Second Pillar of Investing - Overvaluation increases fragility of our investment & Stock Market is not always right

Valuation of a company is like a balloon which can burst if there is too much air and on the other hand there is a lot of scope to grow if there is too little air.

I try  to invest in companies which are robust or antifragile and try to avoid companies which are fragile. I explained how to measure fragility of a company through my earlier post How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

All the fragility parameters I explained in the said post are from the point of view of a company. However, valuation of a company is an additional fragility parameter which is relevant from the point of view of an investor and irrelevant from the point of view of a company. In this post, I will try to explain about the valuation of a company which is also an equally important fragility parameter for an investor. 

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Stock Market is not always right

Does the stock market know everything and can it rightly value the company?

The answer is No. Valuation given by the stock market is like a balloon. A Balloon can have too little air and there is still a lot of scope for infusing more air into the balloon or a balloon can have too much air in which case, it can burst at any moment. Similarly, sometimes a company is undervalued and sometimes it is overvalued by the stock market. Our goal is to invest in a company when it is undervalued and exit when it is overvalued. Let me explain this using stock markets favorite meme stock ITC as an example.

As we can observe, the stock price of ITC Limited dropped from Rs 320 per share in Aug 2018 to Rs 165 per share in May 2020 and again increased to present level of Rs 396 per share in April 2023.

Now lets look at the P/E of the company during this period. P/E is one of the valuation parameters. It is nothing but Market Capitalisation of a company by Profit earned by the company. Market capitalization of a company is the valuation given by the Stock Market to a company. Profit earned by a company is like an interest earned on a Fixed Deposit. Hence, P/E ratio gives an indication of how many times the market capitalisation of a company is as compared to profit earned by a company. It does not makes sense to compare PE of one company to another company as PE should ideally be higher for high growth companies as compared to PE of a company with moderate growth.

For example, Both company A and company B earned a profit of Rs 100 Crs in FY2022. If company A is expected to grow at 15% yoy for next 10 years and company B is expected to grow 10% yoy for next 10 years, then projected profits for company A in year FY2032 will be Rs 404 Crs as compared to projected profit for company B in year FY2032 of Rs 259 Crs. While both companies earned the same profits in FY2022, their profits are projected to be different in FY2032. Accordingly, company A should ideally have higher market capitalisation as compared to company B to factor in higher growth. Accordingly, the PE of company A should ideally be higher than PE of company B.  

Can PE of the same company change over a period of time, if it is growing at the same rate yoy? I dont think so. Lets look at PE of ITC Limited in the last 5 years. 

It dropped from 35.4 in Aug 2018 to 12.9 in May 2019 and then increased to present PE of 26.9.

Look at the fluctuation of PE of ITC in the past 5 years. It is interesting to note that at a share price of Rs 320 per share in Aug 2018, the PE is 35.4 which is higher than PE of 26.9 in April 2023 at a much higher share price of Rs 396 per share. This is mainly due to increase in Profit earned by the company in March 2018 of Rs 11493 Crs to Rs 18500 Crs in the last 4 quarters i.e. from March 2022 to Dec 2022. 

Is the drop in PE to 12.9 in May 2020 justified? Look at the financial performance of the company in the last 10 years.

ITCs sales and profits have been growing yoy at a constant pace except for slight dip in profits in FY2021 which was temporary in nature due to COVID-19 related lockdowns. I believe the dip in PE in May 2020 is not at all justified looking at the strong performance of the company during the past several years. This is proof enough that the valuation given by the stock market is not always right. The company was clearly undervalued in May 2020. 

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How to identify if a company is overvalued or not?

One easy way to reduce fragility in our investment due to overvaluation is by simply investing in a company through SIP mode in which way we will be investing in the company at various points of time i.e. when it is overvalued and when it is undervalued. This way, over a period of time, our investment will be average valuation and thereby avoiding overvaluation.

However, if we are not comfortable with this strategy and would like to avoid overvaluation altogether, then let me try to explain how I identify whether a company is overvalued or not.

