The ART of Valuation

Investing Strategies
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Note: 1) I am using certain stocks as example to convey my thoughts. I have used these stocks because of my familiarity with these stocks. Request everyone, not to give too much emphasis to selection of stocks and letas not digress from main topic by starting debate on individual stocks, rather than thought process. 2) This thought process in mainly for Type C stocks, stocks with disproportionate growth.

I have not yet invested in any company following this process, but am trying to study various stocks with possibility of disproportionate growth in market cap over next 5-10 years.

  1. One of the most important points to remember and understand that everystock CANNOT BE VALUED. Infact I would go one step ahead and say, valuation should be the last thing one should look into [By this I am not suggesting valuation are not important, but by initiating our thought process with valuation, we block our mind to see tremendous opportunity which lies ahead of the company or get too focussed on quantitative cheapness that we failed to see risks in the business model. Many investors ignore the risk of black swan events. I think black swan events in the last 10-20 years and occurring with frequent intervals and one just cannot ignore it completely]

  2. **Ignore excel sheets, historical returns including ROE and ROCE and focus solely on BUSINESS MODEL AND SCALE OF OPPORTUNITY.**Again by no means I am suggesting historical ROE and ROCE are not important. But for many of such business when they are in their initial stage of high superlative growth, these ratios might be meaningless due to high expenses compared to current scale of operations, high investments in R&D etc. Read success story of Parag Milks here_http://forbesindia.com//article/big-bet/how-parag-milk-foods-got-it-right-with-cheese/35431/1_aIf he had gone about analysing this opportunity in a conventional wayalooking at the amount that would have to be invested, the return on that investment and so onahe would probably have decided it wasnat worth the risk. But he did what a classic entrepreneur wouldahe deleted the Excel sheets and took a gut call. aI realised it was now or never,a he says. He decided that there was an untapped opportunity in processed cheese and that Parag Milk Foods would ride the coming wavea

  3. **Think like a venture capitalist:Have an investment horizon of 8-10 years and act as if you are investing in unlisted company and you will get exit opportunity only if company is ableto scale up its business model profitably.****If you think you will be comfortable in investing such business even if itas an unlisted company, then only invest else not.**Thinking in terms of decade will ensure that you eliminate companies where you suspect technological obsolesce, product obsolesce, regulatory changes or suspect management etc.

  4. **Position size:**Again I think, mortality rate will be higher in such companies in initial stages when then is high possibility of superlative growth. Obviously superlative growth companies will be operating in innovative or untested field and there is very possibility that company may fail. So itas important to invest in such companies as a basket of 3-4 companies restricting position limit for each company to around 5%.

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Cont…

Let me take an example of Muthoot Capital vs Intec Capital:

Now if one starts their analysis with focus on valuation and historical growth and ratios, definitely Muthoot Capital is better than Intec Capital. But for me Muthoot Capital is not type C stock but Intec Capital is. Main reasons 1) Size of opportunity for SME business vs size of opportunity for 2W finance over next 10-15 years 2) Existing competition in SME finance vs 2W 3) Future competition in SME business vs 2w [Machine Finance is not like simple lending to 2W. 4) Yes ROE and ROCE of Intec are not respectable at present, but compare their employee expenses and other expenses as % of assets under management with other companies. 5) Look at the growth achieved by Shriram Transport Finance and Shriram City Union by operating in a niche field. Both these companies show possibility for creation of tremendous wealth by companies operating in niche field and huge opportunity size. 6) Lastly past actions of Muthoot Capital [which I highlighted in Muthoot thread] does not give me comfort on management.

Secondly lets take example of Shriram City Union. Again this is a company which is operating in a filed with tremendous growth and highly underpenetrated [SME lending]. Now this company and Intec Capital both are in SME business, but Shriram City Union restricts maximum loan at 20 lakhs and does not lend amount higher than 10 lakhs without immovable and other tangible assets security whereas Intec Capital lends money without any tangible assets security. One can think of a joint bet on Intec Capital plus Shriram City Union to gain from possibility of tremendous growth in SME lending.

