5 Methods of Valuation of Shares used by Top Hedge Funds

Valuation of Shares

There are a lot of ways of valuing companies and it’s shares. The valuation of shares can be an analytical, statistical or logical exercise and even the greatest investors of the world have used different frameworks to look at businesses. In this post, we shall examine some ways in which you can value the share price.

In this article, we shall look at five methods of valuing shares of a company or business

  1. Discount cash flow analysis
  2. Acquisition price method
  3. Fixable problem method
  4. Sum of parts method
  5. Hidden assets method

These methods are uniquely different from each other. While it is not practical and advisable to evaluate every opportunity using all these five methods, it is wise to use at least two of these valuation of shares frameworks in looking at an opportunity. This way you can be certain that your view is in congruence of how it might have looked via a different window (mental framework)

Discounted Cash Flow Analysis

The first & foremost valuation of shares methodology is the discounted cash flow approach. 

The Discounted Cash Flow model is an approach where we estimate the future free cash flows that a company is going to produce from now until eternity and discount it back to the present.

Now a lot of people say “which discount rate should I use? 8% or 10% or 12%?”. 

In all honesty, it doesn’t really matter what the discount rate is at this point. What is more important is whether you’ve roughly correctly understood a company’s cash flow for the next 5 to 10 years. This is where you need to focus your attention because this is the part which will include everything we checked out earlier. This includes – industry, competitive advantage, management, growth, your circle of competence etc.

Often people email me asking me – “where can I find annual reports?”. So, I have made a list of sourcing from where you can find annual reports and other financial statements of Indian companies 

Acquisition Price Method

Another way of valuation of shares is to look at companies will be in terms of M&A activities. 

At times where there are acquisitions happening or deals being drawn where bigger companies are buying smaller companies, then it allows you to look at the EBIT multiples or revenue multiples at which such companies are being acquired. This is an indicator on the company’s worth and you can use it as a base to see if the company you are much interested in is cheap or expensive. 

Here is a report on Industry Multiples in India that you might find very interesting.

The report has looked at different industries in India and focused on four metrics that are generally used as price multiples.

IndustryEV/SalesEV/EBITDAP/EP/B
Consumer Discretionary : Apparel2.320.144.54.3
Consumer Discretionary : Auto Parts and Equipment1.712.925.14.4
Consumer Discretionary : Household Appliances2.725.345.78.5
Electric and Gas Utilities2.29.915.11.9
Energy Industry0.85.67.61.2
Household and Personal Products4.624.532.37.1
Industrial Machinery Industry2.620.633.14.5
Internet Services and Infrastructure2.112.917.94.0
Application Software1.711.418.13.0
Materials : Chemicals2.514.222.23.5
Materials : Construction Materials1.810.927.63.1
Materials : Metals and Mining1.06.29.11.3
Healthcare: Pharmaceuticals and Biotechnology3.715.723.83.5
Real Estate6.614.318.52.0
Automobile Manufacturers Industry1.911.622.05.2
Media Industry2.911.519.93.3
Healthcare Facilities and Services Industry2.320.530.23.8
Independent Power and Renewable Electricity Producers Industry2.99.38.60.8

Let’s try an example.

So let’s say a medical diagnostic centre (a much smaller Dr. Lal’s Pathlabs) wants to exit the business and you are interested in having a business in the healthcare industry. You ask for the books and find the following information about the business :

  • Sales (revenue) = ₹50,00,000
  • Debt = ₹20,00,000
  • Earnings before depreciation, interest and taxes (EBITDA) = ₹18,00,000
  • Net Income (profit after tax) = ₹11,00,000
  • Total assets = ₹25,00,000
  • Total liabilities = ₹15,00,000
  • Capital (equity) = ₹10,00,000

Now let’s try the four multiples on offer

First, the section under which we need to look is “Healthcare Facilities and Services Industry”

  • EV/Sales = 2.3 .. With sales = ₹50,00,000, the enterprise value comes ₹1,15,00,000
  • EV/EBITDA = 20.5 .. With EBITDA = ₹18,00,000, the EV comes to ₹3,69,00,000
  • P/E = 30.2 .. With E = ₹11,00,000, the EV comes to ₹3,52,00,000
  • P/B = 3.8 .. B (book value) = total assets minus total liabilities = ₹10,00,000, the selling price comes to ₹38,00,000

As you can see (and as we warned), each method gives very different answers.

This is very common in valuation of shares. Your job will be to measure you each methodology and see what counts best.

If that’s not enough we see that the average multiples in the financial sector are a lot different including the metrics that are tracked.

IndustryMarket Cap/ RevenueP/TBVP/EP/B
Financials : Banks4.60.618.10.6
Financials: Consumer Finance5.22.118.12.2
Financials : Specialized Finance5.51.510.21.5
Other Diversified Financial Services2.93.020.42.5

Fixable Problem Method

A classic value investing moment which comes often when a company’s stock gets beaten down due to fixable factors. 

Due to some issue, the company misses an earnings estimate or two and the analyst community dooms the company’s stock with sell recommendations which brings down the stock price into a value investor’s buy territory. 

The value investor has to only see if the problem is fixable or not. 

