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We often come across a lot of different financial ratios with complex names and become confused about the kinds of metrics to use when analyzing different companies listed in the stock market. In this article, we will discuss how to analyse the debt and valuation of a company (by using Tata Steel as an example).

Understanding Debt and Valuation

Debt refers to the total amount of money that a company owes to external creditors or lenders. It can arise from various sources, including loans, bonds, lines of credit, and other forms of borrowing. When a company borrows money, it agrees to repay the borrowed funds over time, often with interest. Companies take in debt for financing operations, expanding their business, investing in new projects, acquiring assets, or managing cash flow fluctuations. Debt can be an important tool for companies to raise capital and achieve their growth objectives. However, it also comes with the responsibility of making regular interest payments and eventually repaying the principal amount borrowed.

Meanwhile, valuation means finding the real worth of a company. Market participants use it to determine the price they are willing to pay or accept when selling a business. Thus, value investing is based on the true value of a business compared to its market value.

The market value of a business is the worth that the market assigns to it. To calculate the market value of a publicly traded company, multiply its share price by the number of outstanding shares.
Intrinsic value is the true and accurate worth of a company. It is the anticipated or calculated value determined through fundamental analysis.
If the market value of a company is higher than its intrinsic value, then the stock is currently overpriced or overvalued. On the other hand, if the intrinsic value of a company is lower than its market value, then the company is undervalued.

Debt Analysis Ratios (Leverage Ratios)

For a company, debt (leverage) is like a double-edged sword. They can scale their business and improve sales with the help of debt funds. However, if not used wisely, the interest to be paid for these borrowings can eat up the company’s profits. It could also lead to a crunch in the cash reserved for future operations.

The following are the different types of leverage ratios:

1. Debt-to-Equity Ratio

Equity is the value attributable to the shareholders of a company. It is calculated by subtracting liabilities from the value of the assets. The debt-to-equity ratio tells us how much borrowings are present in a company compared to its equity.

Debt-to-Equity Ratio = Total Debt/Total Equity

We can find the total equity of a company in its balance sheet. By adding the borrowings from the current and non-current liabilities, we get debt. For Tata Steel, the ratio stood at 0.76X in FY23, which means that for every ₹1 equity in the company, there exists ₹0.76 as debt. A higher Debt-to-Equity ratio indicates a higher amount of debt compared to equity.

From the graph shown above, we can conclude that Tata Steel has been able to reduce its debts, although it has increased slightly this year. The company’s Debt-to-Equity ratio is also aligned with the industry average. We can also conclude that the steel sector is capital-intensive, and each manufacturer has to raise funds through debt to conduct its operations.

2. Interest Coverage Ratio

The interest coverage ratio helps us to know how much the company can earn with respect to its interest payment. It is also known as the debt service coverage ratio.

Interest Coverage Ratio = Earnings Before Interest & Tax (EBIT) / Finance Cost

To calculate EBIT, we add Finance Cost (listed as an expense) to the Profit Before Tax (PBT). For Tata Steel, the Interest Coverage Ratio stands at 5.29, which means for every ₹1 paid as interest, the company can generate ₹2.29 as revenue. A decreasing interest coverage ratio tells us that the company does not generate enough revenue to service its debt.

In the graph above, Tata Steel’s interest coverage ratio was higher than peers in FY22 but fell to the industry average in FY23.

Valuation Ratios

As stock market investors, it is always ideal to buy shares of a company when it has a cheaper valuation. Valuation is the process of determining the true value of an asset or company. For example, the real estate prices of a particular plot surge when there is an announcement of a new township or tourism project. The ones who bought the plot earlier at a cheaper rate tend to enjoy the higher valuation of the property.

Similarly, investors can measure the valuation of each stock they invest in.

1. Price-to-Earnings (P/E) Ratio

The Price-earnings ratio gives you an insight into how much the stock market participants are willing to pay for the stock for every ₹1 profit generated by the company.

Price-to-Earnings Ratio = Current Market Price/Earnings Per Share (EPS)

To calculate EPS, we divide the net profit of a firm by the total number of its shares. Tata Steel’s P/E stands at 14.57, meaning that for every ₹1 profit generated by the company, investors are ready to pay ₹14.57.

Tata Steel is slightly undervalued compared to peer companies. Meanwhile, JSW Steel is valued at a P/E of 39.89, making it a more expensive option.

Every industry/sector has a different range of valuation. Thus, we cannot define a standard P/E range for all stocks. Therefore, we must compare the valuation to its industry averages.

2. Price to Sales (P/S) Ratio

We used Earnings Per Share (EPS) for calculating the P/E ratio. However, changes in tax slabs, new accounting rules, one-time payments, etc. can influence EPS. To overcome this, we can consider the total sales of a company to find its valuation. A low price-to-sales ratio (P/S) means that the company is relatively undervalued.

