So, with the key stock indices still down by 30% from their recent highs, even after rebounding from 7500 to 9000 levels in April, brings us to a question - " Is the right time to invest or wait for further Blood Bath to happen??" To be honest, I don't have an answer to this question, but I definitely know one thing from my past experience during the Global Financial Crisis of 2008-09 that it is times like these that present your best bargains. I am not saying to jump with all your cash in the markets but since Stock investing comes with an inherent risk, if you have a time horizon of minimum 2-3 years with no immediate liquidity concerns, some proportion of your wealth can be allocated to Stocks.
But, a word of CAUTION.....as far as I comprehend it, this time India's economy is as badly affected unlike the 2008-09 crisis, where mainly the banking & finance sector was in trouble. This lockdown will affect many sectors & businesses adversely & many of them can go belly up & declare bankruptcy and in this largely interconnected financial world, the contagion can spread as fast as the COVID itself. So we need to pick our stocks very wisely.
I would like to share a very simple formula which, if used judiciously, can help picking good companies with compelling valuations! Before coming to the actual formula, let's discuss the various factors that I keep in mind while selecting a stock. These are the main compelling factors, other than some more research & parameters that need to be kept in mind.
1. Return on Capital Employed
In layman's term, it is similar to the profit a company generates on every rupee invested by the company in its business. Companies generating higher Return on Capital Employed (RoCE) have better competitive advantage than their peers with low RoCE. Let's assume that TCS & Infosys both incur a cost od Rs1,000 cr to open a new office campus with similar workforce capacity but if TCS generates a profit of 200cr from this office compared to Infosys which generates 150cr then definitely TCS is doing something differently than INFY or must be having some "Competitive advantage" which allows it to generate a much better profit on same incremental investment!!
RoCE = (EBIT / (Net Fixed Assets + Net working Capital))
where EBIT = Profit before Interest & Taxes
& Net Fixed assets = Value of Plant, Equipment & buildings (after depreciation) except Goodwill
Net Working capital = Accounts receivable (Debtors) + Inventory(Finished & Raw material Stock in hand) - Accounts payable (Creditors)
To keep it simple, EBIT is the Profit a company generates before paying Interest expense on its Debt & Taxes to Government. It is a better indicator of profitability than Profit after tax or Net Profit because it is not affected while comparing companies having different levels of Debt & different tax rates.
Net capital is simply the total capital which has to be deployed for profitable operations - it has two components :
(1) Fixed Assets - No viable operations are possible without establishing good Plant, Machinery & Offices to produce quality goods & services which a company intends to produce & profit from!
(2) Working Capital - After you have established the Fixed assets, you need working capital to purchase raw material, pay salaries, pay utility bills, give credit to your buyers, keep stock of finished goods & raw material for hassle free operations.
Summary - Better RoCE distinguishes better businesses from not so good ones, because somehow they are able to generate better profits with same amount of capital, isn't it interesting?
2. Earnings Yield
Now that we have shortlisted some names that are consistently generating better returns on their capital, but our investment in them won't mean much if we are paying too much for them. In short, even after the company is good , it doesn't mean the Stock is good! Remember Price is what you pay & Value is what you get, so if you pay 1000 bucks for something which which earns just 1 buck per year, would you buy it even if it has fabulous return on capital??
Earnings Yield (e/p) = (EBIT / Enterprise Value)
Enterprise Value (EV) = Market Capitalisation + Net Debt
Market Cap = Share Price x Number of Shares Outstanding
Net Debt = Outstanding Debt - Cash in Hand
EBIT - already explained along with RoCE
It would be simpler to understand Enterprise value as the tangible value of a company if the entire company is acquired by someone, inclusive of Net Debt which the new acquirer has to assume as part of the takeover. To acquire the entire company the acquirer has to buy all the shares outstanding @ prevalent share price (market cap) as well as takeover the debt outstanding of the target company or repay it. In both cases it would be part of the cost of acquisition.
A practical aspect of this ratio is that it determines how much return are you getting on your investment? Compare two companies in this regard - again we take a hypothetical case of TCS Vs INFOSYS. We have seen earlier that TCS was generating better RoCE but it may be possible that it's stock is not cheap. May be the market cap of TCS is 50,000 cr & debt is 10,000 cr making its EV as 60,000cr. On other hand due to recent under performance & bad news, INFY shares may be trading at a very low price making its market cap 25,000cr & assuming same debt as TCS at the level of 10,000cr it's EV turns out to be 35,000cr.
