| Page http://www.linkedin.com/in/nitinkolapkar INTRINSIC VALUATION OF EQUITY SHARE OF A COMPANY This report was made during summer internship at Stoic Advisors LLP Company. Stoic started recently to provide investor education in India. Stoic is run by an eminent value investor who walks on the principles led by Benjamin Graham. Submitted by: Nitin Kolapkar (15IB341) JUNE 2016 Industry Mentor: Faculty Mentor: Mr. Puneet Khurana Prof. Arindam Banerjee CFA USA Faculty - Finance and Accounting Managing Partner BIMTECH Stoic Advisors LLP
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Table of Contents
List of Tables .......................................................................................................................................... iii
List of charts and graphs .................................................................................................................. iv
Summer Project Certificate .............................................................................................................. v
Letter of Authorization ...................................................................................................................... vi
Letter of Transmittal ......................................................................................................................... vii
Executive Summary ......................................................................................................................... viii
About Stoic Advisors Llp ................................................................................................................... x
Concept of Value Investing ............................................................................................................... 1
Overview of Indian Economy .......................................................................................................... 3
Overview of Indian Paint Industry ................................................................................................ 5
Asian Paint .............................................................................................................................................. 8
About Asian Paint .............................................................................................................................. 10
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EXECUTIVE SUMMARY
“Price is what you pay and value is what you get”- Warren Buffet “Intrinsic value” is the worth of an enterprise to one who owns it “for keeps.” Logically, it must be based on the cash flow that would go to a continuing owner over the long run, as distinct from a speculative assessment of its resale value i.e. book value. DCF model and earning power value model can be used for calculating the intrinsic value of an asset or business. In Discounted Cash Flow model, we use FCF because FCF is what we finally get out of that business. The discounting factor that we use in DCF is weighted average cost of capital (WACC). Value investing is a concept coined by Benjamin Graham in his fabulous book “Security Analysis” written in 1934. He led basic principles that value investor uses in the intrinsic valuation of an asset. This principle is still found to be relevant in today's’ age. Many value investors walk on the way defined by Ben Graham. Framework for intrinsic valuation: Analyzing fundamentals of the company which includes studying Income statement (earning power of the company), Balance Sheet (Insights about assets of the company), Cash Flow Statement (Which differentiate accrual accounting vis a vis cash based accounting), Management leadership (How the management is utilizing assets in order to create value for their investors). Using this fundamental, we actually calculate what the company or an asset is worth today. In this research report, we have used two-stage DCF model for intrinsic valuation of Asian Paints and Hero MotoCorp Ltd. Since both the companies are market leaders in their respective industries we were keen to know about their fundamentals. Both the company have consistently created value for their investors. After intrinsic valuation of those two company, it was found that Asian Paint’s share price is undervalued whereas Hero MotoCorp Ltd.’s share price is overvalued. We have also used the concept of margin of safety of 30% for both the stocks in order to come out with the final buy price. MOS is used as a safeguard mechanism because no one can predict the future precisely. A value investor should think ahead of the management in order forecast the future of the company. But no research can ever be wrong or right. All researches are justifiable. Because no valuation comes without an assumption whether it is earnings, capex or FCF. It is the time which can only tell us about the mistakes what we have committed during the valuation. Forecasting is a vital part of the intrinsic valuation because, at the end of the day, results of forecasting give you a signal to take a decision on the stock. Key learning points of forecasting:
1. What all things we need to forecast 2. What is the sensible way of forecasting 3. What errors we generally commit in forecasting 4. How to avoid those errors 5. What is conservative way of doing forecasting 6. What is base rate forecasting
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7. What is the best case scenario forecasting This internship report will give a complete view of value investing and how it differs from what we have learned in academics. There are many differences in opinions of academicians and value investors about principles of investing.