**Disc:**No investment for Intec Capital/Muthoot capital/ Shriram City Union from Type C stock perspective as of now. My current investment in Intec Capital is more from a special situation in open offer.

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It may be worthwhile to start putting the points discussed so far into some framework to create a base for further orient our discussion to tie up three major focus areas of this discussion i.e. Capital Allocation, Business Quality and Valuation and further refine Based on the discussions in this thread. A quick personal view on broad principles of each of the focus areas.

- Quality of business: Based on discussion so far, and as Donald has so beautifully categorized the hierarchy of businesses based on business quality, we can define broadly four category of business

- Businesses having strong quantitative matrix and consistent business performances

(Mayur/Cera/Atul)

- Businesses having consistent business performance and some intellectual property

(Kaveri/Shriram Transport)

- Businesses having consistent business performance, intellectual property and high

visibility of decent compounded growth for next 5-10 years (Astral/Amara Raja)

- Businesses having consistent performance, IP and high probability of

disproportionate growth (PI/Poly Medicure/MCX)

- Valuation: In my opinion we should have rough idea of what is "cheap" and "fair" valuation for each category of businesses based on previous trading multiples for type of businesses, as Donald mentioned earlier, acquisitions, delisting, take overs, mergers etc. This differentiation is critical, as we have observed. For a business whose sole ISP is consistent performance record, PE of 12 may be fair but for a company having strong IP and high probability of disproportionate growth P/E of 12 may be cheap.

- Capital Allocation: We should allocate capital to each combination of business quality/valuation range to keep the balance. However, obviously, the proportion of capital allocation should be "disproportionate" based on expected returns! I would also like to add that in addition to each category of business, we should also make some allocation for "opportunistic bets for special situations, turnarounds, short term re-rating etc.

So, for better visualization I am creating a table here

Obviously, this is just a framework and numbers on valuation as of now are my hunch and needs to be further honed (based on actual data as discussed earlier). Capital allocation also is my personal take and we can debate it. However, the underlying principle is that one should allocate disproportionate capital to high quality businesses (60% in this case), and even within that, disproportionate capital to high quality businesses available cheap (35%). Secondly, P/E is not the only parameter to assess cheapness.

Even though, there are some suggestions that we should ignore paying attention to parameters like ROCE/ROE/Free cash flow/ leverage, and focus on scalability and growth I personally feel that all these parameters having in place on consistent basis is an inherent part of ensuring a strong and sustainable business model in place. Until, a business passes such test, as "passive owners" who are not driving the business like an entrepreneur, we may be exposed to disproportionate risk (which venture capitalist can take with access to large funds and deep pockets, ability to drive business decisions and directions).

I will be glad to hear more views and take this discussion forward.

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It shall provide us some guidance if we study the thought process of some of the greatest entrepreneur/investors in search of A+ Businesses

Ajay Piramal after the Abbot deal as he says in one of the analyst meet- We want to reallyinvest in new types of businesses and a new portfolio which we thought will be the portfolio for the future where we have

(1) High Long Term growth which is driven by

(2) Increasing market demand with

(3) High Long term margin potential due to some IP or some other proprietary advantage.

(4) In the businesses that could grow with M&A AND

(5) Where we know we could add value.

Vinod Khosla- We invest in companies across lots of industries where innovation is designed to create a new product/service or to completely disrupt the economics of the existing products.

Warren Buffett- Invests only in Co’s with proven track records with ever expanding moats at reasonable price.

It is really interesting that the most successful ones think with the time frame in mind for decades before investing in any enterprise.

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Most successful investors need to invest such a large sum of money that they can not exit any investment on a short notice. That is the reason for thinking in terms of decades. We small investors have an edge over them as far as exit problem is concerned. We can exit any investment on a short notice without damaging the price. Their thinking is driven by their concerns. We should not be approaching our investment decisions based on some other investors problem just because they are big. As long as investment is good for next 2-3 years with huge potential upside, we should go and pick that.

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A brief one - couldn’t help posting - finding some space in vacation.

