Before buying any company, I must check my default check list.Apart from that even if all the check lists are satisfied,the most important thing I should not ignore is “valuation”.Remember that a company may be a good one since last 15 years or it might remain excellent for next 20 years.But its stock price will not be good in between this time period, from a buyer’s point of view.Stock prices oscillate in between cheap and expensive and I need to buy a good business in cheap or fair valuation.Sometime the stock price may not come to my calculated valuation and for years and I might have to sit with cash.It is okay if I sit with cash.But I need that margin of safety so that if the stock I purchased do not rise ,then also I can sit with mental peace.A good purchase price provides me that mental peace.
Scenario-1
Often you might be hearing this in business news channels that a particular stock is corrected 40% from its 52 week high and looks attractive.If the business is not worth investing,then there is no point in calculating the valuation of the stock.It does not matter how much % the stock is corrected from its top.I just don’t understand the logic behind it.TCS…no doubt …it is a good company… as on 19.07.2022…its stock price is Rs.3074/- and its all time high was Rs.4043/- .So,it means as on date the stock is corrected 32% from its all time high. Now TV channels are telling that TCS looks attractive.
Give me a break…
Look at its current market cap …its 11.21 Lakh crore …so at its all time high its market cap was 14.79 Lakh crore.
Even if you buy TCS at current price …if you think to make your money double in TCS ,then its market cap needs to be 22.42 Lakh crore.Lets say its earnings will justify its stock price ,then its current EPS (i.e. Earnings per share) i.e. Rs. 104 need to be doubled i.e. Rs.208. TCS has nearly 22% margin.So in order to make EPS double ,its revenue needs to be doubled i.e. from 1.95 lakh crore to 3.9 lakh crore.Lets say it will happen over next 5 years it means its revenue needs to be grown at 14% .But its revenue is growing at 5.71% since last 5 years.So if the whole IT industry will grow at 15% for next 5 years ,then it will cross India’s GDP perhaps.Again what other IT companies will do ? TCS is not the only company in this planet.Perhaps it need to go to the Mars for getting projects.
currently TCS is available at 30 PE multiple.Its growing at 5% and PE is at 30.It does not make sense.
Two things can happen…
1st… its stock price may stay there constant as it is for several years and gradually its earnings will increase slowly and justify its price.In this case you will not loose money in paper.But you will get -ve 6% yearly because in India inflation is around 6% minimum.
2nd…its stock price will collapse because market will not give 30 times premium to a 5% growth company.Lets say if it re-rates TCS to 15 PE multiple.So you will loose 50% of your money in paper.
In both way you will loose money.
Lets say we give premium to TCS …since it can give whole EPS to shareholders …still the 30 PE and target 22.42 Lakh crore market cap in next 5 years looks insane.
I may be wrong…but I don’t want to take that much risk to make my money double.
Where we make the mistake is…we see the correction in stock price in isolation.
But we need to see the following things in together
- Current market cap of the company
- Current Price to earning multiple.
- How much headroom is there for the market cap to go up (considering the profit growth).
- What % of the EPS, the company can give to shareholders as dividend without affecting its business.
Scenario-2
Often we take the wrong reference point to evaluate the companies in different situations.I consider these as false indicators.Some of these examples are.
Bank deposit interest rate during COVID pandemic is very low …say 3.5%.So, if TATA Power is available at 4% dividend yield,then we should buy its stocks.PSUs are available at 5% dividend yield ,so we should buy them.These are all wrong metrics which seems right in extra ordinary situations.You need to ask yourself, that whether you want to own the businesses like TATA Power and PSUs.If not then it just does not matter in what dividend yield these stocks are available.If the business is an investment grade and headroom for multiple year growth is available and stock is available at 5% dividend yield and low PE ,then it makes a perfect buy.But you need to consider all the parameters together.Remember you invest in a business for growth in earnings not for dividend yield only.
When interest rates are low,even the companies with 5% earnings growth ,available at 40 PE will attract you.This is a perfect illusion, as you are taking only the interest rates as the bench mark for calculating the valuation and ignoring the inflation completely.As per simple economics, interest rates should beat inflation and at present in INDIA ,it is not beating the inflation.So ,your mind will tell you that its ok to buy the stock at 40 PE since interest rate is very low.Remember that ,what is important is the "sustainability of growth in the prices of your stocks " .This is the whole point for which you are investing in stocks and this can only be justified by growth in the earnings of the company.But if you are justifying the growth in stock prices due to low interest rates,then it is nothing else just a bubble.
