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Level 1: A primer to investing in the stock markets .................. 3
A guide to investing in stock markets .......................................... 3
Numbers jungle unfurled ........................................................... 6Cash flows vs income statements .............................................. 10
Cash flows: The health parameter ............................................. 12
The dividend attraction ............................................................. 14Look (at the downside) before you leap ...................................... 16Troubleshooting for retail investors ............................................ 19
Level 2: How to put a price to stocks ...................................... 22
Book value: Weighing on assets ................................................ 22
Stocks: Measuring expectations ................................................. 27Valuing super normal growth .................................................... 32
P/E ratios: Reality check .......................................................... 35
EVA Another barometer for corporate performance ................... 40
Perception vs Valuation: Directly proportionate? .......................... 44Dow Theory: An insight ............................................................ 47
Net asset value: unlocks hidden potential ................................... 50
Level 3: How to create your own portfolio .............................. 55
Equitymaster Portfolio: Revisited ............................................... 55
Equitymaster portfolio A review .............................................. 59The Core, Stars and Flyers..................................................... 64
Other Investment Avenues ..................................................... 69Gold is GOLD .......................................................................... 69As good as gold! ...................................................................... 72
Understanding Debt Markets .................................................. 74Debt markets: The other alternative .......................................... 74
The different measures of debt. ................................................. 79Risks associated with bond ....................................................... 82The yield curve ........................................................................ 86
Identifying stocks: Do's and dont's ........................................ 90
Identifying an aluminium stock: Dos and donts.......................... 90Identifying an auto stock: Dos and Donts................................... 94
Identifying an auto anc. stock: Dos and donts......................... 100Identifying a banking stock: Dos and Donts............................. 104
Identifying a cement stock: Dos and donts.............................. 107
Identifying a construction stock: Dos and donts....................... 111
Identifying a domestic pharma stock: Dos and donts................ 115Identifying an engineering stock- Dos and donts...................... 119
Identifying an FI stock: Dos and Donts................................... 123
Identifying an FMCG stock: Dos anddonts.............................. 126
Identifying a hotel stock: Do's and don'ts ................................. 129Identifying an MNC pharma stock: Dos and donts.................... 132
Identifying a paint stock: Dos and Don'ts................................. 136
Identifying a power stock: Dos and Donts............................... 140
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Identifying a refinery stock: Dos and Donts............................. 144
Identifying a Retailing stock: Do's and Don'ts ............................ 147
Identifying a shipping stock: Dos and donts............................. 151Identifying a software stock: Dos and donts............................ 156
Identifying a steel stock: Dos and donts .................................. 159
Identifying a sugar stock: Dos and Donts................................ 162Identifying a telecom stock: Do's and Don'ts ............................. 165Identifying a textile stock: Dos and donts................................ 172
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Level 1: A primer to investing in the stockmarkets
A guide to investing in stock marketsHow would you decide whether Hindustan Lever is a better buy in today's market or is Infosys
Technologies? Or for that matter should you be investing in stocks at all? Well, to answer these
questions it requires nothing short of a thesis. Nevertheless (the ideal solution is better avoided!)
we make an attempt to equip the retail investor with a tool that will help him identify an investment
opportunity.
The diagram below is a representation of a classical Top Down approach to investing in stock
markets.
In order to capture the essence of the top down approach to investing, lets evaluate each one of
these investment criterions.
Politics
Politics has a very strong bearing on stock markets. Investment decisions continue to be weighed
down by prospects of instability in the government. Indian investors are well versed with the
fallout of such a scenario.
Then again, investors must analyze or look into policy initiatives of the government and weigh
whether they will be pursued at all or not. One example of this is the disinvestment of holdings in
the domestic energy and telecom sector, which comprises public sector companies such as
Mahanagar Telephone Nigam Limited (MTNL) and Bharat Petroleum Corporation Limited (BPCL).
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These companies have failed to move in sync with a bullish market largely due to the uncertainty
regarding government policy. Other policy initiatives of the government, like the decision to
participate in the World Trade Organization (WTO) also have a bearing on the markets.
For example, in India's case, we require a stable government with a strong sense of fiscaldiscipline. At the same time, there is a need to push through the second phase of reforms. If the
incumbent government were not to deliver on any of these counts, one can expect an adverse
fallout on the bourses (surely in the long run).
Economy
How the economy performs is influenced to a great deal by the political climate in the country. To
put it another way, the economy cannot continue to post robust growth in absence of a conducive
policy environment. Moreover, with India becoming a member of the WTO and foreign capital
finding its way into the country, the need to track the global economy has never been felt as much.
In the Indian case, performance of the agricultural sector is a key factor affecting overall
economic growth. This is not only due to the fact that this segment accounts for over 25% of
domestic GDP. But it employs over half the Indian population, which looked at it in one-way, is a
massive consumption base. Therefore if the agricultural sector were to falter (due to a weak
monsoon or for some other reason) overall economic growth will surely be affected. Companies
with a high exposure to rural markets (or agriculturally dependent) will be worst affected.
Another factor that needs to be looked into is the fiscal deficit of the government. This can be met
either from borrowings or creating money. While exercising the first option puts upward pressureon interest rates, the latter contributes to inflation. Thus, either option, if not handled well, can
have adverse consequences for the economic environment and stock valuations could be hurt.
Investors must also take note of developments in foreign trade and forex reserve position of the
government. Exchange rate movements too can have significant impact on corporates. These are
just some of the important economic indicators that need to be looked into while deciding where
to invest.
Industry
After having looked into the broader parameters, an investor must carefully analyze the industry
in which he proposes to invest. For example, an investor can assess the industry on certain
factors like: demand, supply, bargaining power of suppliers, bargaining power of customers,
threat of substitutes and existing competition (akin to Michael Porters model). Such an analysis
will clearly bring to light the state of the sector. For the sake of an example lets analyze the
cement sector in brief.
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Demand for cement is estimated to grow at over 8% per annum over the next few years even as
capacity additions slow down to a trickle. Demand growth in FY00 was put at 15%, marginally
lower than the increase in supply. Growth in future will benefit from increased spending on
infrastructure i.e. roads and housing. As there is no substitute for cement, there is no threat of an
alternative for now. However, there is intense competition in the sector, which has led to apressure on realisations. Indeed, in FY00 realisations increased only marginally despite the surge
in demand. Consequent to this, the bargaining power of customers is also higher. However recent
consolidation in the sector is a step towards limiting the level of fragmentation in the sector. As
consolidation gains pace the sector can benefit from lesser price competition and in turn possibly
better realisations.
Management
Lets suppose an investor zeroes in on the cement sector. The next step is to identify the
promoter/management he wishes to invest in. Taking our example forward, during the recent
slowdown in the Indian economy, a number of cement manufacturers posted a sharp decline in
profits. However, Gujarat Ambuja Cements came out relatively unscathed. Credit for this needs to
be given to the management. Investors must choose proactive managements, which are
capable of generating above industry average returns.
Company
After having seen that the policy environment in conducive, the economy is expected to remain
buoyant and the industry scenario for, say, cement is positive, there is a need to decide on a
company to invest in. A company in the cement sector can be expected to do well only if the other
macro factors are favourable. However, within the sector companies earn differential returns
mainly due to company specific factors. For example, for a cement company location (with
reference to markets and raw material deposits) is of prime importance. Cement companies in
south India are facing intense competition and are facing a decline in realisations. However, the
situation in the eastern markets is better. Then there are issues pertaining to financial
performance, efficiency and costs of production. These are just some of the factors that need to
be evaluated.
Lets take another example. In the software sector some companies earn higher margins mainly
due the value added nature of their work. Infosys, which is gradually venturing into software
products, commands margins that are substantially higher than, say, NIIT, which draws a large
part of its revenues from the highly competitive computer education business. Then issues such
as employee turnover need to be looked into, as people are their key assets. Among the other
factors that are of importance are the customer profile and their geographical spread (North
American markets usually yield the highest returns).