Now, as previously mentioned, we assumed that both have office creating profit of 200cr & 150cr respectively. Now to demonstrate the effect of Earnings yield assume both companies have 50 identical offices generating exactly the same earnings spread across the world. Total EBIT for TCS would be 50 x 200 = 10,000cr and for INFY would be 50 x 150 = 7,500cr.
Earnings yield for TCS = 10,000 / 60,000 = 0.167 or 16.67%
& for INFY = 7,500 / 35,000 = 0.214 or 21.42%
So even if TCS has better profitability, it's still not as good a bargain as shares of Infosys!! Only a judicious combination of both factors can help us getting over this dilemma of chosing which stock is a better investment!
Summary - Better earnings yield means better "Bang on our buck", we have to ensure that we are getting the best VALUE out of the PRICE we are paying.
3. Compounded Average Growth Rate (CAGR)
The only logic behind investing in stocks is that we are actually investing in businesses which we hope will increase their revenues & profits over time and we ,being a partner, will benefit from that growth. A relevant analogy is if we take the case of a company such as Reliance - suppose it was earning 100cr in profits in 1990 & the company was valued at 1500cr (all these figures are just hypothetical to get some clarity of thought). Over the next 30 years from 1990, the company diversified into Refining, Telecom & Retail and with the help of little luck and a very dedicated & hard working management team, which was willing to take calculated risks, the company was able to make 25,000cr profits in 2020.
Now are you getting along with the practical aspect of this powerful concept? Will the market cap still be the same? I wish it was, but even by a very conservative estimate the Market cap would be upward of 200,000 cr now. Assuming no or very less equity dilution of shares during this period, you & I can imagine what fabulous returns this single investment would have generated for us ! A growth of 250 times profit in 30 years is no mean feat yet there are many examples that have achieved relatively similar performance and we can't afford to overlook these marquee management driven companies!!
CAGR (g) = (((Profit of latest year) / (Profit 5 years back)) ^ (1/5)) - 1
CAGR for Reliance over 30 yrs would be 250^(1/30)= 1.202-1=0.202
We are considering 5 year CAGR of Net Profits (Profits after Tax & all expenses) for our calculation. We could have used EBIT here but for growth rate, PAT is a better indicator of the bottom line growth of the company compared to EBIT & with similar margin levels, tax rate & debt and % interest both figures would yield identical results. It would be helpful for us in identifying growth accelerators and considering them for further study because even a single stock like that in the portfolio can generate fabulous overall returns !
Summary - Growth is Life & that's the reason we invest in stocks rather than Bank FDs so successfully identifying high growth companies and investing at the right price would multiply our wealth many times over a considerable period of time!
4. Debt To Equity Ratio
From my personal experience as the owner of a business, I can surely tell you all is not so simple when we have a business to run & generate profits. There are regular threats & opportunities that present themselves before us from time to time. Sometimes the market for finished products is bad for a prolonged period may be due to an aggressive competitor and we start making lesser profit margins than earlier or may be even a loss temporarily in hope of improving our efficiency & restore the profits. Sometimes, the debtor cycle gets prolonged and the receivables take 90 days instead of earlier 30 days. Many times a regulatory disruption such as GST or Demonetisation or a Black Swan event (a perfect example being current Pandemic) wreaks havoc on businesses. Sometimes, a new business proposal for new business verticals or factories (to support growth) is executed by managements in a hope of taking their companies to the next orbit.
But many of the above & other factors compel the company to borrow money to finance their operations, either in the form of borrowing from Banks or issuing interest bearing Corporate Bonds on which a regular interest payment has to be made and the principal to be returned in the end.
Now suppose a company has borrowed a huge amount of money to establish a new factory & some time later the factory starts generating loss or less then expected profits, which make even the interest payments on the loan very difficult. Unless prudently resolved, this debt keeps on increasing due to the power of compounding; the company reaches a stage where it's existence is at stake due to the spiralling debt !!
In business history, there are numerous examples of businesses that were once very profitable & had the best brands , which exist no more and have become insolvent. Besides scams, family feuds and inability to adapt to new business environment, I think high Debt is one of the most important reasons for business failure & it needs careful & cautious consideration while selecting the stock.
Sometimes, taking Debt is a very effective capital allocation decision & debt must be taken otherwise achieving high growth is not possible, especially in businesses that require setting up huge initial Fixed investment in terms of Plants, Licenses, Mines or Technology to keep generating profits but how much Debt is too high and can the company safely assume & repay it is a valid question !