Price-to-Sales (P/S) ratio = Current Market Price/ Sales Per Share

To calculate Price-to-Sales ratio, we divide a company’s revenue from operations by the total number of shares. The P/S of Tata Steel stands at 0.52, which means that for every ₹1 earned as revenue, the company’s investors value it 0.52 times.

Tata Steel has a low P/S ratio.

3. Price to Book (P/B) Ratio

Suppose a company ends its operations after liquidating assets and settling all debts. Any final amount remaining within the firm has to be distributed amongst its investors. This amount is known as the book value of a company.

The sum of the total equity and cash reserve from a company’s balance sheet is its book value. By dividing the book value by the total number of shares, we get the book value per share.

Price to Book Ratio = Current Market Price/Book Value Per Share

For Tata Steel, the P/B ratio stands at 1.24, meaning that the stock is trading at 1.24 times its book value.

Here, JSW Steel has a P/B ratio of 3.15, which means it has a higher valuation. Conservative investors can consider stocks whose P/B ratio is close to 1. For modern and asset-light businesses, P/B will always be on the higher side.

Using Debt and Valuation Analysis for Investing

In the world of finance and investment, making informed decisions is key to success. Two essential tools that play an important role in this process are debt analysis and valuation analysis. Let’s explore why these tools are vital for investors seeking to make smart investment choices:

Risk Mitigation: Debt analysis allows investors to assess a company’s financial health by examining its debt levels. This helps in understanding the risk associated with an investment. High debt can be a red flag, indicating potential financial distress, while low or manageable debt levels can instil confidence in an investment’s stability.
Valuation Analysis: It involves estimating the intrinsic value of an asset or company. By comparing this value to the current market price, investors can determine whether an investment is overvalued or undervalued. Making decisions based on valuation analysis can prevent overpaying for assets and enhance long-term returns.
Portfolio Diversification: Understanding the debt and valuation metrics of different investments enables investors to build a diversified portfolio. A well-diversified portfolio spreads risk, reducing the impact of poor-performing assets and increasing the potential for overall returns.
Long-Term Success: Debt and valuation analysis provide the foundation for a disciplined investment strategy that considers both short-term fluctuations and long-term growth prospects.
Finding Opportunities: Valuation analysis can uncover undervalued assets or companies with growth potential. These opportunities might not be apparent without a systematic assessment of valuation metrics.
Enhanced Returns: Making investments based on thorough analysis can lead to improved returns over time. By buying undervalued assets and avoiding overvalued ones, investors increase their chances of profiting from market inefficiencies.

Limitations of Debt and Valuation Analysis

While debt and valuation analysis are valuable tools for investors, it’s essential to acknowledge their limitations to make well-rounded investment decisions. Here are some key limitations to consider:

Incomplete Information: Financial statements can sometimes lack crucial information, and companies may use accounting methods that make their financial health appear better than it actually is. This can lead to inaccuracies in debt and valuation analysis.
Market Sentiment: Market sentiment and investor behaviour can heavily influence stock prices and valuations. These factors may not always align with a company’s fundamentals, making it challenging to predict short-term market movements.
Economic Factors: Economic conditions (such as recessions or economic booms) can significantly impact the performance of companies and their debt obligations. Debt analysis may not fully account for these external factors.
Industry Specifics: Different industries have varying debt norms and valuation metrics. What’s considered acceptable in one industry might not apply to another. Ignoring industry-specific dynamics can lead to inaccurate conclusions.
Future Uncertainty: Debt and valuation analysis rely on historical data and assumptions about the future. Unexpected events, changes in market conditions, or shifts in a company’s strategy can disrupt these assumptions and render analyses obsolete.
Limited Scope: Debt and valuation analysis often focus on quantitative aspects, overlooking qualitative factors like company management, industry trends, and competitive dynamics. These qualitative factors can significantly impact a company’s performance.

Note: Never try to analyse a company with only one kind of ratio. Using multiple ratios and comparing them with metrics of peer players across a specific time period will give us a comprehensive insight into a company.

Over the past month, all major global indices have been technically quite weak. Stock markets around the world are witnessing a fall as soon as there are rumors of negative cues. The fear of lockdowns amidst the exponential rise in Covid-19 cases and an increase in US Treasury Bond yield continues to create a state of panic. These factors have often led to major sell-offs in the market.

Last week, another crisis posed a threat to stock markets. Archegos Capital, a New York-based wealth management firm, has collapsed. Many prominent banks are facing heavy losses due to this incident. Let us understand the details surrounding this collapse and the impact it had on the stock market. There is a lot of financial jargon coming your way, and we will try to make it as clear as possible.

Brief Profile – Archegos Capital

Archegos Capital Management is a family office that primarily invests in the US, Chinese, and Japanese stock markets. A family office is a private entity that provides investment or wealth management services for ultra-high net worth investors. They serve very wealthy families, generally those with over $100 million (~Rs 735 crore) in investable assets.

