The ART of Valuation

(P Sharma) #81

A good discussion again.

If there is one person who has spoken the most on this topic it is Warren Buffet. The concept of incremental return on equity is one of his favourite topics. He defines his earnings in partially owned businesses not only by the dividend payments he receives but also by his proportionate share of the retained earnings. His annual reports have the usual GAAP earnings that he is expected by the law to report but also economic earnings which is his share of the retained earnings in the listed companies. He is happy to let the companies retain the earnings as in his mind the capital is growing at a faster rate than what he could have achieved in his wholly owned companies.

On the issue of incremental rate of return on capital and growth, the former is more important without a shadow of doubt. However, high returns accompanied with high growth is the icing on the cake.

Let us take the example of Hawkins. It has very high return on capital and a decent return on incremental capital,though it is dipping. The issue with Hawkins is that the growth is very anaemic.

There are only two ways that you can invest capital to run any business. Either the money goes to fund the fixed assets or to fund the working capital.

It doesn’t take a lot of capital to erect machinery or buildings to bend aluminium sheets or rivet handles to them. This is not to advocate that we should invest in asset heavy businesses. The superior returns on capital is on account of this asset light business.

Therefore, the only recourse Hawkins has to suck in enormous capital is to grow very rapidly and deploy incremental capital as working capital. This is clearly not happening. Therefore one vital ingredient in the equation is missing and we have seen the results. I as an investor would have been happier if Hawkins had retained all the earnings and deployed it in the business with the ROCE that it has.

A better business still to own is something like HLL. It takes large amount of dealer capital and deploys it at very high rates of returns. However, such businesses with negative working capital are few and far between and quickly priced by the market.

The last 15 years has seen a radical change in Warren Buffet’s portfolio. Starting in 1999 he started investing in the utilities business. Utilities are a regulated business and the regulator determines the return that an investor can earn on his investment. For obvious reasons, there is a positive spread of a few percentage points the cost of capital and the allowed returns.

I don’t think that Warren Buffet had a choice. He was dealing in ever bigger numbers and his insurance businesses were churning out a lot of positive float every year. He had to invest large amounts of money every year and the US utilities with a sensible regulatory framework was the perfect avenue for him to deploy this capital and earn the spread. Given that the US power grids needed upgradation after years added to the allure of this sector which demanded large capital.

If we look at the VP portfolio, Astral, Kaveri, Atul Auto etc have managed to achieve both of the above and were probably rewarded by the market in terms of higher valuations.

Another case in point is JB chemicals. The incremental ROE is almost double the headline ROE for the last two years, a point not being appreciated by many in the market today. This coupled with the growth could probablylead toan appreciation in the stock price ( I am invested in JB Chemicals and this is for illustrative purposes only and not a recommendation to buy the stock). Spotting these trends early could be a rewarding exercise for investors.

(Chintan) #82

Excellent food for thought, P Sharma.

At a slight risk of digression, how does one find/calculate the return on incremental capital?

Am I right to equate this to the variable cost for manufacturing the (n+1)st item, where n is the current turnover?

(Piyush) #83

@ P.Sharma.

Great comments. You have mentioned that incremental ROE is double of headline ROE for JB. From where can we get such data for JB and other potential companies?

(P Sharma) #84

There are various ways and terms used to calculate incremental returns. The way I look at it is to calculate the change in the net fixed assets+ WC between two time periods of a balance sheet. Adjust this for cash if the cash is high. Look at the incremental EBIT/PAT for the same time period and calculate the incremental capital return.


I might be totally wrong on this one. Can anyone please say where I’m wrong on my rationale/thought process below.

To calculate this incremental capital return easily, what I do is to look in Cash Return on Invested Capital (CROIC). CROIC tells the business ability to generate cash per invested capital. Now the management can either distribute this cash to shareholder or reinvest the cash into the business. If ROIC (with the cash that was generated as explained before) is higher for the business, then shareholders are better off with the company retaining the earnings. The way how I check is like this: (Eg: Astral; taken from

1). ROCE: 36%

2). CROIC: 43% (with the capital, they generate 36% then cash returns on ROCE is 43%)

3). ROIC: 44% (then the cash generated returns 44%)

4). Dividend Payout ratio: 3.5% (Wow! Prima facie the business employs more incremental capital at the high return so much so that profits are retained to generate more cash and maybe to retire debt)

5). ROA: 12% (not very capital intensive that earnings has to be retained to service next year earnings).

