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Valuation -How to evaluate the PE ratio

I had done a quick valuation exercise of MRO-TEK earlier (see here). I used a certain PE ratio in the post and said that I would explain my approach later. So here it goes … 

To understand my approach, you have to look at the file Quantitative calculation and worksheets – cap analysis and ROC and PE.

You can download this file from the google groups 

The worksheet ‘ROC and PE’ has DCF (discounted cash flow model) scenarios for various businesses such as Low growth, high ROC (return on capital ). For ex: Like Merck or high growth and high ROC like infosys etc.

As you can see, I have put a growth of around 10% in Free cash flow, ROC of 40% and calculated the Intrinsic value (or Net present value). The ratio of the NPV/current earnings gives a rough value of PE for the above assumptions Now I have used various assumptions of growth, ROC etc and created the matrix . See the CAP analysis worksheet –  

The above is for a matrix of ROC (return of capital = 15%). I have varied the growth and CAP (Competitive advantage period).

As you would expect, if growth increases, so does the intrinsic value and the PE. If the ROC increases the same happens. This is however ignored by most analysts and sometimes the market too. This is where opportunity lies sometimes. The third variable – CAP also behaves the same. Higher the period for which the company can maintain the CAP, higher the intrinsic value and higher the PE. CAP or competitive advantage period is not available from any annual report or data. It is the period for which the company can maintain an ROC above the cost of capital. For a better understanding of CAP, read this article – measuringthemoat from google groups. It’s a great article and a must read if you want to deepen your understanding of CAP and DCF based valuation approach. 

As I was saying, CAP is diffcult to estimate as it depends on various factors such as the nature of industry, competitive threats etc. I usually assume a CAP of 5-8 years in my valuations. If it turns out to be more than that, then it serves as a margin of safety. Now when I look at the company, I use the worksheet ‘ROC and PE’ and my thought process (simplified) is as follows 

1. Look at ROC – does the company have an ROE or ROC of greater than 13-14% ? If yes, is it sustainable (this is subjective).
2. Use the above worksheet to select a specific ROC sceanrio.
3. What has been the growth for the company in the last 8-10 years. What is the likely growth (again subjective estimates).
4. What is the likely CAP? This is a very subjective exercise and requires studying the company and industry in detail. If the company checks out, I usually take a CAP of 5-6 years.
5. Plug the ROC, growth, CAP and current EPS numbers in the appropriate sceanrio and check the PE. That is the rough PE for the instrinsic estimate.
6. Check if the current price is 50% of the instrinsic value
7. Cross check valuation via comparitive valuations and other approaches.

 If all the above checkout, it is time to pull the trigger.

 In case the above has not bored to tears, JNext posts: Some conclusions from  table for CAP v/s PE v/s Growth (CAP analysis worksheet), pointers on DCF (boring stuff ??) 

From Value to momentum – MRO TEK

I generally select and buy stocks where the general enthusiam from them is very low. None of my picks shoot up after I have bought them and so  when a few did in the last few months, it was a new experience for me.

One such pick was MRO-TEK. I started looking at the Company a few weeks back when the stock was at around 52 per share. My analysis was as follows

About

The company is primarily into end-to-end solutions and hardware/products-provider in data communications, data access and networking fields, offering a wide range of sophisticated LAN/WAN products.

The company has a JV with RAD corporation and a few other technical collaborations. The company had a split of 30-70 of manufacturing v/s trading a few years back. In the recent years, the split has reversed to around 70-30 in terms of revenue

Performance

The company has had very erratic performance. The projections which the company made at the time of the IPO in 2000, were never met (by a huge margin). Since then the performance has been one step forward and one step back. The ROE has fluctuated between 5 and 15 %. Topline has also fluctuated and has grown by 9% per annum and the Net profit has also grown by roughly the same amount.

The margins have held steady at 9-10% and the asset turns have improved from 1.2 to 2.6

Positives

The company has maintained its margins and improved its efficiency ratios. Wcap ratio has improved from 1.5 to 6 due to improvement in inventory and recievable turns. The company has freed up cash and as a result has no debt and almost 40 Crs of cash on the balance sheet.

