How should one value an Indian business that gets a sizeable chunk of its revenues from an overseas subsidiary? Should a multiple be assigned to the company’s consolidated earnings or should the overseas business be valued separately and added to the valuation of the parent company’s domestic business? As far as the markets are concerned, the answer to that depends on whether you’re in a bear market or a bull market.
The two different methods can throw up valuations that are drastically different, especially when the overseas arm is incurring losses or is operating at much lower profit margins and has weaker prospects. A case in point is Tata Motors Ltd, where the overseas subsidiary, JaguarLand Rover is running losses and has far weaker prospects compared with the company’s domestic business.
In such cases, the overseas arm not only pulls down consolidated earnings, but would also cause analysts to assign a relatively low valuation multiple because of its weak prospects.
Graphics: Ahmed Raza Khan / Mint
If the overseas subsidiary accounts for a majority of consolidated revenues and capital employed, it can materially influence the firm’s overall valuation if the consolidated method is followed.
The markets are fine with this form of valuing these companies in a bear market. But when there’s a rush of liquidity into the markets, as in the past few months, brokerage houses discover that using consolidated earnings can be a constraint. There’s a limit to which they can upgrade earnings and the consolidated valuation multiple.
The sum-of-parts valuation method removes this constraint. Brokerages have discovered that they can easily increase their share price targets significantly without having to raise their earnings estimates in a proportionate manner. The overseas arm can be valued separately and assigned an insignificant value or maybe even zero value—as long is doesn’t have a negative contribution. In some rare cases, a negative value has been assigned to a loss-making overseas unit, but even in those instances, the overall value isn’t affected much.
Meanwhile, stripped off the baggage of a loss-making overseas arm, the domestic business can be portrayed in its full glory and a higher valuation multiple can be assigned to this part of the business.
Many brokerages have used the sum-of-parts method for companies such as Tata Motors, Tata Steel Ltd and JSW Steel Ltd to downplay the pain faced by their overseas subsidiaries. JSW’s US operations are running at about a 15-25% capacity utilization, leading to losses. The company’s domestic business, meanwhile, is doing much better and can justify a higher valuation multiple. Analysts have been attempting to downplay the losses of the US operations, but it must be noted that a large chunk of the company’s capital employed and debt is owing to the US operations.
Holding companies such as Mahindra and Mahindra Ltd have been valued based on sum-of-parts for some time now, but the holding company discount assigned by analysts has reduced considerably in the past few months. Earlier in the year, some brokerages had assigned a discount of 30-40% for the value of the company’s holding in listed firms such as Tech Mahindra Ltd. This has now narrowed to about 20%. According to a fund manager, all this is done by analysts only to justify a higher target price.
The point is such methods of valuation become popular when there’s a rush of liquidity to the markets. That should act as a warning bell for investors.