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The top down approach is a tool with the help of which investors are likely to find sound
investment opportunities in stock markets. Such an approach helps bring much needed objectivity
to the decision making process and must be made use of by investors.
Numbers jungle unfurledWith improvement in technology there is a whole load of financial information now easily
accessible. In fact, users now have access to content that probably analyse the stocks to death.
So before it kills you, Equitymaster.com has attempted to identify some key ratios and what they
signify to help you traverse the numbers jungle alive.
Operating Profit Margin (OPM)
OPM = EBIDTA / Sales * 100
EBIDTA = PAT + interest + depreciation + tax
The operating profit of a company is
calculated as the earnings before interest,
depreciation, tax and other amortisations.
OPM is the acid test of a company's operating
efficiency. In can be compared across
companies in an industry to identify the lowest cost producer. However, it may not give a fair
picture when compared across industries.
Both these players are leaders in their
respective fields. However, the
numbers indicate that Gujarat Ambuja
is more efficient than Hindustan Lever
Ltd. (HLL), which is not necessarily true.
HLL has to incur substantially higher costs in the post manufacturing stage. This includes
packaging, distribution and advertising expense (advertising / sales = 7%). Although, Ambuja
incurs costs under similar heads, in percentage terms these heads constitute a smaller fraction of
its costs (advertising / sales = 1%). Therefore, across industries the OPM may not show the real
picture.
At the net profit level the margins are almost the same between HLL and Ambuja. Being an asset
intensive company, Ambuja incurs higher post operating expenses in percentage terms i.e.
depreciation and interest. The company's capital requirement will be more to set up an asset
Company Sales(Rs m)
OperatingProfit (Rs m)
OPM
ACC 31,385 1,688 5.4%
Madras Cement 4,977 1,316 26.4%
Company Sales(Rs m)
OperatingProfit (Rs m)
OPM NPM
Guj. Ambuja 13,025 3,693 28.4% 12.9%
Hind. Lever 109,176 12,201 11.2% 9.8%
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base. Consequently, it will incur higher depreciation costs on these assets and incur higher costs
for servicing its capital.
Return on Net Worth (RONW)
RONW = PAT / Networth * 100
Networth = Equity capital + Reserves + Preference capital
RONW is a measure of the return on shareholders funds. It reflects the efficiency with which the
management has utilized the shareholders funds that are at its disposal.
Intra industry comparisons will
highlight companies with better
operating efficiencies and
consequently, managements that
have been able to utilize shareholders fund more efficiently.
However, inter industry comparisons
prima facie will not exhibit a true
picture. At a more discerning level it
brings forth certain characteristics of
the businesses.
To set up a cement plant Gujarat Ambuja needs to invest more heavily in assets. It needs
to achieve economies of scale to remain competitive. Consequently, its business model
is less scalable and its requirement for initial capital will be higher. HLL on the other hand
will need to spend heavily on building brands. However, the model is more scalable. It
can test market a product and then undertake a gradual national rollout. Therefore, the
expansion can be funded by internal accruals and consequently, the initial capital
requirement is lower.
The difference in returns also shows that as an industry the fast moving consumer goods
(FMCG) business is more lucrative than the cement business. HLL is in a 'product' based
business, in the retail segment and meets the impulsive demand of consumers, which
enables it to command higher margins. Ambuja on the other hand is in the commodity
business, in the wholesale (bulk buyers) segment and demand is cyclical (economy
dependent).
Company PAT (Rs m)Networth (Rs m) RONW
ACC (589) 10,456 -5.6%
Gujarat Ambuja 1,686 15,075 11.2%
Company PAT (Rs m)Networth (Rs m) RONW
Gujarat Ambuja 1,686 15,075 11.2%
Hind. Lever 10,699 21,033 50.9%
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Return on Invested Capital (ROIC)
ROIC = EBIT / Invested capital * 100
Invested capital = Equity capital + Reserves + Preference capital + Long and short term debt
Invested capital is the capital employed in the
business. ROIC is a critical parameter in
analyzing companies. It reveals the efficiency
with which the management has been able to
utilize the entire resources that are at their
disposal. The factors guiding RONW also hold true for ROIC.
ROIC tells the company the return it earns
from the business before it can service its
capital. This investment return percentage
can be analysed along with the cost of
servicing the capital invested. The resultant
spread between the two percentages will indicate the economic profit / loss percentage attained
by the business. It will give an indication of the esoteric economic value added (EVA) earned in
percentage terms.
Debt to Equity Ratio (D/E)
D / E = Total debt / Equity shareholders funds
Total debt = long + short term debt
Equity shareholders funds = equity capital + reserves
One can dig a little deeper to determine the constitution of the company's capital, which reveals
the proportion of debt and equity shareholders funds carried on its books. It will reveal the
leveraging capacity available with the company.
Company Total Debt(Rs m)
Equity-shareholdersfunds (Rs m)
D/E
ACC 14,873 10,456 1.4
GujaratAmbuja
11,824 15,075 0.8
Company Total Debt(Rs m)
Equity-shareholdersfunds (Rs m)
D/E
GujaratAmbuja
11,824 15,075 0.8
Hind. Lever 1,773 21,033 0.1
Company EBIT(Rs m)
InvestedCapital (Rs m)
ROIC
ACC 1,029 25,330 4.1%
Gujarat Ambuja 2,941 26,899 10.9%
Company EBIT(Rs m)
InvestedCapital (Rs m)
ROIC
Gujarat Ambuja 2,941 26,899 10.9%
Hind. Lever 10,923 22,805 47.9%
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Price to Earnings Ratio (PER)
PER = Market price / Earning per share (EPS)
EPS = (PAT - preference dividend) / shares outstanding
This is the mother of all ratios. It suggests how many times current earnings the stock price is
trading at. Therefore, at a more discerning level, it indicates the number of times the company's
earnings an investor is currently willing to pay for the stock. It also reveals the return the company
will earn on the price paid by the investor to become a part owner in the company. Therefore, the
investor must ask what return do I expect for being a part owner in the company?
Wipro at Rs 9,000 was trading in excess of a multiple of 850x FY00 earnings. At that price the
company would be able to earn a return of 0.12% on the amount invested for acquiring part of the
ownership. Is it worth it?
Comparing the PER across industries will not give an
accurate picture. One of the determinants of the ratio is
the growth in earnings, which will vary across industries
and consequently, the PER's will be different. However,
intra-industry comparison will illustrate how pricey the
stock is vis--vis its industry peers. Therefore, it will
highlight the comparative valuations of companies.
These are some of the key ratios one would like to look at when researching on a company. The
article should help you overcome the impediments of the numbers game.
Cash flows vs income statementsWhile profit statements can be distorted by anomalies in the accounting policies, the cash flow
statement can be considered as a gospel for investors. A cash flow in simple terms is a statement,
which summarizes movement of cash (the lifeline of any business) in an entity. There are several
issues on which cash flow statement scores over the income statement. While the profit and lossstatement gives a summarized view on the profitability of the entity, cash flow measures the
health of the business as well.
Income statement ignores time value of money: Income statement does not look at the time
value of money. A typical example of the same could be refinery companies. The growing deficit
in the oil pool account has reflected in increased receivables in the books of oil companies. The
Company MarketPrice (Rs)
EPS(X)
PER(X)
Madras Cement 4,418 333 13
Gujarat Ambuja 141 29 5
Hind. Lever 184 5 37
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deficit in totality is estimated in the range of Rs 100 bn. In other words, though oil companies
must have booked sales (profits thereon), they have in fact only resulted in huge receivables in
the books of these companies. The government has decided to issue oil bonds to oil companies
in lieu of their respective oil pool account receivables. With lack of a definite period for redemption
of oil bonds it would take much longer before they actually make profits.
The cash flow statement on the other hand recognizes the time value of money. Probably, its the
most conservative way of looking at business. Look how BPCLs growing debt burden is in fact
due to burgeoning receivables.
