CategoryInvestment process

I discussed my approach on evaluating PE ratios (see here). In addition based on the table shown in the previous post, we can work out the assumptions built into the stock price in terms of the ROC, CAP and growth rates. These variables can be compared with the actual and expected results of the company to decide if the stock is undervalued or not. Sounds easy in concept, and it is if you understand the company and the industry well. This approach is also called as expectations investing and I learnt about it in the book -.expectationsinvesting. I would recommend reading this book to understand DCF and the previous post better.

The above approach is a very useful tool in analysing a company. Let me give two examples.

Example A – CRISIL . This company sells for a PE of almost 60+. The embedded expectations are
ROC – 25% (current value)
Profit growth ( Net profit = Free cash flow) – 18% p.a for last 6 years
CAP – 20 years

Basically the company needs to grow at 18% per annum for the next 20 years and maintain the ROC. The company would be earning a net profit of almost 1000 odd crores by then. To make money on the stock in long run, one has to believe that the company will do better than what is implied by the stock price. Will the company do as good or better than implied above? I don’t know and certainly not comfortable or confident of a company to do this well for such a long period of time.

Example B – Novartis. The company sells for an adjusted PE (take cash out from mcap) of around 7.
ROC – 50% +
Profit growth – around 10% per annum for last 6 years
CAP (implied) – 0 years (if you assume terminal value at 10-12 times cash flow).

Basically the company sells for 7 times earnings. Current earnings are around 90 crores on a very low capital base. In addition the company has strong competitive advantage. So with a mcap of around 600 odd crores, the company will earn the current investment back in 5 years. The market is current pricing novartis with an assumption that the company will be out of business in 4-5 years.

I have given the two examples for illustrative purposes only. It does not mean that the stock will do well for novartis in the next few months or do badly for Crisil. But the above analysis is useful in making investment decisions.

I had done a quick valuation exercise of MRO-TEK earlier (see here). I used a certain PE ratio in the post and said that I would explain my approach later. So here it goes …

To understand my approach, you have to look at the file Quantitative calculation and worksheets – cap analysis and ROC and PE. You download this file from the google groups
The worksheet ‘ROC and PE’ has DCF (discounted cash flow model) scenarios for various businesses such as Low growth, high ROC (return on capital ). For ex: Like Merck or high growth and high ROC like infosys etc.

As you can see in excel screenshot, I have put a growth of around 10% in Free cash flow, ROC of 40% and calculated the Intrinsic value (or Net present value). The ratio of the NPV/current earnings gives a rough value of PE for the above assumptions

Now I have used various assumptions of growth, ROC etc and created the matrix below (CAP analysis worksheet in the same file)

The above is for a matrix of ROC (return of capital = 15%). I have varied the growth and CAP (Competitive advantage period).

As you would expect, if growth increases, so does the intrinsic value and the PE. If the ROC increases the same happens. This is however ignored by most analysts and sometimes the market too. This is where opportunity lies sometimes. The third variable – CAP also behaves the same. Higher the period for which the company can maintain the CAP, higher the intrinsic value and higher the PE. CAP or competitive advantage period is not available from any annual report or data. It is the period for which the company can maintain an ROC above the cost of capital. For a better understanding of CAP, read this article – measuringthemoat from google groups. It’s a great article and a must read if you want to deepen your understanding of CAP and DCF based valuation approach.

As I was saying, CAP is diffcult to estimate as it depends on various factors such as the nature of industry, competitive threats etc. I usually assume a CAP of 5-8 years in my valuations. If it turns out to be more than that, then it serves as a margin of safety.

Now when I look at the company, I use the worksheet ‘ROC and PE’ and my thought process (simplified) is as follows

1. Look at ROC – does the company have an ROE or ROC of greater than 13-14% ? If yes, is it sustainable (this is subjective).
2. Use the above worksheet to select a specific ROC sceanrio.
3. What has been the growth for the company in the last 8-10 years. What is the likely growth (again subjective estimates).
4. What is the likely CAP? This is a very subjective exercise and requires studying the company and industry in detail. If the company checks out, I usually take a CAP of 5-6 years.
5. Plug the ROC, growth, CAP and current EPS numbers in the appropriate sceanrio and check the PE. That is the rough PE for the instrinsic estimate.
6. Check if the current price is 50% of the instrinsic value
7. Cross check valuation via comparitive valuations and other approaches.

If all the above checkout, it is time to pull the trigger.

In case the above has not bored you to tears, 🙂

Next posts: Some conclusions from table for CAP v/s PE v/s Growth (CAP analysis worksheet), pointers on DCF etc etc.

I discussed about maintenance capex and its relation with Free cash flow. To recap

Free cash flow = Net earnings + depreciation – maintenance capex

And free cash flow is the money the owner of business can take out or re-invest in the business.

