Valuation Of Shares and Business

Top-down and bottom-up approaches

Before trying to understand the differences between top-down and bottom-up investing, remember that both of these approaches have the same goal – to find out great stocks. Top-down investing involves analyzing the ‘big picture’. Investors using this approach look at the economy and try to forecast which industry will generate the best returns. They then look for individual companies within the chosen industry and add the stock to their portfolios. For example, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the home-building industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.

Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. What constitutes ‘good prospects’, however, is a matter of opinion. Some investors look for earnings growth while others find companies with low P/E ratios attractive. Bottom-up investors will compare companies based on these fundamentals. They feel that as long as the firms are strong, the business cycle or broader industry conditions are of no concern.

The P/E yardstick

One of the key determinants of a good valuation yardstick is its usage. The price to earnings (P/E) multiple wins hands down on that score, being easily one of the most popular valuation tools not only in India but across the globe.

Conceptually, the P/E multiple represents the premium that the market is willing to pay on a company’s earnings, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E ratio is calculated by dividing a stock’s current share price by its earnings per share (EPS) for a 12-month period (mostly the last reported full-year EPS). In effect, the ratio uses the company’s earnings as a guide to value it.

While using P/E as a yardstick for measuring stocks, remember that a stock with a lower P/E is not necessarily a better investment than a stock with a higher P/E. Most P/E ratios you see for publicly-traded stocks are an expression of the stocks’ current prices compared to their previous 12-month earnings. A low P/E must be coupled with the company’s ability to grow revenues and earnings at least as quickly as the price in future to remain attractive. It must also be noted that average P/E ratios tend to vary from industry to industry. Typically, companies in very stable, mature industries which have more moderate growth potential have lower P/E ratios than those in relatively young, fast-growing industries with more robust future potential. Thus, when you compare P/E ratios of two companies as potential investments, it is important to compare firms from the same industry with similar characteristics. Otherwise, if you simply purchased stocks with the lowest P/E ratios, you would likely end up with a portfolio full of similar companies, which would leave you poorly diversified and exposed to more risk than if you had diversified into other industries with higher-than-average P/E ratios.

At the same time, stocks with high P/E ratios need not turn out to be good investments.The important thing is that when looking at P/E ratios as part of your stock analysis, consider what premium you are paying for a company’s earnings today and determine if the expected growth warrants the premium. Also, compare it to its industry peers to see its relative valuation and try to determine whether the premium is worth the cost of the investment.

Discounted cash flow (DCF) analysis

It can be hard to understand how stock analysts come up with a ‘fair value’ for companies, or why their target price estimates vary so wildly. The answer often lies in how analysts use the valuation method known as discounted cash flow (DCF). In simple terms, DCF tries to work out the value of a company today, based on projections of how much money the firm is going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as ‘discounted’ cash flow because cash in the future is worth less than cash today.

DCF serves as a reality check to the fair value prices found in brokers’ reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company’s costs of capital and the risk its stock faces. All of this will help you understand what drives the value of a company’s stock. This will enable you to put a more realistic price tag on the company’s stock.

Using a DCF model probably entails a more in-depth understanding of the company finances than relying on traditional valuation measures such as the P/E ratio. This analysis treats a company as a business rather than just a ticker symbol and a stock.

Economic value added (EVA)-based investing

Economic value added (EVA) is a financial concept that cuts away market chaos to focus on a single investment question: Is a company creating or destroying wealth for shareholders? By trying to answer this question, you will take the first step to pick stocks that outperform the market, which is the dream of every long-term investor.
EVA is defined as the difference between a company’s net operating profits (NOPAT) and its total cost of invested capital over a given time period. This capital charge is necessary to compensate the providers of debt and equity for use of their capital investment at a rate adequate for the risk incurred.

EVA = net operating profits after tax – cost of invested capital

If the EVA is positive, the company has created value above the minimum return required by investors, and if it is negative, wealth has been destroyed.Implicit in the EVA calculation is an important concept – equity requires a return. Not only that, but the cost of equity is typically the most expensive form of invested capital and is linked to factors such as prevailing interest rates and corporate risk. Financial statements recognize the cost of debt, identified as interest expense, but not the cost of equity. Calculating a company’s profit while leaving out the cost of equity is like playing volleyball without the net.

With the full cost of capital deducted from NOPAT, EVA shows whether capital is being used efficiently in the company, and with further analysis, whether high-return businesses are subsidizing low-return businesses or which geographical regions or business segments of a company’s operations add value or destroy value.

Investing using EVA

Recognizing how, in the long term, the efficiency with which a company uses its capital determines how well its stock performs, EVA can provide valuable predictive insights into the future performance of stocks. To describe how to apply EVA to investment strategies, one additional concept – market value added – is required.Market value added (MVA) is the difference between the total market capitalization of a company’s debt and equity and the total invested capital. It represents the market’s perception at a point in time of the company’s ability to successfully invest its capital in the future. Companies which have demonstrated superior EVA performance are typically accorded a higher MVA, a premium over their current invested capital to recognize their perceived potential to gain wealth. Companies, which have an eroding EVA, may find their MVA languishing or, in fact, negative, reflecting negative sentiments in their stock price.From the company’s perspective, the best category is where wealth is being created (high EVA) and the market is rewarding this wealth creation with a high MVA. Growth and momentum investors may find opportunities in this group of companies.

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Risks Involved In Equity Stocks

Valuation Of Shares and Business

Why Monitor And Review Your Equity Investments

Monitoring Methodologies That Can Be Adopted

When To Sell Your Equity Stocks

Stock Market And Taxation

Process Of Investing In Equity Stocks: Online And Offline

Stock Market Myths

Frequently Asked Questions (FAQs) About Stocks And Stock Market

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