(figures in Rs m) 1998 1999 2000
Net Profit 5,327 7,012 7,039
Current Ratio (x) 0.96 1.12 1.22
Debt 14,64516,67325,927
Debt/Equity (x) 0.58 0.55 0.74
The above table would indicate that Oil Co-ordination Committee (OCC) receivables are putting a
strain on the companys balance sheet, which can in no way be reflected through the income
statement of the company. It is only when the investor looks at the cash flow position does he
realize that the situation is strenuous (for no fault on the companys part). In this case, the income
statement of BPCL thus ignores time value of money. Had the OCC receivables been on time,
the interest cost of the company would have been considerably lower.
Difference in Accounting policies: An income statement could be distorted depending
on the nature of accounting policy, which the company follows. A typical example of the
same could be the difference in accounting policies for right off of expenses on content
creation (intangible assets). The treatment of the same ranges from company to
company. A extremely conservative company may write off the entire expense on
software creation in the same year while others may write it off over the useful shelf life of
the content, may well be even ten years. Now, other things remaining constant the
income statement of the company, which writes off expenses over a longer period,
appear better.
Financial Management: A cash flow statement not only provides a snapshot of the
companys operational performance but also its financial management and utilization of
scarce capital. While investment activities provide a birds eye view of the treasury
operations of the company, financing activities provide the financing tactics adopted. i.e
the movement of cash from equity and debt.
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Let us take example of Himachal Futuristic Communication Ltd.
(figures in Rs m) 1999-00 1998-99
Cash flow from Operations 50.6 -87.4
Cash flow from investing activities -333.3 -6.7
Cash flow from financing activities 406.1 99.1
Net cash inflow/( outflow) 123.4 5.0
Net profit as per income statement 86.o 36.0
The above table is self-explanatory. While net profit has grown by three digit rates year after year,
cash from operations have not matched up with net profits. Secondly, inflows from financing
activities (from issue of share capital) were utilized for investment activities (primarily as loans
and advances).
Thus a cash flow statement is a mirror of not only the companys profitability but also a reflection
of the financial structure (including its liquidity and solvency) and the ability of the firm to adapt to
the changing business scenario. Historical cash flow could also indicate the amount, timing and
certainty of future cash flows. It therefore also offers comparability of operating performance of
different enterprises because it eliminates the effects of using different accounting treatments for
the same set of transactions and events.
Cash flows: The health parameterA rupee today has more intrinsic value than a rupee tomorrow. Why is it so? If you have Rs 100
today, you can deposit this money in the bank, which fetches you interest from that day one itself.
That is precisely the reason why cash flows and money management are all about attaining
maximum returns.
It is fine if a company earns adequate profits and commands better market share. But, if your
company is not generating enough cash, which it can utilise for its expansion plans, it is losing on
many fronts. From a shareholders perspective, the company could distribute a part of its free
cash as dividend to the shareholders, who are entitled to every rupee that the company earns.
From a companys perspective, one, this will enable them to plough back money for furtherexpansion plans and secondly it can buy back shares, which will enhance shareholder value.
Having said that, negative cash flow does not necessarily mean that the company is not doing
well. Normally, for green field projects, cash flows tend to be in the negative territory as they build
assets during the initial phase. There is always a lag time between investments and returns. So,
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cash flows from such capital expenditure would start flowing in probably after three or four years
(this period is higher for capital-intensive companies like steel, cement and automobiles).
But how do I calculate free cash flow? A simpler method of calculating a companys free cash
flow is to add depreciation to the net profits and deduct capital expenditure and dividend. An in-depth methodology would be to adjust a companys increase or decrease in net working capital
(current assets less current liabilities) to the above figure. Free cash flow increases if the
company manages to unlock efficiency by reducing the required working capital.
Asian Paints reported a net profit of Rs 973 m in FY00. The
depreciation, capital expenditure and dividend payout were Rs 348 m,
300 m and Rs 401 m respectively. The change in net working capital
(NWC) was negative Rs 145. The free cash flow (FCF) is calculated
as follows:
Let us take a simple example. Assuming that a company spends Rs
100 as capital expenditure in April 2000. The company has projected
cash flows or returns from such investments as follows: Rs 20 in April
2001, Rs 35 in April 2002, Rs 50 in April 2003 and Rs 70 in April
2004. Assuming a discount rate of 15%, the net present value of these future cash flows is Rs
117 (present value factor is determined by dividing 1/(1+15%) in FY01E, 0.87/(1+15%) in FY02E
and so on). Multiplying actual cash flow by PV factor would give you PV of the cash flows.
Effectively, this means that earning Rs 20 in FY01, Rs 35 in FY02, Rs 50 in FY03 and Rs 70 in
FY04 is equivalent to Rs 117 today.
Simple cash flow calculation
(Rs) FY00 FY01E FY02E FY03E FY04E Total
Cash Outflow 100
Cash Inflow - 20 35 50 70 175
Discount rate 15.0%
Present Value factor 1.00 0.87 0.76 0.66 0.57
PV of cash flow 17 26 33 40 117
The debate then arises as to what rate should one discount the cash flows. But generally, the
cost of capital of the company is a widely used hurdle rate because this takes care of a
companys debt and equity obligation like interest and dividend respectively. (Generally speaking,
if the return on capital employed is higher than a companys cost of capital, it is apparent that the
company is managing its cash flows efficiently).
Calculating FCF
(Rs m) FY00
Net Profit 973
Add: Depreciation 348
Less:
Change in NWC (145)
Capex 300
Dividend 401
Free cash flow 765
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Let us consider a practical example: Mahanagar Telephone Nigam Limited has ventured into the
cellular business for which it needed to incur capital expenditure for setting up infrastructure. The
company has set this up at a cost of Rs 3,660 m through which it will be able to serve 0.8 m
subscribers. As per the internal estimates, the company would net Rs 2,000 m as revenues in the
first year of inception itself. But at the earnings level, the company is expected to report a loss inthe first year, primarily on account of capital costs incurred in setting up the necessary
infrastructure. Assuming that the companys cost of capital is 17%, when we discount the
projected cash flows from the cellular business, we get the net present value, which when divided
by the number of shares, we get the fair value of the share. Remember, a company is not valued
for what it has achieved but for what it has planned to do in the future i.e. growth prospects.
It is precisely the reason why cash flow analysis is ranked high by many of the value investors.
So, the next time you plan to invest in a company, ascertain cash flows, as they are the health
parameter of any company.
The dividend attractionThe stock markets in recent months have been a big disappointment for investors. Across the
board selling pressure has led to erosion in capital of billions of investors. The losses have been
significant. In such a scenario, does it make sense to risk investing in stocks again?
Maybe. Look at it this way. Returns from a stock comprise of two componentsdividend and
capital gains. It is the latter that generates most of the attention revolving around stocks. The first,
that is the dividend, has generally been ignored.
Consider this. The return on one-year government paper is under 10% (tax free). On the other
hand, there are several stocks that have a dividend yield in excess of 10% (tax free). There is a
case for investors to put money in such stocks. What we have attempted to do below is highlight
a few such stocks, which at current prices offer attractive dividend yields.
A note of caution is needed here. It is not necessary that companies paying high dividend only
make investment sense. It is possible that the company prefers to invest the money in a new
plant; launch of a new product line or it could be for making acquisitions of brands or companieshaving same synergies. The management might be doing much more to build shareholder value
than it would have been doing just by passing their earnings as dividend. A prudent and efficient
management would not increase the payout ratio by scarifying opportunities for reinvesting
increased earnings in the business. The best example is the companies in the software sector,
which have relatively low dividend payout ratio.
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The unit of measurement is percentage (%). The returns should be seen in combination with the
standard deviation.
Standard Deviation Mean returns
Infosys 3.4% 0.40%
HLL 2.2% 0.10%
Sensex 1.8% 0.03%
Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001
One of the most prolific users of standard deviation was Harry Markowitz. He came out with his
portfolio theory and revolutionized the way people selected stocks. He introduced the concept of
portfolio risk diversification i.e dont put your all your eggs in one basket. According to him the
combined risk arising from two stocks depended not only on the risk of the individual stocks but
also on the how closely their price move together (correlation). Therefore, if two stocks have
almost no correlation then the combined risk of the two stocks can be lower than the lowest of
both the stocks involved.
