Simplifying what is CAPM – Capital Asset Pricing Model: One of the most popular and prevalent laws states that “Greater the risk, greater the reward”. This holds true even when we take into account the stock market and the returns earned. Assets like government bonds come with low risk-low returns, blue-chip equities come with medium risk- medium return, and high risk-returns in equity stock is generally noticed with new entrants.
All seems well and good when we are able to compare different asset classes as above. But how would you differentiate the expected returns between stocks of the same asset class? And even when done among different asset classes how is this differentiation quantifiable?
Today, we discuss the CAPM an investment theory that provides the answers to these very problems. The model has been so integral to financial management that it has even been suggested that finance became a full-fledged scientific discipline’ only when William Sharpe published his derivation of the CAPM in 1986.
What is CAPM?
The Capital Asset Pricing Model provides us with a formula that describes the relationship between expected return and the risk of investing in that security. The CAPM formula provides investors with an expected return that they should be expecting taking up the risk on the security.
On the other hand, it is also used by the management of the company to calculate the cost of equity or the rate at which the will service the shareholder equity in order to fairly compensate its shareholders for taking up the risk.
How to Calculate returns using CAPM?
The expected return for security can be calculated using the following formula:
Where,
Rf = Risk-Free Rate
Rm = Expected return of the market
Ra = Expected return from the security.
Simplifying the Expected Return Calculation Formula
A first glimpse of the formula shown above is good enough to spin heads. Now we go ahead and simplify it in order to make it more understandable.
1. Rf = Risk-Free Rate
Generally, government-issued bonds are known to be one of the most secure investments. This is why the rate provided by these government bonds is termed as the risk-free rate.
2. Beta – Stock’s volatility Measure
Beta here is the measure of the stock’s risk which is captured by measuring the volatility a stock faces in relation to the overall market. Here the average market return is 1. Say the Beta of a company A is 1.5. This would mean that for every 1% increase in the market return the shares of A’ will increase by 1.5%. But also a 1% decrease would mean that shares of A will decrease by 1.5%. Stocks like this are highly volatile.
Take another example where the Beta of a company is 0.5. This would mean that for every 1% increase in the market return the shares of A’ will increase by 0.5%. But also a 1% decrease would mean that shares of A will decrease by 0.5%. Stocks like this are of low volatility.
3. Rm = Expected return of the market
The expected return from the market is achieved by either following what research companies estimate. Or by computing historical averages from the past say for eg. the average Nifty return for the last 10 years. This is used in the formula in order to find the market risk premium. The market risk premium is shown in the formula as (Rm-Rf). This in simpler words shows the additional return available from the market in comparison to the Risk-Free rate.
After reading the above the formula simply becomes,
Expected Return from the Mkt. = Risk-Free Rate + (Beta * Market Risk Premium)
A Simple Example to Understand it further
Let us calculate the expected rate of return for ABC company. Say the risk-free rate is 3% by looking into the current government-issued bond rates. ABC operates in the textile industry which has a Beta of 1.3%. Indian Markets, on the other hand, are expected to rise in value by 8% per year.
Here, the expected return rate can be calculated as,
In this article, we tried to simplify what is CAPM i.e. Capital Asset Pricing Model. This approach has both its pros and cons while calculating the expected rate of return of an asset.
Over the years a number of shortcomings have come about with regards to the CAPM but it still remains widely used because of its simplicity and ease of comparison of investment alternatives. The CAPM however does not remain restricted to finding expected returns but is also used in portfolio building by investors. Its key advantages however will always lie in its ability to translate into estimates of expected return, keeping it useful.
A Beginner’s Guide on How to read financial statements of a company: If you want to invest successfully in the stock market, you need to learn how to read and understand the financial reports of a company. Financial statements are tools to evaluate the financial health of the company. In this post, we are going to discuss the basics of how to read financial statements of a company. Here you’ll learn how to read the balance sheet, income statement, and cashflow statement of a company.
To be honest, you won’t find this post very interesting. Many of the points might sound complex and boring. However, it’s really important that you learn how to read financial statements of a company for achieving success in your investing journey. Reading and understanding the financials of a company is what differentiates an investor from a speculator.
As Warren Buffett used to say “Risk comes from not knowing what you are doing.”. And you can find the risk and potentials of a company through its financial reports. Without wasting any further time, Let’s get started.
How to get the financial statements of a company?
Before we start analyzing the financial statements of a company, the first thing that you need to know is where exactly to find them. Where can you see or download the financial statements of a company that you’re researching?
Well, you can find the financial statements of a company in any of the following sites: 1) BSE/NSE Website, 2) Investor relation page on Company’s website 3) Financial websites (like screener, money control, investing, etc)
In India, Securities exchange board of India (SEBI) regulates the financials announced by the company and try to keep it as fair as possible. Further, if you are using any other non-reputed website, make sure that the reports are correct and not tempered.
Quick Note: We recently launched our stock research and analysis portal, where you can also get the details about the financials of the +4,000 publically listed company in India. You can check out our portal here.
Three Core Financial Statements of A Company
Now, let us understand the different financial statements of a company. The financials of a company are split into three key sections. They are:
Balance sheet
Income statement (Or Profit & loss statement)
Cash flow statement.
The balance sheet shows the assets and liabilities of a company i.e. what it owns and owes. Second, the income statement shows how much profit/loss the company has generated from its revenues and expenses. And finally, the Cash flow statement shows the inflows and outflows of cash from the company.
It’s essential that you know how to read all of these financial statements. Let’s understand each statement one-by-one.
How to read financial statements of a company?
1. Balance Sheet
A balance sheet is a financial statement that compares the assets and liabilities of a company to find the shareholder’s equity at a specific time. The balance sheet adheres to the following formula:
Assets = Liabilities + Shareholders’ Equity
Here, do not get confused by the term ‘shareholder’s equity’. It is just another name for ‘net worth’ of the company. In other way, the above formula can be also written as:
Shareholder’s Equity = Assets – Liabilities
Quick Note: You can easily understand this with an example from day to day life. If you own a computer, car, house, etc then it can be considered as your asset. Now your personal loans, credit card dues, etc are your liabilities. When you subtract your liabilities from your assets, you will get your net worth. The same concept is applicable to companies. However, here we define net worth as the shareholder’s equity.
Why are balance sheets important?
The balance sheet helps an investor to judge how a company is managing its financials. The three balance sheet segments- Assets, liabilities, and equity, give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Key elements of a Balance Sheet
Assets and liabilities are two key elements of a balance sheet. However, both assets and liabilities further comprise of different elements. Let’s define both of these to understand them in details:
1) Assets: It is an economic value that a company controls with an expectation that it will provide a future benefit. Assets can be cash, land, property, inventories, etc. Further, assets can be broadly categorized into:
Current (short-term) assets: These are those assets that can be quickly liquidated into cash (within 12 months). For example cash and cash equivalents, inventories, account receivables, etc.
Non-Current (Fixed) assets: Those assets which take more than 12 months to convert into cash. For example- Land, property, equipment, long-term investments, Intangible assets (like patents, copyrights, trademarks), etc.
The sum of these assets is called the total assets of a company.
2) Liabilities: It is an obligation that a company has to pay in the future due to its past actions like borrowing money in terms of loans for business expansion purposes etc. Like assets, it can also be broadly divided into two segments:
Current liabilities: These are the obligations that need to be paid within 12 months. For example payroll, account payable, taxes, short-term debts, etc.
Non-current (Long-term) liabilities- There are those liabilities that need to be paid after 12 months. For example long-term borrowings like term loans, debentures, deferred tax liabilities, mortgage liabilities (payable after 1 year), lease payments, trade payable, etc.
Now, let us understand these segments with the help of the balance sheet of a company from the Indian stock market. Here is the balance sheet of ASIAN PAINTS for the fiscal year 2016-17. I have downloaded this report from the company’s website here.
Please note that there are always at least 2 columns on the balance sheet for consecutive fiscal years. It helps the readers to monitor the year-on-year progress.
Although the balance sheet looks complicated, however, once you learn the basic structure, it’s easy to understand how to read the financial statements of a company. A few points to note from the balance sheet of Asian Paints:
There are three segments in the balance sheet of Asian paints: Assets, equity, and liability.
