Each bull market is based on its internal logic, one that seeks to explain the seemingly incomprehensible — a vertiginous rise of the markets. So the 1992 bull run had Harshad Mehta’s replacement cost theory. In 2000, Ketan Parekh spoke about the new economy and how it would cast aside the old order. This time, the bull phenomenon has a new logical framework, the esoteric-sounding ‘embedded value.’

This concept has been used to justify a rise in stock prices even as the fundamentals of the Indian corporate sector — operating margins, cash flow — are looking weaker than a year ago. So, is the market missing the woods of the fundamentals for the trees of “hazy” future gains?

Consider SBI, Reliance Industries and Larsen & Toubro. Over the past three months, these companies have seen their stock prices move up by around 50%. The reason for this sudden increase has been associated with the fact that these companies have wholly-owned subsidiaries that will contribute to the cash flows of the company in the near future and thus, need to be valued in the stock price.

A theory for the excesses?

Brokers have given a thumbs-up to the theory that they feel can explain current valuations of the Indian stock market. The theory has been gaining currency for the past two years, but it is only in the past six months that it has been quoted widely to explain the massive rise in certain stocks.

So much so that in August 2007, brokers and analysts believed the Sensex still had an upside of 20% on account of embedded value in certain stocks, which had not been reflected in the stock price. By the beginning of November, the market had moved up by 29% and had exhausted almost all of that value.

That, however, was not the end of the story. According to research reports, more than 20 stocks that are a part of the Sensex still have upsides that are not noticed by the market. Most reports are bullish on large cap stocks like ONGC, Tata Motors and SBI and believe there is still an upside for these stocks in a market that is hovering around 20,000.

Embedded or embattled?

Simply explained, embedded value is the market putting a valuation to earnings that are somewhat visible but may not be completely evaluated as they do not form the main aspect of the company’s business. Broking houses in India are seeing embedded value in many stocks.

Bharti Airtel for its towers, Bajaj Auto for insurance, ITC for hotels and paper — these are some of the companies that have assets or subsidiaries that are not valued in the mainline assets. The earnings are fairly visible to analysts or the markets and some amount of value can be attached to their businesses. The market, though, is now trying to attach embedded value to all companies — whether their earnings are visible or not.

Embedded value is calculated by doing a sum of the parts (SOTP) valuation — the stock price is divided into different businesses to arrive at valuations. While fund managers agree that the SOTP methodology itself is not a problem, the way it has been applied is. This happens when analysts try to value subsidiaries that will take a long time to show cash flows into present values of the stock price.

“The sum of the parts method should be used for understanding valuations as of today and not of the future. It has to do with today’s real numbers... If analysts are using embedded value to calculate values of businesses where earnings are not visible, then this becomes an exercise in fantasy. Embedded value is not about the future, but is about the present and those who are valuing the invisible future in stock prices have not understood this concept,” says Shankar Sharma of First Global.

The runaway value

Take, for example, Reliance. A research report based on August 1 prices stated that Reliance Industries had an upside of 25% when the stock price traded at 1,798. At that point in time, the valuation of the retail business worked out to Rs 80, which was constant for some time.

Much of the change in stock price was taking place due to the increasing value attached to the exploration and production side of the business. In the sum of the parts calculation of the Reliance stock price, the value of exploration and production had gone up by 135% in less than seven months and was at Rs 719 at the end of June 2007.

All broking firms that have brought out reports on embedded value use the SOTP method for companies whose subsidiaries will take a long time to show any business.

In October 2007, another broking house released a report on Reliance Industries where the E&P business was valued at Rs 745 and the retail business at Rs 182. Surprisingly, the retail business had a consensus value of Rs 80 in August 2007, which jumped to Rs 182 in a span of only three months, without any material change in business prospects.

According to the research report, the reason is associated with the fact that Reliance Industries has invested Rs 2,000 crore during the quarter into Reliance Retail and the “loyal customer base” has crossed the 1.5 million-mark. But the link between this and the cash-generation capabilities of the business is at the moment not very clear. After all, it’s cash the market values and not market share.

But Reliance Retail is not alone. State Bank of India is experiencing something similar. Analysts feel the AMC and insurance arm of SBI need to be reflected in the bank’s stock price. Insurance is a business where companies sell products for a long time before they actually start showing cash flows. But analysts feel the trick lies in grabbing the market share as this ensures future profits.

Based on this logic, both ICICI and SBI carry a part value of their insurance and AMC business in their stock price. The market feels the stock price should reflect the values of these businesses which are wholly owned subsidiaries. In August, the SOTP upside associated with SBI was around 44% when the price was at Rs 1,548. Today, the stock is up at Rs 2,237, capturing the SOTP valuations.

For most banks, their insurance subsidiaries are yet to have any impact in terms of profitability. Given the fact that some are gaining market share, it is important to see how relevant these market shares will be in terms of profitability. Tridib Pathak, CIO of Lotus Mutual fund considers embedded value only if the broader certainity of the business and cash flows are visible.

“People tend to go overboard. During the bull market phases, all aspects of the business get considered and during the bear market phase, even the main activity of the company is ignored by the market and stock prices lag behind. It is human behaviour,” he says.

A 'model' explanation

Optimistic research heads and analysts are running their spreadsheets again to rerate businesses. They believe many companies have changed strategies and there is an improvement in business — as a result, there should be a change in their embedded values as well. The trouble is, ‘embedded value’ is a broad concept. In many cases, even the simple revaluation of land gets carried forward in the stock price. Companies like Hindustan Unilever, which have undervalued real estates, are also getting rerated.

Shriram Iyer, head of research at Edelweiss Capital, which has worked on a report on embedded value, says as far as their report was concerned, the stocks achieved the target price mentioned therein. He feels that in a dynamic market, he will have to revisit the report to see if anything has changed for companies to revise their valuations in terms of their sum of total parts of businesses. But he agrees that barring a few exceptions, there may be no point in looking at embedded values or SOTP when the market is hovering at the 20,000-mark.

All this is reminiscent of the way markets had given internet companies large valuations in 2000. Back then, the revenues never materialised and stock prices collapsed. But then, these aren’t like internet companies. “The big problem today is that many companies who are ‘embedded value’ stars have real revenues in other businesses and hence, it is that much harder to disagree with valuation of loss-making subsidiaries,” says the India head of a multi-strategy fund.

Only visible earnings matter

Even if we agree that the business of wholly-owned subsidiaries should be valued into the stock price of the company, the fact remains that in many cases, the cash flows from these subsidiaries are not clear.

For the value of subsidiaries to be reflected in the stock price, the company should have made plans or announced the strategic sale of these assets; or there is an IPO or even demerger of these assets, and the subsidiary has a certainity of business and cash flows. When such things are not in the news, the value of these subsidiaries becomes at most speculative.

“Analyst reports clearly state that the main line businesses are expected to grow at 17-18% this financial year. That is fine. But the valuation of the subsidiaries into the stock prices and their growth rate is humongous.

Sometimes the growth rates for the subsidiaries are more than 150%. We understand the main businesses, and have no argument against the valuation of subsidiaries; thus, we accept whatever analysts tell us,” says a fund manager who does not agree with the sum of total part of stock prices or the embedded values in stock prices.

He believes these are concepts used in insurance, and there are people working overtime to apply the theory to stock prices. But Mr Iyer feels this approach to valuing companies is credible as significant value exists in balance sheets which is not near-term earnings accretive. “Some assets need to be valued separately to arrive at a fair price of the stock. It is a valuation tool and needs to be revisited all the time,” he says.

Source: ET