Valuation theories

“… the problem was not that no one cared about intrinsic value. Rather, by the late nineties it seemed that few even believed in the concept.” From the book “Bull” by Maggie Mahar

A classical sign of a raging bull, when the old valuation theories are thrown out of the window and new justifications are being presented – and these are justifications of the current situation only.

Read the chapter “On Valuation” for further details …



Cycle is the destiny

This is what the history of financial markets suggests. Cycle is the destiny. Cycles are destined. However, one tries – and that includes large corporate houses, or banks or financial institutions, or regulators, or governments – one cannot change the destiny. At most, one can only delay the inevitable.

Cycle is the destiny

Lessons from Unicorn valuations

Read a nice and very relevant post by Joe Duran titled What unicorns can teach you about increasing your firm’s value.

There are a few things that he has talked about. I would like to draw your attention to the valuations some of the financial firms have received.

  • Betterment: After 8 years in business has estimated gross income of $ 10 million and valuation of $ 700 million. Invested capital: $ 205 million
  • Personal Capital: After 7 years in business has estimated gross revenue of $ 17 million and valuation of $ 425 million. Invested capital: $ 170 million

Betterment’s valuation is roughly 70 times the annual gross income, whereas Personal Capital’s valuation is roughly 25 times annual gross income. We are talking about gross income and not net profits.

People argue that this is not about the current revenue, but about the future potential. They could be right. I just don’t know and I am skeptical.

The argument about the future reminds me of the following paragraphs from the book:

Nicholas Barbon argued that “things have no value in themselves, it is opinion and fashion which brings them into use and gives them a value.”

Harshad Mehta argued that the price of a share is a function of the market’s perception about the future and not the past.

Enjoy while the game is on. Have faith in the future, but be cautious.

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Timing the market or buying cheap?

A few days ago, we wrote a blog post Timing the market …. I got a call from a friend, Priyesh Sampat, who read the post and had a question. He asked about a certain strategy adopted by some financial advisors, which changes the allocation between equity and debt based on the P/E ratio (or P/BV ratio) of the market. Even some fund houses have schemes that change the allocation between equity and debt based on certain valuation parameters.

I did not refer to such a strategy, which I would call tactical asset allocation strategy based on market valuations. Market timing generally means getting completely out of a scheme or an asset category based on a negative view. In case of tactical allocation, one would change the allocation but not reduce the same to zero.

Here is an excerpt from the book that talks about the relation between valuation at the beginning and the next five year returns:

Stock markets have enormous amounts of data and hence we decided to take an example from that market. We have taken the PE ratio as an indicator of valuation and the Nifty Total Return Index as a proxy for the equity asset class.

The PE ratio is derived by dividing the current market price of a share by the profit per share of the company. Since both these are mentioned on a per share basis, one can also calculate the PE ratio by dividing the company’s market capitalization by the profit generated by the company. The higher the ratio, the more costly the share; and lower the ratio, the cheaper the share.

The PE ratio is a function of too many parameters in case of a company and hence it is very difficult to generalize the above line while comparing two different companies. At the same time, when we are looking at a broader (diversified) index, the PE ratio could act as an indicator of valuation of the overall market or a segment of the same. Over the last two decades, since the inception of the National Stock Exchange, the PE ratio for the index has moved between roughly 9 at the bottom to 29 at the top.

The Nifty Total Return Index (TRI) is constructed using the same composition as the CNX Nifty Index, with the dividends paid by the companies reinvested in the index. Thus, the Nifty TRI could be helpful to calculate the total returns generated by the index – the sum of both the change in the index value plus the dividends thereof.

Below is a graph of the 5-year return from the Nifty TRI against the Nifty PE ratio at the start of the investment period.

PE ration vs future returns

(Source: Nifty TRI and Nifty PE ratio data from

It is clear from the above chart that investments made at lower valuations have generally delivered higher returns. However, if the investments have been made at high PE ratios, the future returns have been lower.

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Timing the market …

Who says timing the market is impossible? Look at the behavior of most of the investors and you will be amazed to see their impeccable sense of timing: Consistently, they buy high and sell low.

Read the excerpt below from the book, “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

If the market valuations are high, an investor would be better off having a lower allocation to equity and vice versa. Let us check this with the reality. Do investors at large follow this rule? Some of the data points are presented here for a quick check on the above.

During the quarter of December-2007 to February-2008, the Sensex was at around 19,000 points. It was in the same range in the quarter of July-2013 to September-2013. However, in the first period, investors across the country invested close to Rs. 25,000 crores in equity mutual funds, net of redemptions. In the second period, mutual funds saw an exodus of Rs. 3,600 crores after adjusting for purchases. Subsequent to the huge inflows, the Sensex went down from 19,000 to 9,000; whereas after the huge redemptions, the same went up from 19,000 to 28,000. If the investors were right as a group, the reverse should have happened. (These numbers and periods have been taken randomly. To put things into perspective, compare the Sensex level with the net flows in equity mutual funds).

Buy high, sell low seems like the mantra that people follow on average. However, as logic would suggest that mantra would be the surest road to disappointment, if not ruins.

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Valuations in the new era

In 1934, the great investment theorist Benjamin Graham wrote of the pre-1929 stock bubble:

Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

(Source: Four Pillars of Investing – Lessons for building a winning portfolio by William Bernstein)

William Bernstein writes further in “Four Pillars of Investing”, “Even the most casual investor will see the parallels of Graham’s world with the recent tech/Internet bubble. Graham’s $100 stock sold at 40 times its $2.50 earnings. At the height of the 2000 bubble, most of the big-name tech favorites, like Cisco, EMC and Yahoo! Sold at much more than 100 times earnings. And, of course, almost all of the dot-coms went bankrupt without ever having had a cent of earnings.

To see a similar pattern across time periods, across geographies and across asset categories, read the chapter on “Valuation” in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”. There were cases of such ridiculous valuations in real estate stocks in India in 2007-08, real estate prices in Japan in the 1980s, tulip bulbs in Amsterdam, technology companies in the 1999-2000 – such events have occurred at an amazingly high frequency.

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Intellectual and emotional level understanding

On an intellectual level, most investors have no trouble understanding the notion that high past returns result in high prices, which, in turn, result in lower future returns. But at the sam time, most investors find this almost impossible to accept on an emotional level. By some strange quirk of human nature, financial assets seem to become more attractive after their price has risen greatly. …

… If prices fall drastically enough, they become the lepers of the financial world. Conversely, if prices rise rapidly, everyone wants in on the fun.

William Bernstein wrote in “The Four Pillars of Investing – Lessons for building a winning portfolio”.

Eventually, it’s all in the mind. The value of an asset is always in the way it is perceived. When you think of market price, it often gets misleading. The crowd sets the prices of the assets and the crowd depends on the same. This often becomes a vicious or a virtuous cycle. The crowd leads itself astray.

Here is an excerpt from the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

Speculative euphoria as the Pied Piper

Large-scale speculation in any asset is a recurring phenomenon. History suggests that every now and then, we will witness euphoric activities – the asset may change, the people may change, the place may change; but there will always be some such events at an amazing regularity.

This is the period when common sense takes a back seat. Incidentally, the current indicators, all point in only one direction – that of the current momentum. The Pied Piper of speculation is at work. Just like the story above, the music is heard only by those who get into the spell of the market and they cannot control themselves from following it. In the story, the Pied Piper took the children to the other side of the hill never to return. In real life, the Pied Piper of speculation takes investors’ money to the other side of the mountain (called expensive markets).

People chase the hottest fad assuming that this is never going to end. The immediate past is extrapolated into infinite future.

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