It adheres to the basic formula of the balance sheet: Assets = Liabilities + Shareholder’s equity. Please note that the first column of asset (TOTAL ASSETS = 9335.60) is equal to the second & third column of equity and liabilities (TOTAL EQUITY & LIABILITY = 9335.60).
Now, let us move to the second important financial statement of a company.
2. Income Statement
This is also called the Profit and loss statement. An income statement summarizes the revenues, costs, and expenses incurred during a specific period of time (usually a fiscal quarter or year). The basic equation on which a profit & loss statement is based is:
Revenues – Expenses = Profit
In simple words, what a company ‘takes in’ is called revenue and what a company ‘takes out’ is called expenses. The difference in the revenues and expenses is net profit or loss.
The fundamental structure of an income statement:
Revenue
– Cost of goods sold (COGS)
——————————————- = Gross Profit – Operating expenses
——————————————- = Operating Income – Interest expense
– Income taxes
——————————————– = Net Income
Note: The revenue is called TOPLINE and net income is called the bottom line in the income statement.
Most of the investors check the income statement of a company to find its earning. Moreover, they look for growth in their earnings. It’s preferable to invest in a profit-making company. A company cannot grow if the underlying business is not making money.
Here is the Income statement of Asian paints for the Year 2016-17:
Here are a few points that you should note form the income statement of Asian Paints:
The top line (revenue) increased by 8.04% in the fiscal year 2016-17.
On the other hand, the bottom line (net profit) increased by 11.84% (Rs 1802.76 Cr –> Rs 2016.24 Cr) in the from the fiscal year 2015-16 to the fiscal year 2016-17.
This shows that the management has been able to increase the profits are a better pace compared to the sales. This is a healthy sign for the company.
For Asian paints, the diluted EPS also increased from Rs 18.19 in the year 2015-16 to Rs 20.22 in year 2016.17. This is again a positive sign for the company.
This is the third key part of a company’s finances. Cash flow statement (also known as statements of cash flow) shows the flow of cash and cash equivalents during the period under report and breaks the analysis down to operating, investing, and financing activities. It helps in assessing the liquidity and solvency of a company and to check efficient cash management.
Three key components of Cash flow statements
Cash from operating activities: This includes all the cash inflows and outflows generated by the revenue-generating activities of an enterprise like sale & purchase of raw materials, goods, labor cost, building inventory, advertising, and shipping the product, etc.
Cash from investing activities: These activities include all cash inflows and outflows involving the investments that the company made in a specific time period such as the purchase of new plant, property, equipment, improvements capital expenditures, the cash involved in purchasing other businesses or investments.
Cash from financial activities: This activity includes inflow of cash from investors such as banks and shareholders by getting loans, offering new shares, etc, as well as the outflow of cash to shareholders as dividends as the company generates income. They reflect the change in capital & borrowings of the business.
In simple words, there can be cash inflow or cash outflow from all three activities i.e. operation, investing, and finance of a company. The sum of the total cash flows from all these activities can tell you how much is the company’s total cash inflow/outflow in a specific period of time.
Here is the Cash flow statement of Asian paints for the fiscal year 2016-17.
From the Asian paints cashflow statement, we can notice that the net cash from operating activities has declined from Rs 2,242.95 Crores to Rs 1,527.33. This may be little troublesome for the company as the net cash from operating activities shows how much profit the company is generating from its basic operations.
As a thumb rule, an increase in the net cash from operating activities year over year is considered a healthy sign for the company. However, while comparing also look at the data for multiple years.
Quick note: In financial statements, generally accountants do not use the negative sign. For example, if the expense is to be deducted, it is not written as -40. When writing minus sign, accountants use parentheses (—). For the same example, it will be written as (40), not -40.
Summary
Through this post, we tried to explain the three core financial statements of a company. It is important to read and understand all the three financial statements of a company as they show the health of a company from different aspects.
The balance sheet shows the assets and liabilities of a company.
The income statement shows how much profit/loss the company has generated from its revenues and expenses.
Cash flow statement shows the inflows and outflows of cash from the company.
While investing in a company, you should pay special attention to all these financial aspects of a company. As a thumb rule, invest in a company with high-income growth, large assets compared to its liabilities and a high cash flow.
That’s all! This is how to read financial statements of a company. Although it’s not enough, however, this post aims to give a basic idea to the beginners about the financial statements of a company.
If you want to learn (in details) about where to find the financial statements of an Indian company and how to effectively study the reports, feel free to check out my online course on HOW TO PICK WINNING STOCKS here. I have explained everything about financial statements in this course.
Further please comment if you have any questions. I’ll be happy to help you out. Happy Investing!
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
Understanding the difference between ROE vs ROCE: As investors, the financial ratios have become an essential part of our decision-making process. This is because ratios measure and give us a more comprehensive picture of companies’ operational efficiency, liquidity, stability, and profitability in comparison to the raw financial data from various statements. Today we look at two profitability ratios namely the ROE and the ROCE with an attempt to better understand them
Return on Equity (ROE)
The Return on Equity ratio enables us to measure a company’s performance by dividing the annual net returns by the value of the shareholders’ equity. The ROE ratio helps us to judge the effectiveness of a company’s management to use the shareholder contribution available in order to generate profits
— ROE Formula
Return on equity (ROE) can be calculated as Net Income of a company divided by its Shareholder Equity.
Net Income: The Net Income considered here is the income remaining after the taxes, interest, and dividend to preference shareholders is paid out.
Shareholder Equity: Assets – Liabilities
ROE brings together two financial statements. It includes the Net income from the income statement and the shareholders’ equity from the Balance Sheet.
— Example to understand ROE
Take two companies A and B in the ice cream business. Both companies have made a profit of 20 lacs for the financial year 2019-20. But how are we to compare the greater of the two in this scenario. After taking a closer look we find that the investments received by the 2 companies are: Company A – 1 crore and Company B – 2 crores.
The ROE computed for company A is 0.2 and for company, B is 0.1.
This puts the returns from the two companies in a whole new perspective. Despite both of the companies reporting the same profits, the management of Company A is more efficient in converting the money invested into profits. Hence, it would be wise to invest in Company A as management is more efficient in generating profits.
When the ROE’s are compared over a period for a company it enables us to judge how the management had evolved in allocating the shareholders’ equity appropriately. An increasing ROE will mean that the management has been improving its efficiency of investing the shareholders’ capital over the years in order to generate higher profits.
On the other hand, a decreasing ROE represents a deficiency in the management’s ability in using the resources and poor decisions made in investing capital over the years.
Return on Capital Employed (ROCE)
The Return on Capital Employed ratio shows us the effectiveness of a company’s allocation of capital. The ROCE ratio is acquired by dividing a company’s operating income by the capital employed.
— ROCE Formula
Return on capital employed can be calculated by dividing EBIT (Operating Income) by its Capital Employed.
Operating Income: The operating income is what we get after the total sales is deducted by the operating expenses like wages, depreciation, and cost of goods sold. In other words, it is the Earnings before interest and tax charged (EBIT).
Capital Employed: Assets – Current Liabilities or Equity + Debt.
— Example to understand ROCE
Let us take a similar example as that taken in the case of ROE. The same companies A and B are in the ice cream business. They have earned a profit of 20 lacs and have an investment as follows: Company A -1 crore and Company B – 2 crores. But in addition to this, the debt taken by the companies is Company A – 3 crores in loans and Company B – 1 crore in loans.
The ROCE computed for Company A is 0.05 and Company B is 0.067.
This provides a better perspective as to how the two companies have employed the capital available with them in order to earn profits. This shows that an investment in company B would be favorable.
When it comes to ROCE, as the ratio considers capital as a whole it is also important to take into account the cost of capital when making judgments. When the Return on Capital (ROCE) is higher than the Cost of that Capital it would make a favorable investment. But a case where the Cost of Capital is higher than the return on that capital (ROCE) is a red flag. Here the existing shareholders would choose to exit and potential investors would prefer to stay away.
ROE vs ROCE: Key Differences
ROE
ROCE
Income consideration
The income considered here is the Profit after all the Interest and Taxes are charged.
In a situation where the government has increased the taxes, the ROE will take into effect its impacts.
The Income taken into consideration here is the earnings before the taxes and interests are charged.
Changes in Interest and taxes do not impact the ROCE. The ROCE is only impacted by the changes in operating expenses like wages etc.
Capital
The ROE considers only the shareholder capital employed.
