The valuation matrix 

ONE of the most fundamental ways of valuing companies is through the price-to-earnings (PE) ratio, which is essentially a multiple of the company’s annual profits.

Let’s say you are buying a bicycle shop that made a net profit of RM1mil last year. If you pay RM5mil for the shop, then you are paying a price equivalent to a PE ratio of five times.

It’s a pretty simple metric. And the same applies when valuing public listed companies. The equity market enables what we call price discovery, which means it somehow ascribes the right value to companies, at least theoretically.

Certain sectors like hospital operators, which are generally businesses which have higher barriers to entry, trade at higher PEs than say a company that merely trades in construction material.

Those with vast experience in capital markets have imbued this sense of PE valuations into their thought process. But even then, anomalies do happen.

Take the case of the recent ACE Market listing of Pan Merchant Bhd. At a time when markets are depressed, this company, a manufacturer of industrial filtration equipment, sought to get listed at a PE multiple of 32 times its financial year 2024 net profit.

Without a doubt, the company has its strengths. It provides niche products and services and has an international presence – with exports spanning Asia, Europe, the Americas and Africa.

Still, in today’s depressed market, it will be difficult to find investors willing to buy shares valued at such a high PE.

Sure, new listings tend to be marketed at prospective PE valuations, typically lower than their historical PE based on the expected rise in profits in the following years.

Still, the historical PE does and should always be a factor to consider. At least two research houses didn’t think the IPO price was justified, as they valued the stock below the 27-sen IPO price. Not surprisingly, the public portion of the offering had around 28.9 million shares undersubscribed.

It is assumed that Affin Hwang Investment Bank took up this unsubscribed portion shares as part of its underwriting commitment for the IPO, which would have worked out to a cost of around RM7.8mil.

Affin Hwang was the principal adviser, sponsor, sole underwriter and placement agent for the IPO.

The RM7.8mil that the bank had to fork out for Pan Merchant’s shares is more than the earnings it made from its fees from the deal. It can always dispose this block of shares in the future.

The usual process of pricing an IPO is one where the adviser gauges the demand from the market.

As is always the case, the issuer, meaning the owners of the company going for a listing, will want to get the highest price for their company, just as any seller or a house or car would be.

But that exuberance is usually tempered by the adviser who gauges the market and tells the seller what the reality is. This is done by a book building process, which is more pronounced in large offerings.

In smaller flotations, it is easier to gauge the demand as there are only a limited number of shares on sale. No underwriter wants to actually end up having to exercise their obligation. No doubt banks get paid a fee for underwriting. Affin Hwang earned a fee of 2.25% of the value of shares underwritten at the IPO, which works out to only around RM367,000.

The bank is now saddled with RM7mil worth of Pan Merchant stock, bought at the IPO price of 27 sen, and whose value is now slightly depressed with Pan Merchant now trading at only 22 sen.

What more, such large blocks are difficult to offload into the market.

The situation of underwriters having to exercise their obligations by having to buy the shares are few and far between.

Investment bankers are usually able to strike the perfect balance – convincing the issuer to price the issuance at a realistic level and ensuring that there are enough takers for the shares.

One old story in which this transpired was back in 2011, when OSK Investment Bank, led by the iconic stock broker and deal maker Tan Sri Ong Leong Huat, ended up as the largest shareholder of DBE Gurney Resources Bhd.

This happened after the investment bank underwrote a rights issue by the poultry company.

DBE Gurney launched a renounceable rights issue but only about 52% of the rights were taken up by shareholders, so OSK as the underwriter, purchased the remaining shares and became DBE Gurney’s single largest shareholder, holding a 27% stake.

It was estimated that it cost OSK RM18.1mil, based on the issue price of 10 sen per rights share. Notably, Perak-based DBE had been loss-making over the past four financial years prior to that exercise.

Within months, OSK was exploring selling its DBE stake to poultry-integrated companies. However, by late 2011 no sale had materialised, possibly due to valuation disagreements, it was reported then.

But the block of shares was eventually sold many years later to a different group, which transformed the company into Lagenda Properties Bhd today.

Coming back to Affin Hwang, it now holds around 3.15% of shares in Pan Merchant, assuming it has not begun disposing of that block in the market. It may have to find a willing buyer to take those shares off them.

Meanwhile, this PE valuation story brings us to the UMS Holdings Ltd saga, the Singapore Exchange (SGX)-listed company that will dual list on Bursa Malaysia on Aug 1.

This company had been attracted to dual list on Bursa Malaysia on the belief that our “market” values semiconductor firms higher than what the Singapore market does.

Going by that theory, and the fungibility of shares from both exchanges, the thinking is that demand from investors here would drag up the PE value of the SGX-listed shares of UMS.

What boggles the mind is that why would Malaysian investors pay more for a share that trades just across the Causeway, which can be easily accessible through all the seamless trading platforms that are in operation today?