Here are 5 ways in which investors can value company based on fundamental factors

From a practical perspective, this shows the metrics that would influence valuation 1) Importance of Cash Flows vs Profits 2) Growth 3) Return on Invested Capital, 4) Discount Rate, and 5) Capital Structure.

Pankaj Tibrewal

I have often been asked – what factors move the valuation of a company?

Over the years, the following principles have been the guiding force for us. At the most fundamental level, ‘Value’ of any asset is the sum of all its futures cash flows discounted to present.

From a practical perspective, this shows the metrics that would influence valuation 1) Importance of Cash Flows vs Accounting Profits 2) Growth 3) Return on Invested Capital, 4) Discount Rate, and 5) Capital Structure.

Importance of Cash Flows vs Profits

Accounting Profits are generally the centre of all financial discussions. However, companies that have created long-term value have shown that it is cash flows along with profits that are most important.

Companies with good profits but weak cash flows get a lower multiple from the markets. On the other hand, companies who consistently get premium multiples from the market are those that have consistently generated good cash flows.

For example, Amazon for many years didn't generate much in the way of accounting profits but generated very strong free cash flows. Consequently, markets rewarded it with a premium multiple.

Growth

Whenever Growth (G) increases, (near term, medium, and long term), the overall value of the company increases, assuming all other factors being equal. However, one needs to keep in mind that not all growth is good.

If a company’s Return on Equity (ROE) remains below the cost of equity for long periods, high growth is toxic and destroys the value of the firm as the company needs to constantly raise capital (debt or equity) to meet growth needs.

Growth only adds value if the ROE of the company is higher than the cost of equity. Also, in companies with high ROEs (30-50%), growth is the most important lever for value increase and a further improvement in ROEs doesn’t add much value.

In today’s world with so much disruption, it’s not at all easy to forecast growth from a medium to long term perspective. Also, in sectors where the terminal value of the firm is challenged, markets assign lower multiple despite short term growth.

ROE/ROIC and its sustainability

When ROE or Return on Invested Capital (ROIC) increases, the NPV and P/E also increase as one has to invest less to generate the same rate of earnings growth.

Similarly, whenever a company’s ROCE/ROE deteriorates then the company goes through a de-rating process. For companies with low ROE, Delta ROE (change in ROE) adds higher value and P/E rises exponentially.

On the other hand, in high ROE companies, delta growth (change in growth rates) adds more value rather than further improvement in ROE.

For example, for a 30 percent ROE company, if ROE improves to 35 percent it will not add much value but if growth improves from 15-25 percent the value increase is far more.

Also, one should examine if a large gap exists between ROE and ROIC, implying the leverage effects that one needs to discount. It is a given for financial cos (they are supposed to leverage) but one should examine for other companies.

Cost of capital

Lower discounting rate translates into higher PE multiples. It’s a very sensitive variable for P/E expansion or contraction.

Capital Structure and Capital Allocation

Companies with high debt generally get lower valuation multiples as markets remain worried about the company's ability to service debt in case there is a downturn in the future.

From a capital allocation perspective, companies where incremental capital is being allocated to businesses with high RoE, they get a better multiple than companies where incremental capital is being allocated to businesses with low RoE.

(The author is EVP & Sr Fund Manager, Kotak Mahindra Asset Management Company)

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