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When stocks get ‘re-’ or ‘de-rated’

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Just as a re-rating can inflate returns from stocks of high-growth companies, a de-rating coupled with slowing earnings growth can be a double whammy for investors.

Shanthi Venkataraman

“Real estate stocks have been de-rated because of sub prime risks”… “Telecom stocks are being re-rated by institutional investors”…. When you come across such phrases in debates about stock markets, have you ever wondered what re-rating or de-rating is?

We know that the price-earnings multiple, the most commonly used valuation metric, refers to the amount investors are willing to pay for every rupee earned per share. When this multiple expands, or in other words, when investors are willing to pay more for every rupee earned by a company, a stock is said to have been re-rated. Multi-fold gains in share prices typically occur when earnings growth is combined with a re-rating of the stock. The stock of Larsen & Toubro, for instance, has more than doubled over the past year, outpacing the company’s earnings growth of 60 per cent. This is because investors have rewarded the company’s performance by assigning it a higher valuation.

Re-rating of mid caps

Re-rating often occurs in mid-cap stocks as the company’s ability to scale up its business and grow faster than its larger peers becomes clear.

Balaji Telefilms, the television content provider, for instance, was recently re-rated as the proliferation of new channels provided it significant scope to scale up its revenues.

The stock has almost doubled since March, commanding a multiple of 20 times the trailing earnings as against 12 earlier. Stocks belonging to sectors such as media, infrastructure or retail now command more fancy valuations compared to a few years ago, as investors have steadily gained conviction in the growth prospects of such sectors and have chased these stocks.

Even whole markets undergo re-rating. With Indian corporate performance consistently beating investor expectations over the past couple of years, valuations have climbed from about 15 times the past earnings in 2004 to about 20 times the FY-07 earnings currently, as investors factor in higher growth rates.

De-rating

Conversely, when the market begins to expect growth rates to moderate, stocks get “de-rated.” This de-rating may happen much ahead of the actual slowdown in performance. Hotel stocks have been de-rated over the past year on anticipation that fresh supply in the next two years will dampen room rentals. So although hotel companies continue to deliver a 25-30 per cent growth in earnings, their valuations have dropped to the mid-teens.

Just as a re-rating can inflate returns from stocks of high-growth companies, a de-rating coupled with slowing earnings growth can be a double whammy for investors. Sugar stocks, anyone?

Revaluation of stocks

Valuation multiples may also undergo a change as investors start to become more selective in their buying. When a sector is in a take-off mode and several players are in the fray, it might be hard to tell which company is best placed to grab a chunk of the market share.

There may also not be too many investment options in the listed space. In such instances, all stocks that operate in that particular space may enjoy similar valuations.

This was the case with real estate stocks about two years ago. However, as more companies tap the primary market, investors start to gain a better perspective of the sector.

For instance, after the IPOs of real-estate behemoth DLF and other larger real estate companies, better disclosures on land banks, titles and so on have enhanced investors’ understanding on how to value real estate stocks.

Consequently, there is now a greater polarisation in the valuations of real-estate stocks. The market is willing to pay more for larger companies with a better execution track record. But smaller-stocks have been de-rated.

Valuation and liquidity

Finally, growth expectations are not the only factors that drive valuation re-ratings. Liquidity and risk appetite too play a role.

When investors are flush with liquidity, they are willing to pay more for a stock. But when the same investors turn risk-averse, they may not be willing to pay a high valuation, even though the fundamental picture may not have changed. Call it the “wealth effect”.

This is particularly true for stock markets such as India, which are dependent on foreign fund flows.

While the Indian economy remains firmly on its growth track and corporates continue to beat earnings estimates, valuations of stocks are off their highs.

In the latest correction too, stocks with high valuations have been beaten down, although earnings estimates have not changed.

This reflects the liquidity tightening and waning risk appetite at the global level.

In the absence of liquidity to fuel a re-rating of stocks, investors will have to rely on earnings growth alone to drive stock performance and will, therefore, have to be more selective.

So a stock’s performance does not depend on a company’s earnings growth alone. The trick is to identify stocks before the market re-rates them and book profits when growth rates start to peak.

Of course, if it was as easy as all that, we would all be Warren Buffets.

(This article was published in the Business Line print edition dated September 2, 2007)
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