Business Quality: Calculating the Value Drivers of the business

Am on vacation whole of this week; brief comments only for us all to take forward. Thanks Ankit - gives us a rough idea to start with - which is a good starting point.

Now 1 yr figures or even last 3 year figures wouldn’t be indicative/correct picture. You sure would have looked at the figures over 10 year periods.

1). How does the normalised EPA and RoIC figures look?

2). How many have accelerated or decelerated in recent years?

3). Do we see clear anamolies anywhere - on EPA comparative basis & Mr market’s valuations? (like we found for AJanta?

I didn’t find any other thread to post this hence posting it here.

Please help me in clearing my query.

VST Industries
A company having excellent parameters Debt Free, ROE 40+% ROA 70+% Div yield 4%.

Even professor bakshi has a writeup on this stock https://fundooprofessor.wordpress.com/2011/04/24/vantage_point/ out which mostly vibes coming are positive

Despite such excellent parameters why is this stock trading at only 16PE compared to peers?

To figure out I also read annual reports. The thing I notice is they have more than 170Cr+ current investments in mutual funds kind of instruments.
Can this be the reason stock is undervalued?

Also one thing I find surprising is (I stay in bangalore), I visted many pan shops in city, nowhere I could find any shop who keeps VST brand cigarettes also none of my colleagues who smoke prefer VST brand charminar. I am not sure from where do they get sales of 800Cr?

Can someone please help me to understand this, even if it would be a personal opinion it would be fine, I just want to take it as a learning.

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Hi Donald/Abhishek/Akbar/Dhwanil,

Thank you very much for the giving such a good read. Right now i am going through some VP pages to understand how a seasoned investor think. I feel understanding different method will help me to develop analyzing skill required for investing.

I would also like to do the exercise done here in the excel. None of the excel link is working here. Could someone please attach a working excel.

Regards,
Anupam

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Hi All,

Can someone let me know how to calculate Working Capital.

This is from one of the post in this forum-

Mayur Uniquoter 2007 2008 2009 2010 2011 2012E
Revenues 66.26 90.24 115.05 164.73 248.56 310.7
EBIDT 6.67 10.57 11.78 27.92 40.87 49.71
Depreciation 1.52 1.39 1.59 2.08 2.67 3.44
EBIT 5.15 9.18 10.19 25.84 38.19 46.28
Operating Margin 7.77% 10.17% 8.86% 15.68% 15.37% 14.89%
Working Capital 13.42 11.88 12.07 22.21 33.01 32.94
Net Fixed Assets 15.95 21.32 22.65 23.15 31.3 45.83
Net Other Assets
Invested Capital 29.37 33.2 34.72 45.36 64.31 78.76
Capital Turnover 2.26 2.72 3.31 3.63 3.87 3.94
EBIT/Invested Capital 17.53% 27.65% 29.36% 56.96% 59.39% 58.75%
ROIC 11.75% 18.53% 19.67% 38.16% 39.79% 39.36%

This is from screener-

Mayur Uniquoter Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
Share Capital 5 5 5.21 5.41 5.41 5.41 5.41
Reserves 12.69 14.47 18.99 23.55 36.64 55.6 80.47
Borrowings 11.37 10.81 8.98 7.85 4.41 7.77 3.76
Other Liabilities 16.35 17.17 23.38 23.98 35.79 40.62 69.41
Total Liabilities 45.41 47.45 56.56 60.79 82.25 109.4 159.05
Fixed Assets 16.44 15.94 21.32 22.65 23.15 31.3 45.09
Gross Block 24.79 25.74 32.4 35.26 37.75 48.48 66.07
Accumulated Depreciation 8.35 9.8 11.08 12.61 14.6 17.18 20.98
CWIP 0.48 0.76 0.1 0.43 0.25 3.35 3.98
Investments 0.07 0.07 0.07 1.01 0.06 0.06 11.72
Other Assets 28.42 30.68 35.07 36.7 58.79 74.69 98.26
Inventories 7.14 9.08 7.2 6.99 9.83 14.55 30.71
Trade receivables 15.28 16.81 20.4 21.56 25.63 31.59 40.6
Cash and Bank 2.1 1.14 4.41 5.76 19.58 22.83 19.04
Loans and Adv. 3.9 3.65 3.06 2.39 3.75 4.33 5.72
Total Assets 45.41 47.45 56.56 60.79 82.25 109.4 159.05

Now how to calculate Working Capital. In the net i found the formula is
Working Capital = Current Asset - Current Liability. with this formula number i am getting from Balance Sheet is not matching with the number given here.