6). PE: 39 times TTM. (Of course, Mr Market is not a fool. Incidentally Mayur and Astral have identical M Cap/sales ratio.)

P I Industries and Mayur also seem to have high ROIIC. Mayur’s ROA is 23% which seems to suggest that it is not Capital Intensive and ability to employ more and more incremental capital is at question. We should see Mayur’s increasing market share and this business market value if Mayur can do more capex to have sustaining high ROIIC. It would be interesting to see ROIIC over the years for various business and observe if the ROIIC is sustainable for a long period of time.

I’m challenged but going to try and see if I can get this ROIIC ratio thingy on Screener with the calculations illustrated by P Sharma.

(Niraj Kumar) #86

Another important matrix for valuation of company /stock is EVA (Economics Value Add) which is simply can be defined asthe profit earned by the firm less thecost of financing the firm’s capital. Equity is considered more costly than debt in this calculation and considering indian conditions assuming average cost of capital to be 15 % a simplified formula can be calculated as(Net profit + Interest - Total Capital Employed * .15 ). Most of the companies tried to give EVA for measuring performance of senior management and company and few companies like Pidilite, Godrej etc also follow this to calculate performance of the company. This is established through various research in last 15-20 years that companies with positive EVA usually has better stock market return in long term assustainablelevel and a good indicator for future stock price performance.

(Dhwanil Desai) #87

Again, very relevant discussion on a very important aspect of valuation and investment. This is one of the more important but less discussed topic. Typically, as an investor, we look at historical (5 year/10 year) return ratios (ROIC) while analysing business but fail to notice the return generated on incremental capital deployed. However, as Donald so aptly pointed out, the future value of business depends on how much return is generated on incremental capital deployed in the business and the growth. I did a small exercise for some of my portfolio stocks/VP portfolio stocks for last 5 years to further understand whether high return ratios that I see for each year actually translates into the high returns on the additional capital deployed. Sometimes, high return ratio is just an optical illusion and absolute returns are high just because, historically, business has yielded very high ROIC hence, though the return on incremental capital is mediocre, the resultant overall return still looks attractive. Here is the summary table of the exercise

09-10 RoIIC 10-11 RoIIC 11-12 RoIIC 12-13 RoIIC 5 yr avg. RoIIC 5 yr avg. top line growth (CAGR) 5 yr avg. bottom line growth (CAGR)
Mayur Infinite 67% 73% 26% 61% 28.5% 48.5%
Atul Auto 40% Infinite 147% Infinite 832% 27% 54%*
Astral 129% 43% 12% 32% 33% 33% 34%
Cera Infinite 27% 12% 29% 29% 25% 28.5%
Ajanta 44% 46% 34% Infinite 78% 21% 35%
Kaveri 13% 87% Infinite 90% 107% 45% 41.5%
Shilpa 239% 124% -88% 26% 84% 18% 2.4%*
Swaraj Infinite 77% 115% 6% 71% 18% 21%
ARBL 139% -16% 267% Infinite 112% 16.5% 29%

* As the difference in bottom line numbers was very large due to extraordinary circumstances in 2008-09 resulting in very low numbers and hence quantum jump in 2009-10), we have calculated CAGR on 4 year basis starting 2009-10.

Link to the detailed analysis is here

Following are some of the observations/caveats in my opinion

- I have only considered capital invested in the business to calculate the RoIIC and excluded cash + Investments (unless it's in subsidiary/associates for which the numbers are consolidated)

- I have used number from Edelweiss and there may be marginal difference in numbers from some other source

- Wherever, the difference in total capital deployed between two successive years is negative and NP has increased, in mathematical terms the returns are infinite. However, one must understand that for most of this business this may be an aberration for specific period/s.

- As companies deploy capital to put up fixed assets to meet with forthcoming growth, it takes time to ramp up the production/sales from these new assets and to stabilize the operations at new assets. Hence in years where such large capex becomes part of gross block/net block, the returns from such incremental capital may be very low for initial years. Hence it is prudent to look at moving 3 year/5 year average to smooth out such aberrations.