Archegos Capital was founded by Bill Hwang, a former equity analyst at US-based Tiger Management (which no longer exists). In 2012, he was found guilty of insider trading and was charged by the Securities and Exchange Commission (SEC). Bill Hwang and the firms he managed had to pay $44 million to settle all charges. He was also forced to stay away from the investment advisory business. Thus, Hwang converted his firms into a family office. A point to be noted is that family offices are outside the regulatory scrutiny of the SEC. Most of their information or transactions are not available in the public domain.

The Collapse of Archegos Capital

Last week, Archegos Capital was forced into a fire sale of securities worth ~$20 billion (~Rs 1.46 lakh crore) after some of its portfolio stocks witnessed a significant fall. A fire sale refers to selling assets or securities at a very low price. Some of the prominent stocks in the firm’s portfolio included ViacomCBS, Discovery Communications, Baidu Inc., GSX Techedu, and Tencent Holdings. The company had huge exposure to these particular stocks due to swaps.

What are Swaps and Leverage?

Swaps are a kind of derivative instrument that can be traded over-the-counter (OTC) amongst large institutional investors. Such trades do not have to be reported to the public. It allows investors to take huge positions in securities without having to pay large sums of money upfront. For investing in swaps, financial institutions often borrow millions of dollars from banks— known as leverage. So, the underlying securities were the publicly traded shares (ViacomCBS, GSX Techedu, etc) and swaps gave Archegos Capital the benefit of leverage. Bill Hwang had made huge bets on these stocks and was hoping they would perform well.

He used leverage, which is money borrowed from banks (or even brokers), for buying these shares. Prominent banks agreed to fund these transactions as they believed in Hwang’s expertise in managing money. Moreover, the lenders would also receive a lot of money through commissions.

When such transactions are conducted, a portion of stocks that a firm intends to buy are often pledged in the form of collateral with banks. More importantly, the investor has to immediately bring in additional money as collateral as soon as the stock prices begin to fall. This is because a decline in share prices leads to a fall in the value of margin with the broker/bank. This demand for additional money or collateral is referred to as margin calls, which are triggered when the value of shares falls below a certain requirement.

What Happened to Archegos?

Swaps often increase the size of investments in stocks by enabling investors to infuse only a limited amount of money. However, when the underlying investments show a decline in value, banks and brokers usually sell the shares they hold on behalf of their clients. If a client is unable to pay when a margin call is made, lenders begin to sell the shares to recover what is owed to them. If the stock prices continue to fall, these lenders would start to incur huge losses.

This is exactly what had happened to Archegos Capital and its lenders. There was a large-scale selling of ViacomCBS, Baidu, and Tencent shares— which led to the stock prices falling sharply. ViacomCBS fell 23% last Wednesday and another 30% on Thursday, as analysts downgraded the stock on account of being overvalued. The shares of other companies Hwang had bet on, such as GSX Techedu (a Chinese ed-tech company) and RLX Technologies, also started falling.

To cover their losses, Archegos Capital initiated a fire sale of the stocks in their portfolio. However, the firm was unable to meet its lenders’ calls for more collateral to secure equity swap trades they had partly financed. Most of the firm’s prime brokers such as Goldman Sachs and Morgan Stanley quickly offloaded the stock in all of Archego’s investments. As shares of the companies mentioned above were being sold or simply dumped, its stock price started falling heavily.

The Impact

As per reports, two major lenders are likely to face severe losses due to their exposure to Archegos Capital. This is because the value of the collateral they were holding in the form of stocks was losing value very quickly. Japan’s largest investment bank, Nomura Holdings, is likely to face a loss of up to $2 billion. Switzerland-based Credit Suisse said a default on margin calls by Archegos could be “highly significant and material” to its first-quarter (Q1 CY21) results. As per sources, Credit Suisse’s losses are likely to cross $4 billion.

The stocks of all major banking and financial services firms that had exposure to Archego Capital saw a huge fall on Monday (March 29). Morgan Stanley shares fell 2.6% and Goldman Sachs Group took a hit of 1.7%. The shares of Nomura posted a record one-day decline of 16.3%. Credit Suisse shares dropped 14%, its biggest fall in a year.

Conclusion

Now you know how Bill Hwang and his firm, Archegos Capital Management, caused a mini-crash in the markets over the past week. It clearly shows the risk posed by large firms that are able to operate outside the purview of strong regulators. As mentioned before, family offices do not have to register with the Securities and Exchange Commission, nor do they have to disclose transactions. They continue to deal in securities worth billions based on rash decisions and greed. If such trades are left unchecked, it could lead to major systemic risks. The collapse of Archegos has made entities realise the importance of limits or strong regulations on swaps and leverages.