Simplifying Value Investing
A lot of Investors have lost money buying bad business’ at Cheap Valuation because of half information of Value Investing. According to me Value Investing is not buying a bad business at bad prices, its about Buying a Good Business at Fair or Below fair Valuation. Even though the below blog is not exhaustive, it simply tells you what really goes in Valuing a Stock.
A Stock Price is a Function of 3 primary things
- PE Re-Rating (Valuation)
- Sustainable Earnings Growth
- Dividend Payout
1) Valuation (PE Ratio’s) are largely a function of 3 primary things
- Growth Rate of the Company (Opportunity Size)
- Return on Capital Employed a business can generate
- Interest Rates (Cost of Capital) and Sentiment (Liquidity).
2) Sustainable Earnings Growth is again largely a function of 3 things
- Volume Growth of the Product
- Price Growth of the Product
- Margin a business can generate
3) Dividend Payout is largely is again a function of 2 important things
- Free Cash Flow a Company can Generate (ROE>Growth)
- Reinvestment opportunities
There is nothing more to stock Markets mathematically and the one who understands this understands everything to investing.
Though in India there is a 4th added factor which is fairly important and mostly a Qualitative aspect and that is management Quality. A Quality of a management doesn’t guarantee you that you will make a lot of money, though all this says that there won’t be permanent loss of capital.
Management Quality becomes a very Important Phenomena is a bear market though in bull Markets are all about chasing growth.
Lets understand each factor in a Little bit in Detail.
1) Valuation – PE Ratio, Dividend Yield & P/B works really well for Matured Companies where growth Rate is less than Cost of Equity Capital, but for younger companies who are emerging Leaders the right way to Value them is Opportunity Size to Market Cap. Lets take an Example Voltas which is a Leader in A/C Space where the Penetration is just 4% & India Sells 50 Lakh A/C against 19 Crore A/C Sold in China. It Quotes at 20000 Crore Market cap for 3200 Crores of Room A/C Turnover, This is because the Market is giving premium valuations for long term predictable growth opportunity.
Return on Capital Employed – ROCE is just Net Operating Profit after Tax divide by Fixed Asset + Working Capital Employed in the Business. A ROCE tells you a lot about the Business when compared with competition about its Efficiency of Capital & Competitive Scenario.
Interest Rates & Liquidity – The Value of the Stock is the Present Value of Future Cash Flows Discounted at Risk Free Interest Rates + Equity Risk Premium. In a Low Interest rate Cycle, typically cheap money buys assets which are Predictable Sustainable Growth at elevated Valuation whereas In a High Interest Rates Cycle the Markets are happy buying Hard Assets like Real Estate, Gold. Liquidity in the Short term decides Valuation not the other way round.
2) Sustainable Earnings Growth Rate – This is Simply but not easy, Sustainable Earnings Growth is Just Depending on Volume Growth* Pricing Growth* Margins. Remember Customers Decide the Revenue & Competitive intensity Decides the Margin of the Business & pricing power. The Revenue Growth is dependent on the opportunity Size of the Industry but Margins are dependent on the Competitive Advantages that the company has & Differentiated Products. There are 4 key Competitive Advantages
A) Economies of Scale which Companies like Dmart & Walmart have
B) Networking Effect which companies like Visa, Google, Facebook have
C) intellectual property rights or customer goodwill. Nestle, Hindustan Unilevar, Nike, would be good examples here.
D) A fourth and final type of moat would be high customer switching costs – Microsoft Office, Salesforce CRM are great examples of companies that benefit from high customer switching costs.
3) Dividend Payout – A lot less has been spoken about Capital Allocation & dividend payout, this is the most important part of Valuation of the Company. This is where some real business skills come where we need to back Management who are smart at allocating Capital in opportunities which have an expected return on Increment capital employed of Higher than the Cost of capital. Dmart has a Large Opportunity size & has to do exactly the same thing of Buying new stores with Freecash flows from old stores for next 10-15 years. On the Other hand there are companies like HDFC AMC which dont need capital to grow & should typically give out 100% of FreeCash flows as Dividend. Markets hate companies which generate a lot of FreeCash but dont have a Reinvestment or a Distribution strategy as this leads to sub optimal returns for shareholders like CDSL, BSE etc
The Above blog is ofcourse not Everything to Valuation but is a great starting point.
The Author of this Blog is Amit Jeswani,CFA,CMT, Founder of Stallion Asset. All the above stocks are for Education purpose only & are strictly no recommendations.