The ROCE considers the total capital employed (inc.debt) by the company.
Ratio Depicts?
Effective management of shareholders' capital.
It shows the efficiency of a business operation.
Stakeholder Significance
The ROE is of more significance to the shareholders as it shows them the returns the company provides for every Rs.1 they invest. It is of greater significance to shareholders as it shows them what is left for them after the debt is serviced.
The ROCE is of significance to both the shareholders and the lenders. This is because the ROCE also shows the effectiveness of the total capital employed in the company.
Using ROE and ROCE – The right way?
A shareholder may also use the ROE and the ROCE ratios in comparison to each other. When the ROCE ratio is greater than the ROE it signifies that a major portion of the profits earned is diverted to service the debt of the company. This would not be taken positively by shareholders. However, it is also important to consider that a company with a high ROCE ratio is able to raise debt at attractive terms. The high ROCE improves the valuations of a company. This is because it shows that the company can easily raise debt for its future operations.
Both the ratios even when used individually cannot be used as a comparative across various industries. The averages ROE for the computer services industry is 17.29%. Whereas the average ROE for a Biotech company is 3.83%. Hence they can only be judged effectively only when they are compared with companies in the same industry.
In the case of judging companies on the basis of ROE and ROCE, Warren Buffet prefers companies that have ROE and ROCE which are close to each other. According to him, a good company should not have a gap of more than 100-200 basis points. A situation where the ROE and ROCE are close implies that both the equity shareholders and the lenders are taken care of. And at the same time not compromised at the cost of the other.
An overview of Company Annual Report, it’s meaning, purpose, contents and more: You might not be surprised to know that Warren Buffett, the third most richest person on this planet and one of the most successful investor of our time, reads over 500 pages each day. Most of the time, he’s busy reading the annual reports of different companies that either he’s planning to invest or already invested in. And believe me, reading the annual report of multiple companies is not an easy task as each report easily consists of 200-300 pages or more.
“So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life.” – Warren Buffett
In this article, we are going to discuss what is a company annual report, its meaning, purpose, why investors read annual reports and finally how to read annual reports efficiently. Let’s get started!
What is a Company Annual Report?
While some companies publish their Annual Reports to provide necessary information about its company’s financial performance and to comply with the statutory requirements, there are some other companies that use the Annual Reports as a tool to advertise their products and services and that is reasonable too.
The Annual Report is the medium of communication between the company and its shareholders, investors and other readers. It is the best source to know about any company’s operations, services along with its financial performance in the past, present and what are its upcoming plans and goals.
Moreover, the Annual Report is a statutory compliance every company must adhere to. It is a single source of highly useful information that is used differently by a different set of users such as Shareholders, Income Tax Authorities, Investors, Securities and Exchange Board of India (SEBI), etc. Be it either financial statements or corporate governance, or company vision and mission or ratio analysis, everything is compiled and presented in an Annual Report. The financial health is measured from these reports.
What is Purpose of the Annual Reports?
Basically, the purpose of issuing an Annual Report is to communicate to the shareholders, stakeholders, media and other relevant authorities that how the company performed in the financial year, its vision and mission, whether the company is working towards its set targets, what all are its assets, liabilities, what are their main areas of operations and what other activities they are doing. The ultimate purpose is to showcase the financial performance and provide an assurance that the company’s financials have been audited by the professionals and they represent true and fair financial statements in all manner.
Contents of the Annual Report
Whilst the fundamental purpose of publishing the Annual Report is to provide company information, financial performance, significant accounting policies and related notes and future goals to its shareholders, investors and other related users, many companies use Annual Report to advertise their products and services and other achievements along with the basic necessary information as discussed above. We will be highlighting the critical and important contents of every Annual Report that is required by every company by some of the other regulatory body.
(Example: Asian Paints Annual Report for Year 2018/19 – Source)
— Director’s Report
The Director’s Report is a letter from the Board of Directors of the company to its shareholders and other investors and readers about a brief of the company’s main activity, financial performance, management’s responsibility in preparing the books of accounts and financial statements and appointment or re-appointment of auditors in the annual general meeting of the company along with other particulars of major accounting policies followed in the recently completed financial year.
The report will also communicate details if the company is planning anything major that will impact significantly on shareholders’, investors’, its payables’ or receivables’ decisions such as any merger or acquisition, or any other occurrence of extraordinary event. The Directors will also communicate the reasons if the company had losses during the financial year and their plan to recover or make it profitable.
— Auditor’s Report
The Auditor’s Report is a letter of auditor’s opinion about the truthfulness and fairness of the financial statements and that the financial statements comply with generally accepted accounting principles and any other recognized accounting standards. Auditors address the shareholders of the company and express their opinion about the financial statements to them.
Auditors are the professional Chartered Accountants recognized and authorized by the professional bodies and government authorities to issue and certify such reports. The auditor’s report contains auditor’s opinion on the financial statement, the basis of the opinion, auditor’s responsibility to carry out the audit and to issue such report, management’s responsibility and any other reporting responsibility such as compliance to legal and regulatory requirements.
For the readers of the financial statement, an auditor’s report and his opinion provide very crucial details. The opinion can be unqualified opinion, qualified opinion or the auditors may give a disclaimer of opinion.
The unqualified opinion means that in an auditor’s opinion, the financial statements give a true and fair view of the financial statements. Whereas, the qualified opinion means the auditors believe that the company has deviated from its mandatory compliance to represent true and fair financial statements or certain accounting policies and principles are not complied by the company. The disclaimer of opinion represents that the auditor is not able to give any opinion on the financial statements for certain reasons such as, the management might not allow them to qualify the report or they were refrained to carry out the audit as per their satisfaction or any other such matter.
— Statement of Financial Position or Balance Sheet
The statement of financial position is a balance sheet of a company as on the last date of the financial year. The balance sheet contains assets, liabilities and shareholders’ funds or equity. This statement will indicate what are the Non-current assets, current asset a company holds, how much non-current or current liabilities a company needs to settle and how much is shareholders fund including accumulated profits and reserves.
— Statement of Income and Comprehensive Income
This is the statement where readers of the Annual Report will find financial performance during the year for a company. The statement contains Income, Expenses and other extraordinary income or expense made by the company during the financial year. The income and expenditure from operations and major services and other general, sales and distribution expenses are covered under the first part of the income statement that will give the net income or net profit during the year. The second part will include details of unrealized income, foreign currency transaction loss or gain, dividend, transfer to reserves under comprehensive income statement.
— Statement of Cash Flow
The Income statement will include only the income and expenses of that year for a company which may also include such income or expenses that are accrued but actually not paid. For example, the receipt of payment for the revenue booked in the last week of the financial year might be pending. Hence, it may happen that actual cash has not been received or paid but it is booked as it relates to that year and to comply with the accounting principles. However, from the statement of cash flow, the readers can understand that how much cash inflow or outflow has been made by a company from operational, financial and investing activities.
— Notes Accompanying to Financial Statements and Significant Accounting Policies
This portion of an Annual Report will contain company basic information about the activities, its date of incorporation, its license number and the shareholding pattern. The significant accounting policies will contain the company’s policies for accounting income, expense, recognizing asset or liability or any other such policy as approved and issued by the relevant accounting bodies for companies to mandatorily follow. The notes will also include off-balance-sheet items such as contingencies from which the information regarding the company’s liability or gain can be guessed based on its possibility to occur.
Types of Readers of an Annual Report and their Purposes
The different kind of audience of an Annual Report would fetch different information and the focus of information will also be changing depending on who is reading the financial statement.
Shareholders: Shareholders of the company would want to know from the company’s Annual Report whether the money they invested is being utilized properly or not, whether the company is adequately utilizing its resources and utilizing them for the main activities of the company keeping in mind the vision and mission of the company and if it makes enough profits to pay dividends.
Investors: The investors would want to know whether the company is making money if they invest into their company’s stocks, what are company’s future plans that will raise its market value so that if they invest now, they can get more return, is the company paying the dividend to its shareholders.
Employees: Employees would read the Annual Report to understand how much company as a whole has performed during the financial year and if the company is making necessary profits to pay their salaries and other benefits in future. Many times, employees are working at some remote location where the corporate offices are not located, when they read the Annual Report, they can understand the ‘big picture’.
Customers: Customers would focus on the quality and new additions to the products and services. The Annual Report will provide and highlight these details and ensure the sustainability of the business.
