Similar P/E for cement & IT 'extraordinary': Kotak Institutional Equities

Brokerage says IT services firms score over cement on key parameters such as return on average capital employed, free cash flow to Ebitda ratio, dividend, and buyback payouts vis-a-vis PAT

Many stocks in the cement sector are trading at similar valuations or higher valuations to companies in the information technology (IT) sector, which domestic brokerage Kotak Institutional Equities (KIE), finds “quite extraordinary.”

“It seems that the market is either applying different valuation principles to the two businesses or assuming the two businesses are similar. The latter is certainly not true given the cyclical, commodity and capex-intensive nature of the cement business versus the high return on capital employed (RoCE) and high cash-generation nature of the IT services business. The former may reflect anchoring bias,” say strategists at KIE led by Sanjeev Prasad.

The brokerage highlights that IT services companies score over cement firms over major financial parameters such as return on average capital employed (RoACE), free cash flow (FCF) to Earnings before interest, taxes, depreciation, and amortisation (Ebitda) ratio, dividend and buyback payouts vis-a-vis their profit after tax (PAT) and also net profit growth.

“The top four cement companies have had an average RoACE of 11 per cent and an FCF-to-EBITDA ratio of 38 per cent, while the top-5 IT services companies have had an average RoACE of 41 per cent and an FCF-to-EBITDA ratio of 57 per cent over FY2013-22,” KIE report states.

So what explains the cement sector’s valuation premium? Market experts say that current valuations are more or less in line with historical valuations for cement stocks such as ACC, Ambuja Cements, Shree Cement and UltraTech.

KIE says that the argument that historical multiples justify high valuations has two flaws.

“Cement companies’ multiples are lower on an ex ante basis compared to forward multiples on reported EBITDA/EPS, as earnings of cement companies eventually turn out to be lower than consensus estimates,” it says. And second, “the fair value of any company (different from price) is based on discounted cash flows of the future, which, in turn, depend on several variables related to the future. The past or past multiples have little relevance in the valuation of a company/stock on a first-principles basis.”

So how does one value cement stocks? KIE says fair value for cement stocks would be between 6 and 8 times of enterprise value to Ebitda (EV/Ebitda).

“We see 6-8X EV/EBITDA multiple on normalised EBITDA as a fair multiple for a cyclical, commodity business, based on a 10-12 times FCF multiple and a 60-70 per cent FCF-to-Ebitda ratio. We note 10-12 times FCF as a reasonable ‘normalised’ valuation of cyclical businesses based on 12 per cent weighted average cost of capital and 2-4 per cent growth in perpetuity (inflation),” KIE says.

Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd