Business Quality: Calculating the Value Drivers of the business


(Donald Francis) #1
Posted byDonaldat April 13. 2012

Started reading this book, Valuation: Measuring & Managing the Value of companies, this week primarily to clear my thinking on the importance of Discounted Cash Flow as a Concept, versus the demonstratedfutility of using the DCF tool(predominantly) to determine Value.

However as I give it a careful read, suddenly I have become alive to thinking more clearly about the drivers of value of a business, as also some ways of measuring that!


This Valuation tome by Tom Copeland and Tim Koller is a costly $56 book. However for slightly adventurous ValuePickrs like me, there are very good"Used" alternativesavailable for as low as $5 including shipping. My first experience with "used" books (2010) was so exceptional, that I have always been ordering "Used" when I can. A friend who visits India once/twice a year, drops them by!

I got this very useful book (hardcover) almost new, for just $5! Sometimes on a beginners journey we get put off by the cost involved, so here's a little tip for acquiring wisdom, at low cost!


What drives Value?

The DCF approach is based on the simple concept that an investment adds value if it generates a return on investment greater than that can be earned on investments of similar risk (the opportunity cost of Capital). In other words, for a given level of profits, a company withhigher returns on investmentwill need toinvest less capitalin the business and will, in turn generate higher cash flows and higher value.

We would therefore expect that companies that earn higher returns on capital relative to their cost of capital, to have higher Value. Unfortunately, return on invested capital by itself cannot explain company valuations for the same reason that growth alone does not determine Value.

Other factors matter! Consider two companies starting at the same time with identical expected return on capital over their cost of capital. However one company plans to invest twice as much as the other. As a result, the company withhigher investmentandfaster growthshould have ahigher value, despite identical returns on capital. It becomes clear that bothgrowthandreturn on invested capitalshould drive "Value".

Posted byDonaldat April 13. 2012

While Buffettdiscourages us from using big spreadsheets (DCF)to calculate a company's value, he surely acknowledges that true determinants of a company's value are the free cash flows it earns.

Source: Berkshire Hathaway Annual Meeting 2009 Notes. You can find more from this extensive compilation of Buffet Q&A athttp://buffettfaq.com/

What valuation metrics do you use?

"The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn't look at a single valuation metric like relative P/E ratio. I don't think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it's not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal.You just need to evaluate a business's economic characteristics."

So if value is based on discounted free cash flow, we should reason that the underlying value drivers of the business must also be drivers of free cash flow.

There are twin drivers of free cash flow; the rate at which the company is growing its revenues, profits, and capital base; and the return on invested capitalover and abovethe cost of capital.

Posted byDonaldat April 13. 2012
What are the components of Return on Invested Capital

Since Return on Capital is a core value driver for a company, it makes sense to break down ROIC into its main components. That will help us to evaluate a company's economic characteristics, more easily.

Return on Invested Capital is defined as follows:
ROIC = NOPAT/Invested Capital, where
NOPAT = Net Operating Profit less adjusted taxes = EBIT x (1-Tax rate)
Invested Capital = Amount invested in the operations of the business. Invested Capital is the sum of Working Capital and net fixed assets, and net other assets (net of noncurrent, non-interest-bearing liabilities).
So,ROIC = (EBIT/Invested Capital) x (1-Tax rate),
Now,EBIT/Invested Capital=(EBIT/Revenues) x(Revenues/Invested Capital), or
EBIT/Invested Capital = Operating Margin x Capital Turnover
Assuming the Tax rate remains the same, we now know that a company is likely to have higher Return on its Invested Capital, when it has high Operating Margins or high Capital Turnover, or both.
Thus, there are only two drivers for Return on Invested Capital.
1.Operating Margin- measures how effectively the company converts Revenues to Profits
2.Capital Turnover- measures how effectively the company employs its invested capital
Posted byDonaldat April 13. 2012

Question of the week

In ValuePickr Portfolio we have several companies doing extremely well over the last year and more like Mayur Uniquoters, Balkrishna Industries, Gujarat Reclaim, Ajanta Pharma, even PI Industries.

1. Can we identify which businesses in ValuePickr Portfolio enjoy superior economic characteristics?

We should be easily able to say, Hey company X is a better quality business than company Y, any day!Separating the wheat from the chaff, again:)

Posted byGirish Dat April 15. 2012

I am not sure of real value of DCF in real life. My concern is how do you estimate some of the parameters like growth rate, discount rate etc accurately going many years into future. The other issue is small variation in assumed values can cause large change in outcome. Some say you try to get a value range by using the range of values - min and max kind. Not sure of value it offers in real life investing. Would like to learn from experienced investors.

DCF may be useless for fast growing or cyclical or small/mid size companies. But can it be used to get value range for stable companies like Pharma, FMCG, utilities?

Would be interested to know members view on which is more valuable firm from the list given by Donald. I have personally made decent profit in Balkrishna Industries. Very satisfied with that investment. Learned many things from that investment for future.

Posted byTCXat April 16. 2012

This seems interesting!

Donald, are you/the authors saying that we can use a nice benchmark like Capital Turnover for differentiating between companies.

Those with sustained high operating margins with high capital turnover are companies that inherently have a better quality business! better economic characteristics, a la the Bufett quote, above.

If this is correct, it adds another dimension to the Capital Allocation discussion, isn't it? Somehow I had never thought of companies this way - which are these companies with high Capital Turnover.

Posted byKiranat April 17. 2012

@TCX-

I think we are essentially talking about basic Du Pont's analysis.

High Margin, High Capital Turnover - Great business (eg. Mayur Uniquoters)

Low Margin, High Capital Turnover - Any retail chain (Big Bazaar)

and so on and so forth.

So, high capital turnover only cannot necessarily be used as a benchmark to differentiate between companies.

Posted byVinod MSat April 17. 2012

Hi,

I agree with Kiran that there would beexcellent cos doing great in either parameters. But cos doing great on both cap t/o and margin falls in the very best category - you cannot ask for more:)

Should we just check past data on this or think about who can sustain higher cap t/o together with higher margins in the forseeable future?

Cheers

Vinod

Posted byArindam Ghoseat April 17. 2012

I wanted to be clear about the economic characteristics of Mayur Uniquoters, and compiled this view! And what a view, no wonder many have their highest allocations to Mayur!!

Mayur Uniquoter 2007 2008 2009 2010 2011 2012E
Revenues 66.26 90.24 115.05 164.73 248.56 310.70
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 33.20 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%

Interesting to look at the real progress this company has made in both Operating Margins and Capital Turnover.

I have 2 requests:

1. I could not really understand how to compute Net Other Assets (net of noncurrent, non-interest-bearing liabilities). If Ayush, other CAs can explain how to that will be great

2. Can someone do the same exercise for Balkrishna Industries (Pls use the attached file, it will take just 5-10 mins to fill in the data)

Thanks

Posted byTCXat April 17. 2012

hey arindam,

thx, I will take this up for Balkrishna and revert. will be good to do for a few other companies too.

cheers

Posted byDonaldat April 17. 2012

Some Notes on the terms above:

1. Working Capital : We should include all current assets used in or necessary for the operations of the business, including some cash balances, trade accounts receivables, and inventories.

We should specifically exclude excess cash and marketable securities. These generally represent temporary imbalances in the company's cash flow. For example, in Balkrishna Industries Q2 BS, there was some excess 650 Crs+ held in Cash Investments if I remember correctly. The money had just been drawn from ECB for deploying for capex in Q3 and Q4. Usual cash balance for the company is normally 5-10 Crs.

Excess Cash and marketable securities are the short-term cash and investments a company holds over and above its target cash balances to support operations. Target cash balances are usually less than 3% of Sales, depending on the industry.

