Does value investing hold relevance in the current investment scenario?

As India’s stock markets witness a spate of IPOs (initial public offerings), it is difficult to miss the seemingly high valuations for these listings. Subscribers to many of these IPOs are some large institutions, prompting questions if they are sticking to their professed style of value investment. Indeed, many market participants believe that value investing is increasingly becoming irrelevant.

Value style of investing is the old-school way of investment based on fundamental research. Proponents of this style buy a stock substantially below its fair value and wait patiently for the stock to move towards its fair value. Benjamin Graham, the patron saint of value investing, had used metrics like P/E (price to earnings) and P/BV (price to book value) multiples as indicators of fair value to manage his fund with stunning results in the 1930s to 1950s. Critics, however, argue that these valuation metrics are unlikely to present buying opportunities now, or in future. Undoubtedly, due to the great depression in the US, stocks of a multitude of great companies had been trading at substantially below their book value in the 1930s—a scenario that seems unlikely now.

Investors with a heavy tilt towards value on the value-growth spectrum work to estimate a stock’s fair value with focus largely on the company’s assets as they stand today, and/or on earnings power in near future. At the same time, it is more nuanced than just saying that value investors buy only low P/E and P/BV stocks.

Let us look at a hypothetical company, A Ltd, that was started three years ago. Its stocks are being considered for investments by Mr VI, the value investor. Currently the stock’s market capitalization is ₹750 crore. A’s revenue was ₹100 crore in 2020 and as per VI’s high-confidence forecasts, should become ₹150 crore, ₹225 crore and ₹338 crore in 2021, 2022 and 2023, respectively. A registered a net loss of ₹5 crore in 2020 and VI expects it to deliver net profits of ₹6 crore, ₹25 crore and ₹63 crore in 2021, 2022 and 2023. A’s P/E multiples seem expensive at 125x and 30x based on expected profits of 2021 and 2022. However, VI has high confidence on his estimates of addressable market size, its growth and A’s market share expansion along with a jump in margins. He concludes that at P/E multiple of 12x on expected earnings for 2023, the stock deserves a more detailed look.

This is where the DCF (discounted cash flow) model—a potent tool in a value investor’s framework—comes handy. A DCF model works with the basic construct of finance theory that the fair value of a company is the sum of net present values of its future cash flows. In the above example, let us assume that the time period over which explicit cash flow forecasting can be done with decent visibility is six years, and terminal growth—the constant rate at which the company’s cash flow grows forever—is 2%. The DCF derived fair value is about ₹1,550 crore, i.e. about 2x the current market capitalization Further, summation of the net present values of cash flows for the period 2021 to 2026 represents about 40% of the company’s market capitalization. This is a high figure, providing further comfort to VI to explore the stock further.

Owing to lower confidence in forecasts and magnified risks, typical value investors avoid peeping too far out into future. Let us consider another company Y for which VI’s forecasts and assumptions are exactly like those for C except for some. Y has an explicit forecast period of 10 years (vs six years for C), revenue growth of 22% for first six years (vs 37% for C) and 19% for the explicit period of 10 years, and terminal growth rate of 4% (versus 2% for C). The DCF derived fair value of Y turns out to be almost same as that of A. For Y, the P/E multiple based on earnings estimate for 2023 works out to 18x. For a typical value investor, the Y stock may not make the cut. It is projected to have an elevated revenue growth profile for an extended period—something that value investors are not comfortable with. Risks are heightened further since the summation of first six years cash flows represents just about 22% of the market capitalization (vs ~ 40% for C stock). Thus, with behavioural traits like risk mitigation and less reliance on long-term forecasts, and aided by tools like DCF model. VI avoids investing in Y.

Value investors are not afraid to take counter consensus calls and can display patience over sustained periods. As against general perception that value investment is loss averse and even dogmatic, this style of investment is quite flexible, even if rule based.

Vipul Prasad is chief executive officer of Magadh Capital.