Regards.

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Reproducing my blog-post on ROIC here to seek your feedback:

As investors we are always looking for high quality businesses. Though there is no universal definition of what exactly is “high quality”; businesses that make more money (returns/profit) than a comparable competitor is typically regarded as high quality.

Companies invest in their capabilities to produce goods, provide services or to increase their market reach in their quest to grow. How much investment is needed to achieve this growth determines the quality of the business.

High quality (higher returns) businesses demand premium valuations; sustainability of these higher returns is the key to enduring them.

"Return on Invested Capital" (ROIC) is a metric that helps us identify high quality business. At its crux, it gives us the earning power of the company’s investments/assets. Higher the earning power, better the company.

ROIC = Profit from Operations/Invested Capital

I will try to define these terms below and more importantly explain the calculation in detail using company’s financial statements.

Remember, we are determining the quality of the core operations of the business. Hence, Invested Capital is the money invested by the business to build its core “Operating Assets”. Operating assets generate “Operating Income”.

Profit from Operations:

This is profit from core operations. Other income, exceptional income and extra-ordinary income should not be included in this calculation. Similarly all non-operating expenses should also be excluded. Typical examples of non-operating expenses include, provisions for bad loans, loss on asset write-off and investment losses.

Depreciation and Amortization are real operating expenses (though accountants call them non-cash items), and should be subtracted to get operating profits.

Since ROIC measures returns on all capital (assets) irrespective of how it was funded (equity or debt), we will ignore Interest payments while calculating operating earnings.

The last item is tax. It will be an error if we consider the actual taxes paid by the company, since that will include the tax benefit of the interest payments. We will hence use the effective tax rate to calculate taxes (typically in the range of 25-30% + surcharges).

So,

Operating Profit Before Tax = Earnings Before Interest and Taxes (EBIT)

                                        = Operating Income - Operating Expenses - Depreciation &   Amortization

Profit from Operations = Net Operating Profit After Tax (NOPAT)

                                = EBIT * (1- Effective Tax Rate)

NOPAT and EBIT are widely used operating earnings measure.

Invested Capital:

Before even we define Invested Capital, it is important to understand that we need to use “Beginning Of The Year” Invested capital to calculate current year ROIC. This is because we consider those assets which are in place through-out the year. Assets created during the year may not start generating returns during the current year. Many analysts prefer using the average of Beginning and End of year Invested capital, I personally prefer using the Beginning of Year values.

Effectively, we use previous end of year Balance Sheet to calculated Invested Capital for the current year.

Invested Capital = Total Operating Assets Funded by the Company

                       = Total Operating Assets - Total Operating Assets Funded by Other Entities

                       = Total Operating Assets- Non-Interest Bearing Recurring Current Liabilities

Total Operating Assets

To calculate Total Operating Assets, go through the entire list of assets on a balance sheet and ask the question, What type of income will this asset generate?:

  • Core Operations Income (or reduce operational expense)
  • Other Income
  • Exceptional Income
  • Extraordinary Income

Only if the answer is “Core Operations Income”, include that asset as Invested Capital. Do note that the same asset can generate different types of income for different types of industries. For example, “Loans” will generate Operational Income for Banks but Other Income for a manufacturing company.

The following assets will probably be excluded from the calculations for most of the companies:

  1. Freehold Land - Does not generate any income

  2. Goodwill - Does not generate any income, it is just an accounting variable to hold payments over book value in acquisitions.

  3. Investments in Mutual Funds, Fixed Deposits: Income from these sources is included in “Other Income”, it is usually not a part of core operations for any company (except probably banks and financial institutions).

  4. Cash: Cash will mostly generate Interest income (other income) and hence will be excluded. Some analysts believe that a part of cash is required to run the operations and hence should be included in Invested Capital, I prefer not considering any cash.