2. Non-interest bearing current liabilities: These are Accounts Payable and accrued expenses, and other non-interest bearing liabilities; Usually subtracted from Current Assets to calculate net current Assets or Working Capital; so we need not really worry about the workings here

3. Net Other Assets - ??

Ayush and other CAs in the forum. Kindly comment on the above notes. Any other things to be careful about for the calculations. And please elaborate what should we consider for Net other Assets.

Thx

Posted byTCXat April 17. 2012

This is turning out to be an wonderful exercise - and I am getting new insights!

Check out BKT economic characteristics! File attached, I changed the order of the years in the file recd - so we can copy data easily from someplace like Moneycontrol!

Balkrishna Industries 2012E 2011 2010 2009 2008 2007
Revenues 2800 1997.16 1386.74 1252.43 991.47 877.35
EBIDT 477 371.58 397.16 201.64 233.6 182.62
Depreciation 97 74.44 66.22 56.52 43.83 36
EBIT 380.00 297.14 330.94 145.12 189.77 146.62
Operating Margin 13.57% 14.88% 23.86% 11.59% 19.14% 16.71%
Working Capital 772 572.75 370.61 299.14 359.94 268.75
Net Fixed Assets 1069 687.44 614.89 534.55 424.47 399.37
Net Other Assets





Invested Capital 1841.00 1260.19 985.50 833.69 784.41 668.12
Capital Turnover 1.52 1.58 1.41 1.50 1.26 1.31
EBIT/Invested Capital 20.64% 23.58% 33.58% 17.41% 24.19% 21.95%
ROIC 13.83% 15.80% 22.50% 11.66% 16.21% 14.70%

I took Q2 figures of BS for BKT 2012 data, so removed about 670 Cr of excess cash. is that right?

Posted byNewbieat April 18. 2012

Hi

Thx evryone for the inputs! nice discussion. I would like to see how Gujarat Reclaim fares in this whole thing...I think its a great company....going by what I have read from Ayush and others.

one question - how do we project for 2012 in this sheet. How to estimate WorkinG capital or fixed Assets,etc.

Posted byTCXat April 18. 2012

Re: 2012 projections

I took the BS figures from Q2 results from Balkrishna. Donald had asked to adjust for excess temporary cash so I had done that adjustment to working Capital. You can do the same for Gujarat Reclaim...may be add a 10-15 Cr more on the fixed assets side,etc.

Revenue and EBITDA should be easier. 9 months results are out, we can just extrapolate I think. maybe add a little more on the depreciation side than earlier quarters as there has been big additions to capex.cheers

Posted byAbhishek Basumallickat April 18. 2012

Firstly, thanks to Donald for initiating this thread and secondly, nudging me to look at this. Didn't get a chance to read it before today.

My two cents worth:-

1) DCF is one method of analysis and by no means the definitive method. As I think Girish has mentioned, the number of parameters out there are too large to reduce/eliminate assumption errors.

2) Return on capital - instead of splitting hairs on difficult formulae, I think it is important to understand that at the end of the day, return is net profit or net cashflow divided by either total shareholders equity (if you are looking for equity capital returns) or toal capital employed (if you are looking for overall returns including debt taken). All other return calculations, to my mind, are academic. The reason is taxes and depreciation are as much a part of individual businesses as their operating characteristics.

For net equity returns: Net Profit / Networth

For total returns: Net Profit / All assets

3) Business are primarily of 2 types - I call them the "Fine Italian restaurant" and the "local Chinese". Italian restaurants have a high margin, low turnover business andChineseones typically (except places like mainland china) are low margin, high turnover businesses. Neither is a preferable model as there can be great businesses in both categories. The problem arises when management confuse one for the other or try to be everything to everyone (you cannot sell Nano and Jaguar from the same showroom or make them in the same factory, that is why Toyota has a premium brand like Lexus completely separate).

4) Valuation to me is not a numbers game. I need to have a good "feel" about the company, its ability to scale in the future, market position, market share, the way the management answers questions in analyst calls and other such intangibles which are not directly available in the numbers.

5) Dupont analysis tells us how the RoE is being achieved. And is a good tool for understanding the various levers the business has.

Also, if you could all add your inferences that you are drawing from the data tables that you are putting up here, it would help the others.

Posted byNewbieat April 18. 2012
Here are the details for Gujarat Reclaim. So it looks like the company is making a comeback of sorts...into better times...after 2 or 3 stagnant years.
There just does not seem to be another like Mayur Uniquoters - in terms of business quality. any names??
Gujarat Reclaim 2012E 2011 2010 2009 2008 2007
Revenues 250 187.35 144.82 132.19 110.74 86.49
EBIDT 56 33.18 27.57 26.54 19.01 19.31
Depreciation 7 5.11 4.35 3.96 3.45 2.42
EBIT 49.00 28.07 23.22 22.58 15.56 16.89
Operating Margin 19.60% 14.98% 16.03% 17.08% 14.05% 19.53%
Working Capital 50 26.96 21.28 16.86 16.41 9.87
Net Fixed Assets 100 68.72 48.56 38.09 37.21 32.55
Net Other Assets





Invested Capital 150.00 95.68 69.84 54.95 53.62 42.42
Capital Turnover 1.67 1.96 2.07 2.41 2.07 2.04
EBIT/Invested Capital 32.67% 29.34% 33.25% 41.09% 29.02% 39.82%
ROIC 21.89% 19.66% 22.28% 27.53% 19.44% 26.68%
Somewhere in the thread above, there was mention of Growth. Gujarat reclaim had relatively high RoIC in 2009 and 2010, but Growth was stagnant as was Invested Capital in the business.
Now that Growth is returning and margins and returns are improving, it may make for a good investment?
Perhaps it is better to go with someone who has the ability to keep investing higher amounts of Capital at higher RoIC, and is growing better/faster?
-rgds
Posted byArindam Ghoseat April 18. 2012

Hi Abhishek,

Thanks for writing at length, and wonderful insights!

You are right, we get more a "feel" for the company from how the Management answers queries and the insights we receive from studies on the size of the opportunity, ability of the company to scale up, fund itself, etc. Ratios/Numbers become less important, once you have seen the basics are good.

I think the point Donald and others are trying to work at here is - In the normal way of doing things, we are really not clear which business has thebest economic characteristicsin Warren Buffets words. We do not have the mental models ready to think about businesses clearly in those terms.

If we look at the valuable data that is being thrown up by members, there is a wealth of additional insights - just form a few simple numbers - about the quality of these excellent businesses - apart from what we already know about the Management, opportunity size, etc. Actually the data tells us much about the scalability of the business too!

Assume all of these businesses are available ~7x 2013E earnings. Where will I put in my money - given all of these are some of our prized companies - all have done pretty well too -I think these numbers are a great way to start thinking more clearly on how much Capital to allocate- in addition to the other not-so-objective ways of determining Business Quality.

Invite your views.

Posted byGirish Dat April 18. 2012

Thanks all for useful data and good discussion that is happening here.

Should we also include freecash-flowin the companyfinancialspreadshit? Free cash flow as percentage of sales is useful indicator of company's earning prowess.

Posted byAbhishek Basumallickat April 18. 2012

Hi Arindam,

Very interesting points. Let me try and add my thouhgts more to clarify my muddled thought process though penning it down.

"...not clear which business has the best economic characteristics" - how do you define what is the best economic characteristics, that I think is the question... Is it return ratios, asset turnover, margins, market share etc? Or does it inlcude possible market size and market share in the, say, next 10 years? If yes, then how do you measure that?

"....data that is being thrown up by members...about the quality of these excellent businesses..." - So, let us look at the numbers from one of these companies, say Mayur. (Let me pick Mayur as I have it has the highest capital investment and the second highest weigtage in my portfolio).

What does it tell us? That it has increased sales about 6 times over the last 5 yrs. Margins have doubled but has been in the same range for the last 3 years, not enough to conclusively prove that it has moved into a higher margin business or if its a cyclical upturn. ROIC has again gone up significantly in the last 3 years, but not enough to be sure if its a secular upmove or cyclical one.