Apart from the above, there are other readers too such as suppliers who would focus on company’s business progress and how quickly they can repay their dues and receivables would focus on whether to continue buying from them as a trusted supplier or not.
Quick Note: If you want to download the annual report of any specific publicly listed company, you can check the stock page of our Stock analysis and research portal here.
Other Key Information Provided in Annual Reports
The off-balance-sheet items in the notes to accounts will provide how much liability or any unrealized income company has which has yet not been effected into the financial statements since its possibility to occur or not to occur is remote.
The notes will also contain whether corporate governance is maintained or not and if there are deviations to it then what caused such deviations.
Audit Report’s other regulatory and legal reporting section shall provide the company’s adherence to such other statutory compliances.
The notes will also reveal if the company has changed any particular accounting policy and if the change is made then to what extent it has impacted the financials.
The notes will also communicate whether the company is undergoing any legal proceedings or not that any potential investor would want to know.
The risk analysis is also given in the notes from where various associated risks such as credit risk, interest risk, foreign currency risks are detailed. The company will also mention what steps are taken to mitigate such risks.
Understanding Free Cash Flow (FCF) Meaning & Calculations: Hi Investors. One of the most popular topics in company valuation is the Free cash flow. If you are involved in the fundamental analysis of stocks, you definitely have heard about this term. Nevertheless, for beginners, free cash flow can be a mystery.
In this post, we are going to discuss what exactly is a free cash flow and why it is important to evaluate while researching a company. This might be one of the most important articles for the people interested to learn stock valuations. Therefore, read this post completely. Let’s get started.
1. What is a Free Cash Flow (FCF)?
Free cash flow is the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It represents the cash that is available for all the investors of the company. Now, you might be wondering what is so ‘FREE’ about this cash flow and how it is different from the earnings of the company?
Here you need to understand that not all income is equal to cash. If a company is making earnings, it doesn’t mean that it can spend all the income directly. The company can only spend free cash. There is a crucial difference between ‘cash’ versus ‘cash that can be taken out of a business’, or in accounting terms: cash from operating activities and free cash flow (FCF).
The cash from operating activities is the amount of cash generated by the business operations of a company. However, not all of the cash from operating activities can be taken out of the business because some of it is required to keep the company operational. These expenses are called capital expenditures (CAPEX).
On the other hand, free cash flow is the cash that a company is able to generate after spending the money required to stay in business. This is the cash at the end of the year, after deducting all operating expenses, expenditures, investments etc and is available for distribution to all stakeholders of a company (Stakeholders include both equity and debt investors.)
It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings.
This is because earnings show the current profitability of the company. On the other hand, the free cash flow signals the future growth prospects of the company as this is the cash that allows the company to pursue opportunities to enhance shareholder’s value. Free cash flow reflects the ease with which businesses can grow or pay dividends to the shareholder.
The excess cash can be utilized by the company in expanding their portfolio, developing new products, making useful acquisitions, paying dividends, reducing debt or to pursue any other growth opportunity.
Further, free cash flow is also used as the input while calculating the intrinsic value of a company using the popular valuation technique- Discounted cash flow (DCF) Model.
(Besides, as free cash flow is the additional money that can be taken out of the company without affecting the running of the business, it is also called the “Owner’s Earnings”.)
3. How to calculate free cash flow of a stock?
Companies in the stock market are not obliged to publish their free cash flow. That’s why you can’t find FCF directly in the financial statements of the companies. However, the good point is that it is easy to calculate them.
To calculate the free cash flow of a stock, you’ll require its financial statements i.e income statement, balance sheet, and cash flow statements. There are two calculation methods to find Free cash flow of a company.
Method 1: From the Income statement & Balance sheet
FCF = EBIT (1-tax rate) +(depreciation & amortisation) -(change in net working capital) – (capital expenditure)
Method 2: From the cash flow statement
This is the more popular approach to calculate FCF of a company. Here, Free cash flow is calculated as cash from operations minus capital expenditures (from the cash flow from investing activities).
FCF = Cash flow from operating activities – capital expenditures
Quick Note: To make things simpler, Yahoo Finance has already made the free cash flow of the companies available on their website. Just go to the Stock page –> Financials –> Cashflow statement, and you can find the Free cashflow of the company for last multiple years.
In addition, you can also find the free cash flow of companies on other financial websites like Screener.in, Tickertape, etc. Nevertheless, we advise our readers to do the calculations themselves to avoid any computer-based miscalculations.
4. How to analyze the free cash flow of a company?
While studying the cash flow of a company, it is important to find out where the cash is coming from. The cash can be generated either from the earnings or debts. While an increase in cash flow because of the increase in earnings is a good sign. However, the same is not true with debts.
Moreover, if two companies have the same free cash flow, it doesn’t mean that they have a similar future prospect. Few industries have a higher capital expenditure compared to other industries. Further, if the Capex is high, you need to investigate whether the reason for the high capital expenditure is due to expenses in growth or expenditure. In order to learn these, you have to read the quarterly/annual reports of the companies carefully.
A consistently declining or negative free cash flow of a can be a warning sign for the investors. Negative free cash flow is dangerous because it may lead to slow down in the business. Further, if the company didn’t improve its free cash flow, it might face insufficient liquidity to stay in the business.
Quick Note: If you want to learn free cash flow and discounted cash flow (DCF) model in depth, feel free to check out this online course: HOW TO PICK WINNING STOCKS? Enroll now and learn stock valuation techniques today.
5. Conclusion
In this post, we discussed the Free cash flow (FCF). It is a measure of a company’s financial performance. Free cash flow represents how much cash a company has left from its operations i.e. the cash that could be used to pursue opportunities that improve shareholder value.
However, the absolute value of the free cash value doesn’t tell you the whole story. You have to find out where this cash is coming from and how the company is using it. Whether they are spending this money effectively on operations like giving healthy dividends, buybacks, acquisitions etc- or not. And finally, a consistent negative free cash flow of a company might be a warning sign for the investors.
That’s all for this post. I hope it was useful to you. If you’ve got any doubts related to finding the free cash flow of a company, comment below. I’ll be happy to help. Happy Investing!!
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
Introduction to Dupont Analysis: As investors in the stock markets, it is important to find high-quality along with fairly valued companies to invest our capital. The rationale behind this is simple. Our aim in the markets is to always preserve our capital first and then produce profits.
There are several robust tools that investors use during their stock analysis. In this post, we will make an attempt to share one such powerful framework to assess the quality of stocks that we target for our portfolio -The Dupont Analysis. Here, you’ll learn how to incorporate the Dupont analysis in your study while researching stocks.
The post should be an easy read and we hope our readers find this to be of great value to their time. Feel free to reach out to us or post comments in case of any doubts or clarifications.
1. What is DuPont Analysis? Who made it?
DuPont analysis was created around the 1920s by Donaldson Brown of Dupont Corporation. Initially, when Brown invented the framework it was used for assessing the managerial efficiency of the company before it got adopted by public market investors. His genius was breaking down the formula for Return on Equity (ROE) into its constituent parts to analyze the root cause of ROE.
2. The technical background of the DuPont Analysis
Breaking ROE into its constituents helps us investors analyze the company’s business model and how it manages to achieve excess returns for its shareholders.
Since most investors (including Warren Buffett) use ROE to judge the quality of a stock it would be of great use to us to understand how deep “Quality” actually runs within the business.
To understand how the analysis technique is used let’s start with the very basics. As most of us already know, Return on Equity (ROE) is calculated from the following formula –
Now, our friend Brown brown multiplied and divided the expression to get the following–
This expression is now also summarised as below-
But Brown did not stop there, he took this expression and went one step further. This time he multiplied and divided the expression with Total Assets to give us the DuPont formula-
Which is again summarised as,
From the last expression, it becomes clear that ROE is not merely a ratio (as per the formula we started with) but a framework to understand the business and capital position of the company as a whole.
Valuable insights can be derived from knowing which of the attributes drives the rise or deterioration of ROE over a period of time. It can also be used to compare companies with their peer sets to get a deeper understanding of the differences in the business models between the companies.
Let us perform the DuPont analysis on Eicher motors for the period 2014-2018. The summary table and the evolution of the three attributes from the analysis is as given below.