The company recently completed a buyback program using the surplus cash. The promoters have also been increasing their holding % in the last few years. The company has been paying a decent dividend with a DPS/EPS of around 30-40%.

Negatives

Although the management appears rational, pro-shareholder and is trying to create value, their performance has not been up to the mark. Reading the annual report reminds me of kids in school, who study hard and have the right work ethic, but still manage to flunk one or two subjects each year.

The company operates in a very competitive field with competition from likes of CISCO and LUCENT etc. This industry involves a lot of new technology, high R&D expenditure and high rates of obsolescence. MRO has only recently started investing in R&D and till recent past was mainly a distributor of networking products.

Conclusion

My personal estimate of intrinsic value was around Rs 90/ share. At 52 / share, the company was not a screaming buy, but worth creating an initial position.

I am not too optimistic on the long term economics of the company as this is a very small company in a fast paced and competitive industry. As a result it is diffcult for the company to operate at the top end of the product range and make good margins. Due to my lack of confidence on sustained good performance I conservatively estimated the intrinsic value at around 90 /share

Post script

Once I complete the analysis, I write a single page note detailing my investment thesis. This is more to record my thoughts at the time of the decision. It is useful to keep such notes as I can check them again later and check if my assumptions were true or not.

Well in this case, it never came to that. Almost from the next day the stock suddenly caught the fancy of the market. Somehow everyone has a very different opinion and as a result the stock is up almost 50-60% since then. In my case after creating an initial position, I stop buying it. Personally I buy at 40-50% of my estimate of intrinsic value and if the stock sells above that I don’t do anything. You may think I am leaving money on the table, but I prefer to follow a discplined approach. In my case I am not comfortable with trading and momentum plays and prefer to leave it to other who are better at it.

Valuation logic – 2008 EPS around 6-7 / share

PE ( will explain logic for this in a different post ) = 9-10

Cash / share = 40 Rs/ share

Total = 94 – 110 Rs/share

Maintenance Capex and FCF

 I received the following question from sanjay shetty via email. I will try to answer the question and have also simplified it via several assumptions

You mentioned you “use maintenance capex needed to support unit volumes or competitive position (maintenance capex).”
I downloaded your Excel sheets couldn’t figure out the basis for calculation of the same, especially as companies don’t give break ups of maintenance capex. If you could explain would be great.
Maybe my understanding is incorrect, however I feel that all Purchase of Fixed assets should be deducted from Free Cash Flow especially when the amount out there is a yearly spend by the company to grow it’s business.

Let me start with the following definition for free cash flow (paraphrased) as given by warren buffet

Free cash flow = Net earnings + depreciation – maintenance capex

Now you can take the above formulae as a given or debate whether it is correct. I think it is correct as free cash flow is basically discretionary cash which the owners (actually managers on their behalf) of the business can choose whichever way to invest. It is discretionary cash because the business is left with this cash after it has incurred the required capex to maintain its current position in terms of volume and competitive position. If it does not do that, then the business will start degrading and may eventually be wiped out.

Now the discretionary cash can be spent in the following ways

1. Invest in the buiness itself if the returns are good – most common approach. Value adding if the business earns more than cost of capital . for ex: ITC, asian paints, HLL etc. This investment is in fixed assets and working capital
2. Accquire other company – Eg. Marico
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing – Ex: Merck, Novartis etc

Now the question – How to calculate maintenance capex? There is no precise formulae for that. The best you can do is to arrive at a rough number as companies don’t give this number. Let take the definition above and let me give my approach

If the maintenance capex is to maintain unit volumes, then value sales would be growing at the rate of inflation. So lets take a hypothetical case (simplified)

Sales = 100
Return on equity = 20% ( debt = 0)
Net margin = 10%
Total asset / sales = 2
Total asset = 50
Depreciation = 5 % of asset

Now in year 2
Sales = 105 (5 % inflation)
ROE = 20%
Net margin = 10%
Total asset / sales = 2
Total asset = 52.5
FCF = 10.5+2.5-2.5 [ asset increase = 2.5 ]

So in the simple case above FCF is equal to Net profit. Ofcourse reality is not so simple. However once you get an idea of the basic concept, you can do a rough estimation of the maintenance capex and free cash flow.

Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.

Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.

So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.

The above post may appear fairly academic and boring, but I think the question asked by sanjay goes to the core of how to value a company.
Next post : I will try to explain how I calculate FCF using the excels I have uploaded

Grindwell norton and Free cash flow

I received the following email from sanjay shetty and decided to post it as he has asked a very important question on valuation. I have done some work on it on my own and have put the results in the worksheet – Quantitative calculations.xlsYou can download is from here or use the download link in the side bar. Please see the tabs – Maintenance capex and FCF anal.

My responses are in italics. There is a follow up question from sanjay on maintenance capex. I will post on it in detail shortly with an example. If you have looked at my valuation templates, you may have noticed that I use FCF based on maintenance capex for valuation purposes

Hi Rohit,

I’ve been viewing your blog, after your comment on my blog (http://indiainvestor.wordpress.com).

I had a few questions for you.

What methodology are you using to value companies in India?

DCF, comparitive or relative valuation, sum of parts etc. I try to value a company based on multiple approaches and also depending on the nature of the company

Are you using a Discounted Cash Flow method to calculate Intrinsic value? If so, are you checking the Free Cash Flow, how are you calculating it?

yes, i use free cash flow. I however do not use capital expenditure directly. I use maintenance capex needed to support unit volumes or competitive position (maintenance capex). Difficult for me to explain in brief. i have a few excels uploaded in my google group explaining the calculation.

I’ve see most of the companies I’ve analyzed seem to be blowing enormous amounts of cash, with almost negative free cash flow which is worrying. -

I think the key point is whether the capex is maintenance or for growth / accquisition. Let’s take a short example. If a company earns 5% on capital , and has 10% margins (asset turn is 0.5). Then to grow by 5%, the company will use all its free cash flow. Also 5% growth is roughly inflation, so in this case the company is using all its free cash for maintenance capex
In case of a company growing by 20% and 10% margins (asset turns is 2), growth of 5% requires only 50% of the netprofit . The rest is cash flow which company can use to aqcuire other companies, give dividend or build assets. This is the case with grindwell norton. Grindwell has low FCF as it is investing the surplus cash in assets to increase volumes.

Hope the above clarifies .i have tried to provide a quick explaination and have left a few things out (like adding back depreciation)

Take for instance Grindwell Norton, which you’ve recently mentioned on your blog, Every thing seems rosy however Free Cash Flow is the concern.

I have taken out the detailed calculations by sanjay and put the final computations

                    Free Cash Flow
Mar’ 02        29.178
Mar ‘03        21.802
Mar ‘04        17.149
Mar ‘05        18.481
Mar ‘06         3.121The worrying fact about this company is the amount of cash it’s blowing, though currently it’s Sales, ROIC etc. are all healthy and growing.
Free Cash flow growth is actually going from bad to worse. I’m calculating Free Cash Flow as Net Cash from Operations minus Capital Expenditure which is Purchase of Fixed Assets.

Some interesting ideas

I have been looking at the following two companies for the past few weeks. I have yet to make up my mind on them. I generally prefer to buy at 50% of conservatively calculated intrinsic value of the company. Both the companies trade at a discount to instrinsic value, but above the 50% mark.

The companies are

Grindwell norton

SRF

My personal notes on each company

Grindwell norton

Grindwell norton is in the business of abrasives and refractories. The industry is dominated by two player – Carborundum and grindwell norton. Grindwell has been doing fairly well for the past few years. It has an average ROC of 15%+ for the past few years. It has been able to maintain a NPM of 10%+. The average sales growth has been over 15% on an average and the NP growth in excess of 20%. The asset ratios have improved, especially the Wcap ratio and the profit margins have improved from 7-8% to 10-11%. The company enjoys reasonable competitive advantage due to R&D support by parent, strong sales force, decent brand and a wide customer base. There are reasonable entry barriers  in the industry too.

