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Just about a year ago, the rumour mills were working overtime, leading to speculation about the survival of ICICI Bank. This was soon after the global economiccrisis hit the Indian shores and ICICI Bank owned up to subprime losses. After it announced the extent of the losses, the banks share price went into a tailspinas panicky investors started offloading their holdings. Within two months, the share price crashed from Rs 650-700 to Rs 310. The fall may have seemed scary, but not to analysts and brokerages, who upgraded their rating of the bank from underperformer to buy in October 2008.

What prompted the upgrade in the midst of a downturn? The answer lies in the value of the stock. As the stock corrected to Rs 310, analysts found that the pricewas lower than the market value of the banks investments, or the book value perstock. If we factor in the worst case scenario and erode the entire non-government foreign investments from our target price, our rock bottom valuations are at Rs 445, say Prabhudas Lilladhers banking analysts, Abhijit Majumder and Bharat Gorasiya. On an average, analysts valued the bank at Rs 440 per share (book value).

Given the fact that bank shares usually trade at two times their book value, ICICI Bank soon became the most favoured stock. The stream of upgrade calls were not wrong. Since then, the stock price has more than doubled to Rs 755 and is currently around 1.5 times its estimated 2009-10 book value.

This case offers an important lesson for equity investors - get the price right.No matter which stock you invest in, the cardinal rule is not to overpay.

Yardsticks to Value Stocks in Different SectorsIndustry

Best measure of valueAuto Price to Earnings (PE) multipleBanking PE and Price to Book Value (PBV) or Adjusted PBV multipleCement PE, Enterprise Value to Earnings before interest, tax, depreciation & amortisation (EV/EBITDA), EV/tonneEngineering Forward PE, which reflects the order book position of the companyFMCG PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratiosReal Estate Net asset value (NAV), which is book value at market prices. Also look at debt levels

Telecom* PE and DCF, because there is a future stream of cash flows for upfront heavy investmentOil & Gas Residual reserves of energy assetsTechnology Trailing PE and its growth* Includes utilities

Unlike fixed income options, such as bank deposits, where the returns are guaranteed, the performance of equity investments is determined by the purchase priceas well. Once the stock is bought, there is very little that retail investors can do apart from buying more or selling them. So, if they invest at the right price range (or low valuations), the probability of earning greater returns is higher.

Valuation toolsHow do you know you are paying the right price for a stock? The answer is to check the target investment using a couple of financial parameters. Depending on thenature of the business and the sectors growth prospects, an appropriate tool must be used to value the company, says Hitesh Agrawal, head of research, Angel Broking. This tool is the ratio or financial metric that determines the value of a stock.

Unfortunately, there is no single tool for all industries and stocks. One ratio cannot be applied blindly to value stocks across sectors, says Manish Shah, associ

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ate director, Motilal Oswal Financial Services. This is due to the inherently different nature of businesses. Broadly, there are two valuation metrics: PBV (price to book value) and PE (price to earnings). The former calculates the value ofassets and the latter determines the price investors are paying for the companysearnings per share. A high growth, low capital-intensive company must be valuedon PE, whereas the PBV or the replacement value is the appropriate tool to value capital-intensive businesses.

Another ratio that takes care of the debt leveraging aspect across companies isthe EV/EBITDA (enterprise value/ earnings before interest, tax, depreciation andamortisation), or the enterprise multiple. But, as Agrawal says, it is always advisable to consider two or three valuation tools before taking an investment decision.

The tools that apply to different sectors and industries vary. Cement manufacturers are best valued using EV/EBITDA, real estate firms using NAV, while engineering companies can be valued using forward PE (see graphic). The PBV is used forcapital-intensive businesses like banks and power companies.

Public sector bank stocks are attractive when they are trading below their bookvalues. For a private bank, depending on its size, the ideal PBV ratio is around2. In case of FMCG companies, the PE multiple is a better yardstick because these companies invest upfront in building brands and facilities and derive the earnings in subsequent periods.

What Impacts Stock Valuations in SectorsIndustry

Best measure of valueAuto Volume growth, realisations, operating profit margins, new product launchesBanking Loan growth, non-performing assets, net interest margins, CASA ratioCement Dispatches, operating costs, regional demandsupply equationEngineering Order book inflows, execution skills, marginsFMCG RoE, RoCE, margins, volume growth, new products, marketshareReal Estate Debt levels, liquid assets, inventory levels, promoters ability to raise funds

Utilities/Power Project costs, plant load factors, raw material costs, debtequity ratiosTelecom Revenue per user, growth in usage, new subscribers, non-wirelessrevenues, EBITDAOil & Gas Reserves, efficiency ratios, free cash flow generationTechnology Order inflow, ability to contain costs, service verticals, profitability, client attrition

Comparing with peersAfter deriving the book value, a peer group comparison is needed. Always conducta peer analysis. Consider the sectors potential and see how the company compareswith its peers, says Sonam Udasi, vice-president, Brics Securities.

However, peer group valuation has its own limitations. The target companys valuations might be lower than the benchmark or industry average due to constraints regarding market share or economies of scale, and it might continue trading at a discount. Infosys, which is considered to have superior margins and a high-yielding business portfolio, has always traded at a premium to Wipro, Tata ConsultancyServices and the information technology industry as a whole.

One also has to look at the reasons for the valuation discount versus the benchmarks. Most likely, there is a good reason for the discount. For instance, if a company can address adverse issues going forward, the discount will narrow and the

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stock valuation will improve. If it fails to do so, then the stock will continue to trade at a discount to its peers, says Udasi.

To refine the research process further, comparing the efficiency and return ratios of the stock with the industry or benchmark would help investors take informed decisions. In case of banks, the loan growth, net interest margins and the rise in bad loans can help find the right stock. Likewise, FMCG stocks can be sorted on the basis of return ratios like the return on equity (RoE), return on capital employed (RoCE) and the companys operating margins.

How does an investor find out if a particular valuation method is a good parameter? According to Macquarie Research, the valuation parameter is considered good if the sector consistently shows increasingly strong returns from progressively lower levels of the valuation metric, and increasingly weak or negative returns from progressively higher levels of the valuation metric.

Sustainable growthThe sustainability of the earnings momentum is crucial because all the financialparameters or metrics are based on this presumption. The valuation of the financial parameters needs to be done on expected or estimated earnings potential andgrowth. This is the most difficult and critical part for any analysis, says D.D.Sharma, senior vice-president, research, Anand Rathi Financial Services.

Apart from comparisons with benchmarks, the management quality, transparency, ea

rnings growth and earnings volatility are key factors for driving the valuationsof a stock. Any change in these factors will re-rate or de-rate a stock. So, a standalone comparison of a stock with its peers or benchmark indices will not help much. Look for a change in the earnings potential, growth or management for are-rating trigger, says Sharma. Hence, a company that is currently not earning profits cannot be valued at zero or close to zero.

A typical example is dishtv. The direct-to-home cable service provider is stillin the investment process and is not making a profit now. The loss-making company is currently trading at Rs 42. This is because it is developing a business, which will earn significant profits in the next few years, says Sharma.

The bottom line

Clearly, valuations are not static, but dynamic. Depending on broader factors, such as market sentiment and sectoral preference, these change with time. A stockthat trades at a discount to benchmark valuations, but shows superior earningsgrowth rates and scores better on operational efficiencies, can be a good investment pick. Investors should use the valuation methods mentioned above to zero inon the stocks that have value, while avoiding the ones that trap them by appearing to offer value.