All this tells you what happened over the last 5 years, with no real indication of how it happened and most importantly why it happened. The numbers tell you that it might end 2012 with a revenue of 300 odd crores. How do I know whether revenues can go up to 3,000 cr or 30,000 cr in the future? Can someone me what the net margins are likely to be in 2020? Will they be 15% as it has been for the last 3 years or will it be 8% like the 3 yrs previous to that, or any other number for that matter. I rest my case on this point.

"Assume all of these businesses are available ~7x 2013E earnings. Where will I put in my money - I think these numbers are a great way to start thinking more clearly on how much capital to allocate" - Great question. What I would do if I got say Mayur, BKT & Guj Reclaim all at the same valuation is I would have a 50:30:20 spread amongst them. The logic has nothing to do with numbers here but everything to do with "feel" and circle of competence and understanding of business risk. Mayur has a much higher potential market size and not too may competitors. Management seems sensible. Company is growing. BKT has a niche market which is difficult to replicate easily. Gujarat Reclaim is also a niche business but scalability is somewhat limited to my mind. It cannot increase its sales 10 times in the next 10 years even if it tried to. However, stock prices have a nasty way of misbehaving and making us look like fools. So, you might see Guj Rclm doing the best in the next few years!:)

Aonther way I have learnt to think (borrowed from Charlie Munger from his Art of Stock Picking) is if I have to start a business and have access to unlimited capital, what business would it be? And if I have to harm any business what could I do? Again, taking an example, would I buy Mayur as a whole company today (assuming they are willing to sell and I have unlimited capital)? If yes, why? If no, why not? Also, if I have to start a competitor for Mayur, what would I need to hurt Mayur? Can I take it out of business?

Net net, my thought process is more based on critical thinking and subjective analysis aided by core fundamentals, rather than the fundamentals itself.

P.S 1 : I take all published numbers with a pinch of salt. I am not sure if all the numbers that are published are 100% accurate. Not saying management is not 100% honest in all cases (which is certainly true in most cases). But other than actual cash numbers most are back calculated to a certain degree. So, use the numbers as a guide and not a roadmap.

P.S 2: Girish, free cashflow is an approximation in most financial statements as it is not directly reported. But to my mind it is one of the most important numbers that we should look at. Cash is king, you cannot dispute with it , unless of course you are holding Satyamshares:)


Whew!! That ends my lengthy discourse, and now back into hibernation!!!

Posted byArindam Ghoseat April 18. 2012

Thanks Abhishek,

Very valuable directions. Much of this will allow me to think more clearly. I agree with your philosophy of 50:30:20 roughly between Mayur:BKT: Guj Reclaim - for the reasons you mention.

I have 2 things to point out in the data interpretation.

1. Economic Characteristics - At the simplest level, by this Buffet perhaps meant - does this business inherently have superior economic characteristics - Will my Invested Capital earn more returns for me in this business than say business x - more likely to, because it is incredibly more capital efficient. Not the whole sizing up size and prospects 20 years down the line ...which is a much bigger exercise, no doubt

2. You were looking more at trends of last 3 years. more or less at the same level is the verdict.But If I look at just Capital Turnover - this is a truly 'classy" aspect of the business for Mayur. This has been a steady upclimb to almost 4x. They can put less capital in the business and take out more Sales -every year.

3. This is what amazes me - and sets Mayur apart from any other business we are looking at currently. It is a better business to put my money in -compared to others - as long as it is also growing decently in comparison to others.

4. Free Cash flows - Mayur has a phenomenal record there - and this is ultimately linked to Capital Turnover, I guess. The more capital efficient you are, the less you will need to put in the business ( Working Capital and Capex).

Posted byAkbar Khanat April 19. 2012

Great discussion going on..

There is no doubt that numbers alone cannot give you the full picture. However the numbers do help in building the conviction that we need. Based on our expectations for increasing market and increasing market share, increasing eficiencies or high expectations of growth, can we see evidence of that through the numbers?

Past track record of growth in revenues implies growing market (either gain in market share or increasing market size).

Past track record ofhigher margins and increasing capital turnover implieshigher efficiency.

Whether sustainable or not is a story which is going to unfold, but as investors we tend to underestimate the capacity of a trend to hold. What goes up can come down, but it can continue to go higher before it comes down. ( here I am not referring to stock price, but performance numbers that we discuss.) The margin expansion could continue due to higher efficiency or stay at a higher level. It is not necessary that it should revert back to average in a hurry.

I would like to also re-emphasize a line from Donald's post earlier..

"There are twin drivers of free cash flow; the rate at which the company is growing its revenues, profits, and capital base; and the return on invested capitalover and abovethe cost of capital."

In the previous posts we seemed to focus on ROIC.. we also need to see the Cost of Capital. Here the factors to look at are the level of debt and at what cost and of course the PE ratio.

Posted byAbhishek Basumallickat April 19. 2012

Let us look at the investment criteria that Warren Buffet uses (as provided in The Warren Buffet Way by Robert Hagstorm).

Business Tenets

1. Is the business simple and understandable?

2. Does the business have a consistent operating history?

3. Does the business have favorable long-term prospects?

Management Tenets

4. Is management rational?

5. Is management candid with its shareholders?

6. Does management resist the institutional imperative?

Financial Tenets

7. What is the return on equity?

8. What are the companyâs âowner earningsâ?

9. What are the profit margins?

10. Has the company created at least one dollar of marketvalue for every dollar retained?

Value Tenets

11. What is the value of the company?

12. Can it be purchased at a significant discount to its value?

Now the classification is very important. People tend to focus on some or all the headings. Some people (like me) try to focus more on Business part, some focus more on financial part and so on. I think one of the reason Buffet is so immensely successful is because he focuses on all. Incidentally, only 4 out of the 12 tenets relate to

I am not saying that numbers are not important. Not in the least. Numbers are very important. What I am trying to say is that numbers are a starting point of the analysis, and not the ending point. Trends that are thrown by the numbers are important to interpret, and more critical is to understand the reason why things have been the way it has. So, if margins have gone up, why has it gone up? What has the management said about it on record? Is it repeatable? Asking the second & third order questions are more important, rather than just looking at the numbers and trying to picture a story.

Let me share a personal experience of why I am saying all this. The first stock I bought in my life was HLL in 1999. If you looked at the numbers at that time, it was excellent. ROE of more than 100%, good margins, great dividend paying record etc etc. What happened then? The business slumped and for the next 10 years HLL (then became HUL) was struggling to maintain margins and profitability. Stock markets are replete with such histories. IBM till 1992, Xerox, Kodak all had great numbers and then went into a huge tailspin downwards. So, to me the lesson learnt from all these are that past numbers are exactly that - "past". Use it to look at what the future can hold. But don't bet your house based on past numbers.

Posted byDonaldat April 20. 2012

Hi,

Nice to see much discussion and interaction on the above.

Some company specific data helped us focus on what creates value too -higher Operating Margin and/or higher Capital Turnover leading to higher Return on Invested Capital.

Numbers can never tell the whole story, yes. In ValuePickr's journey of last 2 years, Numbers have been very important though - they have led us to a more promising set of stocks - impressive past performance led us to question - if these can be sustainable?? The subsequent homework, Management Q&As, etc helped us form Conviction about sustainability.

Pros, senior investors, and novices read different things from the same set of data, right? Even when we understand the different stories (as much as is possible), we still end up making different investment allocations, isn't it?

Does it make more sense to allocate more capital to the most efficient business in my portfolio as long as it matches up in growth and sustainability. What would I do if I were the owner of these businesses?

We don't always think in these lines. The above discussion certainly has helped me think more concretely about these issues.

Thank You! and keep participating!

