Shares of multinational companies in India, often called MNC stocks, enjoy premium valuations relative to their Indian peers.
Investors attribute this premium to a host of factors:
- MNCs’ superior growth profiles are due to their proprietary technology, brands, intellectual property, management, or other intangibles.
- Better corporate governance and financial reporting standards lead to lower, or non-existent, minority discounts.
- Less risk and variability of cash flows mean lower betas and thus a higher multiple to current cash flows.
MNC stocks don’t just trade at a premium to the general market, they mostly trade at higher multiples than their own parent companies. For instance, 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 conducted this analysis in two parts. In the first, which we detail here, 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 look at the two groups’ current valuation and calculate the level of growth that would equalize the valuations.
For this analysis, we selected 31 MNC subsidiaries in India with at least INR 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 31 December 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 31 December 2008, the MNC parents had a combined EV of US $1,634 billion and traded at an EV/EBITDA multiple of 8.5x, while their Indian subsidiaries had an EV of US $27 billion (INR 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.
Results
The MNC parents’ DCFs from 2009 to 2019, as discounted on 31 December 2008 on their WACC, yielded a cumulative US $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 31 December 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.
In the next part of this analysis, we will look at the current valuation of the two groups and solve for the differential level of growth that would equalize the valuations.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / ivoris
Navin Vohra, CFA
