Reliance Industries – Why is the stock being re-rated?

Globally conglomerates trade at a discount to focused players. In India we have seen the same thing happen. But some anomalies tend to come up many times. Markets love old companies getting into new businesses. Now for an established company getting into a new business would lead to a de-rating of the stock. I am trying to base my case on Reliance’s proposed foray into SEZ, Retailing, media and a host of other ventures that appear to be very positive from the markets point of view.

Contrast this with a situation if British Petroleum or Exxon Mobil would have indicated its plans to get into retailing or property development. The stocks would have been slammed down very hard.

Analysts tend to value companies in two ways (a) The discounted cash flow method which had been a Warren Buffet favorite and (b) The EPS/ PE way. I have tried to look at how both these valuations would lead to de-rating of the stock in case of the proposed forays. Why the market remains upbeat bests me.

The discounted cash flow method: This method works on the premise that companies that throw up significant free cash flows year after year would have their stocks being valued at a Net Present value of these cash flows. So if Reliance is invest9ng Rs 25,000 crores into its retailing forays and another significant amount into SEZ’s each year the company’s free cash flow would diminish and hence the NPV of the projected cash flow will tend to come down.

The EPS/PE method: Either the company uses its own cash or takes on further debt to expand into its newer territories. In both the cases the Net profit will be adversely affected and so is the EPS. In the first case the company loses opportunity cost of capital that was earning some interest and in the second case the company bears additional cost on the debt.

The RoE and the RoCE would also decline..

Still the stock finds new buyers. This has been an anomaly that I have found too hard to decipher. Normally I would back Reliance into an SEZ and Retailing but a logical impact on the company’s financials reveals that the valuations need not increase at least till such time that the investment phase in the new business is over. Then how could Analysts argue on the re-rating of the stocks. I have two opinions:

a)       The new business is a high PE business as in the case of Reliance Industries Ltd. So while all over the world you may have a petrochemical company quoting at a PE of 10 times a Retailing venture could quote at a PE of 20 times. In the anticipation of the retailing venture going on stream analysts try and re-rate the whole PE upwards.

b)       This one is more popular and an analyst would like to include the cash flow right up to the year that it turns positive and then discount it back to present value. The net result would be an increase in the NPV.

While the exact methodology is very difficult to understand the fact is that existing companies getting into new ventures get their stocks re-rated and then the company is classified as a conglomerate. After a while the stock   is de-rated downwards because conglomerates enjoy lower discounting. After that the company announces a de-merger and the stock gets re-rated again! Can some one throw light on what actually happens?

Yes, i agree but I am trying to raise a point that probably has various explanations one of them being that the market is looking ahead and not into the immdediate future. this is so because in the immdediate future the return ratios /cash flows and everything will be adversely impacted.