Posted byDonaldat April 20. 2012
The next important concept introduced in the Copeland Valuation book is theEconomic Profitmodel. According to the model, the value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year, going forward.
Value = Invested Capital + Present Value of projected Economic Profit
Economic Profit measures the dollars of economic value created by a company in a single year, and is defined as follows:
Economic Profit = Invested Capital x (ROIC - WACC)
WACC - weighted average cost of capital. To keep things simple we take WACC =12% for all companies in ValuePickr Portfolio.
Economic Profit translates the value drivers discussed earlier,ROIC and Growth, into asingle dollar figure(growth is ultimately related to the amount of invested capital or the size of the company).Focusing on Size (say earnings or earnings growth) could destroy value if returns on capital are too low. Conversely, earning a high ROIC on a low capital base may mean missed opportunities.
The authors also say it is important not to confuse Economic Profit, which measures realised value creation, with the increase in the value of a company during the period.TheMarket Valueat any point of time measuresperceived future value creation expectations. The increase in Market Value over a year equals Economic Profit (the realised value creation) plus thechange in the value creation expectations.
The change in Market Value will equal Economic Profit only if there isno change in expected future performanceand if the WACC remains constant during the year.
Posted byRaju Mat April 20. 2012

Hi,

Thanks for the nice discussion. I have some doubts, can someone plz point me where I should look/ help me understand.
Can we say operating cash flow = revenue?

When we compute free cash flow = should the dividends be reduced?

Thanks in advance

Posted byDonaldat April 20. 2012

Question of the week

In ValuePickr Portfolio we have several companies doing extremely well like Mayur Uniquoters, Balkrishna Industries, Gujarat Reclaim, Ajanta Pharma, even PI Industries.

1. Can we identify which businesses in ValuePickr Portfolio have created higher Economic Profit in the last 5 years, in proportion to the Invested Capital 5 years back

Are there businesess that have realised more than their Invested Capital in Economic Profits, over the last 5 years!Separating the wheat from the chaff, again:)

Posted byTCXat April 20. 2012

You can refer toInvestopediafor an education on basic jargons like free cash flow. Even ValuePickr has an excellent compilation in theBasicssection.

Previously Raju M wrote:

Hi,

Thanks for the nice discussion. I have some doubts, can someone plz point me where I should look/ help me understand.
Can we say operating cash flow = revenue?

When we compute free cash flow = should the dividends be reduced?

Thanks in advance

Posted bySubbuat April 20. 2012

Nice discussion. Due consideration should also be given to topics like extractable free cash flow i.e. free cash flow that can be taken out of the business. Intel for eg. has to spend a lot of money on R&D just to remain competitive and cannot return much of its earnings to shareholders.

You do not want you company to pay dividends at the expense of maintaining its competitive advantage.

Lastly, hindsight is 20-20. But looking ahead is where the real challenges lie. Consider Nokia which was a pretty successful company in 2001, but look at it now. This is in stark contrast with Apple. So understanding the drivers of high ROIC and high profit margins are important and identifying companies that are going to show a substantial change in ROIC is also important which is a result of understanding industry dynamics.

Posted byDonaldat April 20. 2012
Looking at a business like this is new for me!
So I have taken Arindam's sheet and added a couple of more rows fro Ecomic Profit added over last 5 years to its business. The results are eye-opening, again!
Mayur Uniquoter 2012E 2011 2010 2009 2008 2007
Revenues 310.70 248.56 164.73 115.05 90.24 66.26
EBIDT 49.71 40.87 27.92 11.78 10.57 6.67
Depreciation 3.44 2.67 2.08 1.59 1.39 1.52
EBIT 46.28 38.19 25.84 10.19 9.18 5.15
Operating Margin 14.89% 15.37% 15.68% 8.86% 10.17% 7.77%
Working Capital 32.94 33.01 22.21 12.07 11.88 13.42
Net Fixed Assets 45.83 31.3 23.15 22.65 21.32 15.95
Net Other Assets





Invested Capital 78.76 64.31 45.36 34.72 33.20 29.37
Capital Turnover 3.94 3.87 3.63 3.31 2.72 2.26
EBIT/Invested Capital 58.75% 59.39% 56.96% 29.36% 27.65% 17.53%
ROIC 39.36% 39.79% 38.16% 19.67% 18.53% 11.75%
Economic Profit 21.55 17.87 11.87 2.66 2.17 -0.07
Cumulative EP 56.05 34.50 16.62 4.76 2.09 -0.07
5 yr EP/Invested Cap
117.46%



I quickly compared this to Balkrishna Industries throwing in much more capital in the business. It added only some 30% of Invested Capital over 5 years!
Think we should throw open examples from outside ValuePickr Portfolio! We have a very limited set. I am interested to see how this works for much bigger companies like HDFC, ITC that we know have been consistent value/wealth creators for many years.
Posted byDonaldat April 20. 2012

Hey,

There are many amongst us - voracious readers, passionate and astute investors. Please also feel free to formulate useful questions - that will prompt us to think more deeply about our investment portfolio.

Hoping the interaction keeps up!

Cheers

Donald


Business Quality: Refining our thinking on "Great Businesses"
(Donald Francis) #2
Posted byTCXat April 20. 2012

Hi Donald,

Once again this is very interesting to pursue. and amazing results for ITC!!

ITC 2011 2010 2009 2008 2007
Revenues 21120.83 18567.45 14985.81 14032.2 12313.83
EBIDT 7974.79 6677.37 5348.23 4965.65 4299.13
Depreciation 655.99 608.71 549.41 438.46 362.92
EBIT 7318.80 6068.66 4798.82 4527.19 3936.21
EBIT Margin 34.65% 32.68% 32.02% 32.26% 31.97%
Working Capital 819.34 -706.17 2588.91 2041.9 1695.22
Net Fixed Assets 8345.07 8142.4 7271.91 6168.83 4744.77
Net Other Assets




Invested Capital 9164.41 7436.23 9860.82 8210.73 6439.99
Capital Turnover 2.30 2.50 1.52 1.71 1.91
EBIT/Invested Capital 79.86% 81.61% 48.67% 55.14% 61.12%
ROIC 53.51% 54.68% 32.61% 36.94% 40.95%
Economic Profit 3803.87 3173.65 2031.91 2047.93 1864.46
Cumulative EP 12921.82 9117.96 5944.30 3912.39 1864.46
5 yr EP/Invested Cap 200.65%



Please help interpret. This is a much much better business to invest in. Ofcourse, the other part is under-valuation in the stock. But with characteristics like these, I think the business must have compounded very well -and stock valuation would have kept pace!

Posted bySubbuat April 20. 2012

Ofcourse ITC is a much better business to invest in. But look at the valuations it is trading at. I believe it is trading at a PE multiple > 35x LTM earnings. Clearly the superior dynamics of the business are already reflected in the share price. Clearly, there is no margin of safety.

The task as a value investor lies in identifying superior businesses trading at low PE multiples.

Another useful indicator I look at is Return on Reinvested Capital.

RoRC = Change in Operating Profits / Change in Invested Capital

This metric shows the returns generated on every $ of capital re-invested. If a company has reinvest $100 and increased earnings by only 5 then clearly management is into 'empire-building' i.e. creating a large company and essentially destroying value.

Posted byAyush Mittalat April 20. 2012

Hi Everyone,

Good discussions here:)The best thing about these exercises is that one gets a practical understanding of the levers of growth and the magic these things can have over longer term.

Yes, Mayur has the best ratios and kudos to many of you guys for understanding the change early and allocating a high % to it. One thing which I would like to see in Mayur is - growth in Balance sheet size also. I feel that growing balance sheet with high ROIC etc is also very important eg: BKT.

Ayush

Posted byTCXat April 20. 2012

Hi Subbu

Many Thanks for your response.

1. RoRC is a very interesting concept. Balkrishna's case seems to be going in that direction - creating a large company but essentially destroying value!!