Non-Interest Bearing Recurring Current Liabilities

By the very nature of any business, some component of the operating assets is funded by other entities. This does not mean the assets are free, but are free to use for a specified duration of time. Consider raw material; payment terms with the supplier allow some leeway (say 45 days) for the payment of received raw material. This would mean that for 45 days of usage of this raw material, there is no charge to the company. As the current batch of raw material is being consumed and paid for, the next batch arrives with another 45 days of payment window. This continues and the business benefits from use raw material for free.

Some companies initiate production only after part payment/advances are received from the customer. This always helps the business to reduce its invested capital since some capital that is required for production is supplied by the customer themselves.

This is why such payables/dues/liabilities are subtracted from the total operating assets to arrive at Invested Capital.

To identify such liabilities from the balance sheet, verify if they meet these three criteria:

1) No interest is charged on the dues if the payment is made in the specified duration

2) Are recurring (and therefore current) in nature (i.e. the benefit is perpetual)

3) Fund operating assets

Add up all such liabilities to get Non-Interest Bearing Recurring Current Liabilities.

Calculating ROIC is a great way to understand a business and deep dive in its balance sheet and income statement.

ROIC also plays a very important role in predicting future earnings, which in-turn helps us calculate the intrinsic value of any business.

References:

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Hi everyone,
Just started learning about valuation after suffering some loss in market.
I understand the concept of Economic profit theoretically. But …

  1. Doesnt profit loss statement consider interest that any company is already paying?
  2. If the answer is that not all of the capital is funded by loan and hence, isnt reflected in interest row of profit / loss, then should we not consider Max return that could have been obtained if the capital that is not funded by loan was used elsewhere (for ex., say company A invested 100 cr out of which 40 cr was funded by loan and rest was from its own cash. Then, max return that could have been realized by those 60 cr may be taken assuming the same amount was put in govt bonds of say 7%-8%)
  3. Sorry for changing subject, but pls can someone elaborate between the difference of invested capital and capital employed?
  4. In invested capital, one should consider net fixed asset, inventories, CWIP and what other part? I understand i can get it by considering difference between Net current asset and Net current liability, but just wanted to understand this better.

And lastly, thanks everyone for posting great stuff.

Everyone who has contributed to this and the related series of threads, thank you so much for these very informative discussions. They form a very solid foundation based on which eager young investors like myself can fasttrack our learning.

@eng10947 I had two foundational questions about RoRC, it would be great if you could answer (it would be great if someone else could answer them as well!):

  1. How do we interpret negative RoRC numbers? This could happen both due to negative operating profit change, and due to negative Invested Capital change. While the former looks bad, the latter looks good. Concrete example is here where I analyze one of the companies in my portfolio (Sonata Software). The relevant years are 2019 and 2020 and the relevant cell is H22. (I have copied the set of tables which were used in this thread and I hope that is ok).
  2. This point is exemplified by considering a great business with negative Working Capital and assets light model. Such a business would have negative invested capital but could still have change in Operating Profit. Is it possible to make RoRC robust ? One immediate thing which comes to mind is to use the subtraction instead of division.
    RoRC_modified = (% Change in Operating Profits) - (% Change in Invested Capital)
    In this way, negative Invested capital changes would benefit the new metric instead of penalizing it. Wanted to know your thoughts on this.
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Just one submission, that there will always be difference in price when you pay upfront and when credit period is offered in payable. Apparently what looks interest free credit period is actually where you are buying goods at higher price then what you pay for cash purchase.

Also one thing can be that credit period under payable outstanding is being provided on the basis of letter of credit and Guarantee issued by Bank where you are required to pay
a) Letter of Credit / Bank guarantee Commission.
b) Interest on bills raised for credit period being offered by supplier.

LC & BG being contingent liabilities do not form the part of main balance sheet and to that extent your Capital invested figure will be less giving a rosy picture.

Yes, off-balance sheet items will impact the invested capital in the true sense. But as long as they remain contingent, there are two ways the think about them. I prefer reducing the (a percentage of) contingent liabilities from the eventual valuation of the company rather than considering them as invested capital.