POOR COMPANIES RICH MULTIPLES

Author: Preetam Mittal

               PGDM RM 2011-2013

               Welingkar Institute of Managament

The document is about common mistakes made by investors while analyzing the financial ratios and how companies manipulate their stock prices.

A premium earning multiple is hard to come to a company and even harder to maintain.

In the recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio.

Countless investors - individuals and professionals alike spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for some reasons, they are not in favorable industries or have poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years.

But investors don’t understand this fact and companies take their advantage and modify the P/E ratio by various means – the most common been -inclusions of debt in the capital structure. When companies are financially leveraged then the one with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers.

Exhibit 1

Leverage distorts the P/E ratio (Hypothetical case)

Exhibit1clearly shows that though both the company has same EV value, their P/E ratios have substantially changed due to inclusion of debt. Taking the example of two companies Apache Corp and Anadarko Petroleum, each of these energy firms in the year 2010 had an EV/EBITDA multiple of just over 5 (source: investing answers.com) the average EV/EBITDA multiple in their peer group was just under 7. That seems to indicate APA and APC were relatively undervalued.

But if you looked at Anadarko strictly on a P/E basis, you'd wonder why shares hold any appeal, trading at nearly 30 times of its net income.

Why PEG is better than P/E ratio?

There are more detailed valuation models available in the market which seldom makes the headline. These are generally the cause of concern for the senior executives as they claim that their company has great growth prospects and many investments projects in hand. Actually, they are not necessarily wrong. Even financial theories suggest that companies which have higher growth prospects should have higher earnings ratios and hence better market value.

But the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history - you're purchasing its future cash flows. What matters is what the company is going to do and not what it has done.

So what's the solution?

The solution is to account for the growth rate of the company or expected growth rate if it can be estimated. Thus, it gives birth to a new and better ratio - PEG ratio, the calculation is as follows:

PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings per Share Growth

In fact, if one goes back a decade ago then one may find that Apple's P/E ratio at that time was as high as 297. So, anyone making investment on the basis of P/E ratios would not have considered it a very profitable investment but had you bought shares of the company then, you'd be up over 7,300% today.

But, if someone calculated the PEG ratio it would be something closer to 1. A crude analysis suggests that companies with PEG values between 0 to1 may provide higher returns (the closer to 0 the more undervalued).

Common manipulation techniques used by the management

There is another very common form of manipulation used by companies called the "big bath," and this can cause these stocks to seem undervalued to investors. This happens when the company incurs a big loss to their bottom line. This method involves the company taking the complete loss in one single period, instead of spreading these losses over years. This will cause the earnings per share to drop significantly for the time period involved, due to the large losses posted. The intention of the company is to foster the idea among investors that this charge is a once only deal, and that the stock will rise considerably after the loss has been absorbed. This will cause investors to see the stock as one of the undervalued stocks, or as an attractive investment and thus will cause the demand and price for the stock to jump up.

One must always keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.

These ratios are completely ineffective for cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples and these requires a bit more investigation. Although one would typically think of a firm with a very low trailing P/E as cheap, but that would precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.

In a similar way, when you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. The denominator of the ratio can be easily manipulated by changing the revenue recognition, depreciation and capitalizing cost methods the company have been following.

The company generally projects “pro forma” earnings, which shows the profit the company would have made in case some bad/extraordinary event didn’t happen. Consider the case of the attack on hotel T­­aj few months back. It would have surely affected its current earnings, but long term scenario remaining the same. Using Pro forma in those cases makes absolute sense to get an overall long term picture. But there are companies which excludes preferred stock dividends, taxes paid, bad investments, etc., and shows a very attractive pro forma earnings. Hence in general, it’s always better to forget about the pro forma earnings as more companies have come to misuse it, than guiding the stock holders.

Sometimes, companies may show an attractive figure as per-share earnings, but in the foot note it may take away a major part of it as special charges. In such cases investors usually do not pay attention or are ignorant about these facts but this ultimately affects the total earnings of the company and reduces the per-share earnings. Sometimes the special charges may not be really so special and it may show all its operating expenses and even losses as special charges.

