Just about a year ago, the rumour mills were working overtime, leading to specul ation about the

survival of ICICI Bank. This was soon after the global economic crisis hit the Indian shores and ICICI Bank owned up to subprime losses. After i t announced the extent of the losses, the bank s share price went into a tailspin as panicky investors started offloading their holdings. Within two months, the s hare price crashed from Rs 650-700 to Rs 310. The fall may have seemed scary, bu t not to analysts and brokerages, who upgraded their rating of the bank from unde rperformer to buy in October 2008. What prompted the upgrade in the midst of a downturn? The answer lies in the val ue of the stock. As the stock corrected to Rs 310, analysts found that the price was lower than the market value of the bank s investments, or the book value per stock. If we factor in the worst case scenario and erode the entire non-governmen t foreign investments from our target price, our rock bottom valuations are at R s 445, say Prabhudas Lilladher s banking analysts, Abhijit Majumder and Bharat Gora siya. On an average, analysts valued the bank at Rs 440 per share (book value). Given the fact that bank shares usually trade at two times their book value, ICI CI Bank soon became the most favoured stock. The stream of upgrade calls were no t wrong. Since then, the stock price has more than doubled to Rs 755 and is curr ently around 1.5 times its estimated 2009-10 book value. This case offers an important lesson for equity investors - get the price right. No matter which stock you invest in, the cardinal rule is not to overpay. Yardsticks to Value Stocks in Different Sectors Industry Best measure of value Auto Price to Earnings (PE) multiple Banking PE and Price to Book Value (PBV) or Adjusted PBV multiple Cement PE, Enterprise Value to Earnings before interest, tax, depreciation & am ortisation (EV/EBITDA), EV/tonne Engineering Forward PE, which reflects the order book position of the compan y FMCG PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratios Real Estate Net asset value (NAV), which is book value at market prices. Als o look at debt levels Telecom* PE and DCF, because there is a future stream of cash flows for u pfront heavy investment Oil & Gas Residual reserves of energy assets Technology Trailing PE and its growth * Includes utilities Unlike fixed income options, such as bank deposits, where the returns are guaran teed, the performance of equity investments is determined by the purchase price as well. Once the stock is bought, there is very little that retail investors ca n do apart from buying more or selling them. So, if they invest at the right pri ce range (or low valuations), the probability of earning greater returns is high er. Valuation tools How do you know you are paying the right price for a stock? The answer is to che ck the target investment using a couple of financial parameters. Depending on the nature of the business and the sector s growth prospects, an appropriate tool mus t be used to value the company, says Hitesh Agrawal, head of research, Angel Brok ing. This tool is the ratio or financial metric that determines the value of a s tock. Unfortunately, there is no single tool for all industries and stocks. One ratio c annot be applied blindly to value stocks across sectors, says Manish Shah, associ

ate director, Motilal Oswal Financial Services. This is due to the inherently di fferent nature of businesses. Broadly, there are two valuation metrics: PBV (pri ce to book value) and PE (price to earnings). The former calculates the value of assets and the latter determines the price investors are paying for the company s earnings per share. A high growth, low capital-intensive company must be valued on PE, whereas the PBV or the replacement value is the appropriate tool to valu e capital-intensive businesses. Another ratio that takes care of the debt leveraging aspect across companies is the EV/EBITDA (enterprise value/ earnings before interest, tax, depreciation and amortisation), or the enterprise multiple. But, as Agrawal says, it is always a dvisable to consider two or three valuation tools before taking an investment de cision. The tools that apply to different sectors and industries vary. Cement manufactur ers are best valued using EV/EBITDA, real estate firms using NAV, while engineer ing companies can be valued using forward PE (see graphic). The PBV is used for capital-intensive businesses like banks and power companies. Public sector bank stocks are attractive when they are trading below their book values. For a private bank, depending on its size, the ideal PBV ratio is around 2. In case of FMCG companies, the PE multiple is a better yardstick because the se companies invest upfront in building brands and facilities and derive the ear nings in subsequent periods. What Impacts Stock Valuations in Sectors Industry Best measure of value Auto Volume growth, realisations, operating profit margins, new product launc hes Banking Loan growth, non-performing assets, net interest margins, CASA r atio Cement Dispatches, operating costs, regional demandsupply equation Engineering Order book inflows, execution skills, margins FMCG RoE, RoCE, margins, volume growth, new products, marketshare Real Estate Debt levels, liquid assets, inventory levels, promoters ability t o raise funds Utilities/Power Project costs, plant load factors, raw material costs, d ebtequity ratios Telecom Revenue per user, growth in usage, new subscribers, non-wireless revenues, EBITDA Oil & Gas Reserves, efficiency ratios, free cash flow generation Technology Order inflow, ability to contain costs, service verticals, profi tability, client attrition Comparing with peers After deriving the book value, a peer group comparison is needed. Always conduct a peer analysis. Consider the sector s potential and see how the company compares with its peers, says Sonam Udasi, vice-president, Brics Securities. However, peer group valuation has its own limitations. The target company s valuat ions might be lower than the benchmark or industry average due to constraints re garding market share or economies of scale, and it might continue trading at a d iscount. Infosys, which is considered to have superior margins and a high-yieldi ng business portfolio, has always traded at a premium to Wipro, Tata Consultancy Services and the information technology industry as a whole. One also has to look at the reasons for the valuation discount versus the benchma rks. Most likely, there is a good reason for the discount. For instance, if a co mpany can address adverse issues going forward, the discount will narrow and the

stock valuation will improve. If it fails to do so, then the stock will continu e to trade at a discount to its peers, says Udasi. To refine the research process further, comparing the efficiency and return rati os of the stock with the industry or benchmark would help investors take informe d decisions. In case of banks, the loan growth, net interest margins and the ris e in bad loans can help find the right stock. Likewise, FMCG stocks can be sorte d on the basis of return ratios like the return on equity (RoE), return on capit al employed (RoCE) and the company s operating margins. How does an investor find out if a particular valuation method is a good paramet er? According to Macquarie Research, the valuation parameter is considered good i f the sector consistently shows increasingly strong returns from progressively l ower levels of the valuation metric, and increasingly weak or negative returns f rom progressively higher levels of the valuation metric. Sustainable growth The sustainability of the earnings momentum is crucial because all the financial parameters or metrics are based on this presumption. The valuation of the financ ial parameters needs to be done on expected or estimated earnings potential and growth. This is the most difficult and critical part for any analysis, says D.D. Sharma, senior vice-president, research, Anand Rathi Financial Services. Apart from comparisons with benchmarks, the management quality, transparency, ea rnings growth and earnings volatility are key factors for driving the valuations of a stock. Any change in these factors will re-rate or de-rate a stock. So, a s tandalone comparison of a stock with its peers or benchmark indices will not hel p much. Look for a change in the earnings potential, growth or management for a re-rating trigger, says Sharma. Hence, a company that is currently not earning pr ofits cannot be valued at zero or close to zero. A typical example is dishtv. The in the investment process and is y is currently trading at Rs 42. ch will earn significant profits direct-to-home cable service provider is still not making a profit now. The loss-making compan This is because it is developing a business, whi in the next few years, says Sharma.

The bottom line Clearly, valuations are not static, but dynamic. Depending on broader factors, s uch as market sentiment and sectoral preference, these change with time. A stock that trades at a discount to benchmark valuations, but shows superior earnings growth rates and scores better on operational efficiencies, can be a good invest ment pick. Investors should use the valuation methods mentioned above to zero in on the stocks that have value, while avoiding the ones that trap them by appear ing to offer value.