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Value investors implement the same sort of reasoning. If a stock is worth 100 rupees and you buy it for 75 rupees, you'll make a profit of 25 rupees simply by waiting for the stock's price to rise to the 100 rupees. On above of that, the company might outperform your estimate offering you a chance to earn even more money. If you had purchased it at its full price of 100 rupees, you would only make a 10 rupees’ profit. Benjamin Graham, the father of value investing, only bought stocks when they were priced at two-thirds or less of their intrinsic value. This is the margin of safety that he believed to give the maximum return.
Value Investing Fundamental No. 3: The Efficient-Market Hypothesis Is Wrong
Value investors don't believe in the efficient-market hypothesis, EMH tells us that all the information in incorporated in price. In today's’ age information is no more an edge of investing. Everyone is full of information. If we say that EMH is true, then no stock can ever be treated as undervalued or overvalued. But value investors believe that the stocks are always either undervalued or overvalued or correctly valued. As I said information is no more remained an edge in investing but processing and coming at one judgment is an edge of investing in today's’ world of investing.
Value Investing Fundamental No. 4: Successful Investors Don't Follow the Herd
Value investors possess many characteristics of contrarians – they don't follow the herd. Not only do they reject the efficient-market hypothesis, but when everyone else is buying, they're often selling or standing back. When everyone else is selling, they're buying or holding. Value investors don't buy the most popular stocks of the day (because they're typically overpriced), but they are willing to invest in companies that aren't household names if the financials are good. They also take a second look at stocks that are household names when those stocks' prices have plummeted. Value investors are actually on the journey like an alchemist to find the gems in the mines of coal. What matters to the value investor is the intrinsic value of stock. There are two types of value investors, first who buy growth stocks and the second who buy junk stock. Junk stock buyer will actually liquidate the whole company assets and earn money out of it. Growth stock buyer sticks with the company for 10-15 years.
Value Investing Fundamental No. 5: Beta cannot be considered as a risk
Beta is nothing but the relative volatility of the stock with the market. According to academicians, there are two types of risk Viz. Systematic and unsystematic. Beta captures systematic risk. But value investors such as Warren Buffet openly criticized the concept of beta and Capital Asset Pricing Model (CAPM is used to calculate the cost of equity) as according to them cannot be a risk. The volatility of the stock cannot be a risk. According to warren buffet risk to business can be categorized into two types. First losing the invested capital and second is a business risk (uncertainty of revenue). Therefore, value investors generally prefer to assume the cost of equity rather than calculate it by the proposed wring method.
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ASIAN PAINTS (NSE CODE: ASIANPAINT, BSE CODE: 500820,
CMP:980, FV: ₹ 1)
Asian Paints Limited (the ‘Company’) is a public limited Company incorporated under the Indian Companies Act 1913. The Company is engaged in the business of manufacturing, selling, and distribution of paints, coatings, products related to home décor, bath fittings and providing of related services. Asian Paints was established in 1942 as a partnership firm. Over the course of 25 years, Asian Paints has achieved many milestones. Today Asian Paints is India’s largest player and Asia’s second largest player in paint industry with a turnover of 155 billion rupees. It has operations in 19 countries and has 26 manufacturing facilities, servicing consumers in over 65 countries. Asian Paints is the market leader in paints since 1967. Especially in decorative paints, Asian Paints has more than 50% market share in Indian paint market. Asian paint has a range of products in decorative as well as industry segment.
Besides Asian Paints the company operates in the whole world through its subsidiaries. To name a
few Berger International Limited, Apco Coatings, SCIB Paints, Taubmans and Kadisco. Asian Paints
has consistently made money for shareholders and have a professional reputation in the corporate
world.
The company is mainly present in the decorative segment, which contributes over 75% of its sales. The company features among the top 10 decorative paint players globally. It has a large distribution network of over 25,000 dealers and 27,000 'Colour World' outlets across India. The company's international revenue comes from countries in the Caribbean, Middle East, South Pacific and Asian regions.
