New-Age Businesses Drive Change In Valuations

The practice of arriving at a valuation and valuing a company is as old as the modern stock market. Evaluating a company involves multiple parameters and formulae but evaluating a market is more complex and sometimes confounds even the veterans. This is because markets are influenced not only by the businesses they include but also by the psychographics and moods of the investors.

While understanding the markets requires a multi-dimensional approach, amateur practitioners usually tend to adopt a linear tactic, focusing on a single aspect such as the fundamental, technical or quant methodology, and ignore the other pieces of the puzzle. For example, the conundrum of the Indian stock market touching new highs every week has confounded the amateurs but not the veterans.

The one-way surge of the Indian stock market since March 2020 has confused market practitioners who follow only fundamental analysis before investing. In this calendar year, the market hit new highs almost every week, and till the time of going to print, there had been no meaningful market correction (over 5 per cent) despite high trailing price-earnings (PE) multiple and mediocre returns on equity. There is a combination of many reasons at play here: strong corporate earnings, corporate debt reduction, low overall interest rates, moderate inflation, liquidity and large inflows from both domestic and foreign institutional investors.

The potent mix of momentum, exuberance and unchecked spirits have led to massive inflation in financial assets. All of this is a bit puzzling for ordinary investors who expect crests to follow troughs.

But for those who keep an eye on the index composition, this situation is not at all confusing. Equity markets are valued and expressed through indices that capture the essence and strength of the various sectors and companies that they host, but very few market practitioners pay attention to the composition of the index and its changes.

Over time, decoding the composition can reveal the trends and patterns of the economic and financial landscape. Ashutosh Bhargava, fund manager and head-equity research, Nippon India Mutual Fund, says, “Index performance cannot be properly explained if the composition is ignored.”

From Tangible To Intangible

In India, there are two stock indices, the Nifty and the Sensex. The Nifty index is made of 50 stocks, while the Sensex has 30 stocks. To understand the performance of the stock market, a look at the index itself can be helpful.

In the past 15 years, the Nifty’s composition has changed drastically, and that has a huge bearing on the index valuation. In 2005-06, the bulk of the index value was coming from capital-intensive, highly-leveraged, old economy companies. Today, tangibles have taken a backseat and data-driven consumer-oriented financials and IT companies with intangible assets like patented technologies and human resources are on top.

In 2005, the energy sector (with a weight of 25.1 per cent) was the biggest component of the Nifty, while financials (14.7 per cent weight) was the third-largest (IT was second). In 2021, the sectors have exchanged their positions. Financials (37.7 per cent weight) is now the biggest component, while energy (11.9 per cent) is the third biggest component of the Nifty; IT continues in the second position with 15 per cent-plus weightage (see Changing Composition).

The valuation of the same index made with different compositions during two different time frames is not comparable. Each sector behaves differently as fundamental valuation parameters, such as return on equity (RoE), debt to equity, earnings multiples and cash flow, vary from one sector to another. So, any historical comparison of the Nifty on PE, RoE and other fundamental valuation parameters would not explain the reasons behind its phenomenal growth.
“For better understanding of market valuation and the resultant index performance, you need to take into account the composition effect of Nifty as sectoral mix can materially alter index valuations,” says Bhargava.

He has a point as sectors such as energy, capital goods and infrastructure, which used to have high index weightage in 2005, were all into cyclical businesses. Even financials, mostly public sector banks and to some extent private banks such as ICICI Bank and Axis Bank, mostly derived value through corporate lending.

However, now the bulk of the market value for financials comes from non-lending businesses like insurance, mutual funds and credit cards, and not the cyclical business of lending. Even the asset profile (loan book) of banks has become more retail oriented, which is less cyclical in nature. Thus, financials, which is a big part of the Nifty, is getting higher earnings multiples, lifting the index in turn.

Reliance Industries is another example where the cyclical petrochemical business has taken a backseat and consumer-oriented businesses of telecom and retail derive major value for the stock price. The share has gone up almost four times in the past five years. On October 6, 2016, the stock’s highest closing price was Rs 550.18 on the Nifty. In 2021 (as of October 21), almost five years later, the peak has been Rs 2,731.85 on October 19.

New Businesses, New Rules

The rise of intangibles or non-financial metrics is, in fact, the big theme that has emerged globally. Brand value, customer data, human resources, software, patents and contracts are all examples of intangible assets. These are getting more weightage from investors than tangibles such as land, building, machinery, cash and bonds.

The growing prominence of intangibles is well reflected in the earnings multiple of companies. Asset-light companies are fetching high premiums compared to their long-term historical averages. On the contrary, companies with top-heavy asset models are trading at a massive discount to their historical averages (see Visible Shift).

In the current market in India, companies like Titan, HDFC Life Insurance and Bajaj Finance are fetching high PE multiples of 174, 121 and 119, respectively. Let’s try and understand this phenomenon.