In one single day, my learning has taken a leap thanks to folks like you:)

2. ITC; I looked at the price charts. Has been cheap several times in the last 5 years. whole markets correct, etc. in 2007 base price was 90, today it quotes at 245, or a 22% CAGR stock returns over 5 years - not bad at all. doubling in 3.5 years

http://www.cmlinks.com/moneypore/profilenew/financial.asp?mainopt=16&cocode=13504

But if I were smart and kept an eye out for ITC knowing it is that great a business, I could have picked up ITC at 65 in Mar 2008 (much before the Sep 2008 global crisis so we are not taking of extraordinary situations). And that would be a very handsome 55% CAGR!!!

As you say all this is hindsight ofcourse:)but we can be smarter right, by knowing what to wait for? or, is that very difficult in practice? Doesn't the market give you a chance every 2-3 years to make a very insightful capital allocation.

We should be able to get good compounding even from well-known/discovered stocks. I mean keep taking the 20% plus compounding without complaints, and then if you get a chance in 2,3,4 years make a big swoop to average down drastically - and then you are owning a much superior business and getting handsome compounding too!!

Is this doable??

Posted bySubbuat April 20. 2012

Your welcome TCX.

Yes, I agree with you. Ideally one could do what you prescribe to generate wealth. Companies like ITC are quite cheap during recessions, global financial crises etc. But its exactly at times like these that investors panic and are too scared to enter markets. Assuming you can conquer your behavioural biases and act rational at all times, this is doable and has been done:).

Posted byAyush Mittalat April 21. 2012

Hi TCX,

BKT destroying value?? Please do share your working.

From what I can make out, it may seem so because of the volatility in the margins of the co over last 3-4 years. 2010 was an exceptional year for the co in terms of operating margins and hence the ratios might throw out such results. I don't think a co with a ROCE of more than 20% consistently can be a wealth destroyer. Also, projects like these are capital intensive in nature and take time for the capacity to come up and results to show up.

Ayush

Posted byAbhishek Basumallickat April 24. 2012

Very interesting points from all participants. Lot to learn from here.

Donald, one small point when you are looking at Economic Profit is that WACC is going to be different for different companies. I think it will be materially different if you start comparing mega-cap companies to small or mid cap ones. So, ITC has access to much lower capital than say, Mayur. So, from that perspective ITC's Economic Profit would be higher than what you have calculated!!

I fully subscribe to Subbu's view, that the problem with ITC (or HDFC Bank or other such perennial value creators) is their valuations. Also, agree with what TCX suggested, you have to wait like a "vulture" (Peter Cundill's words, not mine) and pounce when the market gives an opportunity. Again the problem with a company like ITC is when the overall market turns violently down, it is relatively insulated, so the opportunity cost of getting into other relatively cheaper options at that time is higher!!

Attaching the chart of ITC from 2000 till date. Check the period between 2006 - 2010 where the stock was in a range and the market had gone up and down tremendously in during those days.

Posted byShruti Panchalat April 24. 2012

My question is to Donald.

you said that "Invested Capital is the sum of Working Capital and net fixed assets, and net other assets (net of noncurrent, non-interest-bearing liabilities)." But this amount must have come from equity as well as debt. But as investors aren't we more interested in Return on Equity rather than Return on total capital. Can you please explain to me more on taking ROIC instead of ROE.

Posted byAbhishek Basumallickat April 24. 2012

Hi Shruti, even though the question is directed at Donald, let me put my thoughts here and Donald (and others can add).

RoE is extremely important metric to understand the return that is being earned by the owner's cash. However, as an owner I would want to know/understand what return my business in generating on the total capital that is invested. That will tell me what would happen if the company became totally debt free. Or what would be the impact if I put on more debt. To understand the overall quality of a business, it is more important to look at overall return rather than only RoE. RoE can be increased just by increasing debt levels and can provide a wrong picture of the business.

Posted byDonaldat April 25. 2012

Hi Shruti,

I think PAT Dorsey has explained this the best.... If you still have not read his book, as an analyst you are missing something! following in PAT Dorsey's words

Return on Invested Capital (ROIC) is a sophisticated way of analyzing return on capital that adjusts for some peculiarities of ROA and ROE. It's overall a better measure of profictability than ROA and ROE.

Essentially, ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE. RoIC uses operating profits after taxes but before interest expenses. Again the goal is to remove any effects caused by a company's financing decisions -does it use debt or equity? - so that we can focus as closely as possible on the profitability of the core business.

Posted byShruti Panchalat April 26. 2012

Thanks Abhishek and Donald for the clarification.

Posted byArindam Ghoseat April 26. 2012
Hi,
Some more thoughts on the Economic Profit exercise:
1. On ITC, no analysis is meaningful without going into segment-wise analysis. Tobaco is a monster which hidesinefficiencies of all other segments.
2. For a pure play to see what tobaco alone can do toROIC and EPnumbers, I guessa lean business likeVST Industries should blow out the winds.
3. After economic profit, Market Value Added (MVA) should be looked at to assess how well it has done in terms of adding mcap over the invested capital.
4. On the flip side, having contributedxyz amount of positiveMVA, further comfort for a value investor is limited in that company.
Rgds
Posted byDonaldat April 26. 2012

Thanks Arindam for some good pointers.

I looked at Marico over last 5 years, and it has done one better than ITC!

Marico 2011 2010 2009 2008 2007
Revenues 2346.87 2001.5 1921.85 1575.99 1373.27
EBIDT 432.09 343.62 222.1 211.95 191.95
Depreciation 27.63 25.21 17.03 18.93 35.19
EBIT 404.46 318.41 205.07 193.02 156.76
EBIT Margin 17.23% 15.91% 10.67% 12.25% 11.42%
Working Capital 687.27 499.54 402.11 333.21 165.8
Net Fixed Assets 222.46 129.97 115.91 96.99 95.06
Net Other Assets




Invested Capital 909.73 629.51 518.02 430.20 260.86
Capital Turnover 2.58 3.18 3.71 3.66 5.26
EBIT/Invested Capital 44.46% 50.58% 39.59% 44.87% 60.09%
ROIC 29.79% 33.89% 26.52% 30.06% 40.26%
Economic Profit 161.82 137.79 75.23 77.70 73.73
Cumulative EP 526.27 364.45 226.66 151.43 73.73
5 yr EP/Invested Cap 201.75%









Posted byArindam Ghoseat April 26. 2012

And here's a look at VST Industries!!!

VST Industries 2011 2010 2009 2008 2007
Revenues 558.58 470.54 371.06 338.9 332.83
EBIDT 158.31 100.17 102.3 99.91 96.33
Depreciation 24.42 17.87 15.82 13.72 11.48
EBIT 133.89 82.30 86.48 86.19 84.85
EBIT Margin 23.97% 17.49% 23.31% 25.43% 25.49%
Working Capital -65.87 -82.32 -84.37 -113.12 -74.15
Net Fixed Assets 152.42 132.59 125.44 118.85 94.83
Net Other Assets




Invested Capital 86.55 50.27 41.07 5.73 20.68
Capital Turnover 6.45 9.36 9.03 59.14 16.09
EBIT/Invested Capital 154.70% 163.72% 210.57% 1504.19% 410.30%
ROIC 103.65% 109.69% 141.08% 1007.81% 274.90%
Economic Profit 79.32 49.11 53.01 57.06 54.37
Cumulative EP 292.87 213.55 164.44 111.43 54.37
5 yr EP/Invested Cap 1416.20%



Posted byArindam Ghoseat April 26. 2012

http://www.moneycontrol.com/stock-charts/vstindustries/charts/VST#VST

VST 2007 -380

VST 2012 -1975

5yr Price CAGR = 39.05 %

Posted byTCXat April 26. 2012

Hi Arindam,

This is getting real interesting! Just to get a broader perspective on why some of these businesses have given such excellent returns, I computed 5 yr Sales, EBIT and Price CAGR with the Economic Profits generated!