As I slept over what we have discussed and put on the table so far. the hierarchy for me is getting pretty clear.

Strongly differentiated Finance/NBFC businesses with a unique business model belong pretty close to the top of the rung - This is a pure “Feel” (strong gut) thing at the moment, but I will try to articulate this better conceptually, at a later stage:).

Pursuing that vein, I am studying Intec, SCUF and STF in that order :slight_smile:

Views welcome.

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Hi Everyone

Suven Life Sciences fit the criteria for disproportionate output i guess…

Going through their site… Its too heavy and all over the place…

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Hi Donald,

Very interesting hypothesis.

One curiosity I have is whether there is any specific reasons for studying Intec, SCUF and STF in particular order? Though, being an investor in STFC, I am bound to have bias, personally the comfort level (promoter/track record/business model) is exactly in the reverse order!The reasoning that I have is that NBFC and banking are areas where one is exposed to negative black swans which can completely wipe out the companies, if things go wrong! Hence track record of managing risks, promoter’s integrity and competence are of great importance. Moreover, valuation wise, STF and Intec are in the same range. STFC has virtually no competition in used CV financing business from organized players (I am not sure whether Intec also enjoys such luxury) has excellent track record for last so many years and value driven promoters. Wouldn’t it make more sense to analyse them in reverse order?

stage:)).

:))

Views welcome.

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One of Charlie Munger’s pearls of wisdom fit apt with recent discussion :

Disney is an amazingexampleof autocatalysis. They had all those movies in the can. They owned the copyright. And just as Coke could prosper while refrigeration came, When the videocassette was invented, Disney didn’t have to invent anything or do anything except take the thing out of the can and stick it on the cassette. And every parent and grandparent wanted hisdescendantsto sit around and watch that stuff at home on videocassette. So Disney got this enormous tail wind from life. And it was billions of dollars worth of tail wind.

Obviously, that’s a marvelous model if you can find it. You don’t have to inventanything. All you have to do is to sit there while the world carriesyouforward.

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Dhwanil,

I had to respond to that:) although the order shouldn’t really matter.

For me the promising unknown is far more enticing than the known sure-fire thing!

As I have mentioned before, one good reason we have done exceedingly well in unknowns (that performed well) is we had an EDGE over the average investor in the market. We cannot have much of an edge over the market in the knowns. The knowns can give you 4-5x in 3-5 years but surely can’t match the 8x-15x-20x in the unknowns in the same period (my personal experience).

So the attractiveness will never be the same - provided of course the unknown has something going for it; in this case there is something Shriram guys have themselves acknowledged - that Intec guys have slowly assiduously built a niche - extremely difficult top replicate. check Intec thread for more.

Having said that, there is a time for extremely good bets in the Knowns - in a secular market crash, when everything is beaten down, when panic has set in, but business fundamentals are still good to strong.

I am studying STF too, and I know how well respected it is, the pedigree of having created its unique unmatachable footprint; however the business fundamentals aren’t good - it’s at best a turnaround bet; Some STF veterans I know have actually booked most of the profits in STF recently!

Studying Intec, SCUF and STF together - order really does not matter much :slight_smile: will give me a better handle on NBFC industry, and will allow me to construct management Q&A discussion flow better around issues common to the industry first, and then I can go onto specifics.

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Another Great Discussion, something that is becoming a moat at Valuepickr ;-)!

I was re-reading a book and one of lines stuck me as very relevant to this discussion, to paraphrase:

The valuations will determined by amount, riskiness and timing of the future cash flows.

Hence I think as an investor the question is whats the edge one has in predicting the above better than anyone else ?

In my experience after a while a good investor develops an instinct ofwhether a business is interesting enough [often a function of individual’s investment style/strategy] and after thatthere is no shortcut to hard work!

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Also I think ( and as many have indicated) I think its the “market opportunity size” and trust in the ability of management to scale are the most important parameters for these disproportionate returns.