Titan, with less than Rs 1,000 crore profit in FY21, has a market capitalization of above Rs 2.1 lakh crore at present. If you look through the prism of financial metrics, Titan’s valuation looks very expensive, but if you analyse keeping in mind the nature of business (selling gold), which demands high trust, Titan is considered one of the most trustworthy brands. Clearly, the intangibles are in play here.

A similar trend can be witnessed in the case of Bajaj Finance. The company has been in the cyclical lending business but is now expanding into new businesses by analysing customer data. The latter is why the stock is trading at a high premium.

The magic of intangibles is more profound in new-age digital firms, where the financial metrics and traditional ways of reporting business value have failed to explain their ‘unicorn’ status. “By ignoring intangibles, how will you explain the magical success of unlisted digital companies (so-called unicorns) that are bleeding money but are still fetching valuations much above what listed and established companies are giving,” says a former CEO of a new-age digital company, who did not want to be named.

Traditional ways of reporting business value are ill-suited to the digital economy, he adds. For example, Zomato, with virtually no tangible assets but very high brand value built on the back of a proven business model, has almost the same market cap (Rs 1,08,381 crore) as Coal India (Rs 1,12,408 crore), which has a monopoly with a 70 per cent market share in the coal business.

The rise of intangibles is a global phenomenon and is not restricted to India. According to Ocean Tomo’s Intangible Asset Market Value Study, the ratio of tangible to intangible assets has changed substantially over the years. In 1975, 83 per cent of the S&P 500 assets were classed as tangible. That number has now fallen to 10 per cent versus 90 per cent for intangible assets.

Intangibles have gained prominence with the rapid evolution of technology. Now companies are valued not based on tangible assets on the book but on their perceived business franchises, says the former CEO quoted earlier in the story.  

If you look at the traditional financial metrics, the Indian market looks expensive as MSCI India Index is trading at 80 per cent premium to MSCI Emerging Markets on the earnings multiple.

As per the Bulls and Bears Valuation Handbook (September edition), published by brokerage house Motilal Oswal, the Nifty on a 12-month forward price-to-book basis is trading at 3.3 times, a 28 per cent premium to its 10-year historical average, while India’s market cap-to-GDP ratio at 111 per cent is way above the long-term average of 79 per cent.

Indian equities are trading at 23.4 times the estimated earnings for FY22, while other key international markets continue to trade at a discount to India. Also, India’s share in the world market cap is at 2.8 per cent, above its historical average of 2.4 per cent. In the last 12 months, the global market cap increased 31.1 per cent ($28.3 trillion) and India’s market cap rose 62.7 per cent, the handbook stated.

The price growth is exponential, but experts and market veterans are not flummoxed with the accelerating index values and many valuation theories are circulating to justify the rapid upward movement.

Jaspreet Singh Arora, chief investment officer, Equentis Wealth Advisory Services, says that before India was impacted by Covid in March 2020, the 10-year average of Nifty earnings multiples was 19. Today, Nifty’s PE multiple is 20, “which is just 5.2 per cent above the decade average,” says Arora. This doesn’t indicate being in a bubble zone or valuations being stretched, he adds.

Arora’s point is valid when we stop seeing the PE multiples in isolation and count the factors that are driving them higher than their historical average. One of the factors is interest rate. Currently, the 10-year Indian G-secs (government securities) are yielding 6.25 per cent, which is 20 per cent lower than their 10-year average of 7.5 per cent.

Keeping in mind the 10-year averages, while there is just a 5 per cent premium on the Nifty’s forward earnings multiple, the interest rate used for discounting to get the present value of a stock is 20 per cent lower. If all else remains equal, then the Nifty is still at a reasonable level and may move much higher from the present levels.

Even though the Indian markets look expensive, both domestic and foreign institutional investors (FIIs) are pouring money into it. Total FII flow into Indian equity was Rs 1.4 lakh crore ($19.05 billion) between November 2020 and October 21, 2021. Among the factors behind this massive inflow is liquidity and the opportunity that the Indian market is providing in terms of companies where tangibles are taking a backseat and intangibles are driving the bulk of the value.

Investors who understood this valuation conundrum have been able to mint money in the current bull run. However, those who may just be running with the flow need to be cautious about their asset allocation needs because the popular matrices of stock evaluation will go through an upheaval as more and more digital companies foray into the market. Despite losses, their high market caps reflect investor confidence, and they are looking at future potential, where intangibles have the upper hand over tangibles.

Companies like Byju’s, Paytm and Nykaa, which derive most of their valuation from intangibles, have lined up their IPOs for the coming months. So, keep a keen eye on the changes likely to take place in the index composition itself and the resultant market movement.

rajiv@outlookindia.com