Question on Value Investing....Sanjay Bakshi's Lecture

Q&A: Questions & Answers
1

I found following info in one of Sanjay Bakshi's Lecture (http://www.capitalideasonline.com/articles/index.php?id=694 ):-

Could someone please explain me how did he arrive at numbers 175 and 95?

Let me just give you very quick example. Here are two companies

Company A
Company B
Capital invested
Rs 100 cr.
Rs 100 cr.
Return on Capital
35%
10%
Price/Book
10x
0.20x
Market Cap
Rs 1,000 cr.
Rs 20 cr.
PAT
Rs 35 cr.
Rs 10 cr.
Price/Earnings
29x
2x
Dividend Payout
20%
20%
Dividend
Rs 7 cr.
Rs 2 cr.
Dividend Yield
0.7%
10%

Both companies have same amount of capital invested -- Rs. 100 crores. Return on capital -- 35 percent in A and a pretty mediocre 10 percent in B. A sells for 10 times book, B sells for 20 percent of book. Market Cap รข 1,000 crores for A and 20 crores for B. PAT -- 35 and 10. Price to earnings -- 29 and 2. Dividend payout -- same in both the cases. Dividend actual payment 7 crores and 2 crores. Dividend yield -- 0.7 percent and 10 percent.

Now, one looks like a growth stock, the other looks like a value stock. Now, if you keep the assumptions intact, if you assume that the future will be pretty much as what is been displayed on this slide then obviously company A well turn out to be, not only a better company, but also a better investment.

Company A is no doubt a better business than company B because it earns a higher return on capital and has a rational dividend policy because it retains most of its earnings and so long as the return on capital is high, this money will build up and like an internal compound machine should eventually show up in increased market valuation.

Now, if the model assumptions hold, and if we assume that 5 years from now the same assumptions apply, then over those five years A will produce a 175 percent return, while B will return 95 percent. So A would have been not only a better business but also a better investment.