Rethink PE Ratio Valuation for Capex-High Sectors Like Cement and Specialty Chemicals: Kotak Analysts

Analysts at Kotak Institutional Equities have pointed out that the price-to-earnings (PE) ratio is inefficient in the valuation of sectors such as cement, car tires, oil and gas and specialty chemicals. They recommend re-evaluating this valuation method because earnings in these sectors do not translate well into free cash flow (FCF) or dividends.

“We should revisit the PE valuation methodology to value select sectors in India given their low free cash flow to profit after tax, continuous investments on growing volumes and low-yield businesses,” Kotak analysts stressed.

The bigger issue from now on will be that this valuation methodology will be used for the next few years or decades, given the nature of these businesses and partnerships.

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For example, cement companies will need high capital expenditure (capex) to increase volumes, which will result in FCF lagging behind PAT due to low fixed assets turnover (FATO). While volume growth is driven by demand for housing and infrastructure, maintaining this growth will require large capital expenditures.

Another capital-intensive sector, such as specialty chemicals, will also face a similar problem. Typically, these companies have ambitious plans that would require higher capital expenditure, which would ultimately lead to low FCF in the medium term. Historically, they have also had low FCF/PAT ratios.

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“The current high valuations of the sector’s P/E ratio are based on expectations of strong FCF generation in the future, which may or may not occur after the end of the growth phase due to the contractual nature of the business and increasing competition over time,” analysts believe.

Besides, oil, gas and consumables companies, especially PSUs, that have invested in their core businesses will incur low FCF to their PAT. However, analysts believe that the return on these assets is questionable due to the likely low returns on such projects, limited durability and questionable residual value of the assets.

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