Rethink PE ratio valuation for high capex sectors like cement, specialty chemicals: Kotak analysts

Kotak analysts said that market participants should should revisit the PE valuation methodology for valuing select high capex sectors in India due to their low free cashflow to profit-after-tax

Analysts at Kotak Institutional Equities pointed out that the price-to-earnings (PE) ratio is ineffective for valuing sectors like cement, automobile tires, oil & gas, and specialty chemicals. They recommend reassessing this valuation method since earnings in these sectors do not translate well into free cashflow (FCF) or dividends.

"We should revisit the PE valuation methodology for valuing select sectors in India due to their low free cashflow to profit-after-tax, continued investment for incremental volumes and low-return businesses," Kotak analysts underlined.

The bigger concern from here on would be this valuation methology would be used for the next several years or decades given the nature of these businesses and companies.

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Cement companies, for instance, will need high capital expenditure (capex) to increase volumes, resulting in FCF lagging behind PAT due to low fixed asset turnover (FATO). Although volume growth is driven by housing and infrastructure demand, large capex will be required to sustain this growth.

Another high capex driven sector like specialty chemicals will also face a similar problem. Typically, these companies have ambitious plans that would require higher capex, eventually resulting in low FCF in the medium-term. Historically, too, they have seen low FCF/PAT ratios.

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"The current high P/E valuations of the sector are underpinned by expectations of strong FCF generation in the future, which may or not materialise once the growth phase is over due to the contractual nature of the business and increased competition over time," the analysts believe.

Apart from that, oil, gas, and consumable companies, especially PSUs that have invested in their core business will incur low FCF relative to their PAT. However, analysts believe that the return on these assets are questionable due to likely low returns from such projects, limited longevity, and doubtful terminal value of assets.

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