Investing Basics - Feel free to ask the most basic questions

Request you to please share your views on which are the most easy businesses to understand in terms of understanding their accounting practices , balance sheets etc. I know financial statements can be fudged for any company. My question is with regards to how can we avoid the businesses where probability of any corporate governance issues and fraud accounting is high. Hope my question is clear. if possible please give some examples for learning purpose.

Hello all my friends.in a life of company every variable changes example growth roce roe pe etc but book value changes very slowly.for example i have screened for companies having roe for 10 yers greater than 10 percent and i get companies like balasore alloys and cubex tubings at 0.3 time book so i am getting 30%on present valuations?is it right way of picking stock or any thing i am missing?

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@dineshssairam

Can you please help to understand below points…

  1. Is DCF method useful for any type of company/sector?

  2. Why to calculate 10 years of future growth and why not for 3 or 5 years?

  3. FCF Forcasting - Is it correct to consider the last year’s FCF value (e.g. year 2017) + growth rate as a 1st year’s value while forecasting.

  4. Discount Rate - Is it correct to have a lower rate (between 5 to 10) if a company is having good RoE, RoCE, low Debt and profit growth?

  5. Calculated Value/Price - How to verify the calculated price (correct or not)?

Thanks.

People usually say that a DCF works the best with companies whose cashflows are stable. So, they go on to use a Multiples method for other companies (“Growth” companies), as if that’s any better. I personally believe that a DCF or a DDM can and should be used to value all companies.

When you reduce the number of years, the Terminal Value contributes more and more to the final value. But Terminal Value is more or less an approximation/aggregation. In fact, the shortest DCF is an Annuity. You can just take the company’s current Net Profits and divide it by the current bond yields in the country and call it a day. But to avoid resorting to a lot of approximations, I use at least a 10 year period. I use 15-20 years for companies which have some kind of Competitive Advantage.

It would be technically alright. But in a valuation, you are trying to tell a story and come up with assumptions based on that story, therefore justifying a value. Using mechanical projections is just a lazy way out of logical reasoning.

A Discount Rate is essentially the least rate of returns you expect on your investments. In all fairness, it should be decided by you personally. The CAPM offers a good guidance, but again, a valuation is personal. So every component of it should also be.

PS. I use the CAPM for my public valuations. But personally, I use a Discounting Rate of 15%, which is the long term return on Mutual Funds in India. I consider investing in Mutual Funds to be my ‘Opportunity Cost’ of investing directly in equities.

You can’t. And you are bound to be wrong. But the point is to limit your downside and have an idea of why you are paying what you are paying for any company.

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Very good question. Simply staying away from wrong companies itself will do a lot of good to an investor’s portfolio.

Given below are a few quick pointers (though it is not a very comprehensive answer):

  1. Financial statements of classic manufacturing companies are easier to understand than statements of banks, finance and insurance companies. Income recognition in some of the service companies (e.g. software) is often vague and non-transparent. Some consumer facing companies (e.g. restaurants, education) may have substantial income in cash which is easy for the promoter to divert.

  2. Within manufacturing, financial statements of those who have smaller operating cycles (e.g. FMCG) should be preferred to those with longer operating cycles (Real Estate, Infrastructure etc.). Companies which use ‘percentage of completion method’ to book income (e.g. construction, software etc.) can easily overstate their income or understate expenses by hiding cost overruns.

  3. Companies which do not have any subsidiary / associate / group companies are better than those which have them.

  4. Companies which are into a single product / line of business are easier and more transparent than those with diversified business.

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Many thanks for the help and inputs. I have created first ever valuation excel using DCF.

One question (hoping this will be the last :blush:)

How to forecast growth of the company assuming the comapny is doing good? I know, this can vary person to person. But can one define/assume the ranges for sectors and companies?

E.g. -

  • Small Cap 15%-18%
  • Large Cap - 10%-15%
  • Aviation - G Rate10% (dicount rate 15%), irrespective of the market cap of the company, considering the oil price changes.
  • IT - 18%-20% for the company like JUSTDIAL.

That’s amazing! Kudos to you.

I keep several things in mind when projecting growth:

  1. The historical growth. The most obvious one. It doesn’t hurt to see what the company has accomplished so far in the past. In fact, in the absence of a place to start, I usually start with a 7-year historical average growth (i.e. for the first 5 years of projection).

  2. Industry growth. Once again, fairly obvious. The apple does not fall far from the tree. Find out the historical growth rate in the industry and divide it by the growth rate of the company. Take this ‘multiple’ and multiply it with projected industry growth rates given in research reports (Always make sure that you compare at least 2-3 reports). This could serve as a good benchmark.