The premise was that same factors would not affect the stocks and therefore, risk would be lower.
Probably losses on one of the stocks would be offset by gains on the other stock. Therefore risk
was broadly categorized into diversifiable and non-diversifiable risk. The diversifiable risk can be
made to disappear by a combination of stocks but the non-diversifiable risk has to be borne by
the investor.
The lesson here is very simple. Dont put all your money into one sector. What if the sector has a
de-rating? Obviously all the stocks of the sector are going to take a hit. The IT sector was recently
de-rated as its largest market (the US) was facing tough economic environment and therefore,
the IT spend in the US dropped. This meant lower revenue growth for the industry.
William Sharpe extended Markowitz diversification principle. According to Sharpe, if there was a
part of the risk that could be done away with, why would there be returns for it? Therefore, only
that part of the risk that cannot be diversified would be rewarded. He decomposed risk into
two components. Systematic risk (non-diversifiable) that affects all stocks and is more macro in
nature and unsystematic risk (diversifiable) that comprises of the stock specific risks.
Beta
Beta is the measure of the non-diversifiable or market risk. It gives a measure of how much would
the stock price change if the market moved by a particular amount i.e. the sensitivity of the stock
to market movements. Therefore, it quantifies the extent of dependence of the stocks price on the
macro or market factors. Suppose a stock has a Beta of 0.5, if the market moves by a certain
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amount the stock is likely to move by half the amount, as its sensitivity to the market is low. Again
if a stock has a beta of 2, then the impact of market movement on the stock is likely to be
magnified and be of twice the amount.
Both these measures do quantify riskbut what have one major flaw that is
they do not say what will be the loss in
rupee terms and what is the probability
of this happening. For example volatility tells us that Infosys is more volatile than HLL and more
risky. Also Beta tells us that Infosys is more likely to be affected if the markets move as compared
to HLL. But it still doesnt answer the question that what amount of money does the investor stand
to lose. This answer is provided by a measure known as value at risk (VaR).
Value at Risk
VaR is generically defined as the maximum possible loss (in Rs terms) for given position or
portfolio within a known confidence interval or a specific time interval. There are number ways to
measure VaR.
But basically VaR can be thought of comprising two components.
a. The sensitivity of a portfolio or positions to the change in markets
b. The probability distribution of the markets over the desired reporting period horizon.
If we combine both the components above then we are able to say with a certain level ofconfidence what will be the stock price movement in a day.
Confidence Level 68% 90% 95% 99%
HLL (VaR) 2.2% 3.6% 4.3% 5.7%
Var for Rs 10,000220.0363.0431.2567.6
Infosys (VaR) 3.2% 5.3% 6.3% 8.3%
Var Rs 10,000 320.0528.0627.2825.6
Based on daily returns for period from 15th Dec, 1995 to April 4, 2001
Here for 68% confidence level that can be interpreted as on 68 days out of hundred the VaR is
2.2% (1 times std deviation) of the portfolio value. For an investment of Rs 10,000, the value at
risk works out to be Rs 220. Therefore on 68 days out 100 an investor will not lose more than Rs
220 in a day for an investment of Rs 10,000 on HLL.
Beta
HLL 0.68
Infosys 1.04Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001
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Similarly for Infosys at a confidence level of 99% can be interpreted as 99 days out of hundred
the VaR is 8.3%. Therefore, in 99 days out 100 an investor will not lose more than Rs 826 in a
day on an investment of Rs 10,000 on Infosys.
These are just a few methods used to quantify risk. The purpose of this article was to introducerisk as a measure and stress the importance of valuing risk while investing in volatile markets.
Investing in stock market is not a gamble. But again its certainly not a sure way to make money
nor is it a sure way to lose it either. Investing calls for lot of research and thinking before you put
in your money. Luck can sometimes help you get some easy money but in more than a few cases
luck runs out. Therefore, look before you leap. And leap because you know the risk involved not
because you got a hot tip.
There is no easy way to make money, at least not on the stock markets; not that we know of. If
you still think otherwise, best of luck to you. You are going to need tonnes of it.
Troubleshooting for retail investors
When one invests in the equity markets, one dreams of capital appreciation, regular incomes in
the form of dividends, bonuses and so on. Cut to the world of reality and we find that the Indian
investor community is one harried lot. Forget capital appreciation, investors sometimes are locked
in heated battles with the companies they own shares in.
The complaints range from non-receipt of dividends, bad deliveries, problems in share transfers,loss of share certificates, non-credit of bonuses etc. So whats the recourse for the common retail
investor in such cases?
We spoke to some experts who deal with investor grievances day in, day out. About 85-90% of
the complaints received by the Bombay Stock Exchange (BSE) are about share non-transfer and
dividend non-payments. From the conversations we had with officials at BSE, we formulated a list
or thumb rules, which equip you to take a better recourse.
Thumb rules
Your first step should always be to write to the company and get a clarification from them
as to what went wrong. Sometimes, the company does have a logical explanation to the
issue concerned. For example, BSE receives a lot of complaints regarding dividend non-
payment or a lesser dividend than what was proposed at the shareholders AGM. But it
has happened in many cases that the dividend has been revoked or not approved later.
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Incase the company doesnt reply or the companys reply doesnt satisfy you, approach
the exchange on which the company is listed (i.e. BSE or NSE), the Department of
Company Affairs (DCA) and the Registrar of Companies of the region where the
company is registered.
Experts say that it is better to write to them all at one time. The reason being that all
these institutions have a hold on the companies and can add collective pressure, which
is likely to force the company to either give a reasonable explanation or to take quick
remedial actions.
Added to the above, if the company or the Registrar of Companies doesnt respond after
two reminders, you should write to The Securities Exchange Board of India (SEBI) about
your grievance.
Do not think that all this letter writing will yield no results. It is important to remember thatall these institutions maintain records on the companys investor friendliness. They
actually file all these complaints against the erring company. The companys are scared
of them and do not want to invite their ire. For example, the stock exchanges on which
they are listed have the right to blacklist them. BSE has developed a Z category shares,
under which the regular erring companies are placed on a watch, which has a negative
impact on the stock prices of these companies. The exchanges also hold the right to
delist the company as a last resort.
You can also sue the company and demand damages. One can either file the complaint
with the Company Law Board or the consumer court. But one must weigh the pros and
cons of taking the battle to court. For one, Indias legal system is slow and time
consuming. Secondly, court battles are costly affairs and are neither advisable nor
practicable for small retail investors.
Always keep photocopies of all your correspondence with the company and the
institutions you are writing to for recourse and file it. This will act as a handy reference
tool and an important proof in case the dispute gets prolonged.
At all times, please remember that as a shareholder you have the right to information, theright to your dividends, bonuses, all at the right time. Do not desist from staking a claim to
your rights.
To avoid all this hassles in the first place, it is advisable to read about the companies before you
invest in them. Always prefer companies with a reputed management and a good track record.
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Avoid fly by night operators, unless you are absolutely sure of their business propositions.
Remember, prevention is always better than cure.
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Level 2: How to put a price to stocks
Book value: Weighing on assetsIn general, we can assume a companys share price to be the sum of two components. The first
component is the price assuming that the company does not grow in the future. The remaining
part would be derived from expectations of growth in earnings going forward, the present value of
future growth opportunities.
For high growth sectors, a significant component of the stock price would be a function of the
future growth expectations, while for the not so rapidly growing sectors the markets would look at
other options for determining the stock price. And the assets a company holds is a good place to
start. Stocks that derive a large part of the price from future growth prospects are known as
growth stocks. (Read more). This article is focused on the theoretical aspects of book value andhow to put a price to a stock using the book value.
The difference between assets and liabilities gives net worth of the company. Net worth is that
part of business, which belongs to the common shareholders (the owners). Net worth per share of
the company is known as book value.