I try to project the profits likely to be earned by a company 10 years down the line. We need to make lot of assumptions for the same like:

1. Whether the industry is growing or at a mature stage. For example, FMCG is a mature industry in India as the Total addressable Market has already been captured. Whereas Healthcare is a growing industry as a very small population is able to get access to adequate healthcare in India.  If the industry is growing, then I give a higher growth rate for the company as compared to a mature industry.

2. Growth of industry can be limited to domestic, that is within India or can be global. For example, the IT services industry and Pharmaceutical industry grew at an impressive pace in the past few years and most of this growth is attributable to exports. On the other hand, there are companies which grew domestically without relying on exports like Bajaj Finance.

3. We can even find pockets of growth in mature industries primarily due to 2 factors, inflation and premunisation. Sale price of the product keeps increasing every year due to inflation. This inturn increases sales of the company. Premunisation is another factor with which a company can grow, for example, sales of SUVs in India are growing at a faster pace than hatchbacks. Similarly, people shifted from buying surf excel soap, to powder to liquid.

4. Another factor of growth is a company increasing its market share yoy within the industry. One example is Patanjali which clocked a turnover of Rs 30000 Crs in FY2021 as compared to negligible turnover 10 years ago whereas all other companies in FMCG segment grew at a constant pace of ~11% yoy and multiplied their sales by 3X in 10 years. 

After analyzing growth potential, industry growth, etc, we need to conservatively arrive at projected Profits after 10 years from now for a company. We need to assume a conservative terminal PE 10 years from now, like say 20 for a growing company and PE of 10 for a moderately growing company. We need to multiply the terminal PE by projected profits 10 years from now to arrive at projected market capitalisation 10 years from now. We already know the present market capitalization given by the stock market.  Projected market capitalisation 10 years from now divided by present market capitalisation gives us a multiplier from which we can arrive at the projected CAGR of our investment by investing in the company for the next 10 years. Below is the comparison table. 

Let me explain this using ITC as an example. Profits of ITC grew from Rs 7704 Crs in FY2013 to Rs 18500 Crs in current FY i.e. profits multiplied by 2.4 times. Majority of profits of ITC are from its Cigarettes division which always has the regulatory risk. To factor in the same, if we conservatively assume profits of ITC will only multiply by 2 times in next 10 years as compared to 2.4 times in past 10 years, then profits in FY2033 will be Rs 37000 Crs. If terminal PE is assumed as 15, then market cap in FY2032 should be Rs 5,55,000 Crs. Present market cap is Rs 4,91,000 Crs. Projected Mrkt Cap by present Mrkt Cap is 1.13 times which implies a CAGR of hardly 1.5% on our investment. At present market capitalisation, dividend yield is around 3%. Even if we include dividends paid by the company, the returns we can earn is 4.5%. Remember market capitalisation in May 2020 of ITC was only Rs 1,90,000 Crs. Projected Market Cap of Rs 5,55,000 Crs divided by Market Capitalisation in May 2020 of Rs 1,90,000 Crs gives us a multiplier of 2.92 times which implies a CAGR of 12%. Dividend yield was 8% in May 2020. If we include dividends also, then projected CAGR in our investment would work out to 20% CAGR for next 10 years which is a decent return. 

ITC was definitely undervalued in May 2020 as compared to present levels. I invested in ITC at Rs 180 levels in 2020 and exited at Rs 388 levels recently due to the above calculations. I may turnout to be wrong in my calculations and ITC share price can give handsome returns in the next 10 years. But, remember, error of commission is unforgivable as compared to error of omission. 

Its like we need not try to hit a sixer with each and every ball. We can choose which ball to go for a sixer.I prefer to pick easy balls for trying to hit a sixer rather than a difficult ball. At present share price, ITC is like a difficult ball to try for a sixer. 

Disclaimer: This is not a Buy/sell recommendation. I am not a SEBI registered advisor. I only tried to explain the concept of valuation in this post.

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Summary

Even if we identify a fundamentally strong company which is either robust or antifragile, investing in the company when it is overvalued introduces fragility in our investment. Hence, entry valuation is an equally important parameter while making an investment decision. And finally, No, the Market is not always Right. 

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