Similarly there are cyclical problems that come from oil price movements or monsoons or simply that soft drinks don’t sell as much in winters.

Let’s see one such fixable problem through an example.

Nestle India Maggi Noodles

In 2015, an officer of the UP Food Safety and Drug Administration ordered tests on a dozen samples of Nestle’s Maggi instant noodles. 

The lab tested for monosodium glutamate (MSG) to check Nestle’s claim that Maggi had none. The lab found MSG in Maggi noodles and “very high quantities” of lead (17.2 parts per million while allowed was 2.5 ppm). The UP FDA filed a complaint in the courts and the Food Minister directed the regulator to conduct nationwide tests. Maggi delivered almost 30% of all revenue for Nestle India. The news broke out on 28th May 2015.

As expected, the price started to dip for Nestle India and while it took some time, it did go down by almost 30% over the next three months.

The real question is – would Maggi now have totally evaporated from India?

The answer is – NO!

It is important to know if the problem is a quickly fixable one.

Like negative news is fixable. 

Or is the problem a slow burn e.g. typically seen when company labour forces strike as it takes about 3-4 quarters for the company to come back to steam

Or is there a permanent issue like a bond default or technology has moved

If you invest based on a permanent issue, then you will fall into what is called a “value trap”. A value trap is where all quantitative parameters seem to show that there is a lot of value in this business however the fundamental catalyst for price appreciation is missing like revenue, market share or earnings growth.

Sum of Parts Method

Another way to do valuation of shares is to look at the sum of parts approach. An example of that was when ten years or so back, when Bill Ackman discovered that Wendy’s owned a real gem called Tim Hortons which is sort of like the Dunkin Donuts of Canada. You go to Tim Hortons for coffee and donuts.

Ackman saw that the value of Tim Hortons, if it were a separate standalone business, was worth the entire market capitalization of Wendy’s. And that the market was only valuing the Wendy’s burger business and were assigning no value to Tim Hortons. 

So he went in and bought a bunch of stock, hired Blackstone to do an analysis and push the company’s spin-off of Tim Hortons. This unlocked the value of Time Hortons and the stock of Wendy’s and Tim Horton combined to be worth double of the original value. 

We see many such examples in India aswell with Reliance Industries being the more promising value unlocker. Post the death of Dhirubhai Ambani, the company was split into Reliance Industries, Reliance Capital, Reliance Energy, Reliance Communications etc.

Hidden Assets Method

A big branch of value investing involves the discovery of hidden assets in a business which the seller is not evaluating.

A quick example.

Say, you want to buy a wallet for yourself and find one for ₹300. But on further examination you find that the shopkeeper had mistakenly left a ₹500 note inside the wallet. This means the price of the wallet has dropped dramatically from ₹300 to minus ₹200. This is deep value for you as you are getting the wallet free of cost and you are earning ₹200 on top of it.

Now you might say that’s just good luck.

That’s true and that’s what hidden value finding is all about. Here are some real-world examples –

I ran today’s stock screener and found that there are 30 companies in the NSE which have more cash in the company than the total value at which one can buy 100% of the company

Here is a sample list.

Name of CompanyMarket Capitalization (in ₹crs)Cash and Equivalent (in ₹crs)
NBCC (India) Ltd2,9974,832
Garden Reach Shipbuilders & Engineers Ltd1,7802,428
DEN Networks Ltd1,5232,164
Indiabulls Integrated Services Ltd344886
Tejas Networks Ltd306370
Hindustan Media Ventures Ltd301583
HT Media Ltd2491,577

Some of these companies will be known to you. Notice that the cash in the company is higher than the market capitalization (i.e. value of all outstanding shares in the company or market price per share * number of shares). 

In other words, if I had enough money, I could have bought NBCC (India) Ltd for ₹2,997 crores .. gone to the bank .. written a check for ₹4,832 crores in my name .. and come out with a profit of ₹1,835 crores. 

That’s a return on investment of 61% !

This is just one example of hidden assets. 

A word of caution – value investing and investing in general is not a simple thumb-rule based selection set. Cash in the balance sheet is one of hundreds of various parameters one has to see to identify the right stock to invest in.

Another interesting hidden asset analysis that you might want to do yourself is comparing the price movement of Bombay Burmah Trading Corporation Limited with Britannia Industries Limited. Here’s a useful chart

Most important, it is important to note that Britannia Industries has 240,318,294 equity shares of ₹1 each. Of these 121,732,190 equity shares is held by The Bombay Burmah Trading Corporation Limited. That’s a little of 50% shareholding of Britannia Industries Limited.

This means, if you see a big gap between Britannia stock prices and that of Bombay Burmah Trading then it might be time to understand the cause of such gap and be ready to go long or short the stock.

My Learnings on Valuation of Shares

It is important to grow as a value investor. 

I use the word “grow” because we all start with some thumb rules which are old-style. These are things like don’t pay more than 10 times earnings for a decent business or over 15-20 times for a great business etc. 

Over time, I have realised that these are mis-applied rules of thumb and in the process, I have missed out on some really good stocks like Infosys and Titan. I am little more peeved about Titan because I was seriously evaluating it at the same time when Rakesh Jhunjhunwala did his investment in Titan Industries.

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