So what does book value tell us? Firstly, it is the value received by the shareholders on the sale
of companys assets at prices mentioned in the balance sheet. Since the value is determined
from accounting journals its is known as book value. Also, book is an approximate indicator of the
inherent value in a stock price and can therefore be assumed to be the no growth component of
the stock price. This is what makes the number so useful. For low growth industries or when a
company is passing through a period of low (or negative) growth the book value can be used as
an indicator of the stock price or a floor for the stock price.
Industries like banking, manufacturing and automobiles are basically asset intensive in nature
and therefore, looking at book value as a tool for making investment decision makes good sense.
While book value is a good tool to determine stock price for such industries, there is a word of
caution. Assets include land, buildings and inventory amongst other things. The valuation, as per
accounting standards for these assets could be vastly different from their real market value. The
real market price, of the assets, could be much higher or lower.
Consider Indian Hotels Company (IHCL), the companys prime property in South Mumbai is much
more valuable than that shown in the books due to the fact that building has been fully
deprecated and is carried on the books for almost no value. The book value grossly understates
the sell-off value of the company. On the other hand, consider the IT companies with old
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computers. The computers are not of much of value on resale. Here the book value overstates
the sell-off value.
While using book value makes sense for certain industries, for other it does not. It does not make
sense to use book value for services and FMCG industries not advisable. This is due to thesimple fact that stock price contains a significant proportion of growth component. Let us take a
look at a few examples.
Networth(Rs m)
No ofShares (m)
BVPS (Rs) CMP (Rs) BV/P (%)P/BV (x)
L&T 39,599 249 159 181 87.9% 1.1
SBI 134,615 526 256 220 116.5% 0.9
HLL 24,882 2,201 11 203 5.6% 18.0
Infosys* 20,803 66 314 3,819 8.2% 12.2
Telco 32,538 256 127 138 92.2% 1.1
*As per FY02 balance sheet; All others numbers from FY01 balance sheet
L&Ts book value for the year-end March 2001 is Rs 159. Thus, approximately 88% of the current
market price is based on the assets the company has. For SBI the book value is Rs 256 and the
stock price of is Rs 220. This translates to the fact that the markets are valuing the bank lower
than its book value. However, there is a catch. SBI had net NPAs (Non Performing Assets) of Rs
68 bn in FY01. NPAs are loans given out by the bank that have gone bad. Though the amount of
Rs 68 bn is owed to SBI by various borrowers, and theoretically is an asset, it is unlikely that the
bank will recover most of the money. Thus, if we exclude the NPAs from the banks net worth, thebook value works to be Rs 125. In this case the book value supports around 57% of the current
market price. Similarly, for Telco the book value supports 92% of the stock price.
Let us take the case for HLL and Infosys. While HLL stock price is Rs 204, the book value works
out to be only, Rs 11. Similarly in the case of Infosys, the book value works out to be Rs 314 and
the stock price is Rs 3,819. Thus, the book value accounts for 5% and 8% of the stock price for
HLL and Infosys respectively.
This variation in the price of Infosys and HLL is due to the fact that these companies dont need to
have significant amount of assets for their business. Their most valuable assets, intellectual
capital and brands, are intangible in nature. Consequently, it is very difficult to put a price to these
intangibles. This make valuation of the companys very subjective. Incase of an unfortunate event
the price of these stocks can erode rapidly.
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(Rs m) TotalAssets
FixedAssets
Sales Sales/Total Assets (x)
Sales/Fixed Assets (x)
L&T 108,20546,710 73,787 0.7 1.6
SBI 2,615,050 25,933 300,212 0.1 11.6
HLL 57,345 12,035 106,038 1.8 8.8
Infosys* 25,397 5,577 26,036 1.0 4.7
Telco 79,766 38,236 68,036 0.9 1.8
*As per FY02 balance sheet; All others numbers from FY01 balance sheet
This is evident from the fact that Infosys and HLL have sales at 1x and 1.8x times their assets.
The number is low for Infosys as it holds a significant amount in cash and investments.
Considering only net fixed assets (NFAs), the sales work out to be 9x and 5x the fixed assets for
Infosys and HLL respectively. The Sales/NFA for SBI works out to be very high 12x, as banking
business requires low fixed assets. However, the Sales/Asset for SBI is 0.1x. This is because the
business requires significant amount of advances and investments.
Price/book value
A very interesting ratio emerges by the comparison of the market price (market valuation) to the
book value (accounting value of assets less liabilities). While one measures the earnings power
the other reflects the part of price backed by assets. A market-to-book ratio of about 1.5 times is
that the firm is worth 50% more than what past and present share holders have put into it. The
ratio indicates what kind of a price investors are willing to pay for Rs 1 of book value of the stock.
The price to book value for a stock can be calculated using,
We know that price of a stock (P),
D
P = ----
r-g
Where
D = Expected value of dividends next year
r = Required return on equity (Read more)
g = perpetual growth rate of equities
Now substituting dividends by Earnings Per Share (EPS)* Payout Ratio
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EPS * Payout Ratio* (1+g)
P = ---------------------
r-g
The EPS can be written as the Book Value (BV) * ROE (Return on Equity)
BV* ROE * Payout Ratio* (1+g)
P = -----------------------------
r-g
Thus,
P ROE * Payout Ratio* (1+g)
--- = --------------------------
BV r-g
The bank rate (at interest rate at which SBI borrows from the RBI) is 6.5%. SBIs beta is 1.04 and
market risk premium is assumed to be 7%. Therefore, the cost of equity ( r ) for the bank works
out to be 13.8%.
Further, SBI had a ROE of 16% in FY01, the payout ratio was 12.9% and the dividends were
expected to grow at CAGR of 9% for the next five years. Thus, substituting the values in the
equation we get the theoretical P/BV for SBI should be 0.6. Currently, SBI trades at 0.9x its bookvalue. Once the P/BV is determined by using the equation, using the BV the price can be easily
determined.
Thus, calculating the theoretical price to book value should give an idea about the fair value of the
stock. However, the investment decision cannot be made on this ratio alone. Other qualitative
and quantitative factors have to been taken into consideration. The Price/Book Value is useful
when evaluating banks. This is because there the difference between the market value of the
loans and their book value is likely to be very less.
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A study of the valuation of three majors one from the automotive sector (Telco), one from the
banking sector (SBI) and one company with diversified business interests (L&T) indicates that
P/BV of 1x serves as a good measure of floor price of the stock price. In the period between
1994-1998 not one of the three stocks mentioned traded below a 1x its book value.
However, post 1999 many things changed. Firstly, the markets as a whole took fancy to new
economy and old economy stocks like Telco, L&T and SBI were no longer in favour. Also, Telco
ventured into its car project and the company posted losses. However, since third quarter of FY02,
Telco car Indica started toppling the sales charts. SBI as we mentioned before has NPAs to the
tune of Rs 68 bn.
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However, a trend that is evident for all the three stocks is that the P/BV has declined over a
period of time. This can be explained on a case-to-case basis. SBI has seen a sharp decline in its
payout ratio during the period. L&T on the other hand has seen the ROE decline steadily.
However, the effect of the decline in ROE has been offset to some extent by an improvement in
the payout ratio.
While value stocks do not offer swift gains, but they are not prone to rapid erosion in value either.
This makes them excellent candidates for a retail investors portfolio. Knowing how to price them
will certainly help. L&T for all its value does not seem a good buy at a P/BV value of 4x.
Stocks: Measuring expectationsThe most mysterious thing especially with the software stocks has been their price. The price of a
security can be broadly divided into two elements viz. the intrinsic value of the stock and the
speculative element. But from the point of view of making a long-term investment, and not punting,
it is the intrinsic value that ultimately matters. Arriving at the intrinsic value is, however, of little
help as many times the stocks are nowhere near their correct valuations and in recent times
speculative element in stock price has increased considerably. The idea of this report is to help
you evaluate whether market assumptions that go into pricing of the stock are realistic or not. The
attempt is not to put a correct price to the stock.
The price of a stock is fundamentally based on two components. The future cash flow from
expected dividends and the expected capital gains on the stock.
