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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 clip_image001.gif

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 –  clip_image002.gif

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 ??) 

I am currently reading the book – The Black swan by N N Taleb. This is a great book on low probability, high impact events which are termed as black swans.I am still in the middle of this book. One key point which I came across is ‘confirmation bias’ on which the author has devoted a complete chapter.

The basic idea behind confirmation bias is that once we make a decision, we tend to look for evidence to confirm it. As a result we tend to ignore any negative information which could refute our decision. As a corollary to this concept, any additional information is of no use as it would only re-inforce the decision and not add any more value to the decision making process.

Like others, I am equally susceptible to this bias. My approach to reduce its impact is to write a single page thesis on an investment idea and sometimes post it on my blog. I try to gather negative information and also prefer to get negative feedback on my idea. That helps me in wieghing all negative information and arrive at a better decision (hopefully).

I am not sure if I have been entirely successfull in it, but I have rejected a few ideas after selecting them, once I was pointed out some key information (which I had missed out). In a few other cases, the negative information, which I had missed earlier resulted in reducing my estimate of intrinsic value for the stock – for ex: I missed the impact of liabilities in the case of VST. As a result I ended up taking a smaller position

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


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


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


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%.


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.


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

2007 has been one of those years where it was difficult NOT to make money in the stock market. At the risk of offending, let me say even a monkey would have made money. Don’t get me wrong, if you have done well this year, it does not make you a monkey 🙂 (by that measure I am a monkey too, not that I am complaining).

The monkey term is more to randomly picking stocks than to a monkey IQ. This was one of those years where almost all types of stocks did well. If you avoided some of the sectors such as IT, everything else was in a bull market. From Aug to Oct the large caps did well and since then the Mid caps have caught fire. I have seen some of the stocks almost double in the last 1-2 months. When I wrote earlier, on midcaps in may there were a decent number of opportunities available. However the valuation gaps have started closing since then and the number of opportunities have come down (although there are still a few around).

So whats in store for the next year? As if I know !! and so does no one else. I have long stopped bothering about market forecast and which sector is going to do well etc etc. The smart thing to do is to analyse companies and if you can find one selling below intrinsic value, buy it. Not all your picks will do well at the same time (unlike 2007!), but a few would.

If I  started investing this year or during the current bull run (from 2003 onwards), I would want to re-analyse my approach to ensure that it was due to my own stock picking skills and not due to the rising tide. I do that every year in the following manner

  • did my portfolio do better than the market index such as Sensex
  • Which stocks did better than average and which did not
  • What was the reason for the stocks which overperformed (luck?)
  • What the reason for the stocks which underperformed and how to avoid the the cause of the underperformance

It is important to do the above analysis to ensure that the good performance was not due to luck and can be repeated again. Luck can make you money in the short run, but in the long run you will give it back. So it is critical to be brutually honest with yourself.

I had written on Ashok leyland earlier.

My valuation was as follows
The company sells at a PE of 12. The current EPS is around 3.3 per share. The company can be expected to grow at 10-12% over the next few years. In addition the company has some competitive advantage such as a known brand name (especially in the south), long operating history and experience in the market, rational management and a decent distrubution/ service network.The company can be valued at around 16-18 times PE and given an intrinsic value of around 60 Rs/ share.

I recently got this email from Vishnu

I have been going through Eicher JV deal with VOLVO. It would be great if you can share your opinions.

Eicher is stepping down its Commercial Vehicle and Component business into a JV with VOLVO which is paying 275 million USD in CASH and 75 million USD in terms of VOLVO’s truck distribution business in the JV.

Cash(VOLVO) is paying 1045
VOLVO India Truck distribution 142
TOTAL VOLVO Share (45.6%) 1187
EICHER Share in JV (54.4%) 1416.070175
Eicher Market cap 1314
* All figures are in Crores (INR)

I have already shared my opinion on the above opportunity with him. What struck me was that the deal involved the Commercial vehicle business and the deal was valued at approximately 2000 crs. Eicher motor’s CV business had a PAT of roughly 62 crs (pretax – 82 Crs) and hence the private market value (the amount that a private investor would be willing to pay for the company, in its entirety, were it not public) seems to be around 25-30 times earnings

So Ashok leyland can be valued at 70-90 Rs/share by the above metric. My own conservative estimate was around 60/share.

Whats the point of this analysis ? well private market valuation is another approach to valuation. It may be more than your own estimate as it may include controlling premium. However if you can find the private market value to a business you are looking at, it helps in calculating the intrinsic value.

In case you are wondering if I really benifited from my research, I did not completely. I have this tendency to do detailed analysis and build my position over a period of a few months especially if the price drops reaches or drops below 50% of my estimate of intrinsic value. Ashok leyland is around 54 now, so basically the price went up before I could go beyond my initial position. That unfortunately has happened several times this year.

Why should a quick price increase be unfortunate? Well that’s another post for this wacky idea.

Maintenance capex calculation

December 11, 2007

I discussed about maintenance capex and its relation with Free cash flow. To recap

Free cash flow = Net earnings + depreciation – maintenance capex

And free cash flow is the money the owner of business can take out or re-invest in the business.

Maintenance capex however does not have a precise formulae. That does not mean you cannot calculate it. But as you can see, if valuation is based on free cash flow which itself is based on an imprecise measure such as maintenance capex, it cannot be precise in itself.

Valuation depends on free cash flow, project growth rates , terminal value and the discount rates. All these are estimates and hence valuation is itself an estimate. That is the reason I find it assuming when analysts give reports where they give precise valuation targets and on top of that even the duration (next one year !!) when the target would be met.

So, coming back to maintenance capex, how do I estimate it? let me warn you at the outset. My approach is self developed, imprecise and only roughly right.

I will use my valuation template to explain my approach

Worksheet – anal – In this worksheet I fill up the sales, depreciation, wcap etc. On line 26, I calculate the additional capex (additional fixed asset and Wcap for the year). Line 27 is capex as % of sales.  This gives me a capex trend (total) for a period of time for the business.  I then use this trend to estimate the maintenance capex.

For ex: if the business has an asset turn (on average)  of 2, then I would assume capex as 2.5% of sales

Sales = 100

Asset = 50

Inflation increase in sales = 5

Corresponding asset required = 2.5 (2.5% of sales)

If the business is asset heavy (commodity industry) then the maintenance capex as % of sales is high.

If the asset turn is 1, then maintenance capex would be roughly 5% of sales. You can compare this % with depreciation as a % of sales to see if both are roughly equal.

You may find some errors in my worksheet and I plan to load an updated version soon. I don’t use these worksheet very frequently now. After using these worksheets for several years, I am now in a position where I can look at the numbers and estimate if the company looks roughly undervalued. A lot of companies don’t pass that test and are rejected outright. If a company passes that filter, I fill up the excel and go through the entire exercise (which is not very precise in itself)

I have loaded a few samples in the google groups. If you go through this exercise yourself several times, you will see patterns and it will be faster for you too.

In addition to the above excel, please have a look at the excel – Quantitative calculation – worksheet : Maintenance capex to see the relationship between Sales, Asset turns, Maintenance capex and ROC.

Ofcourse you can have a counter argument – who the hell wants to go through such an elaborate exercise to value a company? Don’t I have better things to do life 🙂