Kotak Institutional Equity Research has identified several flaws in the valuation practices prevalent in the stock market.This has exaggerated the ‘fair’ values of stocks and understated potential risks to the business models of companies, it said.
“We note two broad problem areas on the disconnect between valuation approaches and business models and the inordinate focus on near-term earnings.
“These practices have persisted for a long time, resulting in a mistaken orthodoxy about valuations,” it said in a note.
In September, domestic brokerage firm Kotak Institutional Equities dropped its recommendation on mid-cap stocks as it could not find too many stocks beyond the BFSI space that offer decent potential upside to their 12-month fair value.
Read more:‘Growing disconnect between fundamentals and market valuations’
Ever since it stopped reommendation, the mid-cap has made many new highs. The Midcap index is up 39 per cent so far, compared to a 13 per cent rise in the Nifty50 index.
“The flaws prevalent in market for long enough to be treated as cardinal and correct investment rules when they are patently incorrect,” it said.
“In our view, the wrong valuation methodologies exaggerate ‘fair’ values of stocks (both down and up relative to ‘true’ fair values) and understate potential risks to business models,” it added.
Observations
According to the Kotak report, two broad errors include the use of historical multiples to value companies irrespective of their changing business modes and changing operating environments, and the use of composite multiples to value companies irrespective of the nature or provenance of earnings (India or overseas). The consumption-related sectors are prime examples of this oversight.
The market’s comfort with high multiples for high-growth but capex-intensive companies such as construction materials and specialty chemicals) is a discrepancy. The fair value of such businesses should be on the basis of free cash flow and discounted cash flow (DCF).
Read more: Market Valuations High, Consumer Trends Uncertain: How Should Investors Strategise?
A traditional DCF approach will likely show a much lower value. A multiple-based approach will most likely overstate the value of such companies in the high-growth phase.
“We note that several specialty chemicals companies have hardly generated any free cash flows over FY2014-23 and may not do so for the next few years either,” it said.
There has been propensity to use multiples for companies irrespective of the nature of earnings—recurring or non-recurring (limited-opportunity).
This results in ‘limited-opportunity’ earnings being treated as recurring earnings, it said.
“We see this problem in the electrification theme currently for electricity generation equipment suppliers and in the pharmaceuticals sector,” it said.
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