Why do MNC stocks command premium valuations?

By Larissa Fernand |  24-06-20 | 
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Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

It is quite often that stocks of multinational companies, or MNCs, command a higher valuation on the Indian stock market.

This comment is telling: "The company's promoter being Hulst BV, an investment holding company registered in the Netherlands, is a part of BPEA (Baring Private Equity Asia). Being an MNC it commands good corporate governance and thereby by returning the excess cash they generate wealth for shareholders at the right time," Manali Bhatia, Senior Research Analyst at Rudra Shares and Stock Brokers told Moneycontrol, regarding NIIT Technologies.

Think about your own perception of some MNC stocks: Hindustan Unilever, Siemens, ABB, Bata, Astrazeneca Pharmaceuticals, Bosch, Pfizer, 3M, Huhtamaki PPL, Procter & Gamble, Heidelberg Cement India, Esab, Timken India, Honeywell Automation, Abbott, Maruti Suzuki, Nestle, Britannia, Vedanta, Castrol and Gillette.

The reasons for the premium are varied – history of making money for shareholders, dividends, superior corporate governance, strong parentage, globally recognised brands, intellectual property, technological proficiency, intangibles, low debt exposures and executive control in the hands of independent boards.

Raunak Onkar, Head of Research at PPFAS, had a different take. He believed that they might have lesser corporate governance issues, but they are not as transparent as perceived. Most MNCs do not hold conference calls or analyst meetings, and it is not easy for analysts to access management. Very few offer public disclosures with quality that matches those of their domestic counterparts.

Navin Vohra and Garima Arora dig deeper to find out why shares of MNCs in India enjoy premium valuations relative to their Indian peers.

Navin Vohra, heads the Valuations, Modelling and Economics practice of Ernst & Young India. Garima Arora is an Associate in the Valuations practice of Ernst & Young India.

Here is their report that initially appeared in Enterprise Investor.

MNC stocks don’t just trade at a premium to the general market, they mostly trade at higher multiples than their own parent companies.

A set of MNC companies we selected were trading at an enterprise value (EV)/EBITDA multiple of 30.1x historical. By comparison, the parents of this set traded at a mundane 13.7x historical earnings.

The difference in valuation between parent and subsidiary can be largely explained by one of two contradictory narratives.

It could reflect divergent growth profiles: MNC parents face mature, saturated, and fiercely competitive home markets, while their subsidiaries enjoy a more benign growth environment in a fast-growing developing market.

Alternatively, high valuations in India may reflect restrictions on residents investing outside the country, which may fuel a liquidity-driven bubble.

Growth or Liquidity?

We decided to test which hypothesis is true by conducting a discounted cash flow (DCF) analysis of the MNC parents and subsidiaries.

On the assumption that the companies’ weighted average cost of capital (WACC) will remain the same except for the differing inflation rates of the currencies in which the cash flow is measured, the divergent valuations should be determined by the growth profiles alone. This allows us to test whether growth or liquidity explains the premium in MNC valuations.

We back-tested the valuation of these two groups to understand to what degree the growth differential explained the difference in valuation. (In a later post, we shall look at the two groups’ current valuation and calculate the level of growth that would equalize the valuations.)

We selected:

  • 31 MNC subsidiaries in India with at least Rs 10 billion in revenue, for which the MNC parent was the largest shareholder for the last 10 years and controlled operations and management.
  • We did not include companies whose parents had multiple Indian subsidiaries.
  • The initial valuation date was December 31, 2008, or near the onset of previous financial crisis. This captured the various phases of the business cycle up to December 2019 as well as 10 years of cash flows.

On December 31, 2008, the MNC parents had a combined EV of $1,634 billion and traded at an EV/EBITDA multiple of 8.5x, while their Indian subsidiaries had an EV of $27 billion (Rs 1,359 billion) and were valued at an EV/EBITDA multiple of 14.8x.

The cash flows for 10 years up to March 2019/December 2018 were extracted from the CapitalIQ database. For companies that conducted acquisitions or divestments, we made adjustments so that these transactions were reflected in the cash flows. For example, an acquisition during the latter part of the cash flow measurement period meant a high outflow due to the price of the acquisition and the corresponding impact on profitability. Hence, such acquisitions / divestments were reversed.

The real WACC was the same for the set of parents and subsidiaries. We added a premium of 3.55% to that of the Indian subsidiaries’ WACC to reflect the difference in WPI inflation in India and developed countries between 2009 and 2019.

The results

The MNC parents’ DCFs from 2009 to 2019, as discounted on December 31, 2008 on their WACC, yielded a cumulative $909 billion. That amounts to 56% of the EV of this set. By contrast, the cumulative MNC subsidiaries’ DCFs equaled 49% of their cash flows.

Since the set of MNC subsidiaries traded at a 75% premium to their parents on December 31, 2008, the ensuing cash flows justified a substantial part of the premium valuation.

If the MNC subsidiaries were also trading at 8.5x EV/EBITDA, their ensuing 10 cash flows would have explained 85% of their value, much higher than for the MNC parents. Or, if the MNC subsidiaries had been trading at 13x the historical  EV/EBITDA multiple, then the ensuing cash flows would have explained 56% of the value, as in the case of their parents.

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Raj Rishi
Jul 1 2020 05:08 AM
 MNC have good management and can take decisions on there own for benefits of company without any external pressure makes them premium.
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