Financial Ratio
2014
2015
2016
2017
2018
Net Effect
ROE
19.2
24.5
31.3
31.2
27.9
Increased
Net Profit Margin
5.8
7
21.9
23.7
21.9
Increased
Asset Turnover
203.3
222.4
105.5
100.3
94.1
Decreased
Leverage Ratio
162.9
156.2
135.2
131.1
135.5
Decreased
From the table, we can see that the company has improved its ROE from 19.2% to 27.9% in 5 reporting periods.
We can also see that the company decreased its leverage and asset turnover but this drop was offset by close to 3.7 times rise in the net profit margins.
Further, notice that the leverage ratio has been stable since 2016 while asset turnover has seen a drop in 2015-2016 and then moderate decreases from 2016-2018.
This analysis can now set the foundation for further analysis, the questions raised from the above figures could be as below ( this may not be very exhaustive but may give an idea as to how the framework is used)-
What is causing the decrease in asset turnovers? Is it because of rising inventory? A fall in efficiency? Or perhaps a decrease in capacity utilisations at manufacturing facilities?
Is the Net Profit Margins led by rise in prices or decrease in costs of goods sold?
What caused the spike in net profits and the corresponding drop in asset turnover?
Answering the above questions in additions to questions generated by assessing the financial statements could help the investors analyze Eicher Motors in greater depth.
Since ROE is used as a measure of the quality of management by many investors, the incorporation of DuPont Analysis could help quell any illusions developed by using ROE at face value.
According to DuPont formula, ROE is a function of net profit margins, asset turnover, and the leverage ratios. A rise or dip in ROE could be because of a corresponding rise/fall in any of these metrics and hence a high ROE doesn’t always indicate better performance.
Our readers are advised to use DuPont Analysis along with the other stock evaluation frameworks and not to solely depend on data provided by the financial websites. In addition, you can read further about DuPont analysis here.
That’s all for this post. I hope it was helpful to you. Happy Investing!!
Dilution of a company’s shares is a common scenario in the equity market. However, there is multiple effects on the valuation of the company in terms of market value and EPS (earning per share) calculation after dilution. In this post, we are going to discuss how dilution affects the company’s valuation.
This is going to be a technical yet interesting post and we would advise our readers to read this carefully. Feel free to reach out to us or post comments in case of any doubts or clarifications.
1. What is dilution?
Simply define dilution is the term used to describe the reduction in ownership or voting rights in a company.
Let’s understand this through the following example.
Assume a Company A’s equity is divided into 100 shares and we own 10 shares in the company, i.e we own 10% equity in the company. Now, let us assume that the company decided to fund its expansion plans by issuing new shares in the stock market (follow-on offerings). So, on the day of issue, the company issued 100 new shares in the market and a foreign firm with interests in the Indian market acquired all of the new shares issued.
Now, the company’s new equity is broken up into 200 shares out of which the foreign investor owns 100 shares (50% of equity) while we own 10 shares (5% of equity).
In the example, the follow-on offering is said to be dilutive for the company’s shareholders since their effective ownership has decreased in the firm.
Dilution can happen due to various some of the reasons are given below (may not be an exhaustive list)
Follow-on offerings in capital markets
Conversion of options and warrants by the holders
Conversion of convertible bonds into equity
Offerings of new shares to partners during acquisition or Joint-Ventures
3. How to identify companies where dilution is likely?
In most cases dilution happens when the company has desperate needs for infusing capital into its operations. Since modern financial ecosystem provides multiples routes and opportunities to achieve this aim, the most common strategies used by companies are to raise capital through debt offerings or through the issuance of new shares in the secondary public markets.
In case the company raises money through debt, this route need not always result in dilution of equity holdings for the investors. Dilution through debt happens only in case the company pledges to give its equity as collateral for a certain amount of debt.
4. How to calculate the shares outstanding after dilution for calculating market cap?
The shares outstanding after dilution would simply be as per the following equation,
Total dil. shares outstanding = common shares +newly issued shares
where, the newly issued shares could primarily come from (but not limited to) conversion of convertible preferred shares, conversion of convertible debt and also from shares issuable from stock options
This is shown by the following expression,
Newly issued shares = shares from conversion of conv. preferred shares + convertible debt + issue of stock options
The calculation of the new shares from convertible preferred shares and convertible debt are pretty straightforward since most of the time these shares and debt are issued at a fixed conversion rate.
For example, Assume a Company ABC has issued 1000 preferred shares and 50,000 convertible bonds amounting ₹50 Lakh in debt. Also, the company on the date of issue stated that each of the 10 shares of preferred shares could be converted for 1 common share and 5,000 of the bonds could be converted for 100 common shares.
The newly issued shares post-dilution would be the sum of 100 (from preferred shares) and 1,000 (from convertible bonds) which is equal to 1,100 new shares.
(The shares issued from stock options is slightly complicated and is usually calculated using the treasury stock method. We shall review this method in another post.)
5. How dilution affects the company’s valuation?
Dilution affects the company’s valuation of terms of its different calculations. Here’s how dilution impacts the company’s market value and eps calculation-
— Market Value
Due to the rise in the total number of shares outstanding after the dilution, Market Value may change significantly after dilution, depending on the extent of the dilutive effect of the newly issued shares.
The formula for calculating Market Value remains the same, except that we will now use.
Total Diluted Shares Outstanding instead of Total Common Shares Outstanding.
Market Value = Price per share Total Diluted Shares Outstanding
— Earnings per share
The impact on earnings per share due to dilution is may become quite profound depending on the extent of dilution and is very important since EPS is very commonly used by investors in the final calculation of the intrinsic value of a stock.
Since companies normally get a tax benefit for interest paid on debt, after dilution this benefit is no longer applicable and we may see our net income being boosted by the after-tax amount of debt.
Another change that happens is due to dilution of the convertible preferred shares, in case the preferred shareholders were paid the dividend out of the net income of the company earlier, they need be paid anymore after dilution since they have the same status and rank as the common equity holders in the company. The change in the formula due to the dilution is illustrated by the following expressions,
The basic EPS of a company is given by the following formula,
The diluted EPS of a company is using from the below formula,
In this post. we understood the impact of dilution on the valuation with the help of equity dilution example. Today, we learned that dilution can have a significant impact on the Market Value and EPS calculations of a company and may distort the true value if it is not incorporated during the analysis of a company.
Since dilution mostly comes at the expense of the common investor, we advise that our readers scrutinize the annual report to find whether dilution is good or bad for them. A careful look at the financial statements is required to make the necessary changes during dilution analysis. Afterall, a decrease in the existing shareholder’s ownership in a company also means a decreased profits.
That’s all for this post. I hope this is helpful to the readers. Happy Investing.
Evaluating the intangible assets of a company is a crucial part of the fundamental analysis, especially in a generation with a lot of leading companies in the technology and service-based industries.
However, most investors ignore this part and focus more on the physical assets like land, building, equipment, etc. One of the major reasons why people skip the part of studying intangible assets is because these assets are a little difficult to evaluate. After all, how would you correctly measure the value of a brand or non-physical assets of a company?
In this post, I’ll try to demystify intangible assets in simple words so that you can understand what exactly are intangible assets, why are they valuable for a company and how can you evaluate the intangible assets of a company.
Overall, it’s going to be an exciting post. Therefore, please read it till the end because I’m sure it will be helpful to you in assessing companies better.
What are intangible assets?
Intangible assets are those assets that are not physical in nature, yet are valuable because they contribute to the potential revenue of the company.
A few of the common examples of intangible assets are brand recognition, licenses, customer lists, and intellectual property, such as patents, franchises, trademarks, copyrights, etc.
Quick Note: Contrary to these, TANGIBLE Assets are those assets that have a physical form. For example- land, buildings, machinery, equipment, inventory, etc. Further, financial assets such as stocks, bonds, etc. are also considered tangible assets.
Although intangible assets do not have an obvious physical value such as land or equipment, however, they can be equally valuable for a company for its long-term success or failure.
For example, companies like Apple or Coca-Cola are highly successful because of the significant brand equity. Since it is not a physical asset and tricky to calculate the exact value, still brand equity is one of the primary reasons for the high sales of these companies. In India, companies like Hindustan Unilever, Colgate, Patanjali, etc also enjoy the benefits of enormous brand value.