- However, it is very important to understand the limitation that the analysis is based on historical numbers and future may look very different than the past. Few of the companies have old and depreciated assets and are sweating those assets to keep up with the growth. However,these companies need to create new assets to cater to the forthcoming growth in future. Hence what is the likely return generated on the capital deployed to create these new assets?

Let's take example of Swaraj Engines: It plans to add capacity of 30,000 with total capex of 38 crores. Average realization for SEL is around 85,000 for each engine. Hence at 80% capacity utilization, estimated topline is 204 crores. Average NPM has hovered from 10.5% to 13%. So let's take average NPM of 11%. Thus, expected NP is 22.4 crores. Normally, as the production increases, Wcap requirement too increases, however, SEL has bucked the trend and has operated on negative/negligible Wcap since last few years. Thus no additional capital required for WCap. Thus 22.4crore on yearly basis for Capital addition of 38 crores means, payback period of 1.7 years and ROCE is 60%. This is superlative by all means.

Similar calculation one can make for Atul Auto for upcoming plant of 50,000 capacity at 100 crore capex.

I personally feel, that at this juncture it is also important to draw inference from this analysis in sync with analysis of two critical aspects

1) Is company able to deploy large capital in the business and still able to generate high return on that?

2) If the additional capital requirement is not large, even to keep pace with further growth, then whether the management is returning the excess capital to shareholders or not (through dividend/buybacks)?

Valuation assigned to the business by the market may depend a lot on answer to the above two questions in addition to the RoIIC.

(biju john) #88

hi dhwanil,

just looking at the swaraj engine case,what happens the next year,he made 22.4 cr,say he distributed 20% as dividends as is the norm in most companies and the rest adds on to the networth assuming all the 38cr was equity,so what would he do with the 15cr he has added to his networth,iam sure he cant start another plant as there may not be a market for it or in crease prices/margins.So the returns in the next year would be 22.4/38+15.We can look at Balkrishna industries as an example,they set up capacities and then found themselves in the midst of a recession.Maybe i made an error. Iam invested in atul,howevr iam not confident that all the volumes that they churn out from the new plant can be consumed by the market.

(P Sharma) #89


Totally agree with the last point of yours. Will the management be able to deploy incremental capital and earn high returns on it or at least a significant positive delta on it as compared to the market rates to make it worthwhile for the shareholders to let the management retain their earnings? If the management is able to do it, then this is the best case scenario for the shareholders.

The most prudent course for the management if it is unable to do this is to return the money to the shareholders and not fritter it in deworsifications. The downside here is that with the management returning the money to the shareholders means that the increase in networth/book value is lower and consequently the market value.This can have a big impact on the long term valuations.

We can always argue that the shareholders have some other avenue to invest this money at higher returns and will still be rewarded. This is a big ‘if’ but a better situation than the existing management squandering the money.


The market opportunity for SEL is limited and hence even if it is the market leader, there is only so much it can grow and hence a limitation to the capital it can deploy to earn higher returns. This is why the opportunity size coupled with the incremental return on capital is investors ultimate dream.

This very situation is faced by Warren Buffet and it would be interesting to know what happens on the May 3rd AGM. This was a statement made by Warren Buffet a few years ago which was revised subsequently;

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we canât create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.

Berkshire Hathaway will most likely miss this target this year. The increase in book value would be lower than the increase in the S&P. Warren Buffet’s test is that if Berkshire Hathaway is not able to achieve this, then the shareholders are better off investing in a S&P index fund( There have been some minor repurchases of Berkshire Hathaway stock).Let us wait and watch what his response would be. Just a caveat ,that the reported book value for wholly owned businesses doesn’t reflect the market value and some of the underperformance is owing to that.

(Utkarsh Patel) #90

Excellent discussion here.

I just want to point out an observation I have had. Most of the companies we have in ValuePickr have had significant margin expansion over the course of past few years. In a sense, I feel this inflates the ROIIC tremendously, there is nothing wrong in it.

A company in flux in past, due to change in product mix, and favorable product portfolio at the end of margin expansion cycle (which is of major interest to us now) may not be able to generate high ROIIC generated during margin expansion cycle.