5Yr Sales CAGR EBIT CAGR Price CAGR 5Yr EP/ Invested Capital
ITC 14.44% 16.77% 25.39% 200.65%
Marico 14.34% 26.74% 35.10% 201.75%
VST 13.82% 12.08% 39.05% 1416.20%


Does this data tell us something?? Please help interpret.

Posted bySubbuat April 27. 2012

I think the problem with VST is that it is reliant on government subsidies, farm credit etc which creates a bit more uncertainty with respect to demand. Overall I'd still consider it a very good stock with decent valuations. But considering the perennial headwinds involved it is never going to trade at a PE multiple of 30+ like Marico or ITC. The market believes that Marico and ITC have stronger, sustainable competitive advantages relative to VST.

Hope it adds value. I think such numbers must be juxtaposed with a reasoning of the drivers behind the numbers.

Posted byTCXat April 27. 2012

Hi Subbu,

This was referring to VST Industries - the cigarette maker, not VST Tillers. The makers of the original Charminar brand!

Rgds

Posted bySubbuat April 27. 2012

Thanks TCX. Upon briefly going through VST Industries, I have no doubt it is a company with good fundamentals. But if you want to compare VST ind with Marico or ITC one has to look at management's plans, diversity of the business i.e. number of strong brands for the future and dividend payout ratio as well.

The problem with such large strong companies like ITC and for that instance even Microsoft is that they have one super product which generates strong margins. Now management has the task of investing the profits generated from these super products into other business lines which may or may not be successful. Microsoft ventured into video games like XBOX etc which may or may not be as profitable as Windows.

Apple, meanwhile has managed to deliver a string of blockbusters from ipod to iphone to ipad.

The valuations of such stocks therefore depend on how management plan to use cashflows and what your opinion of the strength of the other business lines are.

Posted byShruti Panchalat May 10. 2012

For the calculation of ROIC, Invested capital, should we leave out investements? If yes can you explain why?

Posted byDonaldat May 10. 2012

Hi Shruti,

This was addressed in an earlier post.

We should specifically exclude excess cash and marketable securities. These generally represent temporary imbalances in the company's cash flow. For example, in Balkrishna Industries Q2 BS, there was some excess 650 Crs+ held in Cash Investments if I remember correctly. The money had just been drawn from ECB for deploying for capex in Q3 and Q4. Usual cash balance for the company is normally 5-10 Crs.

Excess Cash and marketable securities are the short-term cash and investments a company holds over and above its target cash balances to support operations. Target cash balances are usually less than 3% of Sales, depending on the industry.

You can identify excess cash balance and investments- by comparing these in the BS for a few years. Calculating as a percentage of Sales will help highlight big differences.

Posted bybiju johnat May 19. 2012

WACC for ITC could be different from Mayur and is dynamic,it would be changing from year to year based on capital structure

WACC=Ke(E/E+D)+Kd(1-T)(D/E+D)

ITC has zero debt,the second part vanishes and always the cost of equity is higher than cost of debt.

so we have only the first term,ke

ke=risk free rate+beta(excess market returns)

=9+0.33*8=11.64,the WACC would be higher for a company having higher beta


(Donald Francis) #3

Thought of taking this discussion forward, again in a bid to differentiate one business from another.

a) Updated the Mayur Economic Profit Table

b) added in Arindam's suggestion of seeing how much of Market Value is Added every year. and the increasing Gap to Economic Profit created

The larger the Gap, smaller is the comfort zone for a value investor in the company??

Mayur Uniquoters 2007 2008 2009 2010 2011 2012 2013E Comments
Revenues 66.26 90.24 115.05 164.73 248.56 317.48 398.52
EBIDT 6.67 10.57 11.78 27.92 40.87 54.20 67.75
Depreciation 1.52 1.39 1.59 2.08 2.67 3.87 5.11
EBIT 5.15 9.18 10.19 25.84 38.19 50.33 62.64
EBIT Margin 7.77% 10.17% 8.86% 15.68% 15.37% 15.85% 15.72%
Working Capital 13.42 11.88 12.07 22.21 33.01 29.58 33.98
Net Fixed Assets 15.95 21.32 22.65 23.15 31.3 49.07 70.33
Net Other Assets







Invested Capital 29.37 33.20 34.72 45.36 64.31 78.65 104.31
Capital Turnover 2.26 2.72 3.31 3.63 3.87 4.04 3.82
EBIT/Invested Capital 17.53% 27.65% 29.36% 56.96% 59.39% 63.99% 60.05%
ROIC 11.75% 18.53% 19.67% 38.16% 39.79% 42.87% 40.23%
WACC 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00%
Economic Profit Added (EP) -0.0739 2.17 2.66 11.87 17.87 24.28 29.45
Mkt Cap (Mar End)
22.40 12.90 77.42 137.47 242.23 500
Market Value Added (MVA)

-9.50 64.52 60.05 104.76 257.77 (over prev yr)
Dividends


2.71 5.42 7.31 10
Total Value Added (TVA)


67.23 65.47 112.07 267.77
Perceived Future Expectations


55.36 47.60 87.79 238.32 (TVA-EP)

Waterbase - Can it be Next Avanti Feeds?
(Atul Garg) #4

Donald,

I see, Perceived Future expectations is TVA-EP. But how to really interpret it in a meaningful way.


(Donald Francis) #5

Hi Atul,

Let me bung in more examples, and might be the picture will be clearer.

Some things should probably be obvious that if a company of Mayurs size (400 Cr Fy13E) has managed to add ~400 Cr of Market Cap over last 3 years, it has done a stupendous job.

Then there's the flip side, as Arindam put out earlier. Going forward, how much more comfort does a Value Investor have?

-Donald


(Donald Francis) #6
Mayur Uniquoters 2013E 2012 2011 2010 2009 2008 2007 Comments
Revenues 398.52 317.48 248.56 164.73 115.05 90.24 66.26
EBIDT 67.75 54.20 40.87 27.92 11.78 10.57 6.67
Depreciation 5.11 3.87 2.67 2.08 1.59 1.39 1.52
EBIT 62.64 50.33 38.19 25.84 10.19 9.18 5.15
EBIT Margin 15.72% 15.85% 15.37% 15.68% 8.86% 10.17% 7.77%
Working Capital 33.98 29.58 33.01 22.21 12.07 11.88 13.42
Net Fixed Assets 70.33 49.07 31.3 23.15 22.65 21.32 15.95
Net Other Assets







Invested Capital 104.31 78.65 64.31 45.36 34.72 33.20 29.37
Capital Turnover 3.82 4.04 3.87 3.63 3.31 2.72 2.26
EBIT/Invested Capital 60.05% 63.99% 59.39% 56.96% 29.36% 27.65% 17.53%
RoIC 40.23% 42.87% 39.79% 38.16% 19.67% 18.53% 11.75%
WACC 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00%
Economic Profit Added (EP) 29.45 24.28 17.87 11.87 2.66 2.17 -0.0739
Mkt Cap (Mar End) 500 242.23 137.47 77.42 12.90 22.40

Market Value Added (MVA) 257.77 104.76 60.05 64.52 -9.50

(over prev yr)
RoRC 52.80% 92.97% 68.34% 151.68% 79.56% 101.83%
change in Op profits/change in Invested Capital
5 yr RoRC 80.43%






Finally think we have some data that adds more perspective.
Over the last 5 years, for every 100 Rs in incremental invested Capital, Mayur has been able to deliver Rs 80 in increased EBITDA . This is darn good. The 5 yr figure may make more sense for comparisons across companies as come like BKT have lumpy cash flows, and some like Kaveri come out of nowhere (riding on Intellectual Property sucess). Thanks Subbu for your very useful pointer on RoRC somewhere in the above threads - I just was lazy in trying that out:)) that time itself; better late than ...
Atul - I dropped the MVA gap track (though interesting as a concept) - as it was becoming academic, and as you guessed:) leading nowhere!
Now let me throw up BKT's and Kaveri's data for more perspective.