(P1-P0)
As expected return (r) = D1/P0 + --------
P0
Where,
D1 = Divided expected
P1= Price at end of year one
P0= Current market price
D1 + P1
Rearranging we get, P0 = ---------
1 + r
P1 would again depend on the next years expected dividend and the stock price at the end of
year two so on and so forth.
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D1 D2 D3 D4 Dn + Pn
P0= ---- + ------ + ----- + ----- + ........ -----------
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)n
Thus, the current stock price is nothing but the present value of the dividends and the future
market price at a terminal date. To arrive at a stock price we need to know the future price, the
expected rate of return and the expected dividend.
Estimating the required rate of return
The key variable here is r, the expected return. The value of r, i.e. expected return will vary
according to the risk perception regarding the company in question. More the risk more the return
will be expected.
To determine expected return the risk profile of the individual stock is to be measured. The
benchmark against which risk for an individual stock is measured is the equities market as a
whole represented by indices like DIJA (Dow Jones Industrial Average), BSE Sensex and NSE
Nifty. By plotting the returns of a particular stock against the index, the sensitivity of a stock to
that particular market can be measured. This measure is known as the Beta or sensitivity of the
stock to the market. If the beta is less than one then the stock is less prone to factors affecting the
market as a whole. If the beta is more than one the stock price is very sensitive to events in the
market.
The expected return can be calculated using the capital asset pricing model (CAPM). According,to the CAPM, the expected risk premium on a stock is the market risk multiplied by beta or the
sensitivity. Thus, we can conclude higher the value of beta higher the sensitivity and higher the
expected risk.
Expected risk premium (Rp) = beta * (Rm - Rf)
Where, Rm = Return on markets
Rf = Risk free rate of return
Once we have estimated the risk premium, all we need to do is add the risk free rate of return to
the risk premium to get the expected return on the stock. As the risky investment will provide for
returns at least equal to risk free investments and additional returns, which are proportional to the
risk profile of the investment.
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Thus, expected return r = Rf + Rp
For the risk free returns Government security yields can be used. Thus, for Infosys the expected
rate of return was 21.1%.
CompanyRisk freereturns*
Beta Marketpremium
expectedreturn ( r )
Infosys 10.3% 1.5 7.0% 21.1%
Satyam 10.3% 1.6 9.0% 24.9%
As per company's FY01 balance sheet.
*Yeild on Government securities dated 2021
Estimating the terminal price
It has been observed that over longer period of time the dividend component of a stock price isfar greater than the present value of the future price. Thus, for simplicity's sake we will assume
that the stock price is a function of the dividends only and neglect the terminal price.
The stock price therefore is the present value of dividends paid out by the company. Assuming
constant dividends for simplicity the stock price is now the present value of a perpetuity
discounted at r or the expected rate of return.
Thus, D
P0 = ---
r
If g is the assumed growth for of the dividend over a course of time, the value of the stock price
changes to
D
P0 = ----
r-g
Rearranging the previous equation would give us a very interesting interpretation of the expected
rate of return.
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Thus,
r = D + g
--
P0
The expected return therefore is a combination of the dividend yield and expected growth. We
often use terms like growth and income stocks. The stocks, which derive a greater component of
their price from dividend yield, are income stocks. While stocks that largely owe their price to
growth expectations are growth stocks.
Infosys is expected to pay Rs 15 in dividends this year. At the current market price of Rs 2,956,
this works out to be 0.5%. Thus, remaining 20% return is expected from the growth in the
business. On the other hand HLL is expected to give a dividend of Rs 4.5 in FY02. The
company's cost of equity works out to be 19.7%. Consequently, the implicit growth rate is 17.6%.
To estimate the expected growth rate in a stock price we have to delve a bit deeper. Assume that
the company does not see any growth in the future and pays out all i ts earnings as dividends. In
such a case DPS (dividend per share) = EPS (earnings per share).
Thus, DPS
r = --------
P0
Rearranging we get
DPS EPS
P0 = ----- = -------
r r
Infosys is expected to earn an EPS of Rs 124 in FY02. Therefore, the price of the stock assuming
no growth and cost of equity as 21.0% would be Rs 589. Of the current market price Rs 2,956, Rs
589 is on assumption that the company will continue to have a constant EPS (no growth) of Rs
124 for a considerable period of time in the future.
Thus, Rs 2,368 in the price is due to the present value of the growth. The company pays dividend
of Rs 15 and therefore the money ploughed back into the business is Rs 109. With a return on
equity of 36.4% this investment is expected to generate Rs 40. Assuming that the investment
generates Rs 40 every year
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(40)
NPV = -109 + ------ = Rs 80
0.21
Returns on growth oppurtunity
Div for FY02E (Rs) 15
Money ploughed back 109
ROE 36.4%
Cash in flow from investment of Rs 108 40
NPV of this investment 80
Thus the price due to growth,
NPV
PO = -----
r - g
80
2,368 = -------
0.21- g
Solving for g we get a growth rate of 17.3% embedded into the stock price. Of course this growth
rate is for a considerable period of time. However, any deviation in growth rates from this
estimated (towards the downside) in the near future would adversely impact the stock price.
According to Gartner, markets for IT services are expected to grow at a CAGR (compounded
annual growth rate) of 16%, from a size of US$ 749 bn in FY01 to US$ 1,174 bn in 2004.
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In Satyam's case assuming a cost of capital to 24.9%, and an estimated EPS of Rs 52 for FY02
the price considering no growth comes to around Rs 208. However, the stock is trading at Rs 146,
as on a consolidated basis it is making losses.
Before concluding we would like to make a point, i.e. companies like Infosys have shown asupernormal growth rates of 100%, which is not sustainable over a long period of time. Eventually,
the growth rates fall in line with the growth in GDP and therefore, a growth rate for perpetuity is
the growth rate of the global GDP. This is a single digit growth figure, which is below 5%. The
decision that has to be made now is will Infosys be able to grow at 17% for the foreseeable future?
And will Dr. Reddy be able to grow at 12% for a considerable period of time? This will help you
determine the price of the stock is realistic or not.
Valuing super normal growthIn theprevious article, we had seen how to put a measure to the growth expectations embedded
in a stock price. In this article we attempt to price a stock, which is expected to show very steep
earnings growth.
We came across very simple formulae, for determining the price of a stock. If g is the assumed
growth for of the dividend over a course of time, the value of the stock is determined by
D
P0 = ----
r-g
Where Po= expected price
D = Dividend paid out at the end of the year
r = Expected returns
g = Perpetual growth rate of dividends being paid
However, the problems here are twofold. Firstly, the growth rate is not constant and can vary
significantly year to year. For example, Infosys grew by more than 100% in FY01 but the growthfor FY01 is expected to be 30%. Secondly, the value of g is more than r and therefore, the
formulae cannot handle this calculation.
Thus, the best method to arrive at a price is to estimate expected the dividends for every year for
those years in which supernormal growth is expected and then to assume a perpetual growth rate.
This is because a steep or supernormal growth cannot last forever. Eventually, the growth figure
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will fall in line with the GDP growth rate of the major economy in which the business operates.
Otherwise eventually the business will become bigger than the economy.
Thus, the value of a stock is the present value of the expected future dividends. To recall
D1 D2 D3 D4 Dn + Pn
P0= ---- + ------ + ----- + ----- + ........ -----------
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)n
Here, future dividends are estimated based on the growth expectations.
D1 D1(1+g2) D2(1+g2) D3(1+g3) Dn/(r-g)
P0= ---- + ----------- + ----------- + ---------- + ... ----------
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)n
The dividends after a foreseeable period of time are expected to grow at a constant growth rate
perpetually.
Estimating the required rate of returnclick here
Thus, the variable that becomes most critical in the calculation is growth. Estimating growth rates
accurately would give an accurate idea about the value of the stock. The growth rates can be
assumed by looking at past data, macro economic numbers, industry growth rates, relative
market share data and other qualitative aspects.