In decorative paints, Asian Paints has a presence in interior wall finishes, exterior wall finishes,
enamels and wood finishes. Asian Paints has contributed a lot to the industry by its technologically
prudent innovations such as Colour Worlds (Dealer Tinting System), Home Solution (Painting
Solution Service) and Royal Play Special Effect Paints, etc. Asian Paints has always remained ahead
of the competitors in identifying consumer sentiments. They set a trend of consumer involvement in
the selection of paints in the paint industry. They came up with Signature Stores in Mumbai, Delhi,
and Kolkata, where consumers are educated about colors and how colors can change their dream
homes. They also set up AP Homes a multi-category store which provides a complete solution for
home décor (Kitchen, bath fittings, sanitary wares, paints, furnishings) in Coimbatore (Chennai).
Asian Paint had tied up with Henkel Adhesives, Germany for manufacturing and distributing Loctite
brand of adhesives. Asian Paints got success in vertical integration for manufacturing Phthalic
Anhydride and Pentaerythritol, which is used in paint manufacturing process. Asian Paints also
operates through PPG Asian Paints PVT LTD (50:50 JV between Asian Paints and PPG Inc, USA,
one of the largest automotive coatings manufacturer in the world) in order to service exponentially
growing Indian automotive coating market.
Asian Paints is highly motivated to enter and capture the home décor market. In order to do so, it
has acquired 51% stake in Sleek Group, a leading kitchen solution provider and Ess Ess Bathroom
Products Ltd., a prominent player in bath segment.
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Alone Middle East and Africa contributes 55% to total foreign sales. Revenue from Middle East
economies this year is affected due to low crude oil prices and ISIS turbulence.
This year AP has registered 8.6% growth rate which is quite disappointing given that the industry
growth rate is 12-13%. AP’s technological innovation and respective diversification will definitely offer
fruits in short to medium term.
Asian Paint’s profit after taxes increased at the rate of 11% CAGR in last five years. This year AP
has witnessed a quite promising PAT growth of 20.3% which is attributable to the lowered crude oil
prices. EBITDA margin has been increased from 17.3% in 2014-15 to 19.64% because of lower raw
material (crude derivatives) prices. Currently, crude oil prices are around $ 50 a barrel and it seems
that it will remain at this level for short to medium term. which is also quite optimistic about the
prospective growth of AP.
AP is diversifying its business with the foray in complete home décor solution. It has started to open one stop solution store which can give you a complete solution for your dream home.
To meet up the increasing demand of paints in emerging markets AP has started the expansion of
existing paint manufacturing facilities as well as starting few newer facilities. The capacity of Rohtak
plant in Haryana is been doubled this year from 200000 KL per annum to 400000 KL per annum.
Company’s older facilities at two locations viz. Ankleshwar Gujarat and Kasna in UP is been
modernized this year. AP has procured land in the states of Karnataka and Andhra Pradesh in order
to set up new manufacturing facilities in near future. AP is set to complete 400000 KL capacity plant
in Vishakhapatnam in phases with the approximate investment of 1750 Crores. In addition, AP is
investing approximately 2300 Crores to set up paint manufacturing facility with the maximum
capacity of 600000 KL in phases in Mysore Karnataka.
42.95%
38.11%
35.30%
33.90%
34.75%
48.15%
40.78%
42.15%
40.53%
44.72%
44.00%
46.00%
48.00%
50.00%
52.00%
54.00%
56.00%
58.00%
60.00%
62.00%
30.00%
32.00%
34.00%
36.00%
38.00%
40.00%
42.00%
44.00%
46.00%
48.00%
50.00%
2011-12 2012-13 2013-14 2014-15 2015-16
Retu
rn o
n C
apital E
mplo
yed (
%)
Retu
rn o
n E
quity
& I
nveste
d C
apital (%
) Performance Ratio
Return on Capital Employed (%) Return on Equity (%) Return on Invested Capital (%)
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INTRINSIC VALUATION (DCF MODEL)
“Intrinsic value” is the worth of an enterprise to one who owns it “for keeps.” Logically, it must be based on the cash flow that would go to a continuing owner over the long run, as distinct from a speculative assessment of its resale value i.e. book value. DCF model can be used for calculating the intrinsic value of an asset or business. In Discounted Cash Flow model, we use FCF because FCF is what we finally get out of that business. The discounting factor that we use in DCF is weighted average cost of capital (WACC).