Grindwell has recently sold a stake and netted almost 100 Crs from the sale. The Company is debt free and has almost 100-150 Cr in cash and investments. The company is however trading at 20-30% discount to intrinsic value which is above my target price

SRF

SRF has the following business segments – Technical textile divison which  includes tyre re-inforcements, belting fabrics etc. This division makes up almost 50% of the revenue, but contributes to less than 10% of total profits with Pre-tax margins of around 10%. This business segment is facing a lot of competition and has seen margins drop for the last few years. The chemical business makes up 40% of the revenue and almost 90% of the profit. This division is highly profitable with pretax margins in excess of 50%. The profitability of this division has gone up in the last few years. The rest of the revenue is from packaging films business. This business made a loss in 2006 and has just turned around in the current year.

The company has seen margins rise from 4% to around 10% (excluding one time CER gains). The ROC is around 15%+. Sales growth has been 15%+ and NP growth has been 20%+. The company looks undervalued on current measures. However the key point is the sustainability of the margins in the chemicals business. It is diffcult to see how the division would maintain such high margins. If the net margin of the company were to drop to around 6-7% from current levels (which are roughly the average margins), then the EV/Net profit ratio would be around 9-10. At these levels the company is at best undervalued by 20-30%. Need to do more analysis.

Real estate valuation – pschyological baises

I think there are several psychological baises working in case of real estate. The first is incentive caused bais. Typically real estate is sold via brokers or by sales agents of the builder. They have an incentive to sell the property and typically earn a commision based on sale price. It is quite obvious that the broker or sales agent would be motivated to sell at as high price as possible. In addition it is likely that he will give you a bullish outlook for the property prices.

The second strong bias is social- proof and deprival super reaction tendency. You see you friend buy a property and make easy money. At the same if you have not invested money and feel deprival super reaction tendency as everyone one else is making easy money.

So these two tendencies work together and motivate us to look for a property. Combine this with the incentive caused bias where the broker is constantly trying to create a scarcity (he will tell you that he has a lot of buyers and if you don’t buy now  you may regret as the price will go up), lack of information and overoptimism on our part and this creates a combined effect. All these factors add up and can cause the buyer to become irrational.

I personally think the risk of bubbles are higher in real estate for the following reasons

• the common notion that real estate cannot lose value and represent something limited which is land
• High amount of leverage. Typically loans on a property is around 20%
• Lack of transparency and information in this market.
• All the above psychological factors

Real estate valuation – Inverting the problem

As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

In the last post, I developed the basic logic that real estate valuation depends on the rentals. Lets say you are looking at a property valued at say 50 lacs (5 million) . Now the reason to invest in this property is that you expect to make more than fixed income. Lets say you expect 15% p.a.

So the property should be worth 1 Cr (10 million) in the next five years. Such a property to sell at 10 Million, should atleast yield a rent of 40000 Rs/ month (assuming a P/R of 20). For some one to pay a rent of 40000/month, that individual should be earning atleast 170000 rs / month pre-tax.

How did I come up with number? assume a 30% tax rate and that a person would not prefer to spend more than 30% of his net income on rent in the long run. So we are talking of a person making 20-22 lacs per annum.

I agree salaries in india are rising and will continue to do so, but think of it this way -  How many people can earn 20-22 lacs per annum (or 50000 usd ) ? 20 lacs per annum or 50000 usd is not a very bad salary globally. To give a comparison, 50000 usd income is around the median income in the US too. On the flip side, with dollar depreciation and margins of IT/BPO companies getting squezed do you think it is feasible for indian companies to keep increasing salaries at 15% for the next 5-6 years and still be competitive?

Going one step further, if the investor thinks he can sell the property for 10 million , the person buying it will have to do a similar math. If the next investor expects 15% p.a , then he may agree to buy the property for 10 Million at a P/R of 20. However the property should then be 20 million, 10 years from now and needs a tenant making 40 lacs p.a  (100000 dollars) to support the rents.

At any point during the next 10 years, if the above assumptions break, due to drop in salaries or recesion, the P/R (like P/E of a stock) could fall and returns could drop. I would agree that in the above scenario there are a lot of assumptions and ifs and buts. However one should think hard before going ahead with a big investment decision.

Please note that I am not talking of local knowledge of real estate. If someone has special knowledge of an area and knows that the area would develop in the next few years, then that person has an information edge and can make high returns. My example is of a general case of an apartment in a city which is what most of the investors put their money in.