Debt to Equity Ratio (d/e) = Net short & Long term Debt / Net worth or Shareholder's Capital
Net Debt = Short term debt (payable within 1 year) + Long term debt - Cash & Bank balance
Net worth = Total Assets - Total Liabilities
Net debt is simple to understand & its elaboration can be safely skipped. Net worth is the money which will be left if the company is liquidated today and the proceeds from sale of its plant, equipment, land bank, stock in hand, getting all receivables from customers is used to pay all creditors including suppliers, banks, corporate bond holders, Government liabilities such as taxes & any other unpaid utility bills - electricity & gas etc. In simple terms it is the "Leftover Tangible Value" if the company ceases its operation & decides to return all money back to shareholders. It can also be considered the sum of initial investment by promoters while starting the company plus the total retained earnings every year from the beginning of operations. For a profitable company, this figure would keep on increasing year on year!!
Debt equity ratio helps identifying companies having High Financial Leverage or risky assets which can be prone to disaster in unfavourable business environment. With great emotional & financial pain I have learnt to stay away from red flagged companies with high d/e ratios even if they are available at a throw away price because the market is already betting on their failure & that's the reason why they are available at a throw away price. Although d/e ratio depends a lot on industry but I have made it a point from some of my past investing experience to prefer companies with d/e below 0.5 & completely rule out those with a d/e ratio more than 2.0. Also, the direction of d/e ratio over period of years help identifying companies which are progressively reducing their debt levels, a good example is Indian Hotels.
Summary - High profitability, Decent Valuations & past growth are meaningless if we waste our money buying a stock which is on the verge of collapse, better take a two wheeler ride than boarding a plane which is destined to crash because it is short of fuel !!
5. Dividend Yield
As we discussed earlier, a company finances its operation either by borrowing or by introducing capital from its shareholders. Lenders take their return in the form of interest payments but what about Shareholders? Are they not entitled for return on their capital for bearing the risk of investing in the company rather than choosing a less risky investment??
Some solace for shareholders can be found in the process of reinvestment of the earnings in generating progressively higher returns in future by expansion. With higher earnings in future, the revaluation in share price can more than make up for the returns expected by the shareholders. However, what if things go bad? Ten years down the line some scam is uncovered & the company heads into turmoil? What a bad deal for an innocent investor who had the patience of holding this stock for 10 years, only to be cheated in the end whereas a simple investment in an FD would have fetched him appx 1.5 times return on the original investment.
With the advent of capital markets, things were very simple. There were two types of capital - risk free debt capital & risky equity capital. Debt holders had a preference on the assets of the company in case of liquidation of assets but their earnings were capped at a fixed rate of interest only. However, the shareholders had a subordinate or lesser right on the assets of company in case of liquidation & were to receive anything leftover after paying all liabilities. To compensate for this risk, they were logically provided a higher return on their capital in terms of redistribution of all profits after tax among them. This redistribution of profit came to be known as Dividends. Starting with a very simple concept, things started getting complicated over time partly due to need for expansion, partly due to tax purpose & most of the times due to our inclination towards earning super normal profits, in short greed & speculation!!
Compared with initial days when most earnings were redistributed as dividends, we are now in an era when getting good dividend from our investment has become a rarity! I assign a decent weightage to dividends due to 2 factors:
(1) It provides some comfort even when stock markets are not doing very good & they have tendency to do that for years at a stretch! Its very discomforting to watch the value of our investment going down although the company is doing fairly & generating good profitability but stock prices are suppressed due to overall pessimism in the market.
(2) A covert reason is that companies regularly paying handsome dividends remove the doubt of any wrong doing such as cooking the books for showing profit instead of actual loss because dividends are paid from actual / physical cash and not an arbitrary PAT figure which can be adjusted by financial jugglery by adjusting Depreciation, off book liabilities etc (many of creative accountant friends know what I am talking about !).
So both of the above factors provide some comfort for a shareholder & good companies have a track record of returning a good proportion of their earnings back to shareholders. Sometimes due to tax purpose, companies buy back their own shares, this can also be considered a positive indicator.
Dividend yield (d/p) = Dividend per Share / Market price per share
or in simple terms total dividend paid in whole year by the company divided by the market capitalisation of the company. In case of buy backs, I add the figure of total buybacks in the year in dividend paid to account for this positive step by the company to avoid taxes on dividends.
Summary - A good dividend yield provides an annual cash flow from our investment which can serve our liquidity need or can be reinvested in any better opportunity or may be the same stock, whatever we may deem fit. Better stick to the basics of capital allocation, we need some annual return on our capital !
Here Comes The Formula ....
Now we have the 5 factors with us, which I think are most important. There are many many other factors that prudent investors consider while researching on their targets but these are the ones I pay attention to:-
1. Return on capital employed (RoCE) - indicates good profitability & competitive advantage.
2. Earnings Yield (e/p) - indicates good valuation.
3. CAGR (g) - indicates history of good growth & potential to continue doing so in future.
4. Debt/Equity ratio (d/e) - its absolute value as well as direction over time indicates financial leverage & riskiness of the company.