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Year 2011-12 2012-13 2013-14 2014-15 2015-16
Long Term Borrowings 201.64 266.67 283.82 285.12 335.15
Short Term Borrowings 110.51 0.00 0.00 0.00 0.00
Total Borrowings 312.15 266.67 283.82 285.12 335.15
Interest Expenses 31.31 33.93 28.97 31.16 27.03
Cost of Debt 10.03% 12.72% 10.21% 10.93% 8.07%
Average cost of Debt= 10.39%
Calculation of cost of equity took a different turn in value investing the world from the academics. Academics taught to calculate the cost of equity using CAPM method. But many value investors like warren Buffet criticized the concept of Beta (β). The volatility of the stock cannot be categorized as a risk. According to academicians, more risk gives more return. But many studies suggests that high or low beta can’t determine the returns. Take a simple example of a stock. If a stock whose intrinsic value is 1 rupee and you are getting the same stocks at the price of 0.8 rupees and 0.5 rupees on different occasions. Which stock will you buy? According to the concept of beta the stock which you are getting at 0.5 rupees is less risky as compare to 0.8-rupee stock. But unfortunately both the stocks are same. The value investor cannot leave the opportunity to buy 0.5-rupee stock. According to academician risk is measured as a beta, which is nothing but the relative volatility of stock price with the market. Value investors consider it as a flawed concept. According to the value, investor business has two types of risk. Viz. the first risk of permanent capital loss and the other risk is that there’s just an inadequate return on the kind of capital we put in. “The real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will over his prospective holding period, give him at least as much purchasing power as he had, to begin with, plus a modest rate of interest on that initial stake.”- warren Buffet According to a value investor, you don’t need to take the risk to earn money which is contradictory to the concept of beta which tells if you take more risk then only you will get more returns.
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Therefore, value investors generally assume the cost of equity rather than calculating it by the CAPM method. Here we are assuming the cost of equity to be 16% which is 5 percentage point more as compared to the cost of debt as equity investor takes more risk as compared to debtors. Taking into consideration AP’s business model, future prospect, various risk parameters it becomes easy to assume how much return do I expect from such a stock. Indian housing market is about to revive in near short-term gave the prudent monetary policy by RBI. Recent cabinet approval to the seventh pay commission has kindled hope that it will generate demand and money circulation in the market. Middle east economies are also on the verge of revival as crude oil prices regaining their shape. Recent Indian Meteorological Department’s report predicts better than expected monsoon this year which will revive the rural economy in the short run. Inflation is at all time low around 5.5%. AP is diversifying its business with the foray in complete home décor solution. It has started to open one stop solution store which can give you a complete solution for your dream home. To meet up the increasing demand of paints in emerging markets AP has started the expansion of existing paint manufacturing facilities as well as starting few newer facilities. The capacity of Rohtak plant in Haryana is been doubled this year from 200000 KL per annum to 400000 KL per annum. Company’s older facilities at two locations viz. Ankleshwar Gujarat and Kasna in UP is been modernized this year. AP has procured land in the states of Karnataka and Andhra Pradesh in order to set up new manufacturing facilities in near future. AP is set to complete 400000 KL capacity plant in Vishakhapatnam in phases with the approximate investment of 1750 Crores. In addition, AP is investing approximately 2300 Crores to set up paint manufacturing facility with the maximum capacity of 600000 KL in phases in Mysore Karnataka.
