Wednesday, October 20, 2010

Forecasting equity prices in turbulent times

The markets have been very volatile over the past few years. Investing in these times has been fraught with risks. In such a market, it is very difficult to make investment decisions based on valuation models. Almost always these models indicate that stocks are over priced. Equity fund houses are adding to the confusion with their near-random buy-sell ratings. There seems to be little logic behind these recommendations.

However, there is a method wherein we can logically explain the variations in valuations. We can look at equity prices as composed of two components, a value component and an asset inflation component.

Value component can be expressed as a price band based on fundamental assumptions. The output of most models is usually a price band. These assumption are dependent on the company and economic situation. As we tweak these assumptions for a base case, bull case and bear case we end up with a price band. The price or value is based on various valuation models such as sum-of-parts, residual income, etc. Normally, prices should vary within these bands and the inflation component should be bare minimum. However, in recent years the prices have moved out of the valuation range.

The movement is because of asset inflation because of the high liquidity being pumped into the market. Those are not the only reasons and each market has a different variables that influence the asset inflation for that market. The role of equity analyst, therefore, also includes forecasting the expected asset inflation. From a first principles, in a market influenced by foreign capital flows, average daily volume should be a good indicator. For example, in India, the asset inflation component for large cap stocks with high volumes could be to the tune of 35-40%. For mid-caps or firms out of favour the range may be 20-30% while small caps may have inflation factor of 10%. As the global picture changes, the macro analyst can thereafter adjust the asset inflation component at the country level. I believe this is a better way to present equity research prices.

Let us take an example.  Let us say that the value component for stock like Bharti Airtel comes to INR 300 per share. Now telecom as a sector is a little out of favour and the inflation factor for Bharti Airtel would be lower than usual 35-40% for large-cap stocks. Let us say it is 20-25%. Therefore, the expected price range for Bharti Airtel will be INR 360-375.

Long Bharti