A deep Value stock

Prof bakshi had posted a quiz to his students. You can find the answer to his question in the comments section. I have posted on the same company earlier.

In addition you may find my response in the comments section too. There are several other answers from others in the comments section such as VST, wyeth, divyashakti granite etc. Some of the ideas sound pretty interesting and I would be looking at them closely.

My suggestion – if you are interested in value investing, read prof bakshi’s posts ,articles and interviews. There is a lot you can learn from him.

As an aside – i am reading a book : seeking wisdom – from darwin to munger. This book has been recommended by charlie munger himself. I dont remember the exact comment, but it seems he liked the book so much he bought a copy of this book for all his friends and relatives. He also said that if there are more books like this, he could bankrupt gifting them. I am not sure of the authenticity of the comment. But after reading 60 odd pages, i can tell you that this is a great book, especially if you are looking at developing a latticework of mental models. For those you who may not know charlie munger, he is the vice chairman of berkshire hathaway and a long term partner of warren buffett.

Allahabad Bank

My notes on Allahabad bankAbout

Allahabad bank is one of the oldest banks in India with over 2000 branches. The bank’s branch network is predominant in UP, Bihar and other northern parts of the country. The bank also has 47 specialised branches for various business activities such as Industrial finance, Collection service, Treasury management etc. The Bank is a PSU bank

The bank was a basket case a few years back. I was reading a research report when the bank came out with an IPO in 2002. The bank had NPA of 10.5% which was actually a reduction from 15.1% in 1998. So technically the bank had a zero networth till 2002. The bank has improved its performance since then.

Financials

The Bank has improved its financials substantially in the last few years. The following Key parameters of the Bank have shown improvements from 2002 to 2007

ROE – 11.2 % to 22%

CAR – From 10.5% to 13%

Net NPA – from 10.5% to  0.9%

ROA – From 0.6% to 1.3%

Absolute Net NPA – from 1160 Cr to 315 Cr

Credit deposit ratio – from 48% to 65%

Income growth has been 15%+ for the last 5 years

Net profit has also grown by 20%+  per annum over the last 5 years

The following financial numbers have remained stable or not shown much of an improvement

Other income as a percentage of total assets

Provision ratio has dropped to 70%

Yield on asset – In line with fall in rates over the past few years.

Positives

• - The key indicators such NPA, ROE, CAR, ROA, Credit deposit ratio, income and netprofit growth are good for the bank.
• - The bank has been expanding its branch network and also getting into the international markets. In addition the bank has kept its NPA’s low in percentage terms and absolute level.
• - The bank is also increasing the other income component. The other income which comprises of fee income, trading etc has grown at a much faster rate this year as compared to the Net interest income.
• - Operating costs as a percentage of total income has dropped mainly due to reduction in manpower costs. The bank has thus become more efficient in the past few years.

Risks

The biggest risk for the bank is political interference. As the majority shareholder is our government, you can never be sure what hairbrained scheme they will come up with. In the past there have been loan melas, loan writeoff etc. This has reduced in the last few years, but you never know.

In addition the NPA are controlled. However the bank operates in UP, bihar etc. There is a small risk of the rise in the NPA.

Comparitive Valuation

The bank is currently selling at a PE of around 5 and a P/B of around 0.9. On a comparitive basis SBI sells for a PE of around 17 and P/B ratio of around 2.5.  SBI is a bigger bank, but on Key parameters such as ROE (around 18% ) , Growth rates (net profit around 8% for last 5 years)  etc is not much better than Allahabad bank.

The other top notch bank HDFC is priced at around 35 time PE and P/B of around 6.5. On certain parameters such NPA and  growth the bank is ahead of Allahabad bank, however ROE is higher for Allahabad bank. Finally the market recognizes the qualilty of HDFC bank’s management and performance and has priced it accordingly

Conclusion

Allahabad bank is one those non-glamorous, dull stocks. However key to investing is not how sexy the stock is or how much sizzle it has, but whether you can buy a stock at a discount to intrinsic value.

Personally I feel the stock is a bit undervalued, however I have yet to make up my mind on it . I don’t see an immediate catalyst to unlock the value, however if management continue to perform as it has in the past 4-5 years, the returns should be decent.