Component of Capital Structure (%) Weightage of capital raised
Cost of Debt 10.39% 6%
Cost of Equity 16% 94%
WACC 15.65%
Year / Rs Crore 2012 2013 2014 2015 2016
Net cash (used in) / generated from operating activities 880.48 1081.12 1370.89 1143.6 2045.69
Payment for purchase of fixed assets -740.67 -585.49 -163.01 -336.28 -686.72
FCF of AP is increased with the rate of 57% CAGR. In last financial year, FCF is been increased by 68%. Assuming AP’s FCF will increase at the rate of 35% for next five years and 20% there onwards for next five years. And calculating the terminal value on the basis of perpetual growth model at the rate of 12%. Here we have forecasted FCF for next 10 years.
Hero MotoCorp Ltd. is the world's largest manufacturer of two – wheelers. In 2001, the company
achieved this coveted position of being the largest two-wheeler manufacturing company in India and
also, the World No.1 two-wheeler company in terms of unit volume sales in a calendar year. Hero
MotoCorp Ltd. continues to maintain this position till the date. Hero MotoCorp (HMCL) is a leading
2W manufacturer globally and the market leader in the domestic motorcycle segment with
approximately 52% market share. HMCL has four manufacturing facilities in India, located at four
different locations Viz.Gurgaon, Dharuhera, Haridwar and Neemrana. HMCL’s total capacity is
7.7mn units/year as of FY2014. Over 2008 to 2014, HMCL recorded a strong volume growth of 11%
CAGR, with its two strong brands (Passion and Splendor) and a well-entrenched dealership and
distribution network around rural India. Rural areas contribute for 49% of total volumes of the
company. Hero MotoCorp Sales from operation grew at an impressive 25.88 % CAGR. The company
is sitting on the reserves in excess of Rupees 5,582.70 Cr and is enjoying debt-free position for the
past 13 years. The company has an impressive dividend history and has maintained an average
dividend yield of 3.93 % over the last 5 financial years.
INDIAN TWO WHEELER AUTOMOBILE INDUSTRY OVERVIEW
Indian 2W market is continued to dominate in the automobile industry. 2W production accounts for
79% of total vehicle production in India against 75% five years ago. Two Wheelers sales registered
growth of 8.09 percent in April-March 2015 over April-March 2014. Within the Two Wheelers
segment, Scooters, Motorcycles, and Mopeds grew by 25.06 percent, 2.50 percent, and 4.51 percent
respectively in April-March 2015 over April-March 2014.
1.17
1.34 1.37
1.48
1.591.64
2010-11 2011-12 2012-13 2013-14 2014-15 2015-16
Two Wheelers Domestic Sales Units(Crores)
The overall outlook for the 2W industry remains to be promising because in a country like India four out of five homes don’t possess 2W. There is tremendous room to grow in emerging markets such as India. Besides, over the last decade, 2W ownership in rural homes significantly increased. Automobile Export has been increased at the rate of 14.9% in Apr-Mar 2015 over the same period last year. 2015-16 has proved to be lukewarm for 2W industry as it has witnessed only 1% growth in export in number of units.
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Domestic sale of 2W is increased by ~3.2% which is quite disappointing, main reason behind this slower growth is consecutive drought for last two years. The 2W industry comprises three distinct categories Viz. entry, Deluxe and Premium. In 2014-15 entry and premium category accounts for 18.8% of the sales each whereas deluxe category accounts for 62.4% of sales. Deluxe, Entry and Premium have witnessed -2.1%, 8.4%, 21,5% growth during 2014-15.
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HERO MOTOCORP LTD (HMCL) PERFORMANCE HIGHLIGHTS
Hero MotoCorp (HMCL) reported 3.6% revenue growth in FY2015-16, which is quite disappointing in the wake of industry growth rate of 12.5%. Rural economy performance is sluggish from last two years because of weak monsoon in many parts of the country. Sales volume of 2W for HMCL slashed by around 4% YOY. Increased revenue is seen by the realization and contribution from each vehicle is increased YOY. HMCL’s sales volume will decline in near-term given the poor sentiments of rural India. Indian rural region accounts for about half of HMCL’s total sales volume. Poor monsoon for a second consecutive year and a small incremental increase in MSP’s have badly impacted rural income levels and rural demand. HMCL have to postpone a plan to expand manufacturing facility by two-quarters given the poor demand in the market.
