In search of the Magic Wand to Value Equities

Before we embark on the journey of finding out the magic wand to value equities, let us understand the determinants of equity values

Determinants of Equity Value

When you own and operate a business like say retail garments shop or a bread factory, you are in effect earning from selling the garments or baking the breads. Your profits are wholly and solely derived from your business activity. However, when you invest in stocks your income comes from the following three sources:

1.       Initial Dividend Yield

2.       Growth in Earnings

3.       Change in valuation (Price / Earnings Ratio).

I explain these three return sources from stocks very briefly for those of you who are not familiar with it. Dividend is nothing but the distributed earnings (profits) of the company and when it is expressed as a ratio of the stock price it is termed as Dividend Yield. Growth in earnings is the profits made by the company over your holding period of the stock. In the example of garments retailer or manufacturer of breads it would mean the profits derived from the sale of garments or breads, respectively. The third concept is the change in the Price / Earnings (P/E) multiple. P/E is nothing but the market price of the stock divided by the earnings (profits) of the stock. It means how many times earnings is the market ready to pay for a company. Suppose, the P/E multiple of a stock is 10 it simply means the market is ready to pay 10 times today’s earnings for buying the entire company. Today, the market might be ready to pay 10 times earnings –it all depends on the expectations of future earnings and profitability of the company – if the expectations increase, the market would be ready to pay a higher multiple of say 12 times while if the expectation of future earnings decreases than the market would like to pay a lower multiple of say 8 times. This brings me to the third source of return from stocks which is change in the P/E multiple, an increase in the P/E multiple would result in a positive change in the stock price while a decrease in the P/E multiple would result in a negative change in the stock price. Kindly note, that the first factor of dividend can be positive or in worst case zero while the second and third factors can be positive, zero or even negative because the company can make losses also and the P/E multiple may contract also.

The best valuation Tool for Equities

Equity prices are valued in comparison to what they give the investor in return for the money paid for them. Generally, equities give us the following in return for the price paid for it:

Ø       Earnings

Ø       Sales

Ø       Book Value

Ø       Replacement value

Ø       Dividends

 

When you divide the current market price by any of the above mentioned items, it denotes how many time the current “value determinant” is the market ready to pay in terms of price. For example, when we compute equity values based on earnings, we divide the current market price share by the earnings per share (EPS) which in ratio form would be denoted by the P/E ratio.

Now, let us examine each one of the above tools so as to search for the magic tool to value equities.

Ø       Earnings

Valuing the price of the stock against its earnings or the P/ E ratio is the most common valuation tool used by market participants. I don’t know the reason for it but its simplicity, intuitiveness and fundamental inclination calls for its wider use. As mentioned earlier, it simply depicts the number of times the stock price is quoted in terms of the company’s current earnings. All other things being equal, a stock with a low P/E multiple is more attractive than a stock with a high P/E multiple. However, rarely are all the other things equal. For example, in a commodity company a high P/E might infact signify a good buying opportunity provided the high P/E is not because of high P but because of the E being at a cyclical low and expected to rebound from thereon. However, earnings can be very volatile and difficult to predict. Further, earnings can sometimes be slaves to accounting policies and gimmicks.

Ø    Sales

The other common valuation tool is used to compare price with the Sales of the company via the Price / Sales (P/S) ratio. The major flaw with this valuation tool is that it gives importance only to the topline (sales) and not the bottomline (profits). Thus a loss making company with high growth rate in revenues might command a high P/S ratio. Also, its easy for a company to increase sales by selling additional goods on credit to sub-standard customers which will result in higher sales and correspondingly increase in debtors.

Ø    Book Value

This is another exciting valuation tool – the relationship between the price and the book value of the company. The book value is nothing but the net wroth of the shareholders – it is derived by adding up the company’s assets (owned) and from it subtracting the company’s liabilities (owed) and then dividing it by the number of shares so as to get the book value per share. However, book value is more of a theoretical value of the company’s assets. It might not reflect the current value of its assets because accounting is on historical cost basis. Further, the net worth might not be the actual worth of the company because assets are only worth what the buyer is ready to pay for it. Importantly, the assets should be able to generate sales and income otherwise it is useless.  

Ø    Replacement Value

In an inflationary environment, book values of assets tend to be under stated and hence we have to look at the “current value” or in other words the “replacement value” of the assets. Stock price divided by the replacement value yields the Q-ratio. While superior to indicators that merely use book value, it is almost impossible to calculate, and is of greater interest to theoreticians than to practicing investors.