In order to get a steady state picture at current juncture of already higher margins in some of the stocks like Ajanta Pharma, won’t it be more prudent to consider incremental sales/incremental capital ( Sort of Capital Turnover for incremental capital) of past few years as it neglects the increase in profits happening due to margin expansion.

Views Invited

(Atul Garg) #91


We had a similar enlightenment in the Quality of Business thread discussion where it was said

Economic Value Added = (ROIC-WACC)* Capital employed

We also concluded that growth only adds value if ROIC > cost of capital.

So what additional insight does RoIIC provide ?

I understand that RoIIC gives us incremental return on invested capital but I am still at loss at the utility of ROIIC as an additional tool that can help us seperate wheat from the chaff over ROIC. What are the the situation where RoIIC can help us but not RoIC.

Appreciate if seniors can demysitfy through an example where RoIIC helped over RoIC.




Great discussion. Thanks Donald for starting it and Dhwanil and others for their views. The incremental capital can result into increase in capex or increase in working capital as Dhwanil pointed out. While evaluating this increase there are a lot of questions that need to be probed:

  • Increase in capex

o Capacity addition: Important thing to understand here is at what capacity utilization is the company currently working at? Is the capex really required? Is there a market for the increased capacity? Are there any supply side constraints that the company is looking to address with the capex?

o Inorganic buyouts: Does the new buyout add to companyâs strengths? What is being paid for the buyout? Is the buyout happening from the same promoterâs company? Lookout for possible red flags. There are plenty of bad examples around this. I have seen this as one of the major source of value destruction.

o New product launch/diversification: Does the newer product add to companyâs core portfolio? Will new marketing/advertising expenditure be required for newer products? Is it a case of di(worsification).

  • Increase in working capital

o Increase in inventory:

Is the increase in inventory due to capex/new product launches? What is the inventory position of newer introduced products and the older one?

On a cursory glance of the companies that Dhwanil has put out I think Ajanta has been very successful in deploying incremental capital and at the same time taking a minimum load on the inventory. The incremental capital has also resulted in increased OPM for Ajanta.

There is another set of companies (generally FMCG) which outsource manufacturing and have almost zero increase in their working capital and capex and an ROIIC analysis does not suit them. Symphony is an example that comes to my mind. Another interesting question that comes to my mind (due to these companies) is about the advertising expenses. Advertising helps in building brands an intangible asset generally not reflected in balance sheet (if it is I will be wary of). But as an investor should I think of it as some kind of capex (which builds a lasting brand) or as some kind of operating expense (you cannot live without advertising in FMCG sector)?

(Dhwanil Desai) #93

Hi Biju,

For the point pertaining to SEL, it all depends on how company deals with the extra capital that it has. Precisely for this situation, I suggest that it is important to consider whether management returns excess capital to shareholders or not. However, this is not such a uncommon situation especially for businesses having asset light models with high return ratios. However, a key monitorable parameter in such companies is how effectively company/management returns excess capital.

As to the setting up new capacities, it is always that demand is built up slowly and that is precisely the reason one should consider the 3/5 year average RoIIC which truly reflects the economics of the underlying business.


(Ayush Mittal) #94

Excellent discussions and examples taken.

One thing which I’ll like to discuss is - that I feel its not easy or its many often risky to extrapolate the past ROEs onto new bigger investments being made by the cos. And this is where individuals judgement comes into play and thats what makes a huge difference in the future value and premium valuations.

For eg: Case in point is GRP - The co has had excellent ROE, ROICE of above 30% consistently for last 10 years till 2012 or 2013. However, one new plant in a new state got them into trouble. (Though i feel the co will come out of the problem)

So extrapolation is ok when the new investment is happening at the same location in the same product line. The moment some new variables come into play, one should be very cautious in extrapolating the past nos.



(Donald Francis) #95

Hi Guys,

Thanks for carrying forward the discussions - excellent inputs from P Sharma, Utkarsh, Dhwanil & others.I have been thinking of how to capture the essence of my excitement :slight_smile: very simply, very practically - and I think I might just have found a way!

1). Let’s just think of 3 our biggest wealth-creators in VP Portfolio - Ajanta Pharma, Astral Poly Technik and Mayur Uniquoters - all 10-15x baggers over last 4 years.

