors must resolve this interplay themselves — by grasping the maths at play here.

Hint: you will hold the stock for a shorter duration than the market will hold it. Market holds a stock forever. So you can use different discount rates for your holding and non-holding periods.

Enterprise value (EV)

Should one look at market cap (i.e. price) or enterprise value? If you are using the current price for valuation based entry point — you are making a mistake. This is relatively simple concept but often overlooked in India (I see it is different in the US where EV is used commonly).

Let us say a 1000 Cr market cap company has 0 debt and 200 Cr in cash. The EV is 800 Cr, so the effective price of the stock is 80% of what it is trading at. Why? Because, as an owner of a company you become the part owner of 200 Cr cash as well. So you are paying less.

But further, if the company uses this cash for growth then effective price will become market price. If, when, to what extent this will happen needs to be accounted for when you are calculating your expected return along with DCF numbers.

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Markets tend to offer complicated stocks whose valuation needs to be done carefully.

Today’s cash burning companies that will turn cash flow positive in the future. Many new-age stocks like PayTM, Eternal started this way when they became public.

A company with high debt today but actively repaying the debt. The interest costs are high today and enterprise value and market cap differ significantly.

A software product business that is spending in R&D today. If the thesis plays out as expected the cost will stop growing, while the sales will keep growing (note #1 is a special case of this — just that over there starting cash flow is negative).

Understanding what kind of return these stocks may give requires a very good grasp of financial concepts and its implementation in numbers. I call this financial sympathy — like mechanical sympathy.