Further, a few more examples of intangible assets can be marketing-based (ex- Internet domain names, non-competition agreements etc), artistic-based (ex- literary works, musical works, pictures etc), Contract-based (ex- franchise agreements, broadcast rights, use rights etc) and technology-based (example- computer software, trade secrets like secret formulas and recipes etc). [Credits: Examples of intangile assets- Accounting tools]
Moreover, in a few industries, intangible assets are more valuable:
Unlike manufacturing companies where inventories and fixed assets contribute to the majority of their total assets, in a few industries the intangible assets are more valuable:
Consumer product companies depend on the brand name. For example- Hindustan Unilever, Godrej, Colgate, etc. The bigger the brand name, the easier are the sales.
Technology companies get the most success by their technical know-how and skilled human resource. Ex- Infosys, TCS, etc.
Banking companies have their computer software license, stock exchange cards and electronic trading platform (websites). Ex- HDFC bank.
Telecom industries use their bandwidth licenses (including spectrum) to enjoy benefits. Example- Bharti Airtel
Drugs and pharmacy companies protect their sales through patents, which means that they can sell unlimited medicines of patented drug and their competitors can’t enter or replicate the same. Ex- Dr. Reddy’s Laboratory, Glenmark Pharma, etc.
And that’s why the leading companies in these industries spend a lot of money in building these intangible assets.
For example, in the IT industry, training and recruiting are more prominent than investing in physical assets like buildings.
Similarly, pharmaceutical companies spend a lot of capital in the Research and development (R&D) which may help them get a patent on a revolutionary drug. And that’s why, while evaluating companies in this industry, the capital expenditure of the different companies/competitors in their R&D work should be carefully evaluated.
If you look into the consumer product companies, they spend a lot of money in advertisement just for brand awareness. Although, this may not lead to instant sales and may add overhead expenses, However, over the long term. branding help these companies to generate more profit.
Valuing Intangible Assets
The intangible assets of a company can be found on the asset side of the balance sheet of a company. For example- here is the intangible assets for Hindustan Unilever (HUL)
You can use the intangible to total asset ratio to evaluate the worth of intangible assets in a company. For example- in the case of Hindustan Unilever, its intangible assets make around 2.05% percent of its total assets.
However, valuing intangible assets are easier said than done. One of the biggest reasons equipment high sales of HUL in India is its prominent brand recognition. A few of the popular brands of HUL are Lux, Lifebuoy, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk, Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality the and Pureit.
Here, do you really think that the brand value of HUL contributes only around 2% of its net assets? I don’t think so. It must be worth more. However, there’s no easy way to correctly evaluate the worth of the brand recognition and other non-physical assets.
Quick fact: According to Forbes, COCA COLA’s brand value amounted to 57.3 billion U.S. dollars. It is the only company in the top seven list that sells carbonated sugar water beverages. Rest all are technology companies with Apple and Google as leaders. This is the power of branding. Read more here: The world’s most valuable brands.
Although intangible assets do not have a physical presence, they add huge value to the company. There may be even cases where the intangible assets are of far greater value than the market value of the company’s tangible assets.
However, while valuing such companies, you may have to put some efforts to study these assets as the accounting conventions do not always value the exact worth of a few intangible assets and they may be reported below their true value in the balance sheet.
Anyhow, look for the intangible assets that are definite (i.e. stays with the company for as long as it continues operations) and difficult to replicate.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
While investing in a company, one of the most critical factors to look at is its growth rate. At what percentage the company is estimated to grow in the upcoming years? This is because, as the company grows & generate more profits, generally, your investment will grow along with it. Moreover, it’s not a viable strategy to invest in declining companies or the ones with no significant growth aspects.
But how to calculate the growth rate of a company?
A common approach that most investors follow is to look into the historical growth rate. Here, they try to find out the rate at which revenue, earnings, etc are historically growing, to assume a similar growth rate in the future.
Although past performance doesn’t guarantee future growth, however, it can give you a rough estimation if you expect the company to perform similarly in the future. Here, investors can use the compounded annual growth rate approach to define growth.
However, forecasting growth based on such estimations may not always be valid. Besides, the estimates can change depending on the ‘number of years’ that you’re considering. For example, past 3-years, 5-years, and 10-years historical growth rate might be totally different. Which one should the investors focus on while forecasting the future?
A better approach while studying growth is to look into the sustainable growth rate (SGR) of a company that focuses on different factors like earnings, shareholder’s equity, payout, etc to find out the growth percentage of a company. But what exactly is a sustainable growth rate? This is what we are going to discuss in this post.
Sustainable Growth Rate (SGR)
The sustainable growth rate is the maximum growth rate that a company can sustain using its own resources i.e. without financing the growth using debt or equity dilution. It is calculated as:
Return on Equity(ROE): ROE is the amount of net income returned as a percentage of shareholders’ equity. It can be calculated as: ROE= (Net income/ average stockholder equity). ROE shows how good is the company in rewarding its shareholders. A higher ROE means that the company generates a higher profit from the money that the shareholders have invested.
Retention Rate (RR): This is the percentage of net income that is retained to grow the business, rather than being paid out as dividends. Retention rate is calculated as: RR= (1 — Payout ratio) = ( 1 — DPS/EPS), where DPS is the dividend per share and EPS is earnings per share.
For example, if a company ABC has a ROE of 15% and payout ratio of 40%, then its sustainable growth growth rate can be calculated as: SGR = 15 * ( 1–0.4) = 15 * 0.6 = 9%.
Ideally, the growth of a company funded by its own resources is the best form of growth compared to any other leveraged growth options. The later scenario may lead to financial stress and in the worst case, bankruptcy.
Moreover, any company can grow faster if it takes a lot of debt and spends on marketing, new product development, acquisitions, etc. However, returning that debt can be a troublesome process if it’s business model is not that strong.
By looking into the SGR of a company, Investors can find out its long-term growth, current life cycle stage, cash flow projections, borrowing & dividend allocation strategies, etc.
Maximum SGR:
According to the sustainable growth rate formula, SGR = ROE * RR = ROE* (1 – Payout Ratio)
Here, when the payout ratio is zero, the SGR becomes equal to the ROE of the company. You can maximize the sustainable growth rate by increasing ROE or decreasing payout (i.e. retaining more earnings rather than paying out as dividends).
Technically, a few ways to maximize SGR is by increasing sales & profit margin, managing account payable & receivables, efficient inventory management, etc. However, a point to note here is that a high SGR is always difficult to maintain. As the company matures, it cannot sustain similar high past growth rates.
Closing Thoughts:
An efficient management’s goal is to grow the company at its sustainable growth rate. If the SGR is 15%, the company can safely grow at this percentage per annum without taking any additional financial leverage. It can be considered the ceiling growth rate of a company while using its own resources.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
Financial statements are one of the widely relied upon tool to analyze a business. However, there are many ways in which companies cook their books and create a false impression of the company’s financial health using accounting gimmicks and financial shenanigans. In this post, we are going to look at how companies cook books and how you can identify such financial shenanigans using accounting red flags.
If you look into the past, you will find that cooking books is not a recent phenomenon, but has existed for a long time. We all know one or the other company which has resorted to accounting gimmicks to dupe investors into believing that the company is doing well. Each market has its own share of such “gutsy” companies which, instead of genuinely improving the business, resorts to cooking books to show improved performance.
Why Companies Cook Books?
The question is, why do companies need to cook books? Why does the management resort to such gimmicks instead of being honest with their investors? Well, cooking books is not just about looking great on paper, some of the common reasons why companies do so are explained below:
1. To meet or exceed market expectations:
Let’s honestly admit one thing, the world is a fiercely competitive place and everyone wants to be on the top of their game. Miss the mark by a few points, and the company’s stock price gets hammered badly by the market.
With ever intensifying competition and “Go big or go home” thinking, the management of every company is pressed to either beat or at least meet the growth expected by the market.
With such mounting pressure to perform, companies that fail to deliver as per expectations, often get involved in cooking books and create a false image of healthy growth.
2. Vested Interests of the Management:
The second reason why companies cook books is because the management has its own vested interest behind it. Nowadays, many companies offer share price linked incentives to their managers.
Such schemes are offered to align the interests of the shareholders to that of management so that both can benefit from the good performance of the business.
Incentives linked to the share price motivates the managers of the company to work harder and deliver a good performance.
When the times are tough, and business struggles to perform, top managers, driven by greed of incentives and fear of being penalized for poor performance start window dressing the accounts to paint a rosy picture of company’s performance.