Year EPS DPS Payoutratio
EPSgrowth
DPSgrowth
FY94 1.2 1.8 143.4% -
FY95 2.0 2.3 111.9% 64.8% 28.6%
FY96 3.2 2.5 78.6% 58.2% 11.1%FY97 5.1 2.8 54.0% 60.1% 10.0%
FY98 9.1 3.0 32.9% 79.4% 9.1%
FY99 20.7 3.8 18.1%126.8% 25.0%
FY00 43.2 4.5 10.4%108.7% 20.0%
FY01 94.2 10.0 10.6%118.0%122.2%
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Let us take the example of Infosys here. Infys dividends in the past 8 years have grown at a
CAGR of 30.8%. However, this is due to the spike (115% growth) in FY00. The CAGR growth
rate from FY94 to FY00 for dividends works out to be 13.5%. This should give a good idea about
what kind of growth rates to expect from the company under normal circumstances.
However, considering the fact that Infosys has established a strong brand for itself, the company
is expected to beat industry growth rates and continue to grow swiftly till it reaches substantial
market penetration. Infosys, in FY01, with revenues of around US$ 367 m had a 0.1% market
share of the US$ 367 bn services market. IBM that has had revenues of US$ 14 bn from services
in the US (10% market share) is expected to post a growth of about 7.5% in services revenues for
FY01.
For the next three years considering that the US economy revives, Infosys the dividends can be
expected to grow at a rate of around CAGR 30%. However, for the next five years after that
assuming that revenue growth starts to decline the dividend growth could be expected to taper.
Then we have assumed the growth to be in the range of 15% between (FY08 to FY011). Growth
after this has been taken to be 10% for the next three years. Finally, the company is expected to
grow perpetually at 5% in the future.
Year EPS(Rs)
DPS(Rs)
Payoutratio
EPSgrowth
DPSgrowth
Presentvalue (Rs)
FY02E 124 15.0 12.1%31.8% 15
FY03E 175 26.2 15.0%40.5%74.5% 23
FY04E 254 44.5 17.5%45.7%70.0% 34
FY05E 330 66.1 20.0%30.0%48.6% 43
FY06E 413 92.9 22.5%25.0%40.6% 53
FY07E 496 123.9 25.0%20.0%33.3% 62
FY08E 570 156.8 27.5%15.0%26.5% 68
FY09E 656 196.7 30.0%15.0%25.5% 74
FY10E 754 245.0 32.5%15.0%24.6% 80
FY11E 867 303.4 35.0%15.0%23.8% 86
FY12E 954 357.6 37.5%10.0%17.9% 88
FY13E 1,049 419.6 40.0%10.0%17.3% 90
FY14E 1,154 490.4 42.5%10.0%16.9% 92
(Note the expected returns have been assumed to be 15%)
At the end of FY14, the companys dividends are expected to be Rs 490. Assuming the dividends
continue to grow perpetually at the rate of 3%, value of the stock based on stable growth in
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FY14E would be Rs 4, 083. The present value of this works out to be Rs 664. Thus the total value
of the stock comes to around Rs 1,472.
However, the stock currently is trading at a price of Rs 4,533 this works out to be a premium of
about 208%. There are certain reasons for which the company commands higher valuations,which could be management quality and transparency. Also another factor contributing to he high
price of the stock is sentiment. The markets could be expecting a recovery in the technology
sector and even stronger growth rates from the company. However, the theoretical calculations
could give you an idea about how low the stock price can move. Post September 11, in the free
fall the company touched a low of Rs 2,156.
A significant part of the price is derived from the companys stable growthrate in the future. For
our calculations we have assumed a very conservative 3%. To justify the current stock price (Rs
4,533) the perpetual growth rate required (consequent to above mentioned growth rates) is
12.9%. The question is what says the company will be able to manage such a fast growth rate?
The S&P 500 between 1925 and 1995 has grown at a CAGR of 10%. This growth rate suggests a
price of Rs 2,467.
P/E ratios: Reality checkOne of the most commonly used tools for making an investment decision is the P/E ratio. This is
due to the fact that that it is very easy to compute and more so, due to its easy availability.
However, using the ratio without understanding its interpretation can be very dangerous
especially for the retail investors, who have limited access to information.
For sectors that have a long history, use of P/E ratios is less risky. However, for sectors that do
not have much of a past, like software, the P/E ratio should be used with extreme caution. Infosys,
in February 2000, touched a peak of Rs 16,932. This would translate to a P/E multiple of 382x its
FY00 earnings. Yet many investors bought the stock as if there was no tomorrow, only to repent
later. In times of irrational exuberance, the P/E ratio can give a clue about the insanity in
valuations. In this article we look at how the P/E ratio can in help you avoid making such
hazardous investment decisions.
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Let us start with what is the P/E ratio. P/E ratio is calculated by dividing the market price of the
stock by the EPS (earnings per share).
Earnings Per Share, EPS (Rs) = Profit After Tax
------------------
No of shares outstanding
Price to earnings ratio, P/E (x) = Market Price
----------------
Earnings Per Share (Rs)
The P/E ratio can be looked at as a price taghow many times the earnings is the market willing
to pay to be part of the companys fortunes. The reciprocal of the P/E ratio (dividing 1 by the P/E)would give the earnings yield on the stock. For example the P/E of a stock is 12, then reciprocal
works out to be an 8.3% yield. Another way of looking at the P/E ratio is that if the companys
earnings did not grow at all in the future, it would take company P/E number of years to get back
the money invested into the company. When Infosys was trading at a P/E multiple of 382 times,
assuming no growth in earnings it would have taken 382 years for the company to earn the
investment back for the investor. We are looking at some really long-term investors here.
And of course no one is willing to wait perpetually to get a return on his or her investments. Thus,
the higher the P/E multiple investors are willing to pay, greater will be the hopes of getting the
investment amount back in a shorter time horizon. Therefore, generally a high P/E would be
based on expectations of higher growth in earnings.
More often than not, P/E ratio is used as relative valuation tool. Different companies from the
same sector are compared on the basis of this ratio. Also, many times sector averages are used
as a benchmark to compare valuations of different companies.
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However, creating sector averages are prone to errors. We have an average P/E of 27x (for FY04)
by taking six companies in a sample for the software sector. For example, if Hughes Software
were to replace Wipro, the P/E could come down from 27x to 24x.
Company Market Cap(Rs bn)*
PAT
(Rs bn)
P/E
(x)
Company Market Cap(Rs bn)*
PAT
(Rs bn)
P/E
(x)Wipro 341 10 33.0 Hughes 17 1 22.0Infosys 347 12 27.9 Infosys 347 12 27.9Satyam 97 6 17.5 Satyam 97 6 17.5i-flex 40 2 22.2 i-flex 40 2 22.2Geometric 3 0 11.8 Geometric 3 0 11.8MphasiS 17 1 16.9 MphasiS 17 1 16.9Sector 844 31 27.0 521 22 23.9
*All numbers for FY04.
However, the greater risk that is embedded in a relative valuation exercise that uses P/E multiple
is, that there is an intrinsic assumption that the markets are valuing the firms in question correctly.
This is a very brave assumption to make. This might not be the case always. While the investor
has to take in to account the fact that the markets do generally tend to be correct, the same
markets do end up with average P/E ratios of 27x for a sector. Therefore, to get a bearing on
realistic P/E ratios investors can use two methods and thus, cross check to find a rational price
for the stock.
a. First method is to calculate a P/E ratio for a stock and compare it with the P/E ratios the
markets are using.
b. Second method is to look at the PEG ratio. That looks at the P/E ratio in light of the future
growth in earnings.
In the past we have seen that stock price is a function of the expected dividends in the
future. Therefore, we have
D
P0 = ----
r-g
PO= stock price
D= Dividend expected at the end of the year
r= required rate of return
g=perpetual growth rate expected
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For calculation of rate of return please follow this linkExpected rate of returns
Dividend can be also expressed as = EPS x Payout ratio
Modifying we have
PO = EPS0 x Payout ratio *(1+g)
-------------------------------
(r-g)
Where EPS0 is the current EPS for the company
Therefore,
P0 = Payout ratio*(1+g)
---- --------------------------
EPS0 (r-g)
P0 = P/E
----
EPS0
Therefore, P/E = Payout ratio*(1+g)
-------------------------
(r-g)
HLL that has a pay out ratio of about 90%, has seen earnings grow at a CAGR of 25% for
between 1986 and 2004. Assuming a perpetual growth rate of 10% for the company and a
required rate of return of 14% the P/E ratio works out to be 14x times. The stock is currently
trading at a P/E multiple of about 17x. Obviously, the markets are factoring in a slightly higher
growth rates.