2). It was very difficult to completely stay put in Ajanta Pharma - not understanding the business that well, but it was pretty easy to stay completely put in Mayur and Astral over last 3-4 years of major value/wealth creation

3). As mentioned before in VALUATION ART #4,MarketCap capturing a Steady-State Valuation )+ a Future Value creation is a very powerful construct for me - in separating the Wheat from the Chaff again - this time among Mayur, Astral & Ajanta!!

4). These 3 are in very different industries with different business models and very different competitive positions. It is safe to say that they are all creating different Future Value for themselves at this juncture - and going to create in the next 2-3 years - right?

5). Now I am sticking my neck out and saying that hey - Ajanta Pharma is creating much higher Future Value than Astral & Mayur today. Let’s assume all 3 keep growing business performance at 25%+ CAGR for next 2-3 years - it will create far higher Future Value in the next 2-3 years. Let’s additionally assume that main business/investment characteristics haven’t changed for any of the 3 (it has for Mayur because of PU, but let’s try and keep things simple. Let’s also assume, they keep doing more or less the same thing that they have been doing so far - keep executing as meticulously as they have been so far.

6). It’s pretty easy to demonstrate who (among the three) is creating superior future value - through the Economic Profit Added (EPA) model that we captured in the Business Value Drivers discussion thread - without much heavy weight-lifting by way of formula/calculations!

7). However, this is not the exciting part. The exciting part is when we can easily see (only when we ourselves have a pretty intimate knowledge of the business/industry & issues) how Mr Market may be getting it wrong - i.e. Market Cap (PE) clearly not reflecting the “superior” future value creation!!

As you ponder over this, let me try & present the tables/data to drive this home, in my next post.

(Donald Francis) #96
FY2013 Ajanta Mayur Astral
Sales (Cr) 839.20 380.54 821.09
EBITDA Margin 25.58% 18.87% 13.84%
Invested Capital (Cr) 460.88 125.81 302.98
Capital Turnover 1.82 3.02 2.71
EBIT/Invested Capital 39.49% 52.95% 31.68%
Tax Rate 28.51% 32.13% 22.28%
RoIC 28.23% 35.94% 24.62%
RoIIC 72.46% 125.56% 24.28%
WACC 13% 13% 13%
EPA 70.19 28.86 35.21
EPA/Sales 8.36% 7.58% 4.29%

* Those interested in the Calculations can find detailed workings in attached Ajanta Excel. Best part is you can upload this excel at and download the same calculations (automated) in a jiffy - for any business of your choice. Eternally grateful to Pratyush & Ayush Mittal for this wonderful service/tool

Ajanta-Pharma.xlsx (78.7 KB)

(Donald Francis) #97

Some observations from my side:

1). Data used is for FY2013. It will be very interesting to do these calculations on FY14 data and see. (Mayur results yet to be out)

2). One must note the huge difference in Margins between Ajanta, Mayur & Astral. Esp with FY14 Margins for Ajanta at 32%

3). From the EPA model discussion, we know there are only 2 drivers of RoIC - Operating Margin & Capital Turnover

4). While Mayur can never catch up on Op Margins with Ajanta, it more than makes up for it by way of Capital Turnover currently ( I stick out my neck again and maintain that this is going to change in greenfield installation for PU; existing PVC plant is 17 yr old fully depreciated plant, uncannily they added another line at half-cost again, but this will change)

5). Again there are only 2 drivers of EPA - Size of Invested Capital & ROIC. Ajanta - Capital Invested is 1.5x Astral (for same size Sales) and ~4x Mayur (for 2x Sales). The above argument can be turned on the flip side saying Ajanta Invested Capital will go higher up once both plants are commissioned, but Capital Turnover will probably slide further down.(FY14 BS is out and it shows a 75 Cr Gross Block addition without additional debt Capital)

6). Mayur shows the best Return on Invested Capital (RoIC)with Ajanta coming 2nd and Astral slightly behind. But the Return on Incremental Invested Capital (RoIIC) figure should really wake us up as to where and how rapidly is future value being created. Astral lags behind by some margin here.

7). We can see that Ajanta is adding more than double Economic Profit Added of both Astral & Mayur.

