Top-Down Valuation (EIC Analysis)

Economy
The stock market does not operate in a vacuum. It is an integral part of the whole economy of a country. To gain an insight into the complexities
of the stock market one needs to develop a sound economic understanding and be able to interpret the impact of important economic
indicators, which may be studied to assess the national economy as a whole. The leading indicators predict what is likely to happen to an
economy. Perfect examples of leading indicators are the unemployment position, rainfall and agricultural production, fixed capital investment,
corporate profits, money supply, credit position and the index of equity share prices. An overall growing or a contracting economy affects every
industry in the country positively or negatively. One can seldom find flourishing industries in an otherwise stagnant economy. Thus,
understanding economy and capital flows, interest rate cycles and currency fluctuations, etc. is very important as it impacts the stock prices.
Economic Indicators
An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance
and predictions of future performance. Economic indicators include various indices, earnings reports and economic summaries, such as
unemployment, housing starts, consumer price index (a measure for inflation), industrial production, bankruptcies, Gross Domestic Product,
broadband internet penetration, retail sales, stock market prices, money supply changes etc. Economic indicators are primarily studied in a
branch of macroeconomics called “business cycles”. Economic Indicators can have one of three different relationships to the economy:
 Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the Same direction as the economy. Therefore, if the
economy is doing well, this number is usually increasing, whereas if we are in a recession this indicator is decreasing. The Gross Domestic
Product (GDP) is an example of a procyclic economic indicator.
 Counter cyclic: A counter-cyclic (or countercyclical) economic indicator is one that moves in the opposite direction as the economy.
The unemployment rate gets larger as the economy gets worse so it is a counter-cyclic economic indicator.
 Acyclic: An acyclic economic indicator is one that is not related to the health of the economy and is generally of little use. They have
little or no correlation to the business cycle: they may rise or fall when the general economy is doing well, and may rise or fall when it is not
doing well.
Economic indicators fall into three categories: leading, lagging and coincident.
Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the
stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession.
Baltic Dry Index, an index that tracks bulk dry freight rates across the world is another leading indicator and indicates a slowdown in the
bookings for bulk dry carriers with its fall and thus indicating a subsequent slowdown in the international trade. Leading economic indicators
are the most important type for investors as they help predict what the economy will be like in the future.
A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a
lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby
providing information about the current state of the economy. Personal income, GDP, industrial production and retail sales are coincident
indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.
Industry
Fundamental analysis consists of a detailed analysis of a specific industry; its characteristics, past record, present state and future prospects.
The purpose of industry analysis is to identify those industries with a potential for future growth and to invest in equity shares of companies
selected from such industries. We look at the product lifecycle phase and competitive outlook in a particular industry to gauge the overall
growth and competitive rivalry amongst the players in the industry.
Company
At the final stage of fundamental analysis, the investor analyses the company. This analysis has two thrusts:
1. How has the company performed vis-à-vis other similar companies? and
2. How has the company performed in comparison to earlier years
It is imperative that one completes the economic analysis and the industry analysis before a company is analysed because the company’s
performance at a period of time is to an extent a reflection of the economy, the political situation and the industry.
The different issues regarding a company that should be examined are:
1. The Management
2. The Company
3. The Annual Report
4. Cash flow
5. Ratios
 Price / Earnings Ratio
The P/E ratio (price-to-earnings ratio) of a stock (also called its “P/E”, or simply “multiple”) is a measure of the price paid for a share relative to
the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are
paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. The P/E ratio has units of years,
which can be interpreted as “number of years of earnings to pay back purchase price”, ignoring the time value of money. In other words, P/E
ratio shows current investor demand for a company share. The reciprocal of the PE ratio is known as the earnings yield. The earnings yield is an
estimate of expected return to be earned from holding the stock. Price-to-earnings ratio is popular in the investment community. Earnings power
is the primary determinant of investment value.
PE = Market Price per Share / Earnings Per Share
There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined.
Price: is usually the current price is sometimes the average price for the year Earnings Per Share (EPS):
 earnings per share in most recent financial year
 earnings per share in trailing 12 months (Trailing PE)
 forecasted earnings per share next year (Forward PE)
 forecasted earnings per share in future year
Trailing P/E or P/E TTM
Earnings per share is the net income of the company for the most recent 12 month period, divided by number of shares outstanding. This is the
most common meaning of PE ratio if no other qualifier is specified. Monthly earning data for individual companies are not available, so the
previous four quarterly earnings reports are used and EPS is updated quarterly. Note, companies individually choose their financial year so the
schedule of updates will vary.
Trailing P/E from continued operations
Instead of net income, uses operating earnings which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls
and write-downs), or accounting changes.
Forward P/E or Estimated P/E
Instead of net income, uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of a select group of
analysts (note, selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as “the situation
changes” (e.g. new economic data is published and/or the basis of their forecasts become obsolete) more quickly than analysts adjust their
forecasts.
Price / Book Value Ratio
A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest
quarter’s book value per share. It is also known as the “price-equity ratio”.