3. To show a consistent growth rate by under-reporting current spurt of growth:
This is something that does not happen pretty often, but there are times when companies do under-report their financial performance. Why? Let me explain.
Investors love companies with strong consistent performance and growth, and company managers know this very well. There are some companies that have a seasonal business, where they perform well when times are favorable and do poorly otherwise.
Such companies during good times minimize the current earnings by under-reporting the revenues or by inflating current period expenses by postponing good financial information for the future period when the company is more likely to underperform.
This again creates an illusion for investors that the company has performed well compared to its peers even during tough times.
As a result, such companies command higher valuations which they do not actually deserve.
How Companies cook books?
Management of the companies may have different reasons behind cooking books, but the way it is achieved has hardly ever changed.
The only way management of the companies can manipulate books is by concealing information, in other words, by hiding it in places where it is difficult to detect easily.
So how do companies cook books? Well, as I said earlier, it’s all about hiding crucial information about the company within the financial statements so that they are not easily traceable.
There are only three ways a company can manipulate earnings, by manipulating earnings, profit, and cash flow.
1. Earnings Manipulation:
Earnings manipulation occurs when companies try to inflate (or in some cases, hide) their earnings such as revenue. There are two ways companies manipulate their earnings.
— Recording Revenue prematurely: Booking revenues in advance is one of the most commonly used financial shenanigan by the companies. It includes booking revenues even before the goods are sold or a project is completed.
An example of such premature recording of revenue was seen in Sobha Developers in 2008-09. In Q1 of 2008-09, Sobha Developers decided to recognize the revenue earlier during a project cycle. This led to a 20% jump in the company’s profits before tax.
— Recording income from investment as revenue: The second most common way to manipulating earnings is by recording revenue from other sources as operating revenue.
If proceeds from the sale of an asset (such as land, building, plant, and machinery) or income from an investment (such as maturity of a bond or proceeds from the sale of shares) is recorded as revenue, it will boost the total revenue of the company.
Since these are a one-time phenomenon, and cannot be repeated in the future, recording such one-time sources of revenue gives a false impression of improved financial performance.
2. Profit Manipulation:
Profit is considered to be the blood of a business, something which is necessary for the survival and prosperity of a business. Just like revenue, even profits can be manipulated in many ways.
From hiding expenses to making a simple change in the way in which depreciation is calculated, there are numerous ways a company can manipulate its profits numbers. Some of the most common ways companies cook books in terms of profit are as follows:
— Making expenses look like earnings: A simple change in accounting policy can have a significant impact on the way profits are presented. Many companies use this approach to manipulate Net Profits.
For example, a simple change in the way depreciation is calculated can change the entire picture, helping company management boost profits.
For Example, a small change in depreciation policy in case of Jet Airways created profits out of thin air. In the Q2 of 2008-09, Jet airways changed its depreciation policy from written down value method to straight-line value method, as a result of which, Jet Airways was able to write back ₹920 crores to its Profit and Loss account.
— Hiding Expenses as Capital Expenditure: Another way to boost profits is by treating expenses as capital expenditure; that is instead of treating it as expenses during the current financial year, it is treated as investment made to expand the business.
One such incident can be found in the USA, wherein the years 1990, AOL was found guilty of delaying expense.
AOL was distributing installation CDs as a part of its marketing campaign, but instead of treating it as an advertising expense, AOL decided to view it as capital expenditure. As a result of this, the entire amount was transferred from profit and loss statement to balance sheet of the company where the campaign would be expended over a period of years.
Because of AOL’s treatment of expenses as Capital Expenditure, the entire amount was written off the P&L Statement, which resulted in boosted profits.
3. Cash Flow Manipulation:
Cash flow is considered to be the most reliable source of the true financial health of the company for the simple reason that cash is difficult to manipulate. Investors like Warren Buffett rely heavily on numbers like free cash flow to assess the financial health of the business.
Since companies know this well, they have devised new ways where it is possible to manipulate the cash flow of a company using accounting gimmicks.
Detecting such tricks can be quiet challenging for an amateur investor who does not have a deep understanding of accounting and finance or does not have free time to go through the books of the company.
Some of the most common cash flow related financial shenanigans are explained below:
— Showing financing cash flow as operating cash flow: There are two ways a company can generate cash for itself, first, from its own business, where profits earned by the business get converted to cash, and second by borrowing cash from an external source in the form of loan by issuing bonds or bank loan.
The cash received from business operations is called Cash Flow from Operating Activity, and cash received from an external source is treated as cash flow from financing activity.
Many companies try to boost their operating cash flow by treating financing cash flows as operating one, which leads to a wrongful impression that the company is generating a lot of operating cash flow from its business.
— Using acquisitions as a boost to operating cash flow:
Cash flows can also be manipulated using mergers and acquisitions, especially if the target company is rich in cash.
Management often tries to win support from its shareholders by convincing the shareholders that a particular acquisition will be highly beneficial for the company.
As soon as the merger takes place, all the cash that belonged to the target company, now becomes a part of the parent company, thus boosting overall cash flow statements.
Investors must always be wary of the financial history of the target company and its business and find out if the merger is really going to benefit the business.
If an acquisition is happening just because it will boost the EPS or the cash flows of the parent company, with no meaningful benefit to the business, then such acquisitions must be avoided at all costs.
Cooking books is not limited to manipulating earnings or hiding crucial details about the weak performance of the company, management of companies go beyond the books and create their own parameters of measuring the growth and performance of a company.
Such parameters, though necessary in certain industries, are still non-standard as per the accounting standards. Because of such creative parameters, managements get an opportunity to change their definition of performance as per their requirements, allowing them to use creative methods to put encouraging but false performance numbers in front of investors.
Some of the examples of such no-standard parameters are explained below:
— Same Store Sales (Used In Retail Stores and Restaurants):
Same store sales is a parameter to measure the performance of retail stores. It gives information about how much sales revenue a store is generating during a fiscal year or more.
Same store sales also give investors an idea of how much revenue a company is generating from its existing stores and how much is contributed by new stores. If the percentage of sales revenue from new store sales is rising, it’s strong evidence that new stores are performing well, sounds rational, right?
This is where companies get a chance to manipulate with numbers without getting noticed. The management of the company may alter the criteria of eligible stores to be used in the metric.
For example, in one financial year, a company may use only those stores older than 3 years to show the same store sales performance while in the next year, if the performance of the stores older than 3 years deteriorates, the management may change the criteria and use only those stores that are older than 5 years.
Companies may keep changing their eligibility criteria as per their suitability to present the desired picture.
— ARPU (Average Revenue Per User):
ARPU stands for Average Revenue Per User and is a performance metric generally used by Telecom companies or DTH service providers. Just like same store sales, ARPU can also be used for manipulating earnings of a company.
Most telecom companies, especially in this age of smartphones, not only generate revenue from selling data, but also by selling ad space, and this is where the manipulation begins.
The right way to calculate ARPU is by calculating total revenue generated from data services provided divided by the total number of subscribers.
However, some companies, to show encouraging revenue growth add advertising revenue to the revenue from subscription, thereby falsely boosting the total ARPU.
How to detect if a company is cooking books?
So far we have seen why and how companies cook books, but the biggest question is, is it possible to detect these financial shenanigans? How would you know that a company is cooking books?
While detecting some of these financial shenanigans requires a degree in finance, most of them can be traced pretty easily if you just observe carefully.
— Improved Revenue with an absence of Cash Flow:
If the complicated accounting terms are giving you nightmares, and you have no clue what to do, here is something very simple and logical thing you can do. Just Watch out for cash flow.
Increase in revenue of the company should be reflected with an increase in cash flow of the company. If you see operating cash flow declining or stagnant even if the revenue is marching upwards, or if cash flow is much slower than the revenue generated, it usually means that the company is generating revenue but is unable to collect cash, or even worse, the revenue numbers are simply fake and bogus.
— If Q1+Q2+Q3+Q4 is not equal to FY:
In an ideal situation, if the financial results are audited, the annual sales and profits should simply be a sum of all the four quarterly sales and profit numbers, except for minor variations.
If there is a significant variation between annual sales and profit numbers and sum of all quarterly numbers, you can say that the books have been manipulated at least to some extent.
