Module for Investors
Advanced Fundamental Analysis - Valuation
6. The universe outside of annual reports
The annual report of a company goes into details of the internal factors of a company. However, those are far from the only factors that influence the value of a company. There’s an entire universe outside of the internal aspects and annual reports of a company. That’s exactly what we’ll be looking at in this chapter. We’ll delve into various key external factors and try to understand how they affect a company’s valuation. So, let’s jump right in.
Current market scenario
The market scenario of the industry that a company operates in plays a huge role in influencing its valuation. The term ‘current market scenario’ here includes multiple factors such as the industry demand, the size of the market, the policies governing the industry, and the broad global scenario. Let’s break these factors down one-by-one.
If a company operates in an industry that’s currently trending or is generally considered to be in demand, its valuation tends to be higher than similar-sized companies operating in a different industry. This is purely due to the increased demand for the industry’s products and greater levels of investments that the companies operating in the said industry enjoy.
Size of the market
Similar to the industry demand, the larger the size of the market for an industry, the higher the valuation of the company that operates in it may be. For instance, if the market size for consumer durables is large, companies operating in that space may likely be valued higher.
Policies governing the industry
The policies laid out by the government can have a significant effect on the valuation of a company. If the policies are restrictive and overly controlled by the regulatory authorities, the company may not enjoy a high valuation.
Broad global scenario
The current global economic, health, social, and political scenarios contribute a lot to a company’s valuation. If any one of these factors go awry, the valuation is likely to take a significant hit.
Okay, so now that you’ve understood the effect that the current market scenario has on valuation, let’s put these factors to the test. Take the automotive industry, more specifically, car manufacturers. Although both the industry demand as well as the size of the Indian car market are both high and hugely positive, the valuation of car manufacturing companies took a hit in the year 2020.
This was primarily due to the introduction of the more stringent BS6 pollution control norms along with the COVID-19 pandemic. These two events basically dampened the current market scenario and led to a huge pileup of inventory of unsold BS4 vehicles, leading to severe losses. Additionally, the COVID-19 pandemic also completely stalled the demand for new vehicles due to widespread lockdowns and job losses. That’s how the market scenario impacts company value.
Sudden or unexpected industry events
Generally, investors dislike uncertainty and unexpected events. The onset of such events tends to derail the flow of business and almost always leads to losses and financial distress, which again leads to lower valuations. But it also would be inaccurate to say that all sudden or unexpected events would lead to a loss in valuation. There are always two sides to the same coin. While some industries may suffer a loss, others might gain under the influence of the same event.
Take the airline industry and the pharmaceutical industry for example. The COVID-19 pandemic, along with the string of lockdowns, essentially crippled the airline industry with all flights grounded for weeks to months. This led to the airline companies experiencing severe losses, since they still had to pay fixed costs such as salaries to employees, airplane leasing fees, and hangar rental fees. Most of the airlines have resorted to cutting down their expenses by laying off their employees. This single unexpected incident has led to a significant drop in the valuation of airline companies.
The pharmaceutical industry, on the other hand, has managed to not only survive, but flourish. Pharma companies have seen an extraordinary increase in their order book with a massive increase in their sales of medical products like respirators, blood oximeters, thermal scanners, and ventilators. This sudden and unexpected event has also prompted both domestic and foreign investors to invest more in the pharma industry, thereby causing a spike in their valuation.
Emergence of new competitors
Another major factor that can affect the valuation of a company is the emergence of a new competitor. Typically, new competitors carry certain significant advantages. Since they’ve had the time to adequately and sufficiently analyse the industry and the user base, they’re generally well-poised to start off with their best foot forward. Also, when new competitors enter a saturated market, they usually bring with them the latest technological advancements that allow them to operate in a much more efficient manner than the existing players.
Take Reliance Jio Infocomm Limited for instance. Their entry into the telecom sector was quite late. Still, they quickly managed to reach the number 1 spot in terms of active user base within just a span of a few years. As a new competitor with infinitely deep pockets, Jio revolutionised the telecom sector by boldly introducing cutting-edge 4G technology along with several low-cost plans and offers to attract subscribers.
The entry of Reliance Jio into the telecom space was responsible for the loss in the valuation of other telecom companies, who up until then enjoyed strong valuations and revenue. In addition to disrupting the telecom sector, Jio also ended up eroding the value of telecom companies, leading to a merger between Vodafone and Idea Cellular.
These three factors are by no means the only ones affecting the valuation of companies. However, they’re some of the most important influencers. Up until this chapter, we’ve only been looking at the quantitative side of valuation. With this, we’ve also now taken a good look at the qualitative side of valuation assessment. In the forthcoming chapters, we’ll talk about how you can build your own valuation model and some of the most important valuation ratios that investors regularly use.
A quick recap
- The market scenario of the industry that a company operates in plays a huge role in influencing its valuation.
- The term ‘current market scenario’ here includes multiple factors such as the industry demand, the size of the market, the policies governing the industry, and the broad global scenario.
- If a company operates in an industry that’s currently trending or is generally considered to be in demand, its valuation tends to be higher than similar-sized companies operating in a different industry.
- The larger the size of the market for an industry, the higher the valuation of the company that operates in it may be.
- The policies laid out by the government and the current global economic, health, social, and political scenarios can have a significant effect on the valuation of a company.
- The onset of some unexpected events tends to derail the flow of business and almost always leads to losses and financial distress, which again leads to lower valuations.
- While some industries may suffer a loss, others might gain under the influence of the same event.
- Another major factor that can affect the valuation of a company is the emergence of a new competitor.
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