Is Exide Industries’ stock undervalued or overvalued?

Exide Industries is the biggest story in the stock market this week. The stock was up almost 17% on Monday and more than 5% on Tuesday. Co-head of research at Equitymaster Rahul Shah explains the scenario around the EV battery stock.

I am sure you must have heard about the famous fable of the 'Elephant and the Six Blind Men'.

It's a story about how a group of six blind men are taken to an elephant enclosure and made to touch a big, full-grown elephant.

Now, obviously, they are touching a giant elephant for the first time and since all of them are well spread out around it, they are each touching and feeling a different part of the elephant.

So, the first blind man touches the trunk of the elephant and starts assuming that the elephant is nothing but a big, fat snake.

No, it's a spear, shouts the second blind man, who's got hold of the elephant's sharp tusks.

Are you all crazy, says the third blind man, who's standing close to one of the legs and thinks it’s a huge tree.

The fourth, fifth, and sixth blind man think of the elephant as a wall, rope and fan, respectively, as they feel its body, tail and ears.

So, six blind men imagine the elephant to be six different things. An intense argument follows, with each trying to make his case.

Soon, a wise man who's been watching from a distance approaches the group and asks all the six men to calm down.

He then tells them that all of them are right as they were all touching different parts of the elephant. The elephant, in reality, is the sum of all of these parts.

Instead of arguing with each other, all they had to do was consider each other's perspective and arrive at a unified picture.

Interesting, isn't it? There are a lot of lessons that one can learn from this story.

In fact, there is a very important lesson around investing as well.

I'd like to believe that the price of any stock in the market is like the elephant in our story, and investors who are trying to value the stock are like the six blind men, each with their own opinion about what the stock's correct valuation should be and the price it should be trading at.

So, there's the stock price and there’s a fair value or an intrinsic value of the stock, which depends on what individual investors think about the future of the company.

A particular investor may be right in his assessment of the fair value of the company. Yet, his value may be quite different from that of another investor who is looking at things differently.

Let us try and understand this better by using Exide Industries India Ltd as an example.

The stock has been a stellar performer and has more than doubled in the past year.

In fact, several experts believe the stock's upward journey may have just started.

So, how should an investor deal with this development? Should he buy, hold, or perhaps take advantage of the current rally and sell?

Well, the answer depends on his estimate of the stock's fair value, which in turn depends on what kind of investor he is.

As far as I am concerned, there are five different types of investors.

The first is a deep value investor, who is only interested in stocks that are trading below or close to their book values. Exide Industries' book value is about ₹147 a share, which translates to a buy price of ₹112.5 after factoring in a 25% margin of safety.

This means the stock needs to fall by at least 70% before a deep value investor will consider buying it. In my view, the chance of this happening in the near future is close to zero.

Our second guy is not a deep value investor but a value investor. What is the difference? Well, a value investor tries to value companies based on its earnings power and not its book value.

Earnings power refers to a company’s earnings per share in a normal year or multi-year period.

For Exide Industries this is around ₹9 a share in my view. There have been years when it earned ₹8 a share and close to ₹10 a share. Thus, ₹9 a share looks like a good number.

The average PE multiple for Exide Industries has been in the 20-22x range the past few years So, we can consider an average of around 21x.

Multiplying the two and factoring in a margin of safety of 25% gives us a fair value of ₹142. The current share price of Exide Industries is ₹377.

Hence, even for a value investor, Exide Industries’ stock is quite expensive and will have to fall by more than 60% before he will think of buying it.

Well, a 60% crash looks like a remote possibility. During the pandemic crash in March 2020, the stock had fallen to ₹130 a share, presenting a huge opportunity to value investors.

Whether this can happen again is anybody's guess. But the possibility does not look as remote as it does for a deep value investor.

The third type of investor could be called a 'growth at a reasonable price' or GARP investor.

This is Warren Buffett territory. The Oracle of Omaha switched his investment philosophy from deep value to GARP.

What is the difference? In my opinion, a GARP investor does not seek a margin of safety.

He still invests based on the earnings capacity or the average earnings power, but he expects this earnings to grow at a decent rate going forward.