8). Given the size of the business - Mayur being half the size of Astal or Ajanta - EPA/Sales provides a better correlation - and that shows Mayur is running Ajanta Pharma pretty close (Does not mean it will have the opportunities to invest higher Capital in the business than Ajanta in future)

9.The kicker - now just compare Mr Market’s (current) valuation of the 3 businesses!! Where do the ODDS lie?

10). Caveat/Disclaimer - there are many things different in the 3 businesses. Investment characteristics will/may change in the short term for these businesses; Business Segments/Profile may also change. The above does not take into account a very important valuation criteria - the value of the business to a 100% buyer of the business; but that’s another very very interesting discussion coming up!

(Atul Garg) #98

Donald, In this model, how do we fit the companies which are paying huge dividends like Accelya ?

(Donald Francis) #99

@Atul - Yes Dividends play a big role. You can just look at Dividend Payout ratio and check how far ahead it is of the norm. For folks more into Capital Preservation, big dividend payouts are a huge turn-on; Future Value Creation while important may not be of primary importance. But for those into Capital Building phase Future Value Creation may be of primary importance.

(Donald Francis) #100

I have had a few calls since morning on the above Topic. Let me reproduce the 1 hour plus conversations - and I had 4 of them including one last night :). There was a common pattern of objections.

Q. This concept of Future Value creation - is it really new? We use it all the time in evaluating start-ups or PE investment.

A. Of course it is not new. But how many apply it diligently, or are very clear about how to use it Sir?. I started looking at it in 2011 - in the Business Value Drivers discussion. Only in this past week I can say with honesty - that I think I know how to use this well as another refinement in my toolset.

Q. So what is the new insight ;)??

A. If you asked me 2 weeks before about relative merits about investing in either of Ajanta, Mayur or Astral now - I would have 5-6-10 points in each business about the pros and cons of the next 2-3 years. However none would have been as compelling or insightful an answer as the EPA table I shared. I know that’s true because without the EPA Metric sitting firmly in my head I did not have this clarity. Obviously without this small refinement I would have failed to transfer my conviction.

Q. Okay. But isn’t this making too many assumptions? That the businesses will retain similar or better RoIC or RoIIC patterns in next 2-3 years?

A. Yes. But we are forgetting to note that the businesses in question - Mayur, Ajanta, Astral - we have been tracking and invested in now for 3-4 years. We have good knowledge of the industry and respective competitive positions. It may not be off-the-mark to say we know/understand what is possible and what is not possible in the industry. It may even be correct to say we have an edge over the market in understanding the business closely. On top of that, we understand the Management - their depth, their bandwidth, their hunger in upping the ante. Every year of association we have got a little better at that - is that a reasonable assumption.

Then all we are saying is that the ODDS are high that the businesses in question will continue to execute and continue to record normalised RoIC levels.

Q. Hm! But is it incorrect to say that this still does not factor in the Risks in the business or in the environment?

A. :). Now its my turn to smile. Sir - Risks can be nailed down to the number of variables in the business. For us Astral was a ZERO RISK investment 2 years back - on 2 counts Mr Market thought were the biggest risks. Forex fears and on CPVC competition (every Tom Dick and Anupam was advertising CPVC manufacturing on the back of Autos - and there were biggies like Supreme adding capacities. With our closer understanding and 360 degree interaction with stakeholders in the business- we thought these are Ignorable Risks.

Other than that if there are environment or other new variables that suddenly crop up - that may well be true for any business. No Valuation modeling or ART can capture that.

Q. Final question. It seems that you are mixing up Science of Valuation while talking about ART of Valuation!

A. Yes. We are doing that. We still maintain the Science part is only 30% of the job. All our hard work, industry scuttlebutts and understanding of the business and continuous refinement in Business Quality thinking and Investment thinking - that is the rest 70% - and they go hand in hand; one without the other can fall flat!

But I wasn’t even doing justice to the 30% Science job so far - I didn’t have a EPA metric to cite between Ajanta, Astral and Mayur!!

VP Q. So now do you agree this is indeed a valuable addition/refinement to an average investor’s toolkit? Something a learning investor should be excited about??

Yes. and Yes. I could finally get my point across.Communicating effectively is an ART :), we have miles to go there… I think all will readily agree to that.