The art of protecting value in your holdings
The Hindu
Some signals help you spot companies that can expand valuation multiples. Here are a few...
As economies around the world enter tighter monetary cycles, it is common to see downward revisions in exit valuation multiples for companies across sectors. An exit multiple is the price-to-earnings ratio for a company estimated for a point in time in the future, that is, the multiple it would command were it to sell out or exit the business at a given point.
Recently, we saw large global institutions downgrading India’s information technology sector, wherein they had cut the target prices significantly across stocks.
A close look at the reports tells us that these institutions had lowered the earnings estimates by only up to 5%, but reduced the multiple by 14-35%. Close to 80% of the target price cut is from multiple reductions.
To mitigate such shock in our portfolio and reduce risk as part of our investment framework, let us explore the factors for businesses where potential exit multiples can expand or stay the same even during a tightening monetary cycle.
An improved balance sheet is a positive signal. When a company repays its long-term debt and moves to zero debt with higher cash balance, it potentially allows such firms to take long-term decisions and not worry about daily capital requirement. The longevity of a business goes up significantly. We have seen how important balance-sheet strength is during the recent COVID-19 pandemic.
As the quality of earnings goes up, it reduces long-term survival risk. Companies are valued based on one big assumption — that they get to survive during all economic cycles.
So, companies that have mastered one or more of the following tend to have higher survival rates: those whose percentage of recurring revenue significantly improves and crosses a major threshold; or, whose significant new sales are accomplished via on-cash channels due to improved competitive position vis-a-vis credit sale; or whose growth is balanced both in terms of geography and product; and companies that are consistently able to reduce concentration risk of the top 5 or 10 clients – this is particularly important for B2B companies whose sector is facing consolidation.
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