6A.11 Sector valuation II: cyclicals, IT services, consumer

Motivation

M06 · 6.10 said "value cyclicals on normalised earnings". This section makes that concrete and adds the sector-specific growth arithmetic for two Indian heavyweights: IT services and consumer staples.

6A.11.1Cyclicals: metals, oil marketing companies, cement#

Proposition 6A.17spread leverage and P/E inversion

(a) If a producer earns EBITDA per tonne $e = p - c$ with price $p$ and cash cost $c$ , then

\frac{\Delta e}{e} = \frac{p}{p - c}\cdot\frac{\Delta p}{p} \quad (\text{for a change in } p \text{ with } c \text{ fixed}). \tag{6A.21}

(b) If value depends on normalised earnings $E^*$ through $V = E^*/k$ while reported earnings are $E_t = E^*(1 + A s_t)$ with $s_t \in [-1, 1]$ a cycle index, then the trailing P/E is

\frac{V}{E_t} = \frac{1}{k(1 + A s_t)}, \tag{6A.22}

lowest at the peak ( $s_t = 1$ ) and highest at the trough.

Proof

(a) $\Delta e = \Delta p$ , so $\Delta e/e = \Delta p/(p-c) = [p/(p-c)](\Delta p/p)$ . (b) Divide $V$ by $E_t$ .∎

With steel at ₹55,000 a tonne and cash cost ₹45,000, the multiplier $p/(p-c)$ is 5.5: a 5% fall in steel prices cuts EBITDA per tonne by 27.5%. With $A = 0.6$ and $k = 12.5\%$ , the P/E swings from 5 at the peak to 20 at the trough while the value never changes. A low P/E on peak earnings is the classic cyclical trap.

Normalising Estimate mid-cycle margins from a full cycle of history (a decade or more of EBITDA per tonne), apply them to normalised volumes (capacity × mid-cycle utilisation), then value on EV/EBITDA or replacement cost (EV per tonne of capacity against the cost of building a new tonne). Link the price input to M10: metal prices to LME and Chinese demand (M10 · 10.9), oil marketing companies' refining margins to crack spreads (M10 · 10.8.3).

Oil marketing companies (OMCs) Profit = refining margin (gross refining margin, GRM, in USD a barrel) × throughput + marketing margin on retail fuel × volume ± inventory gains or losses. Retail petrol and diesel prices in India have at times been held steady while crude moved, so marketing margins absorb crude swings and the stocks trade against crude with a negative sign. Inventory gains in rising crude markets flatter one quarter and reverse in the next; strip them out.

Cement EBITDA per tonne, regional prices, capacity utilisation, fuel (pet coke, coal) and freight costs. The industry is regional, so capacity additions in a region compress that region's prices. EV per tonne of capacity against replacement cost anchors valuation through the cycle.

6A.11.2IT services#

Indian IT companies bill mostly in USD, EUR and GBP and report in INR (and USD).

Proposition 6A.18constant-currency decomposition

Let USD revenue grow by $g_{\$}$ , of which a share $w_j$ comes from currency $j$ , whose value against the USD changed by $x_j$ over the period. Then constant-currency growth $g_{cc}$ satisfies, to first order in the mix,

1 + g_{\$} = (1 + g_{cc})\Big(1 + \sum_j w_j x_j\Big), \tag{6A.23}

and INR revenue grows by $(1 + g_{\$})(1 + \Delta)$ − 1, with $\Delta$ the change in USDINR.

Proof

Revenue billed in currency $j$ is $Q_j$ units, worth $Q_j X_j$ USD at exchange rate $X_j$ (USD per unit). Constant-currency revenue values this period's $Q_j$ at last period's $X_j$ . Then $\sum_j Q_j^{1}X_j^{1} = \sum_j Q_j^1X_j^0(1 + x_j)$ . Writing the constant-currency revenue weights as $w_j$ gives $1 + g_\$ = (1 + g_{cc})(1 + \sum_j w_j x_j)$ exactly, with $w_j$ the current-period constant-currency weights; using last period's reported mix instead is the first-order approximation companies usually apply. INR revenue is USD revenue times USDINR.∎

Example: reported USD growth 2.0% in a quarter, 25% of revenue in EUR and GBP which both fell 3% against the USD: currency effect $-0.75\%$ , constant-currency growth $1.02/0.9925 - 1 = 2.77\%$ .

Other drivers Deal TCV (total contract value) is signed over multi-year contracts and converts into revenue over their life; a large TCV with a long tenure adds little to next year's revenue. Book-to-bill (TCV signed over revenue) above 1 signals growth. Margins depend on utilisation, the employee pyramid, wage-hike timing, subcontracting and the rupee (a weaker rupee lifts INR margins because costs are mostly in INR). Value the business with the value-driver formula of M06 · 6.4: high ROIC, low reinvestment, so most earnings are distributable, which is why IT companies return cash through dividends and buybacks (6A.4).

6A.11.3Consumer staples and discretionary#

Reported value growth is $(1 + \text{volume growth})(1 + \text{price/mix growth}) - 1$ : 4% volume and 6% price give 10.24%. Price-led growth during input inflation (palm oil, crude-linked packaging; M10) does not persist when inputs fall; volume growth is the cleaner measure of demand. Companies such as Hindustan Unilever report an underlying volume growth figure each quarter; compare it with value growth. Gross margin tracks the lagged input-cost basket. Distribution reach (outlets served directly), rural versus urban mix, and the share of new channels (quick commerce, modern trade) drive growth. Consumer franchises trade at high P/E because they combine high ROIC with long runways; M06 · 6.6 shows how sensitive such multiples are to $k - g$ .