Another common mistake made by investors in calculating the EPS is calculating it based on the number of shares currently available in the market and neglecting the convertible debentures available in the market. Companies generally issue fully convertible debentures in the market which the debenture holder converts into equity share when he/she finds the market lucrative. Here at any condition, one should only take the diluted earnings and also check if the company has any plans to dilute further, as it may take away another piece from your pie.

Why management manipulates financial statements?

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business.

Conclusion

Are these ratios the “be all to end all” for pricing a share of stock for a company? Of course they aren’t. There are a lot of factors that go into pricing shares of stock and so it's important to continually sharpen one's skills and put new tools in the toolbox. It makes sense to go through and calculate different multiples such as EV multiple (EV/EBITDA, EV/EBIT), PEG and Dividend yield ratio etc. for all current holdings and for future investments.

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Yellow Metal, Yellow Fuel causing Economy Blues

Name: Vibhu Gangal

Institute: Symbiosis Centre for Management and Human Resource Development

A significant reason for the recent fall in rupee is attributed to macroeconomic deficiencies of India. The article below analyses the same and tries to establish a relation between the steep fall of rupee and the general tendencies, trends and situations prevailing in India that affect the economy eventually.

The demand equation states that the aggregate demand (and the national income at equilibrium) is an algebraic sum of consumption demand, investment demand, government expenditure and net exports. The moment we say 'demand', it is backed by money and indicates a destination where people roll out the money they possess. If this money is spent to fulfill any of these demands which add up to the national income, it’s a positive sign. The more this happens, the more the country grows economically, the more is the national income, the stronger is the home currency. One scenario, where possession of money with individuals of a nation can harm the economy, is when the money possessed gets expended big time towards imports, which makes net exports and overall national income negative, leaving the investment demand of the nation unquenchable. A similar thing seems to have happened in India. Let’s take a closer look at its causes and implications.

Consider an analogy, where we have a dam constructed with an aim to irrigate fields. It has some water collected in the reservoir. This water flows to the fields through channels. Thus, it’s the channels which ensure that the water in the dam gets utilized for growing crops and not for domestic purposes of farmers' households. Had the channels being broken and had the water been routed to households instead of fields, crops could never have grown due to lack of water and the production of the territory could have taken a severe hit. The water is equivalent to liquid rupee with the Indians, crops to the GDP, and channels to the government regulations and policies. In India, a major part of money (water) is spent in buying volumes of gold by families (household demand). If gold was available in India, the tendency of buying gold would have created better circulation of money and the multiplier effect would have done well to the economy. Unfortunately, out of 902 tones of domestic annual gold demand, India produces only two tones and the rest 900 tones is imported. 

More the demand for gold, more are its imports, more is the payment in dollars, more is the influx of rupee in forex market, more is the outflow of dollars from forex market, more depreciates the rupee,  more expensive becomes any imported item including gold. This self-feeding spiral continues and raises ringing-alarm-bells when it reaches a stage where RBI cannot save the rupee by adhoc workarounds like selling dollars and "trying" (rather struggling) to induce more FII participation.

Indians have imported gold worth $61.5 billion (or around Rs 341,000 crore) in 2011-12, recording a growth of 44.4 per cent during 2011-12. Same is the case with petrol. A consistent surge in demand eventually causes the same vicious circle of events. Together, gold and petrol are the biggest burden on trade deficit and have worsened current account deficit badly, causing the sharp decline in value of rupee vis-a-vis dollar. The trade deficit during 2011-12 was recorded at $184.9 billion than $118.7 billion during 2010-11 mainly on account of large imports of fuel, gold & silver accounting for 44.4 per cent of India’s imports. Reports suggest that gold imports contributed to almost one third of the incremental rise in Current Account Deficit over the 2008-2011 period.

Directly, gold contributes 0.36% to inflation index. Indirectly, it makes all imports including crude oil costlier fuelling input costs for all industries ranging from plastics to automobiles. If the input costs rise, so have to be the prices of finished products. Eventually it’s the inflation which kicks off. The time lags between rise in gold demand, rise in import prices and rise in end product prices make the three events appear disconnected to the general public and as the "safest" option, we end up blaming the government without any knowledge of ground level proceedings. Arithmetically, every dollar reduction in international oil prices translates into a cut in product price by 33 paisa.But every time the rupee depreciates against the US dollar by one rupee,it translates into a requirement to raise prices by 77 paisa.