(Donald Francis) #7

And now the data-points for BKT

Balkrishna Industries 2012 2011 2010 2009 2008 2007 Comments
Revenues 2809.98 1997.16 1386.74 1252.43 991.47 877.35
EBIDT 493.49 371.58 397.16 201.64 233.6 182.62
Depreciation 83.14 74.44 66.22 56.52 43.83 36
EBIT 410.35 297.14 330.94 145.12 189.77 146.62
Operating Margin 14.60% 14.88% 23.86% 11.59% 19.14% 16.71%
Working Capital 769.21 572.75 370.61 299.14 359.94 268.75
Net Fixed Assets 1068.68 687.44 614.89 534.55 424.47 399.37
Net Other Assets






Invested Capital 1837.89 1260.19 985.50 833.69 784.41 668.12
Capital Turnover 1.53 1.58 1.41 1.50 1.26 1.31
EBIT/Invested Capital 22.33% 23.58% 33.58% 17.41% 24.19% 21.95%
ROIC 14.96% 15.80% 22.50% 11.66% 16.21% 14.70%
WACC 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%
Economic Profit Added (EP) 146.28 110.87 152.74 38.87 72.24 51.47
Mkt Cap (Mar End) 2503 1291 1241.37 267 1048

Market Value Added (MVA) 1212.00 49.63 974.37 -781.00 1048.00
(over prev yr)
RoRC 21.10% -9.31% 128.79% -64.85% 43.84% #VALUE! change in Op profits/change in Invested Capital
5yr RoRC 24.67%





Over the last 5 years, for every 100 Rs in incremental invested Capital, BKT has been able to deliver Rs 25 in increased EBITDA. Only!


(Donald Francis) #8
Kaveri Seed Company 2013E 2012 2011 2010 2009 2008 Comments
Revenues 643.18 372.44 233.69 163.68 123.06 96.57
EBIDT 125.42 74.24 55.05 37.31 30.42 24.82
Depreciation 9.79 10.01 10.19 4.15 3.22 2.06
EBIT 115.63 64.23 44.86 33.16 27.20 22.76
EBIT Margin 17.98% 17.25% 19.20% 20.26% 22.10% 23.57%
Working Capital 70 38.1 66.62 79.37 56.51 43.69
Net Fixed Assets 110 94.29 104.43 79.22 46.2 36.26
Net Other Assets






Invested Capital 180.00 132.39 171.05 158.59 102.71 79.95
Capital Turnover 3.57 2.81 1.37 1.03 1.20 1.21
EBIT/Invested Capital 64.24% 48.52% 26.23% 20.91% 26.48% 28.47%
ROIC 43.04% 32.51% 17.57% 14.01% 17.74% 19.07%
WACC 12.00% 12.00% 12.00% 12.00% 12.00% 12.00%
Economic Profit Added (EP) 55.87 27.15 9.53 3.19 5.90 5.66
Mkt Cap (Mar End) 1500.00 795.00 458.00 380.00 204.00 383.00
Market Value Added (MVA) 705 337 78 176 -179
(over prev yr)
RoRC 107.50% -49.64% 142.38% 12.33% 24.60%

5Yr RoRC 122.91%





And how does this picture look for Kaveri Seed Company?? Over the last 5 years for every Rs 100 incremental Capital, it has delivered Rs 122 in incremental Operating Profits.


(Subbu) #9

Like most metrics, one must be wary of taking the numbers at face value.

BKT is not as bad as it looks - if you remove 2012 from the equation. In 2012 there is a huge jump in fixed assets and I guess the company must have invested in a new plant or something, the profitability effects of which will only be felt in the next couple of years. So one should probably ignore 2012.

Again, armed with historical financials it is quite easy to identify good companies. But looking into the future is a completely different thing. I guess a good, sustainable competitive advantage drives good RoRC. Competent management that adapts to changing industry dynamics also helps.

RoRC surely helps in weeding out bad companies. But identifying good ones requires conducting thorough analysis on multiple aspects rather than a single metric which is what valuepickr does.


(Rudra Chowdhury) #10
[quote="Donald, post:3, topic:184497495"] > Thought of taking this discussion forward, again in a bid to differentiate one business from another. > > a) Updated the Mayur Economic Profit Table > > b) added in Arindam's suggestion of seeing how much of Market Value is Added every year. and the increasing Gap to Economic Profit created > > The larger the Gap, smaller is the comfort zone for a value investor in the company?? > > > Net Fixed Assets | > Net Other Assets | > Mkt Cap (Mar End) | (over prev yr) > Dividends | > Total Value Added (TVA) [/quote]

Superb, for somebody picking Mayur during Mar -2009 it is already a 38 bagger.

Stupendous wealth creation.

Mayur Uniquoters 2007 2008 2009 2010 2011 2012 2013E Comments
Revenues 66.26 90.24 115.05 164.73 248.56 317.48 398.52
EBIDT 6.67 10.57 11.78 27.92 40.87 54.20 67.75
Depreciation 1.52 1.39 1.59 2.08 2.67 3.87 5.11
EBIT 5.15 9.18 10.19 25.84 38.19 50.33 62.64
EBIT Margin 7.77% 10.17% 8.86% 15.68% 15.37% 15.85% 15.72%
Working Capital 13.42 11.88 12.07 22.21 33.01 29.58 33.98 15.95 21.32 22.65 23.15 31.3 49.07 70.33








Invested Capital 29.37 33.20 34.72 45.36 64.31 78.65 104.31
Capital Turnover 2.26 2.72 3.31 3.63 3.87 4.04 3.82
EBIT/Invested Capital 17.53% 27.65% 29.36% 56.96% 59.39% 63.99% 60.05%
ROIC 11.75% 18.53% 19.67% 38.16% 39.79% 42.87% 40.23%
WACC 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00%
Economic Profit Added (EP) -0.0739 2.17 2.66 11.87 17.87 24.28 29.45

22.40 12.90 77.42 137.47 242.23 500
Market Value Added (MVA)

-9.50 64.52 60.05 104.76 257.77



2.71 5.42 7.31 10


67.23 65.47 112.07 267.77
Perceived Future Expectations


55.36 47.60 87.79 238.32 (TVA-EP)

(Atul Garg) #11

Thanks for explaining it Donald.

But my bad, I am still not able to understand it in a meaningful way.


(Atul Garg) #12

Donald,

I see you dropped that metric in the following post. One less metric to comprehend for newbies like us.:)


(Atul Garg) #13

Subbu,

You are absolutely right. We can not isolate BKT as bad as there is huge jump in fixed assets in 2012.

One observation though, over a period of time the capital turnover for BKT is far lower as compared to that of Mayur/Kaveri, which definitely puts Mayur/Kaveri in a better spot than BKT.

Having said that, for Kaveri, though the performance has been good so far, I am still not very clear about the growth drivers for Kaveri and if this growth issustainableand for how long?


(Donald Francis) #14
Balkrishna Industries 2012 2011 2010 2009 2008 2007 2006 Comments
Revenues 2809.98 1997.16 1386.74 1252.43 991.47 877.35 620.21
EBIDT 493.49 371.58 397.16 201.64 233.6 182.62 146.31
Depreciation 83.14 74.44 66.22 56.52 43.83 36 27.34
EBIT 410.35 297.14 330.94 145.12 189.77 146.62 118.97
Operating Margin 14.60% 14.88% 23.86% 11.59% 19.14% 16.71% 19.18%
Working Capital 769.21 572.75 370.61 299.14 359.94 268.75 248.45
Net Fixed Assets 1068.68 687.44 614.89 534.55 424.47 399.37 259.74
Net Other Assets







Invested Capital 1837.89 1260.19 985.50 833.69 784.41 668.12 508.19
Capital Turnover 1.53 1.58 1.41 1.50 1.26 1.31 1.22
EBIT/Invested Capital 22.33% 23.58% 33.58% 17.41% 24.19% 21.95% 23.41%
ROIC 14.96% 15.80% 22.50% 11.66% 16.21% 14.70% 15.69%
WACC 7.00% 7.00% 7.00% 7.00% 7.00% 7.00% 7.00%
Economic Profit Added (EP) 146.28 110.87 152.74 38.87 72.24 51.47 44.14
Mkt Cap (Mar End) 2503 1291 1241.37 267 1048


Market Value Added (MVA) 1212.00 49.63 974.37 -781.00 1048.00

(over prev yr)
RoRC
-9.31% 128.79% -64.85% 43.84% 22.70%
change in Op profits/change in Invested Capital
5yr RoRC
31.92%





So here's the 5 yr RoRC data for BKT ignoring 2012 (from FY07-FY11). For every 100 Rs in Invested Capital BKT has delivered ~32% .That is the nature of its business. It's asset heavy, it needs to invest more in the business to generate more sales/profits.