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Realization/vehicle grew 6% YOY to 43,414 on account of better product mix, price hikes and increased proportion of spares. Contribution/vehicle, at 13,785 grew 5.8% YOY.
Consumer sentiments in terms of choice are changing day by day with the competitive price point.
Consumers are seeming to shift from lower end executive segment to economy segment, attractive
features offered in 2W industry pushing buyers towards premium segment from the high-end
executive segment. Other biggest threat to the HMCL is a faster-growing market share of scooter
bikes as compared to motorcycle category. Since Honda has a stronghold in scooter segment with
their all-time performing brand Activa.
The sub-segments are growing at a faster pace but HMCL is losing share. Though, HCML able to
market share in the economy category, HCML is facing strong competition from the players like
Bajaj(Platina & CT100), TVS (Star). The latter is gaining market share at the cost of HMC last year.
The consumer preferences are changing, given premium segment is gaining momentum as
compared other segments. HCML seems to be lost the way, HCML needs to improvise their strategy
in order to realign the product mix with changing consumer preferences.
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The company reported a PAT of 3132 in 2015-16 crores against 2385 crores last year 2014-15.
HMCL witnessed quite promising 10.95% PAT margin which is highest in last 5 years. Raw material
prices play a vital role in witnessing margins. Major metals used in manufacturing 2W are Nickel,
Steel, and Aluminum. The prices of those commodities remained as expected for last year.
EBITDA margin, at 15.5%, improved strongly by 300 basis points YOY, given the commodity prices remained subdued. HCML launched a new initiative in order to improve margins, “Leap”. HCML’s margins for last two years remained under stress given their underperforming product mix. Leap program helped HCML to moderate their royalty payment to Honda Motors. Leap program also helped HCML in significant cost reduction. Annual saving has increased from 169 crores in FY2014 to 326 crores in FY15. Further, the targeted saving is 200 crores in FY2016. However, the company continues to focus on the export markets and is likely to invest heavily in advertising & sales promotion. The management has continued plans to enter total 50 markets by 2020 and is targeting volumes sales of 1.2 million units from exports. In FY2016, HMCL plans to enter some of the larger markets like Nigeria, Argentina & Mexico. Marketing expenses are likely to be in the range of 2.15-2.2% of net sales.
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HMCL seems to be losing its dominating position in the market given that its receivable days are
increasing from last five years. Inventory days remained stagnant around 10 days. Days payables
also remained around 30.
HMCL is enjoying negative working capital from a decade but it seems from the efficiency ratio that
picture might change in near future as days’ receivables are increasing at a faster pace but days
payable remained to be around 30. short term cash sources to achieve a capital-intensive plan with
a longer term outlook. Higher current ratio implies healthier short-term liquidity comfort level. A
current ratio below 1 indicates that the company may not be able to meet its obligations in the short
run. However, it is not always a matter of worry if this ratio temporarily falls below 1 as many times
companies squeeze out.
Hero Motor’s average current ratio over the last 5 financial years has been 1.18 times which indicates that the Company is comfortably placed to pay for its short-term obligations.
Interest coverage ratio indicates the comfort with which the company may be able to service the interest expense (i.e. finance charges) on its outstanding debt. Higher interest coverage ratio indicates that the company can easily meet the interest expense pertaining to its debt obligations. In my view, interest coverage ratio of below 1.5 should raise doubts about the company’s ability to meet the expenses on its borrowings. Interest coverage ratio below 1 indicates that the company is just not generating enough to service its debt obligations. Hero Motor’s average interest coverage ratio over the last 5 financial years has been 214 times which indicates that the Company has been generating enough for the shareholders after servicing its debt obligations.
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
2010-11 2011-12 2012-13 2013-14 2014-15
Inte
rest
Covera
ge R
atio
Curr
ent
& Q
uic
k R
atio
Financial Stability Ratios (X)
Interest Cover (x) Current Ratio (x) Quick Ratio (x)