;))! amount, riskiness and timing of the future ofwhether thatthere

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Hi Donald,

I am just responding to the comparison of IP of a NBFC with others like PI, Poly,Kaveri etc. Just get a feeling that the niche segment we are talking about in case of NBFCs is not due to IP - yes evaluating the credit worthiness and repayment capacity of a street vendor or an earth moving equipment is more complex than evaluating a salaried person, but to give it same ranking as that of R&D based companies might be stretching it a bit too far. This business can be done by any bank if they want to without breaking their head. Micro finance, gold loan companies are all getting into this if not already in it.

The untapped sectors or niche sectors tapped by Gruh, Repco, Intec etc are untapped because major banks are not interested in it. They dont want to work hard for extra NIM as the headache of NPAs if some employee or the other falters is too much for them. Also to assess these niche customers they have to go to the customer’s place, understand the business and also send their person to collect EMIs, delayed payments etc. In that sense the Niche NBFCs are type A (in the parlance of the Sr investor) as they are laborious and hard working. To keep the NPAs off they need to be on their toes 24/7 tracking each and every loan. Gruh is doing an excellent job at this.

I am not at all saying that Intec, Repco etc are not good investments, but their IP may not be as strong as we think. Opportunity size is big, entry barriers may not be big.

stage:)).

:))

Views welcome.

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The very fact that I am emboldened to post at this thread again - after a big gap of 4 months - can only mean two things:

  1. We had reached the end - in illustrating our ART of Valuation incremental learnings at VP (from 2011-2013); needed time off to take things forward and imbibe new stuff

  2. there wasn’t anything original that we could come up with that DROVE HOME another (may not be new) exciting & insightful ART of Valuation Tenet - something very simple and powerful - that everyone could look to implement :slight_smile:

I am excited, again. Think we got hold of something simple - something powerful - something that you and me can immediately put to use with (I think) telling effect. Really??

It all depends on my ability to reproduce my conversation with Mr S exactly as it went ;). So pardon me if I can’t get you equally excited immediately - but eventually we will get there.

VALUATION ART #4

Mr S: (A Senior Fund Manager & Friend) How would you incorporate (assess) Future Value creation in a Business and assign a Valuation multiple - with sound economic reasoning?

I must say I didn’t provide a satisfactory answer - how could I - we are still grappling with these things. I told him we toiled hard in trying to decode Business Value Drivers with the very promising Economic Profit = Invested Capital *(RoIC - Cost of Capital); We also played around with lots of lots of examples (Nestle, Colgate, ITC, HUL, Page and scores of others in the FMCG pack) but clarity eluded us.

Mr S: How about breaking the Business Value into 2 components: a steady state value & a future value creation? [Merton Miller and Franco Modigliani - Foundational paper on Valuation
A much simpler read Mauboussin: What does a P/E Multiple mean

)-----

Business Value = steady-state value + future value creation

Steady-State Value = (Net Operating Profit after Tax (Normalised))/(Cost of Capital ) + Excess Cash

Future Value Creation = [Investment *(RoIIC - Cost of Capital)*competitive advantage period]/[Cost of Capital * (1+ Cost of Capital)]

)-----

Seen another way

Value of Firm = Debt + Equity, then

Equity Value = Steady-State Value + Future Value Creation + Excess Cash - Debt

)-----

Steady state Value: calculated using teh perpetuity method assumes that current NOPAT is sustainable indefinitely and that incremental investments will neither add nor substract value

Future Value creation boils down to how much money a company invests, what spread that investment earns relative to the cost of capital, and for how long a company can find value-creating opportunities

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Let’s ignore the heavy stuff (formulas :-)) for a bit and focus on a few things the equations seem to be telling us:

1). We can break up Valuation for a firm (say PE or Market Cap) into a Commodity component (the first part) and a franchise component (the second part). This lets you & me quickly understand how much we are paying (today) for future value creation

2). The huge significance (impact) of Return of Incremental Invested Capital becomes very clear. If that Return is equal to the Cost of Capital, the value of equations second term becomes zero!

