equitymaster knowledge centre intelligent investing

8/12/2019 Equitymaster Knowledge Centre Intelligent Investing

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Equitymaster-Knowledge Centre-Intelligent Investing 1

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

equitymaster knowledge centre intelligent investing

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