In February, just before the pandemic affected stock valuations, Reliance Industries Ltd (RIL) and Tata Consultancy Services Ltd (TCS) were in a neck and neck fight in India. The market capitalization of the two firms hovered around ₹8-8.5 trillion.
In end-March, when stocks were at their bottom, RIL’s market capitalization fell to ₹5.2 trillion, about 16% below that of TCS. A few weeks later, the former announced a deal with Facebook Inc., and the rest is history. At last count, RIL’s market capitalization stood at ₹14.6 trillion, adjusted for the value of the treasury shares it holds and was about 60% higher than that of TCS.
In fact, such is the extent of re-rating in RIL shares that analysts are now scrambling to justify the current market capitalization of nearly $200 billion.
For a conglomerate such as RIL, analysts typically resort to a sum-of-the-parts valuation. The business largely consists of three parts—energy, telecom services and retail. As it turns out, RIL’s market value is now higher than the sum of the value assigned by large investors to its different parts. Based on announced deals in the three businesses, and adjusted for minority shareholding, their value adds up to roughly $175 billion. Public market investors certainly seem to think that there’s a lot more to RIL than what large private equity investors were able to appreciate.
“There is a very simple theory doing the rounds. Private market investors typically buy when they see value on the table, and as and when Jio and Reliance Retail are ready for an IPO, they would expect a decent return on investment. The valuations in the public market reflect this optimism and possibility of value unlocking when IPOs happen,” says an analyst at a multinational brokerage requesting anonymity.
This certainly sounds like putting the cart before the horse. Other analysts don’t refer to an IPO yet, since that maybe some time away. Instead, they say, investors are ascribing an ‘option’ value to emerging businesses such as e-commerce (JioMart) and a super app that will help Jio derive benefits of a large technology platform on the lines of Tencent’s WeChat.
“Our price target (for RIL) implies about $60 billion of digital option value from JioMart ($21 billion) and Jio’s digital business ($39 billion),” analysts at JP Morgan India Pvt. Ltd wrote in a report on 9 September.
Perhaps, as analysts at Kotak Institutional Equities allude to, it all boils down to dominance. “For investors grappling with RIL’s large outperformance, four things are relevant to appreciate—(1) capital, (2) execution and (3) scale that result in (4) dominance. Valuations are less important except at extremes for certain stocks,” they said in a 14 September note. Recent deals with Facebook and Google, as well as reports that a deal with Amazon is in the works, have further strengthened the view that RIL’s dominance is growing and that competition will be left far behind. Analysts also point out that while RIL’s competitors in telecom and e-commerce have struggled with regulators and policymakers, the firm has been relatively better off.
It’s another matter that dominance in the petrochemicals business and now the telecom business hasn’t so far resulted in great return ratios for the company. In FY20, return on capital employed stood at only 10%. Investors, however, still hope for a glorious tomorrow when dominance in energy, telecom, retail, e-commerce and digital services will result in high returns. There is also a general frenzy for technology shares and RIL’s bets on a super app and e-commerce are raising hopes that it may be India’s answer to global tech firms.
Which brings us back to the joker in the pack—the so-called ‘option value’ for emerging revenue streams. “If RIL successfully executes all the digital businesses, then we believe this option value would likely be worth multiples of what it is today over the next 5-10 years, while if RIL is not able to monetize the digital opportunity, there is effectively 25% downside risk to the stock price,” analysts at JP Morgan said in a note.
Assuming all goes well on execution, RIL is well on its way to becoming a $300 billion company in the next few years, says the analyst at the multinational brokerage.
Those looking to take this bet will need to ignore traditional metrics such as earnings and returns and assign an ‘option’ value to intangibles such as scale and dominance.