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Coal in the Earth’s womb, govt’s false arguments
Using the principles of finance used to value assets and firms, one can build a case why Chidambaram's defence is incorrect
Union finance minister P. Chidambaram recently defended the government’s position in the Coalgate controversy by questioning rhetorically: “If coal is not mined, if it remains buried in mother Earth, where is the loss?” He attempted this defence after the Comptroller and Auditor General (CAG) highlighted the potential loss to the exchequer from the sale of the coal blocks in a recently issued report. Using the principles of finance used to value assets and companies, one can build a strong case why the defence put forward by Chidambaram is incorrect. The principles of valuation can also be used to attempt to elucidate the conceptual source for the considerable disagreement with respect to the loss numbers put forward in the CAG report.
In finance, we value an asset as the sum of two components: (i) the value of the asset as it is in its current condition; and (ii) the present value of the growth opportunities that can be created using this asset. Since the assets in question are the coal blocks that were sold to private entities by the government, the value of the assets in their current condition equals the market value of coal that has already been mined. In contrast, the present value of the growth opportunities from the coal blocks corresponds to the value that can be derived by mining coal in future. The first component corresponds to the book value of the assets. The sum of the first and the second component corresponds to the market value of the asset. Therefore, the difference between the market value and the book value of the asset equals the present value of the growth opportunities that can be created using the asset. The market to book ratio equals the ratio of the market value of an asset/company to its book value. Therefore, a market to book ratio that is greater than one indicates that the present value of growth opportunities is significant for the asset/company.
A cursory glance at the market and book values of firms traded in the Bombay Stock Exchange or the National Stock Exchange would inform us that for most companies, the market value is considerably higher than the book value. The accompanying table shows the book value, market value as well as the market-to-book ratios for the five largest listed mining companies. Gujarat Mineral Development Corporation (GMDC) Ltd is into mining of coal and lignite and is, therefore, the most appropriate reference for assessing the present value of growth opportunities in the coal mining industry. However, the other five firms are also engaged in mining and extraction of natural resources and are also useful references in this context. As one can notice from the table, the market-to-book ratios of each one of these firms is greater than one, which indicates that the present value of growth opportunities is significant for these firms. In fact, a market-to-book ratio of 2.9 for GMDC indicates that the present value of growth opportunities in coal mining may be close to double the value of the existing assets. As a result, asking rhetorically: “If coal is not mined, if it remains buried in mother Earth, where is the loss?” is incorrect. Even if coal remains buried in mother Earth, the present value of the future earnings from mining is significant. In fact, based on the above numbers, bulk of the value may lie buried inside mother Earth.
It is not hard to understand the conceptual source for the considerable disagreement relating to the loss numbers put forward in the CAG report. As any finance professional worth his salt will mention, any exercise in ascribing a market value to an asset involves assumptions. In particular, these assumptions have to be more heroic/speculative when they relate to valuing the growth opportunities. For example, projections for the future price of coal, the future aggregate demand for coal, the future market share of a particular company, among others, are necessary when one attempts to put a value on the growth opportunities. Despite painstaking research into the drivers for each one of these variables, projecting these variables will involve some assumptions. As many analysts, those many assumptions and, therefore, that many differing values ascribed to the same asset. Therefore, disagreement about the loss numbers ascribed by CAG to the sale of the coal blocks is understandable. However, ignoring the value underlying the growth opportunities is not.
Krishnamurthy Subramanian is an assistant professor of finance, Indian School of
Business, Hyderabad. Comments are welcome at views@livemint.com
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First Published:28 Aug 2012, 06:38 PM IST
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