Thus, based on the same assumptions for calculating the stock price, the P/E ratio can be
estimated. However, the problem with this method is that retail investors need to make
assumptions about the discount rate, payout ratio and perpetual growth rates. These being not so
widely available would be very difficult to approximate. And if any one was to make the effort, why
not calculate the stock price? There is merit in the argument. We want to point out here is that
many times P/E ratio is used because there is a misconception that while using P/E ratios the
need to make assumptions about the above mentioned variables are eliminated. However, one
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must appreciate that this is not a number pulled out of a hat, but the ratio is determined by the
same assumptions that go into determining the stock price.
However for those who do not want to get involved in the complex process of valuing a stock the
PEG ratio, is a tool that can help.
The PEG ratio is the ratio of the P/E ratio to future growth in earnings. This is based on the thumb
rule that the P/E ratio should be equal to future earnings growth for the stock. Therefore, if the
stock has a P/E ratio of 35, this should be supported by earnings growth of 35% in the future. It is
preferable to use a CAGR for next two to three years. The future growth rates can be determined
from companys earnings guidance or research reports on the companies that give projections
about future earnings. Equitymasters research reports give three-year forward projections for
companies under our coverage.
Thus, this helps to justify whether the EPS has future growth potential to support the P/E. In that
sense this becomes an indispensable tool for the investor.
PEG = P/E ratio (x)
--------------------------
Growth in earnings (%)
The number is calculated by dividing the P/E ratio by the expected growth in earnings. For
example, Infosys has a P/E of 28x (based on FY04 earnings) and the CAGR growth in earnings isexpected to be 22%. Therefore, the companys PEG ratio will be 1.3 (28/22). The use of the PEG
ratio is however based on a thumb rule and is not a valid financial law. The two sides of the
formula have different units: you're comparing a fraction with a percent, meaning that a factor of
100 has magically appeared on one side only.
Taking on from here investors should be very cautious about stocks that are trading at PEG
ratios of more than 0.8.
Company *Current Market
Price
EPS
(FY07E, Rs)
P/E
(x)
CAGR
(FY02E-FY04E)
PEG
Infosys 5,235 337 15.5 21.9% 0.7Wipro 1,447 77 18.9 19.9% 0.9Satyam 310 31 10.0 20.4% 0.5
* As on 3rd June 2004 close
Wipro and Infosys look highly valued based on the PEG ratio. However, this ratio does not reflect
the huge amount of cash these companies are carrying on their balance sheet. Infosys has
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around Rs 6,000 m (US$ 125 m) balance sheet if its buys a business at a market cap to sales
ratio of 1.5x spending Rs 3,000 m (US$ 62.5 m), the company can add about 8% to its topline.
The thumb rule that the P/E ratio should be equal to the future growth in earrings for a stock is
actually based on the time value of money. The P/E ratio is an indication how much shouldinvestors pay for a company? A company that is growing twice as fast is worth twice as much.
But PEG is not suitable to value cyclical companies like semiconductors and chemical
manufacturers, airlines, utilities, or financial companies like banks. It is also not useful in valuing
large, well-established companies. Also, a low PEG ratio might not mean necessarily mean that
the company is undervalued. There a lot of certain facts about a company that the P/E ratio does
not reflect like the amount of debt in the company.
There are two parts to selecting a company the first one is about finding out a viable business
model and second part is about finding a correct price for the stock or put a correct value to the
stock. In this article we have looked at trying to put a value to the stock but more the focus has
been to a clue on how realistic valuations are. All these tools can only aid. All these tools can also
be used against you to justify things like the information technology revolution, which ultimately
turned out to be an evolution. They are no substitute for rational thinking and patience.
For high growth stocks like Infosys a two-stage model has to be used. A growth rate and payout
ratio is assumed for the super normal growth period. A lower growth rate and higher payout ratio
is assumed for subsequent period of time.
EVA Another barometer for corporateperformance
The liberalisation of the Indian economy has led to a paradigm shift in the corporate goals of
public and private companies. The focus is now being primarily on enhancing the shareholder
value in a company.
It was Stern Stewart & Co. who devised an accounting method called Economic Value Added
(EVA) which measures whether the company is generating adequate profits to reward its
shareholders. EVA is the registered trademark of Stern Stewart & Co. It is the financial
performance measure that captures the true economic profit of an enterprise. It is also one of the
measure most directly linked to the creation of shareholder wealth over time.
So how do you define EVA?
To put in a simple terms EVA is the profits generated by any economic entity over its cost of
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capital employed. The entity can be a company, country or the entire human civilization. If the
difference between the above two parameters is positive than the entity is said to be creating
wealth for its stakeholders. A negative EVA on the other hand indicates the company is a
destroyer of value.
So now the next question arises how do I go about in calculating EVA.
EVA = Net Operating Profit After Tax (NOPAT) Cost of Capital
Where
NOPAT= Profit Before Tax + InterestTax + Tax shield on interest In other words NOPAT is the
profits generated from the core operation of the company.
Cost of Capital:It is the weighted average cost of borrowings and equity as on the balance
sheet date.
Cost of borrowings: The cost of borrowing depends on the rate of interest on
borrowings.
Cost of equity: To define the term in a simple term it is
Risk free cost of bank lending rate + Market premium on the risk free equity investment * Beta
variant (R + B * M).Where Beta is the relative price movement of the stock vis a vis the market. In
simple terms the greater the volatility, the more risky the share and the higher the Beta. Lets take
a simple example, a company having a Beta of 1.5 times implies that if stock market increases by10%, the companys share price will increase by 15% and vice versa.
For example an investment of Rs 1,000 in a soaps and detergent shop produces 7% return, while
the similar amount invested elsewhere earns returns of 15%. EVA can be defined as a spread
between a companys return on capital employed and cost of capital (similar to the opportunity
cost of investing elsewhere) multiplied by the invested capital. The EVA from this case would be
EVA = (7%-15%) * Rs 1,000 = (Rs 80)
An accountant measures the profit earned while an economist looks at what could have been
earned. Although the accounting profit in this example is Rs 70 (7% * Rs 1,000), there was an
opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the company can be called as a
destroyer of wealth.
Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to
create more value than the investor might have achieved with an otherwise alternative
investment opportunity of similar risk.
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Now consider this example based on the formula explained above. You can put different balance
sheet and profit figures to know your own EVA.
Particulars (Rs m)
Equity Capital 500
Reserves 7,500
Net worth 8,000
12.5% debentures 2,000
Capital employed 10,000
Weight of equity 0.8
Weight of debt 0.2
NOPAT (as per defination) 1,500.0
Return on tax free government bonds * 11.0%
Beta * 1.1
Market premium * 15.0%
Corporate tax rate * 33.0%
Cost of borrowings * 12.5%
Cost of equity 15.4%
Cost of debt 8.4%
WACC 14.0%
NOPAT as a % of capital employed 15.0%
Cost of Capital 1,400
EVA 100
* Assumptions
As calculated in the above example the company has generated EVA of Rs 101 m. That means
maintenance of shareholder value will require the company to earn NOPAT over Rs 1,400 m. In
other words the % of NOPAT to capital employed should be greater or atleast equal to the % of
WACC.
Where do I use the concept
In the present market scenario every second company is making an attempt to impress the
investors, with their excellent financial performance showing the high growth rate. With the limited
resources available the investor is confused as to who is better and why? Here comes the
concept of EVA, which helps the investors in simplifying investment decision making. Apart from
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looking at only P/E or EPS of the company, EVA helps