(Donald Francis) #15

Subbu,

Thanks for your comments. Appreciate that.

just want to clarify this is not a quest for the holy grail - one hot metric, and making a choice based on that. As you said there are multiple parameters that need consideration when thinking about a business. and then there is the "Undervaluation" or the lack of it that we have to consider.

RoRC (comparing incremental invested capital to incremental operating profits) brought a sharper focus to our weighing the intrinsic economic characteristic of one business versus other. yet another parameter to be conscious of in our decision-making framework, and probably a pretty important one. (I don't think I appreciated it at this level of clarity before!)

Our parameterised model for capital allocation will have several such parameters. This RoRC/RoIC discussion is a step in that direction:). And then there will be the subjectives that will also need to be parameterised like size of opportunity, management ability to harness/exploit the opportunity, et al.

BKT was a wonderful investment in early 2010 at 100, and still is probably for the next 2 years (till undervaluation disappears), but now I can clearly distinguish it from the rest of my pack.


(Atul Garg) #16

I just tried a similar exercise for Astral.

'12 '11 '10 '09 '08

Revenue 578.51 410.35 288.65 192.73 135.81

EBDIT 70.29 54.80 46.25 24.64 25.38

Depreciation 13.38 10.72 8.60 6.17 3.26

EBIT 56.91 44.08 37.65 18.47 22.12

Operating Margin 9.84% 10.74% 13.04% 9.58% 16.29%

Fixed Assets 171.44 116.72 94.00 84.85 58.31

Working Capital 12.61 38.03 38.52 50.62 24.48

Total Capital Employed 184.05 154.75 132.52 135.47 82.79

Capital Turnover 3.14 2.65 2.18 1.42 1.64

EBIT/Capital Emp 30.92% 28.48% 28.41% 13.63% 26.72%

RoCE 21.64 19.94 19.89 9.54 18.70

Cost of Capital(WACC) 12.00% 12.00% 12.00% 12.00% 12.00%

Economic Profit Added 17.75 12.29 10.45 -3.33 5.55

Market Value Added(MVA)

Change in OP 12.83 6.43 19.18 -3.65 22.12

Change in CE 29.30 22.23 -2.95 52.68 82.79

RoRC 43.79% 28.92% 0.00 -6.93 26.72

5 Yead Avg RoRC 18.50%

Astral seems to be lagging on RoRc front. Any comments ??

Does that mean Mayur fares better than Astral..and how about BKT and Astral..??

Is BKT better than Astral as well..(But market seems to be telling something else..?)

Also how to address the situation when Capital employed decreases.

In 2010 Capital Employed decreased and that made RoRc Whopping 650% but I just trimmed it to 0.


(Rudra Chowdhury) #17

Hi Atul,

Not all situations should be painted with the same brush. Astral is in a sweet spot so as to say where the industry segment they operate in is itself stipulated to grow at CAGR 30% (CPVC pipes).

What this essentially creates is HUGE revenue visibility growing forward that all their incremental capex will be absorbed and they will be able to sell their produce with decent margins.Also this is more of a domestic housing play (India centric)

BKT on the other hand is susceptible to vagaries of natural rubber pricing ( effecting margins) and also if there is prolonged recession effecting the auto market BKT might be looking at a disastrous situation with all that expanded capacity by 2015, to face all those fixed costs and high debt without adequate sales growth. (Just a scenario for discussion)

[For case study look at Aban Offshore, how the company was ruined by high leverage coupled with major demand slump after rapidly expanding capacity (fleet size). From 5555 Rs per share on 20/11/07 stock price crashed to 224 Rs on 12/03/09 - a fall of 96%]

Hence, trying to base your investment/capital allocation based on RoRC may not be that fruitful in all situations.


(Dhwanil Desai) #18

Hi everyone,

Great discussion going on here. In my limited experience I have a gut feel that some businesses are inherently better than others. I feel that some inherent characteristics of business make them more valuable and rewarding. I think ROIC/RoE is one of the key parameters to watch for. Most of us will agree with regards to the importance of ROIC/ROE. However, going slightly further, I would like to point out that it is equally important to look at the components that leads to higher ROIC and sustainance of higher ROIC.

As described earlier, ROIC has two components i.e. net profit margin and asset turnover. In my limited experience, I feel that companies that have inherently asset light business model score higher in terms of having more probability of superior business economics.

Why do I believe so? Because, profit margin is something difficult to predict and sustain in a free market environment because the moment one starts earning higher margins competition is bound to come which will take margins lower. Secondly profit margin is dependent on number of factors which may be outside the control of the company (unless company has pricing power to pass on volatility and increase in cost) hence difficult to control.

On the other hand some businesses require very less amount of capital to scale up and produce large returns from every additional rupee invested. Take example of automobile companies which run on assembly model where most of the components are sourced from vendors and only investment needed is in assembling plant. Bajaj Auto, Atul Auto etc are case in point. This inherent business characteristic is instrumental in maintaining higher returns. So if company A and B both have ROIC of 25% but company A has asset turnover of 1 and B has asset turnover of 3 company A has to earn margin of 25% while company B has to earn margin of 8%. Second case seems more reasonable andsustainable over a longer period of time.Moreover for each % increase in margin, ROE increase by 3% for company B while that of A increases by only 1%. Thus Asset light businesses accentuates the impact on ROE in case of change in margins (which may be double edged sword if the margins decrease!).

Another advantage of asset light businesses is that because they are less capital intensive hence typically internal accruals are enough for further investment which means these businesses are less leveraged as compared to asset heavy businesses. This again means fundamentallyasset lightcompanies are more likely to be stronger than companies having business model that requires lot of capital.

I tried to test my hypothesis by screening stocks having market cap of more than 1000 crores and asset turnover of more than 2 and less than two. The first group had far larger number of companies with high ROE and low debt than second group. However this is just preliminary and need to refine my analysis.

In short, I feel that asset turnover is one of the key business charateristics/differentiator that will be very useful in evaluating how the value will be created over a longer period of time. Now this surely does not mean it is the only facotr to watch for. Opportunity size, base effect and moat are other things to watch out for.

Best Regards

Dhwanil Desai


(Subash Nayak) #19

Hi Donald,

Can you please upload a sample spreadsheet with sample RORC, ROIC calculation. I want to do the same for all the growth stock I am investing, tracking


(Donald Francis) #20

Hi Dhwanil,

Excellent. You are able to bring out the different nuances clearly. That shows theclarityin your thinking. Also you write very well. Please keep contributing.

Do you find that there are more insights possible by using RoIC (only drivers are Operating Margin x Capital Turnover) to differentiating between inherent business characteristics, than RoE (drivers are Net Margin x Asset Turnover x Leverage).

I have seen many senior investors point out that it's essentially the Capital Invested in operating the Business (Working Capital+Net Block+Net Other Assets) and the returns on that being a better differentiator. They say RoIC is a better analytical tool for understanding a company's performance than other return measures such as ROEbecauseit focuses on the true operating performance of the company. RoE mixes operating performance with financial structure making peer group analysis or trend analysis less focused.