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the
company. As with most ratios, be aware that this varies by industry.
Price to book value ratio is a widely used ratio. It is necessary to estimate the end-year-book value per share for the next period. This can be
derived from the historical growth rate by the sustainable growth formula (g=ROE*retention rate).
Enterprise Value/EBITDA Ratio
The enterprise value to EBITDA multiple is obtained by netting cash out against debt to arrive at enterprise value and dividing by EBITDA.

Price/Sales Ratio
The Internet boom of the late 1990s was a classic example of hundreds of companies coming to the market with no history of earning – some of
them didn’t even have products yet. Their stock prices soared only to come crashing down later. Fortunately, that’s behind us.
However, we still have the problem of needing some measure of young companies with no earnings, yet worthy of consideration. After all,
Microsoft had no earnings at one point in its corporate life. One ratio you can use is Price to Sales or P/S ratio. This metric looks at the current
stock price relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total revenues of the
company. We can also calculate the P/S by dividing the current stock price by the sales per share.
or
Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the better the value, at least that’s the
conventional wisdom. However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many
questions to answer and the P/S supplies just one answer. Price to sales ratio is relatively volatile in comparison to other ratios. This ratio is
suitable for growth companies. A requirement for a growth company is strong consistent sales growth.
Special cases of Valuation
IPOs
Most firms conducting initial public offerings (IPOs) are young companies for which it is difficult to forecast future cash flows. Most of them are
in pioneering stage or expansion stage and their revenues are highly volatile with very high growth rates which are unsustainable in the future.
To value these companies, discounted cash flow analysis is very imprecise, and the use of accounting numbers, in conjunction with
comparable firm multiples, is widely recommended. The data about the firm is also not widely available and the Draft Red Herring Prospectus
(DRHP) is the only source of information of finances of the company. Relative valuation using multiples such as P/E (adjusted for leverage,
growth rates) and EV/EBITDA are most commonly used for valuing IPOs. Here, we start with an already listed company and take its trading
multiple as base. Then, we make adjustments for information availability (We generally reduce the multiple for non-availability of information
about the company in the public domain due to its privately held nature), phase in the product development, size and growth rates. Analysts
face problems when companies which are pioneers in their industries and having new innovative but never-before-tested business models come
to capital markets for raising capital. Due to their new business models, there are no comparable companies in the listed space. The dot com
bubble and subsequent bust was an example of the market paying humungous multiples to new and innovative business models due to lack of
complete understanding of the business. Valuing IPOs is thus a different ball-game altogether due to lack of information and comparable
companies at times.
Net interest margin (NIM):
For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and interest income is their main revenue
source. The difference between interest income and expense is known as net interest income. It is the income, which the bank earns from its
core business of lending. Net interest margin is the net interest income earned by the bank on its average earning assets. These assets
comprises of advances, investments, balance with the RBI and money at call.

Operating profit margins (OPM)

Banks operating profit is calculated after deducting administrative expenses, which mainly include salary cost and network expansion cost.
Operating margins are profits earned by the bank on its total interest income. For some private sector banks the ratio is negative on account of
their large IT and network expansion spending.

Cost to income ratio

Controlling overheads are critical for enhancing the bank’s return on equity. Branch rationalization and technology upgrade account for a major
part of operating expenses for new generation banks. Even though, these expenses result in higher cost to income ratio, in long term they help
the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based
income).

