Valuation: Measuring & Managing the Value of Companies

Books & Tutorials
21

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 capital_over and above_the 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.

22

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.

4 Likes
23

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!

24

The next important concept introduced in the Copeland Valuation book is the** Economic Profit** model. 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 a single 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.The** Market Value** at any point of time measures perceived future value creation expectations. The increase in Market Value over a year equals Economic Profit (the realised value creation) plus the change in the value creation expectations.

The change in Market Value will equal Economic Profit only if there is no change in expected future performance and if the WACC remains constant during the year.

2 Likes
25

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

26

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:))

27

You can refer to Investopedia Link: http://www.investopedia.com/search/default.aspx?q=free%20cash%20flow#axzz1sUH83lhU for an education on basic jargons like free cash flow. Even ValuePickr has an excellent compilation in the Basics Link: …/…/…/…/basics/stock-market-basics section.

28

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.

29

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.
30

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

31

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!

32

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.

33

Hi Everyone,

Good discussions here :slight_smile: 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

34

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??

35

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 :-).

36

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

37

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.


38

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.

39

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.

40

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.