At present some of the good companies are available at insane PE & Market cap.
Example- TCS,Infosys,D-mart,TITAN etc…
https://themangoinvestor.blogspot.com/2022/07/when-not-to-buy.html
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On valuation I’ve seen in my 2 years journey that you make money when the valuation is so cheap that you don’t need to do too much hardwork on valuation. And probability of not making money increases when doing valuation becomes very difficult.
Scenario 1: I bought a NBFC company named CSL Finance Ltd in February 2021 with price being lower than the book value after substracting all the gnpas( which was very low). The promoter was buying from open market. The mgmt managed the NPA to be stable throughout the covid. The adjusted PB ratio was 0.65. It was a no brainer buy at that price and it became a 3 bagger. Didn’t fall at recent sell off at all. Still the company is available at 1.2 PB ratio but now the valuation is little bit hazy. I mean it’s no longer a no brainer buy.
Scenario 2: I bought Prince pipe after it became a multibagger. The PE ratio was 36 but the earning growth was also superb. It was a 25% grower company at 36 PE so I thought even if it grows by 20% I’ll make money because the ROE ROCE was good. After I bought next 2 qtrs results were also good. But then the crude price shot up margins reduced and the stock price is still consolidating and now in the lower range. Though the sector has tail winds. But I’ve lost in terms of opportunity cost. I could have invested now. Because the valuation is much better now. 15% grower at 22 PE with structural tail winds. But will I buy it? No there are much better opportunities which represent no brainer buys.
Scenario 3: Krsnaa diagonistics, a moated player+good management+ Huge runaway for growth. Excellent growth in last 3-4 years. The stock corrected by 50% because everyone thinks increasing competition in Diagonistics sector js going to hurt the existing players. it’s true for dr lal path labs and other like them. but krsnaa completely operates in different field. So here we have a company which can easily double the earnings in next 2-3 years due to huge operating leverage. So it’s a no brainer buy at this valuation.
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For me, Valuation is the foremost parameter. If a company fails this parameter, then no matter how great it is fundamentally, I will not look at it. Just cannot accept the avoidable risk of multiple contraction plus low valuations would give margin of safety against unforeseen future circumstances.
I have Two Category of valuations depending on the type of business.
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For non-moated businesses (average businesses) - BUY when price is at-least 25-30% Discount to Intrinsic Value calculated based on AVERAGE HISTORICAL EARNINGS (Avg ROCE, Avg EBIT margins etc.).
This ensures that we have two tiers of margin of safety.
One is the flat 30% discount Demanded on intrinsic value.
Secondly, By using AVG Earnings power, we can buy when the earnings are on the lower side of the avg, thus giving a chance for reversion to mean (A very powerful and persuasive phenomenon) and also protecting on the downside against further earnings decline. (some basic business analysis is of-course required to figure out where in the cycle earnings are currently and what are the catalysts for mean reversion)
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For Strong / Moated Businesses - Buy at Fair Value, usually 10-12 EBIT/EV Multiple, so that we get all the future growth + Multiple re-rating chance for free.Here numbers are of secondary concern and business analysis the primary. Significant judgement about business fundamentals, industry dynamics is required to determine the strength and sustainability of competitive advantages. Thus, if a company passes the business analysis test, then buying it at fair static intrinsic value would give us all the good things about growth without having to pay for it!
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How do you do the valuation? I have tried DCF and almost all the time I find them to be over priced. Any suggestions on the right way to do the valuation would be very helpful.
Some times you compare the company with it’s peers then try to see p/e, ev/ebitda, mcap/sales etc.
for Bank and Nbfc PB ratio works best. As a rule of thumb a Bank or NBFC with good roe and asset quality will have high pb ratio. For similar roe, and asset quality a retail focused institutions will get higher valuation than that of a wholesale focused player because of inherent risk with wholesale type of book.
DCF won’t work for a company in growth phase. Then u can use the Cash flow from operations instead of FCF to do the reverse DCF.
Watch this video by @harsh.beria93 to understand valuation. It’s very difficult yet the most important part. Estimating the future growth is something a lot of analysts do and it’s no big deal but valuation is.
One more thing valuation method taught by western books doesn’t work much on Indian companies I’ve seen. A person who read Intelligent Investor would try to buy low pe stocks.but most of the times it’s cheap for a reason.
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Valuations truly make life simpler.
Other than krsnaa which I hold as large % of pf, I would add Sandhar to a no-brainer list.
At 0.6x price to sales with rm prices already taken a hit(Zinc, copper, aluminium) and margins will make their way back to 10% on a conservative basis. Even if one excluded a 2W cycle revival, company grows 15-20%. Promoter making open market purchases too.
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For cyclicals like steel, auto ancillary companies pb ratio, mcap/sales work very nice. just open screener and see the last 10 years pb ratio and price to sales ratio for sail, tata steel, jsw steel, Fiem industry, lumax industry etc.
Then lets say u have found a company which is trading within it’s historical valuation range. or the price is consolidating. But u know that the company is doing something for which the roe, roce will increase in future. maybe it’s developing a higher margin product, or selling off some assets which will make the balance sheet light then u know it’s a rerating candidate. multibaggers are found in such a way. Deepak Nitrite is such an example which did capex for sepciality chemicals which resulted in higher roe roce and earnings in 2020 and the stock got rerated from 10-11 pe to 30 pe along with earnings growth. Price shot up from 400 to 2800. One more example is Prataap snacks the company’s margins are down because of palm oil price rise. and so did the price along with the EV/EBITDA. Now at a 1400 cr revenue the company has an ebitda margin of 4 for fy22. Now with reducing palm oil price and the cost cutting measures taken by the company the margins will rise to around 9-10 as it did in past and the EBITDA will rise disproportionately.Even if sales doesn’t increase the sales, ebitda will rise from some 50 to 135 just because of margin rise. then the company is growing in mid teen rate. With the schools opening demand is also coming back. so Depressed valuation (ev/ebitda, mcap/sales)+margin expansion+ sales growth. So it’s a deeply undervalued stock. Even if you do some dcf the bear case price will come around 1100 and the stock is now at 730. So it’s god damn cheap that u can tell within 5 min.
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I hold them both.
Krsnaa has huge runway for growth+ moat. Plus already corrected by 50% with earnings growing rapidly. So it’s a perfect recipe for consistent compounder.
Sandhar has given a revenue growth guidance of 35% irrespective of industry growth. Plus now rm cost is reducing. promoter is buying from open market. So it’s also deeply discounted.
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Rev growth of 35% in sandhar is a bit aggresive imo(who knows?), even if we take into consideration the upcoming expansion a 20% growth is a base rate that can easily be hit. A no brainer with second order consequences already playing out(RM prices cooling off), but stocks price hasnt yet.
Krsnaa too suffered with industry wide capital outflow but the least susceptible to concerns(B2C, + covid revs almost nil).
Both cases of mispricing with margin of safety imo. Lets see how they play out!
Disc - krsnaa and sandhar make up almost 50% of pf; biased.
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Till now I am also unable to quantify what these …DCF and intrinsic value …are.What I realized that ,the best way to understand a business is to do field work ,reading and logical reasoning.Once I understand the business and if I can convince myself that its a good business,then the next step is to wait for correction (if the stock is expensive) in the stock price,so that the stock becomes cheap with respect to the current earnings,strength/moat in business,ability to throw cash to shareholders etc.This process takes care of margin of safety.My check list helps me in it.Suppose I bought a good business little high price (not abnormally high),then since I purchase stocks in SIP mode,then automatically the avg purchase price goes down.
What mistake I used to make earlier is that,If a well known stock price corrects more from its top ,then I consider the business as a good one and there is no logic in it.
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A general screener query I use to find better performing companies & from the results I apply the DCF & tried to see of the stock price is hyped
EPS > 20 AND
OPM > 10 AND
Sales latest quarter > Sales preceding quarter AND
Sales preceding quarter > Sales 2quarters back AND
Sales 2quarters back > Sales 3quarters back AND
Sales growth > 15 AND
Sales growth 3Years > 15 AND
Debt to equity < 2 AND
Return on equity > 15 AND
Return on capital employed > 15 AND
Promoter holding > 50
My major issue is with valuation & I guess I have to spend more time reading about the company and their annual reports to understand the fair value
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agreed…and I can fool my brain…if margin of safety factor is there
Thanks for the information. As a new investor, this is quite helpful.
In SCENARIO 1 u mentioned valuation is little bit hazy and it’s no longer a no brainer buy… can u plz elaborate this ???