Another aspect is, with booming inflation, with industrial products being costlier than earlier, why would a buyer in international market prefer buying Indian expensive goods when the same is available at a lower price in other countries? Together, with imports already being discouraged due to sharp depreciation of rupee, this fall in exports due to inflation exacerbates the trade deficit causing further decline in rupee value. It all gets again into the self-feeding loop discussed above.

So, where do we break this infinite-loop of events where every step, every action has a well justified reason behind it? But somewhere, somehow you need to break this to get things in place. Weakeningor breaking one block might give a temporary relief to figures, but in long run, this would cease growth. Instead, if every link in the chain is made to melt down in terms of its prominence, its just a matter of time, the whole chain shall cease to be prominent. What I wish to convey is instead of unplanned adhoc and short-term steps like giving subsidies on fuel prices and making efforts to attract hot money sources, this nation needs to plan for a durable strategy which would 'subtly' and 'indirectly' bring about relatively stiff and lasting changes in the economy. Here’s what I mean to say…

Whenever individuals hold disposable rupee, government should ensure that substantial part of rupee gets either invested into banks, corporate bonds, government securities and the share market or it gets to quench 'domestic' consumption demand of goods and services. Let’s remember in a dam, it’s the channels which ensure the usage of water in desired way and ultimately govern the production. Whenever it’sexpected to have an enhanced liquidity among individuals, it should be THE time for government to make capital investment attractive. This would trigger the multiplier to take effect and eventually translate liquidity into growth. As far as demand for gold is concerned, it can be discouraged by raising customs duty exorbitantly. Buying gold should be made at least half as tough as buying a scooter was in late 1980s... Even if the demand for gold reduces partially, this would mellow down dollar appreciation and prevent further damage.

On the other hand, the consumer which demands gold and oil so excessively needs to understand that if he chooses deliberately to intensify imports, he is fuelling inflation to such an extent that he himself is going to get in trouble. A major reason for S&P indicating to downgrade India in terms of its investment-grade rating was a drought of investment opportunities in India. With Indian businesses borrowing big-time from foreign sources, with other events increasing imports and causing rupee to depreciate, Indian borrowers will now pay more for every dollar borrowed. With every firm borrowing millions of dollars, the rupee loss is going to be phenomenally huge and shall reflect on a cost-cutting approach by companies' management which shall also include a cut in salaries. Eventually, a self-check on surge of gold demand can help prevent a number of significant things.

Recently, after a lot of hue and cry on oil price hike, the government declared a subsidy on petrol price. I say why? As a long term plan, the government should let the petrol price rise so that vehicular usage takes a hit, even though the hit is marginal. Towns, where bikes and cars are favorites for personal transport, should be picked up and transformed into towns with a quality mass public transport, quality in terms of speed, frequency, availability, ambience, approachability, grievance handling mechanisms and any and every aspect which makes mass transport well-preferred and equal in status vis-a-vis individual vehicles. This shall help in fading the rise in demand for crude oil and so shall prevent the rest of the spiral.

One may say that it’s the gold which facilitates loans and so fosters investment. But one misses to note that at the time of repaying the same loan taken against gold, the value of the money repaid plummets so much that the good done by the investment gets offset substantially by severe inflation, the root cause for the good and the bad being the same. One may say that if investment in India is on a backseat, why doesn't the government invest? But one misses to note that it would be dumb on the government's front to do so, as it is already burdened under a budget deficit of 5.19 percent and any further disbursement of money would widen it more. One may say that subsidies on fuel shall be continued for some more years as the inflation is cost-pushed and not demand-driven. But one misses to note that it’s the demand which drives the entire spiral discussed above and it’s the drive of this demand which ultimately coverts into a cost-push inflation. Thus, it’s high time now that the administration of the nation gets into a patient and consistent mission of correcting the fundamentals of economy at a macro-level with an aim to bring about a long-term change.

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