We have often seen or heard that a particular stock has got re-rated, which usually means that the company is now commanding higher valuations as compared to its historical averages. There could be multiple reasons for it and in this article, we try to understand some of the common reasons that leads to re-rating of a stock with some real examples. Firstly, we must understand that re-rating of a stock is a process and it could take months or some time years depending on how fast the below factors plays out.
Before we begin talking about stock P/E, it is important to understand a little about market P/E and sector P/E as these factors could also be one of the primary reasons behind the re-rating of a stock. There can be several reasons for overall markets to get re-rated some of it includes macro stability, growth, and reforms & policies etc. For instance, back in 2013, the Indian economy was considered one of “The Fragile 5” due to its deteriorating macros and policy paralysis, however, things changed considerably ever since.
Indian markets became one of the preferred destinations for investment thanks to its improving macros wherein inflation, twin deficits remained at manageable levels. On the growth front, India’s GDP growth remained one of the fastest in the world (last 4-5 years) and the great Indian consumption story remains well intact (thanks to demographics, rising income and low-interest rates). Additionally, our dependence on crude (imports) and monsoon is not hidden from anyone which has worked more in favour for India as crude prices have remained soft and monsoon has been kind on us. The continuous reform implementation has also helped the organized economy to grow faster. All these things have led to re-rating of the overall Indian markets over the last 4-5 years. And yes, the pandemic has distorted some of the macros, but with the on-going overwhelming pace of recovery, India continues to remain one of the preferred markets in the world.
The re-rating of the overall sector can also be one of the reasons behind the re-rating of a stock. Some of the reasons behind re-rating of a sector would be favourable government policies, lower tax rate, allowance of foreign direct investment, change in consumer preference etc. For example, when the GST bill was introduced, the logistics and building material (plywoods, tiles) witnessed re-rating as growth prospects for the sector was expected to improve considerably. But eventually, that was not the case, and the prices corrected 1-2 years later.
Another more recent example is the government’s announcement of production linked incentive scheme for consumer electronics manufacturer led to re-rating of the sector and stocks like Dixon and Amber Enterprise. The on-going pandemic is also one of the reasons for re-rating of diagnostics, health and life insurance sectors. The IT sector has also witnessed re-rating in this pandemic.
In this, the re-rating occurs for reasons which pertain to the stock itself. Here are some of the common reasons behind stock re-rating. Please note that the reasons given for example are not the only reason for re-rating, there can be a combination of other reasons as well.
Small to big
It would be unfair to value a small company to a large company in the same sector as large ones have better-proven record, expertise, and market leadership in the sector or industry. If everything else remains equal except size, then a Heidelberg Cement cannot command the same multiple as compared to an Ultratech Cement. Similarly, there would be valuation difference between HDFC AMC (2nd largest AMC) and UTI AMC (8th Largest AMC). Therefore, large players usually command higher multiple as compared to smaller ones. The re-rating from small to large usually takes time (years) as it’s not that overnight a company becomes a market leader in a particular segment or sector.
Investors love to chase growth. The higher the growth, the higher will be the multiple which investors would be wiling to pay for the stock. Any company growing faster than the industry has the potential to be re-rated. For example, Bajaj Finance, HDFC Bank, Eicher Motors, Avenue Supermart have being re-rated thanks to their stupendous growth shown over the last several years.
Better profitability/Cash flow generation
Revenue growth is imperative but converting it into profitability / cashflow is even more important. Therefore, a company which has improved its margins, profits and cash flow generation consistently gets re-rated. This can be done when the company focuses more on cost control, reducing debtors etc.
Lower financial leverage
Usually, companies having lower levels of debt are preferred more by investors as it reduces default risk. Hence, companies which are on its way to reducing debt or become debt-free leads to re-rating of the stock. Recent example is Reliance Industries which through a series of deals, rights issue has managed to get down its debt which is one of the reasons for re-rating of the stock.
Better corporate governance
Any major issues with respect to corporate governance often leads to sharp de-rating of stock, be it fraud, promoter issues, financial misreporting etc. It is either that the business is finished or the company tries to revamp its business by branding efforts, more clarity in financial reporting and/or change in promoters. It takes a long time in re-building confidence of investors back into the stock and when it does, it leads to re-rating. One example would be Nippon Life AMC which actually witnessed re-rating post the change in promoters from ADAG to Nippon Life. The change in promoters re-instated the confidence of investors.
Investors prefer consumer-facing businesses rather than B2B business as it protects them during economic downcycle. So, companies which are on their way to increase the share of revenues and profits from consumer businesses usually command higher multiple and leads to re-rating. Again, we can quote Reliance Industries which has transformed itself from being an oil & gas to chemicals to now consumer tech player leading to multiple re-rating of the stock recently. Another one would be KEI Industries which has been on its way on increasing its retail business and has been re-rated.