It means the same company was available at 0.65 pb ratio after deducting all the npas and liabilities from the Advances given. So it was a very conservative pb ratio i calculated not something that what the conventional book value (the equity portion). Now the conventional pb ratio is around 1.6 (as of today). So surely it’s not so cheap. Considering 70% of the book is wholesale lending (earlier used to be 100%). But still it can go to PB ratio of 2 since that was historical high valuation. When I bought it, it was a cigarbutt investment, w/o having any focus on growth. Now growth also matters. So clearly valuation is hazy compared to earlier. When valuation becomes hazy probability of making money reduces. Take any popular stock for example. Surely u can get some 20-30% return but it won’t sustain over 3-4 years
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“If price doesn’t scream at you as a bargain, it’s too close” ~ Warren Buffett
There are 2 types of investors who fail consistently:
- Buying great companies at super valuations
- Buying below average companies at cheap valuations
I don’t care what your investing strategy is, the only way to pick great companies is - Pick the Industry Leader, Period!
If a company is an industry leader, it is because they have something special than other businesses in the domain.
Now, the focus shifts on the industry. Ask these questions:
- What is industry’s barriers to entry?
- Is the industry an oligopoly or fragmented?
- What’s the future of the industry in the next 10 years?
- What is the bargaining power of the buyers?
- Does the industry depend on other industries?
- What the industry leader has, which makes it an industry leader?
Asking questions about the industry is easier than asking questions about companies.
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Talking about valuation, I prefer DCF (certainty equivalent cash flows) Valuation.
Calculate cash flows by,
- Go to screener and choose your company.
- Take “cash from operating activity”
- Deduct “Fixed Assets Purchased” under Cash from Investing Activity head.
- Deduct “Investing in Subsidiaries & Acquisitions”
The cost of capital is the risk free rate.
Be conservative while putting a growth rate on cash flows for next 10 years. Calculate the terminal value with cash flows of 11th year.
The value per share you get at last, put a 50% margin of safety on it! That’s your bargain.
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@vansh1208 Could you please share the above-said cash flow with an example for learning purposes? Thanks in advance.
Let’s take a look at Air Conditioner Industry, where Industry Leader is “Voltas”.
Answers to Questions related to Air Conditioner Industry:
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What is industry’s barriers to entry?
Ans - Air Conditioners are a low margin business. Voltas and Blue Star both have a single digit Operating Margins. It’s difficult to enter into the market with price war in mind.
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Is the industry an oligopoly or fragmented?
Ans - An Oligopoly with 4 to 5 recognized players taking the cake.
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What’s the future of the industry in the next 10 years?
Ans - People won’t stop using Air Conditioners, instead as Indian Economy grows, more and more families will afford to buy an air conditioner.
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What is the bargaining power of the buyers?
Ans - Customers do have some bargaining power when it comes to appliances, but the talk can be negotiated to improve warranty services (after sales service) more.
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Does the industry depend on other industries?
Ans - No
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What the industry leader has, which makes it an industry leader?
Ans - Difficult question to answer, but I would say better after sales service and better brand value. Voltas marketing is based on Word-of-Mouth. (these are my opinions, you can add more!)
After getting to know the industry, below is a simple DCF (Certainty Equivalent) Valuation. Although, the Value per share comes out to be Rs. 513.17, a 50% Margin of Safety would push down the value to Rs. 256.58.
So, if I see Voltas Market Price around Rs. 250, it’s screaming at me as an obvious bargain!
Disclosure: Not a Recommendation! Just for academic purposes.
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How did you arrive at the growth rate in perpetuity of 4%, kindly share the calculations.
Thanks
India’s 10 year government bond yield is 7.31%. Given the fact that India is a Baa3 rated country, there is a default spread component in the 10 year government bond yield.
India’s true risk free rate % should be - 7.31% minus 1.87% ( i.e default spread at Baa3 rating) = 5.44%
Now let’s focus on 5.44% growth in Indian Economy:
Any Economy is driven by a basket of large companies and small/mid cap companies. I assume that large companies contribute to about 4% to the economy’s growth and rest 1.44% by small/mid cap companies.
When we are doing a terminal value calculation, we assume that the company (that we are valuing) is already a mature company (as it’s going on forever) and that’s why the growth rate in perpetuity in India is 4%.
The same way, growth rate in perpetuity in US$ will be around 2% (given their risk free rate and composition of economy).
One question that you can have is, why can’t we put a growth rate in perpetuity of 7% or 8% or 10%?
It’s because if you do that, you are implicitly assuming that the company will outgrow the whole Indian Economy, which is a pipe dream! If Indian Economy is growing at 5.44%, your company will grow at a rate lower than that.
Hope that helps!
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