Maintenance capex however does not have a precise formulae. That does not mean you cannot calculate it. But as you can see, if valuation is based on free cash flow which itself is based on an imprecise measure such as maintenance capex, it cannot be precise in itself.

Valuation depends on free cash flow, project growth rates , terminal value and the discount rates. All these are estimates and hence valuation is itself an estimate. That is the reason I find it assuming when analysts give reports where they give precise valuation targets and on top of that even the duration (next one year !!) when the target would be met.

So, coming back to maintenance capex, how do I estimate it? let me warn you at the outset. My approach is self developed, imprecise and only roughly right.

I will use my valuation template to explain my approach

Worksheet – anal – In this worksheet I fill up the sales, depreciation, wcap etc. On line 26, I calculate the additional capex (additional fixed asset and Wcap for the year). Line 27 is capex as % of sales. This gives me a capex trend (total) for a period of time for the business. I then use this trend to estimate the maintenance capex.

For ex: if the business has an asset turn (on average) of 2, then I would assume capex as 2.5% of sales

Sales = 100
Asset = 50
Inflation increase in sales = 5
Corresponding asset required = 2.5 (2.5% of sales)

If the business is asset heavy (commodity industry) then the maintenance capex as % of sales is high.

If the asset turn is 1, then maintenance capex would be roughly 5% of sales. You can compare this % with depreciation as a % of sales to see if both are roughly equal.

You may find some errors in my worksheet and I plan to load an updated version soon. I don’t use these worksheet very frequently now. After using these worksheets for several years, I am now in a position where I can look at the numbers and estimate if the company looks roughly undervalued. A lot of companies don’t pass that test and are rejected outright. If a company passes that filter, I fill up the excel and go through the entire exercise (which is not very precise in itself)

I have loaded a few samples in the google groups. If you go through this exercise yourself several times, you will see patterns and it will be faster for you too.

In addition to the above excel, please have a look at the excel – Quantitative calculation – worksheet : Maintenance capex to see the relationship between Sales, Asset turns, Maintenance capex and ROC.

Ofcourse you can have a counter argument – who the hell wants to go through such an elaborate exercise to value a company? Don’t I have better things to do in life 🙂

I received the following question from sanjay shetty via email. I will try to answer the question and have also simplified it via several assumptions

You mentioned you “use maintenance capex needed to support unit volumes or competitive position (maintenance capex).”
I downloaded your Excel sheets couldn’t figure out the basis for calculation of the same, especially as companies don’t give break ups of maintenance capex. If you could explain would be great.
Maybe my understanding is incorrect, however I feel that all Purchase of Fixed assets should be deducted from Free Cash Flow especially when the amount out there is a yearly spend by the company to grow it’s business.

Let me start with the following definition for free cash flow (paraphrased) as given by warren buffet

Free cash flow = Net earnings + depreciation – maintenance capex

Now you can take the above formulae as a given or debate whether it is correct. I think it is correct as free cash flow is basically discretionary cash which the owners (actually managers on their behalf) of the business can choose whichever way to invest. It is discretionary cash because the business is left with this cash after it has incurred the required capex to maintain its current position in terms of volume and competitive position. If it does not do that, then the business will start degrading and may eventually be wiped out.

Now the discretionary cash can be spent in the following ways

1. Invest in the buiness itself if the returns are good – most common approach. Value adding if the business earns more than cost of capital . for ex: ITC, asian paints, HLL etc. This investment is in fixed assets and working capital
2. Accquire other company – Eg. Marico
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing – Ex: Merck, Novartis etc

Now the question – How to calculate maintenance capex? There is no precise formulae for that. The best you can do is to arrive at a rough number as companies don’t give this number. Let take the definition above and let me give my approach

If the maintenance capex is to maintain unit volumes, then value sales would be growing at the rate of inflation. So lets take a hypothetical case (simplified)

Sales = 100
Return on equity = 20% ( debt = 0)
Net margin = 10%
Total asset / sales = 2
Total asset = 50
Depreciation = 5 % of asset

Now in year 2
Sales = 105 (5 % inflation)
ROE = 20%
Net margin = 10%
Total asset / sales = 2
Total asset = 52.5
FCF = 10.5+2.5-2.5 [ asset increase = 2.5 ]

So in the simple case above FCF is equal to Net profit. Ofcourse reality is not so simple. However once you get an idea of the basic concept, you can do a rough estimation of the maintenance capex and free cash flow.

Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.

Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.

So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.

The above post may appear fairly academic and boring, but I think the question asked by sanjay goes to the core of how to value a company.
Next post : I will try to explain how I calculate FCF using the excels I have uploaded