  3. The Self-sustainable Growth. This one’s given as ‘Return on Equity * (1 - Dividend Payout Ratio)’. As in, if a company has an RoE of 20% and pays out a dividend of 30%, the company’s SSGR is 20%*(1-30%) = 14%. In theory, this is the rate at which a company can grow its Revenues without raising additional funds (Debt or Equity). This, of course, works as a very good upper-limit for growth.

  4. The logical growth. This is the growth that logically follows your story and consequently, the most important one. For example, I had assumed a set of growth numbers for my erstwhile valuation on Avenue Supermarts. My story was that the company would plan for aggressive expansion in the first decade and then slowly settle down (This was also the CEO’s vision for the company). You can look at how I ‘justified’ my growth assumptions here:

I understand that this may not work for each and every company. But always try to find a logical source to compare your assumptions with.

A few pointers:

  1. For the Terminal Period, growth cannot exceed the long term Risk-free Rate in the country. In fact, it should be lesser than, say 90% of the long term Risk-free Rate in the country. I generally use half of it.

  2. Useful Data Sets is a great resource for valuation inputs and verification.

  3. You can always turn to the global authority in valuation for any of your questions:

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@dineshssairam
Dinesh
It would good to know if you found any good companies using this analysis over the last 1-2 years and if they performed well
Theory sometimes is difficult to follow
If you give us companies that you bought using this analysis and profited from, if would highly benefit us in our understanding

The weighted average holding period of my portfolio is about 9 months and change. Essentially, the bulk of my investing activities started from the December of 2017 (What a bad time to invest, right?). So, I don’t think my portfolio’s performance would stand to prove anything.

I did make some ‘cigar butt’ investments when I was in college (This was around the June of 2016 to the June of 2017). I made 2x in both SBI and Raymond, as well as 1.7x in COSYN during this period. However, like I said, this was my earliest attempt at investing in stocks and for a far lesser amount. So once again, regardless of the performance, I don’t think this can stand for lesson too.

The great thing about theory is that, it’s not personal. It’s simply a tool. Someone will utilize it far better than me, but that wouldn’t make the theory wrong in itself.

Thanks for your honesty Dinesh.
So many people would not do it and so many people dont start at the age you are starting so you have a tremendous advantage
However is it possible the theory itself could be more complex that what it appears on first reading.
In theory dcf is very easy to understand, its when you apply it, you come across the many caveats.
How Warren and other value investors select companies is explained and is very easy to understand. The problem comes when you try implement it in your own investment
Remember Warren read Grahams book 8 times before buying any stock and even then he worked for free for Graham until Graham died.
If it was the matter of just reading Graham’s book, why would Warren work free for Graham.
Even after than many readings, Warrent says he is just 20pc Graham and 80pc fisher.
Fisher advocated buying quality companies any not look at valuations per se.
So after many years of following Graham’s cigar butt investing Warren found out it was not necessarily the best way to invest.
Shouldnt we learn from Warren’s years’ of experience instead of learning it ourselves. Experience is a worst teacher after all. It gives the test first, and the lesson later.
Warren just purchased a large stock of apple at the highest pe it was historically trading it. No dcf method will be able to justify that.

Ironically, Warren Buffet himself has claimed several times that he still uses a DCF to determine the attractiveness of an investment. He still keeps market multiples as hurdles in the back of his mind (For example, when he describes investing in See’s Candy, he says ‘A Market Value to Book greater than 3 made me gulp’). If you could quote one instance where WB says ‘Pay any price for a quality management’, it’d be useful. I highly doubt he said that.

Secondly, assessing management capability and doing a valuation does not have to differ from each other. Think about what a management could do to a company’s prospects and convert them into valuation metrics. Here’s what I do anyway:

  1. High Growth Period: Good managements keep the company going regardless of external situations. Bad companies fold their cards during difficult times. So, you could give a longer High Growth Period to ‘good managements’ and shorter one otherwise.

  2. Reinvestment Rate: A good manager is a good capital allocator. So, if you think a company has an excellent management, feel free to increase their capital efficiency during the projection period.

  3. Operating Margins: In the same lines, a good management would be able to increase operating margins substantially for the company. A bad management may not.

  4. Margin of Safety: I usually claim a 30% Margin of Safety for all projections I make. But if you trust the management to deliver, you could demand little to no Margin of Safety on yours.

Whatever I said above also applies to a ‘Good industry vs bad industry’. Essentially, it’s the age old ‘Good management in a bad industry vs Bad management in a good industry’ sort of question. It’s a combination of both, so to speak.