The value investor on the other hand does not expect the earnings to grow but remain stable or grow very slowly.

The reason a GARP investor has a lower margin of safety than value investor or no margin of safety at all is because he believes that growth is his margin of safety.

A GARP investor is not paying anything extra for the growth in earnings, so he is willing to pay the full price for current earnings.

This is how a GARP investor would value Exide Industries.

Everything is the same as a value investor except for the margin of safety. I have assumed no margin of safety versus a 25% margin of safety for the value investor.

Removing the margin of safety gives you a fair value of ₹190, which is about half the current price.

Therefore, the stock will have to fall by 50% for a GARP investor to consider investing in it.

Let us take a look at the fourth type of investor, the growth investor.

This is Peter Lynch territory. He is willing to pay a high PE multiple for a stock if it has significantly better growth prospects than one with a low PE.

To value the company this way, I have not considered the earnings power as I did for a value investor or a GARP investor.

Instead, I have projected the future earnings per share of the company, expecting it to double over the next three to four years – i.e. go from ₹9 a share to ₹18 a share.

Keeping the PE at 21x, we get a fair price of ₹378 a share which is near the current price.

Thus, only a growth investor could find the company's current share price reasonable.

However, even he won't be able to make good returns as the stock is already trading at a high price and there's hardly any upside left.

He needs to buy the stock at a minimum 33% discount to the fair price of ₹378 to ensure a decent upside.

The fifth and the final kind of investor is the momentum investor. Momentum investing is actually trading in my view, as momentum investors don't try to determine the fair value of a stock. They only try to figure out whether it is seeing strong momentum. If the answer is yes, they jump on board and stay as long as the momentum continues. Any sign of weakness and they get out, no questions asked.

Here are the five different kinds of investors again, in one table, for easy reference.

Isn't this like the blind men and the elephant all over again? All five types of investors could be right in their own way, and yet their ideas of the fair value of the company are completely different.

In the end, who should you follow – the growth investor, the GARP investor, the value investor or the deep value guy?

Well, the beauty of investing is that you can choose any of these approaches and still end up making a good return over the long term, even a market-beating one.

Yes, that's correct. Each of these are proven approaches and you can use any of them provided you select the right stocks for each of these categories, try and assess their fair values correctly, and have a proper exit plan in place.

You can't be a growth investor and then fail to predict the future growth of the stocks in your portfolio. A growth stock turning into a value stock or a deep value stock could be a big disaster for your returns.

Likewise, if you are a momentum investor and don't get out as soon as the momentum weakens, you are asking for trouble.

I have seen stocks go from momentum all the way down to deep value, and destroy wealth in the process.

At the other end, if you invest when the stock is at a deep value or value and keep holding on to it all the way up to momentum, you will end up with one hell of a multibagger.

However, such instances are rare and you'd be better off sticking to your zone of investing. So, if you are a deep value investor, you should look to make those quick 50-60% returns and then sell the stock.

There's no point in practicing a buy-and-hold strategy in deep value investing.

Likewise, if you are a GARP investor, you should exit once the stock becomes a momentum stock, unless you are like Warren Buffett, who has a buy and hold strategy.

The bottomline is that each of these approaches can make you money in the stock market, provided you know the line that separates your investing style from others.

As long as you operate inside your circle of competence, you should be fine in my view. Pick a style of investing and stick to it.

On the question of whether Exide Industries is a potential multibagger or a bubble waiting to burst, I think from a deep value, value or GARP perspective, the stock is definitely greatly overvalued, but not so much from a growth perspective.

However, if the strong momentum continues and people continue to pile into the stock with no regard to fundamentals or valuation, it could certainly turn into a multibagger.

Other than this, the possibility of the stock giving huge returns over the next two to three years depends on whether it can increase its profits in a big way. In the past it has not been able to grow its profits very quickly.

This is my assessment of the stock. Your assessment could certainly differ based on the kind of investor you are and how you see the company's future.

Whatever your valuation, please be realistic in your assumptions and stay as close to your comfort zone as possible.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com