Investors should not be “too hung up on the number” or valuation multiples, says SBI MF’s R Srinivasan

SBI MF's R Srinivasan emphasised that likes to buy stocks with sufficient “margin of safety.”

Valuations are way beyond price-to-earnings and price-to-book multiples, and investors should not be too “hung up on the number”, pointed out the chief investment officer – equity of the country’s largest fund house.

“A 55 PE stock may be cheaper than a 10 PE stock, depending on how your (investing) thesis fits into that (a cash-flow model),” he said, in Moneycontrol’s weekly show The Wealth Formula.

Watch the full interview: The secret to buying small-caps, thinking probabilistically and much more | The Wealth Formula

To make his point on valuation, he pointed to Ashwath Damodaran’s suggestion in a book on putting an investing thesis into a cash-flow model, “which is very different for different businesses”.

“You will have a three-year second stage for someone. We have a 20-year second stage for certain businesses like, for example, DMart or P&G Hygiene. That is what defines whether… so a 55 PE stock maybe actually cheaper than a 10 PE stock depending on how your thesis fits into that,” he said.

According to him, if an investor sees both return on capital employed and growth, then he/she needs to look beyond valuation multiples.

“It is an amazing combination (good return on capital employed and good growth) because… what is valuation? PE multiple is effectively (a function of) growth, cost of equity and return on capital. If you kind of reduce that, its growth and the spread over the cost of equity. So, you get a combination of both and you are really super confident, then that's something to bet on,” he said.

Explaining further, Srinivasan said, if you are confident about the right to win of that business, and expect some longevity, then you allow yourself a longer second stage (in the discounted cash-flow model), and “the reason for a (longer) second stage is terminal is just one number”.

He said, “But that differs from business to business. So for somebody like DMart, who has executed so well, probably one of the best business models in terms of what they've delivered so far, except the last few quarters or what the management has done, you have to give it a higher second stage or P&G Hygiene for that matter where there is a huge confidence on volume growth, which hasn't played out though in the last three to five years… I'm just saying you give yourself a long rope when you do your DCF based on your thesis.”

Srinivasan then compared stocks in cyclical and secular businesses, to explain why you shouldn’t be “too hung up on the number (valuation multiple)”.

Also read: How the CIO of the country’s largest MF house hit pay dirt and lost his shirt betting on probabilities

“When you're looking at a cyclical business compared to when you're looking at a secular business, let's say Hindustan Lever compared to Tata Steel, Tata Steel is inherently less predictable. The way you look at Tata Steel will be different from the way you look at Hindustan Lever. If you try to do a DCF, you'll just put it in the garbage. There, you have to time the cycle. You can't give it a huge second stage and assume that there will be growth compounding etc. Whereas in the Hindustan Lever (or consumer-staples business in general), you can safely assume that it will grow for a long time,” he said.

Yet, Srinivasan emphasised that likes to buy stocks with a sufficient “margin of safety.”