Distorted valuation methods hide true value

DURING the height of the pandemic a few years ago, in a column entitled “Valuation is an Art” published on March 13, 2021, the valuation method deployed by analysts came under the radar due to the once-in-a-lifetime rally that was seen among Malaysian glove manufacturers.

Back then, analysts used two distinct methods in valuing them, and they were the discounted cash flow method as well as the traditional price-to-earnings ratio (PER) method.

Both methods were also criticised then, as the valuation parameters applied by analysts were seen as being dictated by the market price of the glove stocks.

While analysts tend to value a stock based on observed market price, as seen in how valuation parameters shift to justify a buy/sell call, there is another emerging trend that seems to be flawed.

This is the usage of the price-to-book (P/B) method to value a company, more so in the glove sector, where the sector itself is in a wider export-based manufacturing industry.

The P/B method

It is a well-known fact that the P/B method is an appropriate valuation method for companies in the financial industry such as banks or insurance companies.

The reason behind the P/B method for the financial sector is that their balance sheet represents assets that are significantly liquid and are valued based on mark-to-market valuations.

Typically, banks or insurance companies are valued at a premium, as observed recently in the sale of a 30.95% stake in Maybank Ageas Holdings Bhd by Ageas Insurance International NV to Maybank at 1.98 times.

The P/B method is also an appropriate method to use during times of distress or when a company is loss-making, especially when an industry is going through a rough patch, where the book value provides a basis for valuing a company.

The problem

The P/B method has a fallacy, as the net asset value of a company is dependent on its dividend policy.

Assuming two companies have a similar net asset value of RM500mil each and both companies are able to generate a net profit of RM70mil a year.

A company’s dividend policy will have a significant impact on how the net asset value grows in the future.

For example, let us assume Company A pays 100% of its earnings as dividends and Company B pays RM20mil as dividends.

For Company A, the shareholders’ funds will be stagnant, while Company B’s shareholders’ funds will rise to RM550mil as RM50mil is added to its reserves.

Hence, since the P/B method is deployed, and if these two companies are valued at two times, Company A will be valued at RM1bil, while Company B will be valued at RM1.1bil.

Does this mean that Company B is more valuable than Company A, or should different P/B ratios be used to measure the two companies?

Hence, valuing a company based on P/B must take into consideration the dividend policy that is being adopted.

Literature has also shown that there is a positive correlation between P/B and return on equity (RoE).

Hence, companies like Public Bank and Maybank do trade at a premium to the overall sector averages due to higher RoEs.

A company that pays out much of its earnings as dividends tends to have better RoEs.

The discount

There are no right or wrong answers when it comes to valuing a company based on a certain discount to its “fair value”, especially when it comes to the P/B method or, in the case of property companies, using the realisable net asset value (RNAV) method.

The best approach to the appropriate discount is to use the historical trend in terms of the observable market price and the P/B or RNAV value.

The difficulty lies when an analyst changes this discount and applies the discount arbitrarily.

How does one justify changing a 30% discount to 20% or to 40% or 50% without quantifying why the change necessitates the different discounts?

Hence, an analyst ought to quantify why a certain discount level is used and not simply change the parameters.

For example, if there is a 10% increase/decrease in the discount rate, there must be a reason attached to it, and that reason must be employed universally to all property companies.

It is difficult to justify an analyst call on the property sector if five companies are valued at different discounts to RNAV.

Another fallacy is valuing a conglomerate with a property segment exposure, while the sum-of-parts method is appropriate, the property segment must be valued uniformly with other similar property companies with an appropriate discount.

Not appropriate

The use of the P/B method is clearly not appropriate when an industry/sector has turned around, allowing companies to return to the path of profitability.

Hence, in the case of the glove sector, it has been a while since these companies have returned to profitability, and valuing them on the P/B method is no longer appropriate.

In the case of the property sector, another common fallacy recently has been the incorporation of landbank sales as part of earnings forecasts.

For property companies, landbanks are a core component and asset to be developed over time, and hence, any sale of a landbank is almost unpredictable and one-off.

Incorporating them into earnings estimates distorts normalised earnings and should not form part of earnings forecasts.

Blowout multiples

In the era of tech, artificial intelligence (AI) and semiconductor booms, revenue, cashflows or even earnings multiplier has taken a quantum leap into the unknown, especially after Space Exploration Technologies Corp, or SpaceX, got listed in June.

Valued at US$1.77 trillion at its initial public offering, SpaceX was valued at close to 95 times financial year 2025 revenue.

Of course, SpaceX is a high-growth company, and analysts have built-in strong expectations in terms of growth and earnings into the future to justify the high valuation for a loss-making firm.

With AI, tech stocks too have gotten a new lease of life in recent times, with even companies listed on Bursa Malaysia getting blow-out valuations with high PER multiples.

Valuing some of these companies north of 30 times or 40 times PER is getting too common.

A word of caution is in order, as any multiples beyond a certain threshold will be tough to justify if the earnings growth does not match.

As a rule of thumb, a stock is only cheap if its future growth is at a higher rate than the PER multiple used to justify its valuation.

Based on the above examples, while one understands that valuation itself is an art and no two analysts will be valuing the same company based on the same valuation matrix, there must be justification as to why a valuation method is used and how the change in the company’s and industry’s fundamentals impact the valuation itself.

In the case of high-growth companies, the PER multiple must be justified with the expected growth, as a company cannot be valued at a PER-to-growth multiple beyond 1.0 times as it is unrealistic.

Distorted market valuation methods can hide a true fair value of a company, and analysts should not be simply chasing stocks, as markets and investors can be irrational.