In essence, what I’m trying to say is that, I’m simply trying to emulate reality in a valuation. It is not acceptable to me to ‘pay any price’ for a company, simply because their management is so good. I could be wrong, of course. But it is far better to be err on the side of caution than to err on the side of recklessness.

I didn’t say any price
Anyway I wish you good luck on your journey
It’s for the people whom you advice with absolute certainty that you have found a perfect solution weather to follow verbatim what you say or to take it with a grain of salt

I’d say that’s misrepresentation. If you had actually followed my posts here or my blog posts, I always say that valuations are personal. I only ask them that they justify it to themselves. It’s the ‘Ignore valuations if X is good’ mentality that I advice against. Valuations matter, notwithstanding the growth of a company or the management quality.

DCF is easy for calculation but predicting the company’s and/or sector’s growth, government policies from now to 10 years in future is very difficult.

But again, all books says DCF is the only method which should be used with benefits over other techniques.

Few things other than government regulations are ability to catch management incorrectly inflating profits
Secondly dcf will look great where there are skeletons in the closet, some market participants will know this and value company lower than what dcf valuation would arrive it
Being in an industry that’s got moat protects against government policies to a large extent but it also comes at a premium where dcf doesn’t make sense even on a market crash
So with dcf you many times thing you have a great bargain and it turns out you are invested in a commodity or a stock with some non balance sheet contingencies

Thanks.

So as per your experience which is the good method to value a stock?

I usually use a shortcut although it leads to the same result
I divide profit over market cap and want something that has roe of atleast 10pc and Low dividend which means the company can invest profits and generate an roe of 10pc
A consistent roe of 10+ percent usually means the company is not into commodity business but as usual not always
If profit over market cap falls below current interest rate or within 1-2 pc I assume I am getting better rate than bank for my investment and because it’s compounding with consistent roe eventually the return is likely to get better than bank interest rate
It doesn’t involve a lot of formulas but I also look at enterprise value
I look at debt, it should not be 4-5 times yearly profit
I make sure operating cash and investing cash together is atleast 5pc of revenue over a 5-10 year period which ensures the company is not just investing in assets and not recovering the asset cost (a typical characteristics of a commodity company)
Plus I read 2-3 years annual report, put a news alert on google for the sector and company

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Thanks for the reply.

Please share the example if possible.

Below are the valuation methods (assuming company is doing good (RoE and RoCE > 15, Consistent Growth) which I found on Investing sites other than DCF.

  1. Industry and Stock P/E -
    Multiply Industry P/E and Sock P/E. If the value is more than current stock price then stock is overvalued. Add 10% for margin of errors.

  2. Historical P/E -
    Current P/E falls below the historical P/E of 3/5 years then stock is undervalued.

  3. P/E comparison with Profit Growth.
    Stock is undervalued when 5 years of average P/E is less than 3 years of average growth.

  4. EPS, Dividend and P/B
    Value of “(EPS + DIVIDEND) / PB” is greater than 10 then fairly valued. If greater than 15/20 then undervalued.

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There are many companies but mostly commodities
If I am only looking at that variable look at Hero Motocorp and TVS Motor
Hero y.e.2013 p.e. 19.8
Hero y.e.2018 p.e. 19.3
TVS y.e. 2013 p.e. 18.3
TVS y.e. 2018 p.e. 43.2

Profit of Hero Motocorp 3692. Whole company can be bought at/trading at 59374cr
If I had unlimited funds putting 59374 into Hero will yield me 6.2pc
EPS growth of Hero over the years
2008 13pc
2009 34pc
2010 53pc
2011 -15pc
2012 41pc
2013 -14pc
2014 -1pc
2015 14pc
2016 33pc
2017 17pc
2018 9pc

I would assume roughly 8-10pc compounded growth
Hence next year on my investment of 59374cr, I could expect the company to earn 4061 (its an example, I am taking higher end to demonstrate)
So year 2, if I owned the whole company I am getting 6.8pc
Its increasing rate of return faster than the bank. Say bank currently is 6.5pc. If I had put in the bank, it would most likely be 7pc next year, 8pc following year but at some stage it will stop going. It cant be 20-30pc unless we have a major problem like Argentina

So you use DCF you get around the same results but the method is faster and easy to calculate in your head without starting up and excel sheet and putting all dcf numbers, discount rates, etc etc which are subject to a lot of debates.

6.5pc is your discount rate as thats what you get at the bank. Why not use backward calculation and see if it makes sense to buy in probably 1/100th the time.

If Hero Motocorp is going to go through an expansion and we see that products are in demand and most of the expansion will be sold we can use current profit multiply it by how much the expansion will be and arrive at the percentage the company is available at.

You still have to look at interest cover, debt, but I have covered that in the first post

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