Other income to total income

Fee based income account for a major portion of the bank’s other income. The bank generates higher fee income through innovative products
and adapting the technology for sustained service levels. This stream of revenues is not depended on the bank’s capital adequacy and
consequently, potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is
also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.
Credit to deposit ratio (CD ratio)
The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised through deposits. Higher ratio reflects ability of
the bank to make optimal use of the available resources. The point to note here is that loans given by bank would also include its investments in
debentures, bonds and commercial papers of the companies (these are generally included as a part of investments in the balance sheet).
Capital adequacy ratio (CAR)
A bank’s capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. The RBI has set the minimum capital adequacy ratio
at 10% as on March 2002 for all banks. A ratio below the minimum indicates that the bank is not adequately capitalized to expand its operations.
The ratio ensures that the bank do not expand their business without having adequate capital.

NPA ratio: The ‘net non-performing assets to loans (advances) ratio’ is used as a measure of the overall quality of the bank’s loan book. Net
NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad
quality of loans.

Provision coverage ratio

The key relationship in analysing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to
gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio
suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not
rise at a faster clip).

The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfil their roles with utmost integrity.
Since banks deal with cash, there have been cases of mismanagement and greed in the global markets. And hence, investors need to check up
on the quality of management.
Firms with negative cash flows
For firms with negative cash flows (generally during the capital expenditure mode), we can clearly not use the DDM and the FCFE for
discounting cash flows. Relative valuation methods such as PE and EV/EBITDA also fail in the valuation of EBITDA negative companies. The
most accepted methods of valuation in such companies are FCFF and P/B methods. In case of certain companies, innovative methods like
P/Sales and P/Consumer, etc. are also used. Many a times loss making but asset heavy businesses are valued by SOTP method based solely on
valuing their assets (such as land banks for some textile mills) on as-is basis.
Acquisition Valuation
At times different businesses bid for others in their own or other industries. Many a times, the motive behind these acquisitions is to make use
of possible synergies between the businesses to create value. For example, an apparel manufacturing company may get into retailing in order to
get vertically integrated and make additional margins on its business as a whole. Similarly, a steel manufacturer may acquire a coal mine in order
to secure fuel supply for its operations. During such times, acquisition of the target company may be strategically very important for the
acquirer and thus the acquirer may pay a premium over its intrinsic value. Sometimes the acquirer gets a control of the target and uses its
management and operational execution expertise to generate more value. In such cases, the additional price paid by the acquirer to get control
is termed as the control premium. Such a premium is generally seen to be given to a majority shareholder of the target which currently has the
controlling stake in the target. Another such premium given is for non-compete clause. This clause makes sure that the management and
promoters of the target company do not start another such similar businesses in direct competition with the acquirer for a specified amount of
time.
Distressed Companies
Distressed securities are securities of companies or government entities that are either already in default, under bankruptcy protection, or in
distress and heading toward such a condition. When companies enter a period of financial distress, the original holders often sell the debt or
equity securities of the issuer to a new set of buyers. In recent years, private investment partnerships such as hedge funds have been the
largest buyers of distressed securities. Other buyers include brokerage firms, mutual funds, private equity firms, and specialized debt funds
(such as collateralized loan obligations) are also active buyers. Investors in distressed securities often try to influence the process by which the
issuer restructures its debt, narrows its focus, or implements a plan to turn around its operations. The US has the most developed market for
distressed securities. Other international markets (especially in Europe) have become more active in recent years as the amount of leveraged
lending increased, capital standards for banks have become more stringent, the accounting treatment of non-performing loans has been
standardized and insolvency laws have been modernized. Investors in distressed securities typically must make an assessment not only of the
issuer’s ability to improve its operations but also whether the restructuring process (which frequently requires court supervision) might
benefit one class of securities more than another. During the recent crisis, we saw many Indian real estate companies trading at historic lows on
account of being highly leveraged and having lack of cash flows to support such leverage. These companies then saw many rounds of equity
infusion through QIP route and restructured/ refinanced or repaid their debt. This, however, presented an opportunity for investors to invest in
such companies at fairly low levels and see the prices appreciate as these companies improved their cash flows and mended their debt levels.
Investing in distressed companies involves a fair amount of judgement about the future path of the company, availability of sustained financing,
improved business conditions and residual value of assets, etc