3). The equation also shows us very clearly the impact of Growth. For companies that have a large spread between the RoIIC and Cost of Capital, rapid growth adds a lot of Value. For large negative spreads, growth subtracts (destroys) a lot of value. So whether the growth for a business is good or bad - depends on its ROIIC.

4). The essence of value creation thus lies in existence of opportunities to invest significant funds at higher than normal rates. The “normal rate” is the Cost of Capital

5.The equation gives you and me a quick sense of the Expectations built into a Stock (which may belie the Economics of the Business)

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5.The equation gives you and me a quick sense of the Expectations built into a Stock (which may belie the Economics of the Business)

Now this is the part that got me excited at the possibilities. The above comes from the efficient market theory precepts - however we all know how often the market is found grossly inefficient.

So here is my reasoning:

1). Consider 2 businesses - both available at teh same multiple say 25x. They have had more or less similar number of years in business, but are in very different industries. So obviously they will have different steady state value and future value creation.

2). We could easily calculate for ourselves the Future Value Creation part - Invested Capital, RoIIC, Cost of Capital are all known, assume similar Competitiuve Advantage Period (CAP)

3). It may well turn out that for Business B, Future Value creation is something like 30-40% of current Market Cap, whereas in Business A, the future Value creation component is insignificant or value-destroying!!

4). To me, this gives me a quantifiable objective framework to decide clearly that I should pay up for Business B and not Business A

Don’t you agree? ???

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If you do, then why can’t we apply this to

a) all VP Portfolio candidates - check where there is the best future value creation, and where there is probably too much of froth?

b) apply to what seems always frothy - perennially expensive stocks like Page, Nestle and decide hey this and this is where it makes sense to pay up and not here

It gets me excited to think this is again a pretty tangible, simple mechanism to really understand Mr Market’s Valuation anomalies (when they exist) and take good advantage of him!!

Its a pity …I haven’t been able to play around with data, and I am going to go complete incommunicado (Silence) for 6 days starting 24th night - doing an Advanced meditation program at AOL International Center at Bangalore - while Kids are enjoying their rollicking boisterous Summer Camp at the same place :slight_smile:

Can folks like Utkarsh, Dhwanil, Vinod MS, Ankit, Om and other young turks take the lead in dissecting this quickly? Will Ayush and Abhishek and Hitesh guide them in getting to the bottom of this exciting puzzle?

Cheers

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I think the best example of returns on incremental investments is Astral. It should be seen a case study in this theory and once we dissect it, we can go ahead and try to find out similar situations. Even the market cap versus opportunity size applies perfectly to Astral.

I guess putting numbers in case of Mayur also might be very very interesting.

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Value = steady state + future value

Very similar and excellent discussion is also there in “Accounting for Value” in which author suggest value = Book value + speculative value. Further speculative value was broken down into steady state value and value for future growth.

Go through the presentation here http://www.forumtools.biz/oiv/upload/OIVLecturePenman.pdf. In the book author made it little complicated by using some extra formulas but even then for me its one of the ten must read books.

Prof Bakshi made it more simple for us to understand the valuation concept in the lecture presentation [Download lecture 14-15 from here http://www.sanjaybakshi.net/bfbv/] and no need to put link for relaxo final lecture. Forgot about the stock, focus only on the methodology…

But before applying the above methodology one should REMEMBER that its WRONG to apply the above SYSTEM to EVERY STOCK. Personally [at risk of being COMPLETELY WRONG] I will not apply above system to stocks like Avanti feeds, Muthoot Capital & Kaveri seeds for various reasons. I will be happy to apply above system to stocks like Symphony, Page Industries &Astral.

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2). The huge significance (impact) of Return of Incremental Invested Capital becomes very clear. If that Return is equal to the Cost of Capital, the value of equations second term becomes zero!

I failed to bring out clearlythe key takeway that I derived from this .

Basically we have another good incremental handle on Capital Allocation - while assessing a business for increased capital allocation - Consider incremental returns on capital first, and growth next. Growth creates Value only if incremental investments generate a return much in excess of the cost of capital.

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