July 2022: Valuations at point of entry determine subsequent returns

We believe that there are two important factors which can help an investor make superior returns in equities over the long term – 1) Buying a high-quality business and 2) Buying it at a reasonable price. A high-quality business, according to us, is one which is highly profitable (as measured by return on equity), generates free cash flow, has a competitive edge (or moat) and has good corporate governance.

While undoubtedly, the quality of the business and its growth has a very large bearing on the returns that one can get from that business over the long term, ignoring the valuation at which the company is bought can lead to disastrous performance even over the long term. Take the example of Infosys which at the peak in 2000, traded at 320x FY2000 earnings. Subsequently over the next decade Infosys delivered a 10-year earnings CAGR (compound annual growth rate) of 35% per annum – but the stock delivered near zero returns from the peak price in 2000 to 2010, because the initial valuation was too high. The price one pays at the time of purchase has a large bearing on the returns that one can hope to make in a high-quality business.

There are different approaches one can take with respect to the valuation of a company. One approach is to look at absolute value – i.e. an absolutely low price to earnings ratio or a high dividend yield (comparable to 10-year bond yields), or market capitalisation less than the net current assets on the balance sheet. While this can be useful to determine a low valuation level, this is also fraught with risk, because many of the companies that trade at a very low absolute value may have a broken business model or poor corporate governance. Another approach is to look at relative valuation – i.e. a comparison of the valuation of a company with other companies in the same sector – this can help identify an undervalued company with respect to its peers. Yet another approach is to look at private market value – what is the value that a strategic buyer (an acquirer of a part stake or the whole company) places on a company. Usually the private market value is towards the top end of the valuation zone. Yet another approach is to compare the current valuation of a company with its historical valuation to determine whether the current valuation is low or high with respect to its history. We use a combination of these different approaches to figure out whether a company is undervalued or overvalued at the current market price.

One must however keep in mind, while trying to buy a company at a low valuation, that when a stock is trading at a low valuation, there is usually a reason for it – either the whole market is down, or the sector in which the company is in, is facing some headwinds, or there could be some specific issue with the company itself. It is then up to the investor to determine whether this problem is temporary in nature or whether there is a permanent damage to the business model of the company. Only when one is satisfied that the problem is temporary in nature, can one proceed to purchase the stock.

While undertaking this exercise, one must pay heed to Warren Buffett’s words “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Investors must spend a fair bit of their time looking for wonderful companies and try to pay a reasonable price for them. Over the last few years, valuations of high-quality companies have been bid up aggressively and are trading at high valuations and this is something that investors need to watch out for.