Ø       Dividends

Although every equity investor is familiar with dividends but very few appreciate the worth of it and actually invest for it. When you invest in a bond or take a bank fixed deposit, what essentially are you investing for – interest. But, when you invest for in equities what primarily is your primary motive behind investing in it – for a majority - it is capital gains. And when you invest for capital gains, there are good chances that you might actually loose rather than gain. Dividend is nothing but the distributed profits of the company in cash to the shareholders. Therefore, to pay dividend the following is required:

a)       Profits

b)       Actual Hard Cash

c)       Intention of the management to distribute the cash from the profits by way of dividends

Dividends by far are the most simple, real and superior valuation tool than the others. Let us see how it fares when compared to the others:

Dividends vis-à-vis Earnings

Ø       Earnings are accounting profits while dividends are real hard cash. A company with forged accounts can show higher income but may not be able to pay bigger dividends because of lack of actual hard cash for paying dividend.

Ø       Dividends are more stable as compared to earnings which can be volatile and erratic.

Ø       Earnings can become distorted during severe economic crisis. For example, during the market bottom in the US after the great depression of the 1929 to 1933, the P/E ratio of the Dow Jones industrial Average (DJIA) was 30 times. A high P/E ratio of that magnitude would reflect extensive overvaluation and considered bearish. However, the high P/E ratio in the US in the year 1933 simply reflected the abysmally low earnings and not high prices. In contrast, the Dividend Yield of the DJIA reflected the correct picture of the market’s undervaluation by surging past the 10% mark.

Dividends vis-à-vis Sales

Ø       Sales only concentrates on topline growth and not on bottomline i.e. profit growth while dividend is nothing but distributed profit to the shareholders.

Ø       Its easy for a company to manipulate its sales by selling additional goods on credit to sub-standard customers which will result in higher sales and corresponding increase in debtors but very difficult to manage dividends because it is nothing but hard cash.

Dividends vis-à-vis Book Value

Ø       Book value is a theoretical measure based on historical prices while dividends are actual hard cash paid out of current profits.

Ø       A company can have a very high Book Value but low earnings and dividends if the funds are blocked in unproductive assets while since dividends are paid out of profits, the assets of the company have to earn those profits so as to enable the management to pay dividend to the shareholders.

Dividends vis-à-vis Replacement Value

Ø       It is very difficult to accurately compute the replacement value while dividend numbers are easily available.

Ø       Replacement value can be manipulated to account for higher inflation but dividends, being hard cash, cannot be.

Conclusion

To conclude, of all the major yardsticks used to value equities, dividends by far is the most superior of all. Hence, don’t ignore dividends in the name of growth or capital gains. Whether it is life or investments, get the ground level basic right with realistic expectations, and there is nothing as real as hard cash in the form of dividends. So, the next time you ignore dividends then do it at your own peril. Therefore, the next time when you invest, do give prime importance to dividends as it is the magic wand to value equities.

The Fund that protects you from all Investment Robbers

As an investor you may face different types of challenges in the current globalize world where the markets and investments are linked. As a fund investor, your life is even more complicated when you have to select between a plethora of different funds offered from various fund houses. You have an option of investing in open ended or close ended funds or equity, debt or commodity funds and many different categories within each of them. Having said all this, which is the best category of fund in there for you? Rather than looking at the positives of each fund, I will look at the different “investment robbers” and how each fund protects and guards you against each of them. The fund which protects you of all the Investment Robbers is the Fund which we are looking for you.

Investment Robber 1: Inflation

Inflation is one of the biggest and the most silent enemy of any investor. Infact, it is that monster which many investors don’t recognize. Many people believe in “saving money” and mistake it for investment. However, they don’t recognize and appreciate the important fact that “saving is not investing”. Never mistake saving for investments otherwise you will be in for a rude shock. You would probably be living in a big delusion because you don’t understand the rules of money. The rules of money permanently altered in the year 1971 when the then US President Mr. Richard Nixon took the US off the gold standard and granted itself the license to print money. Since, then the US Dollar and other world “currencies” have depreciated while the price of all commodities measured against it be it precious metals like gold, silver or industrial metals like steel, copper, aluminum or agricultural commodities – all have gone up and will continue to go up over the long term. Hence, inflation is the Investment robber number 1 against which the fund has to protect your investments. Debt funds don’t offer any protection against this investment robber number 1 of inflation because bonds and money market instruments primarily invest for coupon interest or accrual which is not capable of protecting your money against deprecation in the value of money due to inflation because these kind of investments only offer current income and not capable of providing growth income which will shield your investments against the monster of inflation. Equity funds certainly offer you protection from inflation as they are invested in companies whose earnings are supposed to grow. Also, gold funds would offer you such kind of protection because it is an inflation edge. But then do they protect you from the other investment robbers. Read on.