5. Dividend Yield (d/p) - indicates stable profit generating companies which reward their shareholders consistently for the risk capital (buy backs inlcuded )
Let's call all these factors as the "5 BASIC PREMISES". Follow them religiously & you will be able to distinguish the leaders from the laggards!
The formula = ((1+RoCE)^2 ) X (1+e/p) X ((1+(d/p))^2) X 100 ((1-g)^2) X (1+(d/e)/3)
I have absolutely no tendency or affinity for financial jargon & believe me the ratio is conceptually very simple if you have understood the 5 basic premises , you just have to recognise the logic that we have put in deriving at the ratio. The positive factors such as RoCE, earnings yield, dividends yield & growth have a positive effect on the ratio. Dividend yield usually being a small fraction is considered exponentially by adding it with 1 to provide a multiplier effect. Similarly, Growth & RoCE are probably very important factors in our calculation & need to be given more representation in the formula to reward those companies which have demonstrated higher growth & return on capital than the laggards, hence the squaring!!
Debt to Equity ratio is divided by 3 (its an optimum since 2 is too low & 4 won't practically have much effect) so that companies with high debt generate a lower ratio. The squaring & division of ratios by various numbers have been done after going through a wide range of companies to properly reflect the effect of each of the 5 basic premise on the final formula!
It can be explained by a practical example of Hero Motocorp to arrive at the ratio. For a quick explanation I have jotted down some data from Moneycontrol
Share Price = Rs 1827
No. of shares outstanding = 19.97cr
Total Market Cap = 1827 x 19.97 = 36,485 cr
EBIT = 1012+1098+1136+1081 = 4327cr
( A very important consideration is that we have removed all exceptional earnings accruing due to sale of non core business or any other such factor otherwise results will be affected, also we have taken a sum of last 4 quarters to consider the most recent performance instead of last full year results.
Short & Long term term debt - both zero
Net debtors - 2845 cr (incl short term loans & advances)
Net creditors - 3350cr
Inventory - 1070 cr
PAT in 2015 - 2385 cr
PAT in 2020 - 3385 cr
Dividend per share in FY20 - Rs. 97
Cash & equivalents - 136cr.
Shareholder's Equity - 12850cr.
Total Fixed Assets - 9525
Above set of data is sufficient to calculate all the 5 BASIC PREMISES
1. RoCE = (4327/(9525+565)) = 0.429
Net Working Capital = 2845+3350-1070=565cr
Net Fixed Assets = 9525
2. Earnings Yield = (4327/(36485+0)) = 0.119
3. g = ((3385/2385)^(1/5))-1=(1.4193^0.2)-1=1.07254-1.000=0.073
4. D/E = 0/12,850 = 0
5. d/p = 97/1827 = 0.053
Jotting the above in our ratio we get a value of:
((1+0.43)^2) x (1+0.119) x ((1+0.053)^2) X 100
((1-0.073)^2) x (1+0/3)
= 2.045 x 1.119 x 1.109 X 100 = 253.8 = 295
((1-0.073)^2) x (1+0/3)
= 2.045 x 1.119 x 1.109 X 100 = 253.8 = 295
0.86 x 1 0.86
I think the simplicity & logic behind the concept is now evident after actually jotting down the actual parameters for a real company. As per my experience a number ABOVE 300 is a spectacular score & it must break the ice for us & make us more inquisitive about the company and look for other parameters & information to develop an investment thesis into the company.
By repeating this exercise for a vast array of companies you can yourself discover how powerful this is !
I would suggest to spread your investment in 10-12 different companies spread across various sectors to take advantage of the power of averaging & de-risk your portfolio. Also calculating & updating this ratio over many different stocks can help in arranging them in a descending order and then we can determine our picks from that universe at an opportune time. I am pretty confident it yields good results!!
Due to the length of this article, I would like to elaborate with some more practical examples, later on in a separate post, where we can calculate the formula value of many companies spread over various industries & also give sector wise comparison across industries (some industries have inherent tendency to get low value compared to others, but still we can compare different companies in that sector successfully)
In the end, I would like to reiterate that a prudent analysis can help you pick winners for long term capital appreciation, so try it & see for yourself if you distinguish between good & bad stocks.
Also, my research & analysis may be prone to bias & faults so any suggestions / comments to improve upon the formula would be mutually beneficial. Another thing,
I am yet to arrive at a suitable name for this ratio, any suggestions would be most welcome :))
Happy Investing !
No comments:
Post a Comment