Investment Robber 2: Income Tax

The Government is the biggest investment robber of all who systematically and legally takes away money from your pocket at all the stages of your dealing with it, whether be it savings, spending, investing or insuring. Most of you would be recognizing the threat provided by the taxman but would not be aware of how to actually protect your money against it. Government puts one of the biggest dent in your pocket when you earn return on your investment as it conveniently taxes it. For example, interest on a bond is fully taxable in your hands at the marginal rate of taxation. As far as mutual funds are concerned, all the debt oriented products are taxed and hence pure debt funds will not protect you from this “Investment Robber 2”. Equity funds offer you that protection in the form of tax free dividends and long term capital gain exempt from the purview of the taxman, but then do they protect you from the other investment robbers. Read on.

Investment Robber 3: Interest Rates

Another big enemy of your investments are interest rates. Infact, interest rates are such a big enemy that it affects both debt and equity investments. When interest rates rise, bonds prices fall and so does the NAV of your Bond Fund. Again, when interest rates rise, equities as a general rule fall because the earnings of companies drop due to high finance and interest cost, equity valuations contracting due to rise in the discount rate and high interest rates results in reduced fund availability for equities as debt competes with them for the same investor’s wallet. Therefore, both debt and equity funds would not be able to protect you against this investment robber 3 of interest rates. Gold would in all likelihood able to protect you from the investment robber of interest rate but would it be equally effective against the other investment robbers. Read on.

Investment Robber 4: Market Volatility

Investment robber number 4 would be “market volatility”. Prices of all market determined products, be it equities, bonds or gold, would fluctuate and remain volatile with day-to-day price movements. Yes, the price of an accrual product like a liquid fund would certainly protect you against market volatility but then it would not protect you against investment robber number 1 “inflation” and investment robber number 2 “Income Tax” as well as investment robber 5 which is to follow. So which kind of investment has the wherewithal to save and protect you against the dangerous investment robber 4 of market volatility? Read On.

Investment Robber 5: Incorrect Asset Allocation

The importance of asset allocation can be understood by only one statistical fact which Ibbotson and Kaplan have shown that 90% of portfolio variability is due to asset allocation. This means that only 10% of the variability in portfolio performance is due to individual holdings while 90% of it is determined by how the funds have been allocated. Mr. William Bernstein has said in The Intelligent Asset Allocator that “there are two kinds of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know”. Therefore, a cardinal principle of investment is, which may seem bad news to many is that, the only thing which is in your control is asset allocation because that is what you have full control on. However, neither do equity, bond or gold funds offer you this kind of protection against Investment robber number 5 of “incorrect asset allocation”. Then who indeed does? Read On.

The Fund that protects you from all Investment Robbers

And the fund that protects you from all the Investment robbers is, any guesses, it is a simple age old fund called the “Balanced Fund”. Do not believe it? Confused? Let us see how a Balanced Fund indeed protects you from all the different Investment Robbers.

Protection from Investment Robber 1: Inflation – Balance Fund invest both in equities and debt. The equity component in the Balance Fund protects your money and investment from the big silent monster of inflation.

Protection from Investment Robber 2: Income Tax – Balance Fund is treated as an “equity fund” as far as taxation is concerned and hence on one hand its dividends are tax free while on the other hand it is outside the purview of long term capital gains tax. The beauty of it is that even the “debt portion” of it becomes tax free as equity which never ever happens in any other case.

Protection from Investment Robber 3: Interest Rates – Balance Fund invest both in equities and debt. The equity component in the Balance Fund protects your money and investment from the dangerous killer of interest rates.

Protection from Investment Robber 4: Market Volatility – Balance Fund invest in both equity and debt. As explained in my previous blog on “Investment Cycle” - when one asset class is in a bear market most probably there is some other asset class which is in a bull market. Therefore, a balanced Fund, as the name suggests, balances and evens out market volatility by providing you with the best risk adjusted returns with minimal market volatility.

Protection from Investment Robber 5: Incorrect Asset Allocation - This is perhaps the most important protection offered by a Balance Fund. As explained earlier, the key to long term superior investment performance is asset allocation and what can be better than a Balance Fund which has allocation to both equities and debt. Further, it always by definition buys the cheaper asset and sells the costlier one when one asset class out-performs the other so as to bring the fund back to the optimal asset allocation. Therefore, it automatically by definition follows the most important principal of investment – Buy Cheap and Sell Dear.

To conclude, the name of the Fund is Balance but it is the most imbalance of all the funds as it takes the credit of protecting and shielding your money of all the five investment robbers. So the next time you see a “Balance Fund” don’t just brush it aside because remember that whether it is investments or life, a simple and Balanced approach always works. All the best in your Balanced approach towards investments and life!