— If a company is on an acquisition spree:
Companies make acquisitions as it helps the acquirers grow inorganically while making an acquisition, companies make sure that the interests of both the companies are aligned and that the resources that an acquiring company needs are available with the company that is being acquired, at a bargain price.
In simple words, any acquisition should add value to the company more than what is being paid for it. There are many instances when companies are on an acquisition spree. Firms that make numerous acquisitions can get into trouble, their financials get restated and complicated to understand.
Aside from complicating things, acquisitions usually increase the risk of cooking books and bury the evidence under many layers of financial statements. So if a company is a serial acquirer, but does not show significant improvement in its financial performance, there is a good chance that the acquisitions were made simply to manipulate the numbers.
— If the company has bulging Trade Payables:
Many companies, especially in a competitive, customer-centric market loosen their credit terms, attracting more customers to buy goods and services now and pay later. While this is a great move that helps boost sales revenue, it may create a liquidity crisis in a company.
Longer credit duration means that company has to wait longer for the revenue to be converted into cash, but since a company has to meet its daily expenses in cash form, longer credit means company may run out of cash and may have to either borrow to meet its operational expenses or shut down its operations completely.
The best way to cross-check if the company’s revenue is simply because of loose credit terms is to check if there is a change in days receivables in the past few financial years.
If a company has increased the receivable days, it shows that all the revenue is just on paper and the cash is yet to be realized. Such practice is pretty common in infrastructure companies.
— If the CFO and auditors resign or get fired:
This is by far one of the most vital signs that a company is cooking books. There is an old saying in Latin “Who Watches the Watchmen?” when it comes to financial reporting, the watchmen are the Chief Financial Officer (CFO), and the corporate auditor.
If you find a company that is involved in some of the suspicious accounting activities as mentioned above, and you see the CFO of the company quitting abruptly for no valid or logical reasons, its time to stand guard and find out if there is something going on within the company that has not met your eyes yet.
The same rule applies to corporate auditors. IF a company frequently changes its auditors or fires them after some accounting issues come to light, be watchful and look for warning signs.
There have been many recent examples of auditors resigning after altercation from the company owners, which later revealed that company was involved in dressing up numbers to make things look good on the surface while it was really bad inside.
In the month of May 2018, Deloitte, corporate auditor of Manpasand beverages quit a few days before the declaration of annual result as the company was unable to share crucial data regarding capital expenditure and revenue. As a result, the stock price of Manpasand beverages tanked 20% within a day. You can read the news by clicking here
Another such incident happened recently where PWC (Price Waterhouse Coopers LLP) statutory auditor of Reliance Capital and Reliance Home Finance, quit just before the declaration of FY19 results.
In its resignation letter, PWC stated that as part of the ongoing audit for FY19, it noted certain observations and transactions, which, in its assessment, if not resolved satisfactorily, might be significant or material to the financial statements. You can read the new by clicking here
Conclusion:
If you are looking for a great investment, look for great businesses. The best way to understand if a business id great or not is by analyzing the financial statements of the company.
Since every investor relies on financial statements for his analysis, it’s important that companies remain honest and transparent and give only authentic information.
However, with the ever-mounting competition, and a race to perform better than peers puts a lot of pressure on the management to perform, because of which they often resort to unethical ways to manipulate the number so that the business “appears” healthy.
There is an Old Russian Proverb which means “Trust, but Verify”, taking things at face value can be dangerous and thus it is important that investors, even if they trust the management with the numbers, should always be vigilant and keep checking the authenticity before making an investment decision, after all, it’s your hard-earned money at risk, don’t take anyone else’s word for it.
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About the Author:
This article is a guest post by Ankit Shrivastava, a SEBI Registered Research Analyst. Ankit has been investing in stocks since 2004 and writes about fundamental analysis of companies, principles of investing, investment strategies and a lot more on his blog: Infimoney
Trade brains is a financial education blog focused to teach stock market investing and personal finance to the DIY (do-it-yourself) investors in order to make, grow & sometimes even spend money. #HappyInvesting
What is the ‘Intrinsic Value’ of a Stock? What are its components? How do they affect the way the company’s Stock is likely to behave? We will attempt to answer these seemingly daunting questions in simple terms and with relevant, real-world examples.
Intrinsic Value – What is it Anyway?
I personally rely exclusively on Discounted Cash Flow / Dividend Discounting sort of models to estimate the intrinsic value of stocks. The world’s foremost authority on Discounted Cash Flows, is in my opinion, none other than Mr. Warren Buffett, the billionaire investor and the Chairman of the half-a-trillion-dollar entity that is Berkshire Hathaway. He’s as good a teacher as he is an investor.
Sure enough, Mr. Buffett has talked about ‘Intrinsic Value’ in a number of places. In one of those interviews, he put in candidly:
“To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years. Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time.”
— Warren Buffett.
Think about what he’s trying to say. In a Government Bond, you have pre-determined cash flows (Coupon Payments and Principal Repayment), a time period in which the cash flows will be credited to your bank account (Maturity) and a Risk-free Rate, which allows you to account for the Time Value of Money.
Now consider a Stock. How is it different from a Government Bond? You still have Cash Flows (Dividends and/or Free Cash Flow to Equity), but they’re not pre-determined. Businesses do not produce results in a straight line. You do have a time period, but it’s generally very long. In other words, this will be the entire Business Life Cycle of a company.
You also have a Discounting Rate, which is usually the Risk-free Rate + a Risk Premium you charge to account for the fluctuation in the results (Fluctuation which does not exist in a Government Bond). That’s it. These are the differences. So, if you are in agreement that a Bond should be valued at the Present Value of all its Coupons and Face Value, you should have no qualms in accepting that a Stock should be valued in a similar fashion too — except, it takes more time to value a Stock than it does a Government Bond.
Components of Intrinsic Value
I personally believe that the intrinsic value of a company (And consequently, its Stock) is composed of the following six components:
Without further ado, let’s take a look into each of them and why I think they matter when it comes to Value.
1. Explicit Drivers
Explicit Divers of Value are those factors which are readily considered by amateur investors while investing in a stock. In fact, most Analysts trying to sell their reports highlight the ‘Explicit Drivers’ the most, because they are easily understandable by the common man.
Management Teams also mostly flaunt their Explicit Drivers in order to boost their rapport with the shareholders. It’s made up of two sub-components: Growth and Margins.
Growth
The easiest of all the drivers. We know for a fact that as a company sells more of its products and services, the more it is known and the more revenue it produces. While thinking about how a company can grow, it has to be tied to reality.
For example, a while back I valued D-Mart, the famous Indian retail chain. In it, I had assumed that the company will grow its Revenues at the rate of 35% in the initial years, and dropping to 25% for the farther years. Here is how I attempted to ‘justify’ my assumptions.
I took the Invested Capital of D-Mart from 2009-2018 and used it to calculate Capital Required per Store, based on the CEO’s comment that D-Mart had been growing at a pace of 10 stores per year. I also calculated the Growth in the Cost of Acquisition per store for the period.
This allowed me to project the Capital Invested per store from 2019-2028. Then, working backwards with this information and my own assumptions of Invested Capital, I calculated that from 2019-2028, D-Mart will grow at an average of 19 stores per year. This coincides with the CEO’s vision of boosting D-Mart growth from 10-ish to 15-20-ish in the next decade or so. Hence, my set of assumptions for Sales Growth stood justified.
However, not all growth is good. Sustainable Growth Rate is the rate at which a company can grow its Revenue without resorting to raising additional capital, which is detrimental to Shareholders. Therefore while valuing a company, it is advisable to restrict oneself to the SGR, unless there’s a very good reason that the company’s products will suddenly become more desirable.
Margins
This refers to the Net Margins of a company. Prof. Sanjay Bakshi often quips that the best kind of value creation happens with a ‘Margin Expansion’ i.e. when a company is able to charge more from the customer for the same kind of products or services they have been selling for so long.
Warren Buffet also claims that the best measure of a Durable Competitive Advantage is to ask whether the company will be able to raise prices tomorrow without affecting sales. Of course, it is also not hard to imagine how a company can save more on its Margins by simply being cost-efficient.
Clearly, a steady or increasing Net Margins is a favorable feature in a company. As Prof. Bakshi was so apt to note, indeed Margins contribute a whole lot to Value creation. One only needs to look at some of the biggest Multi-baggers to realize this truth (Say, Symphony, Eicher Motors etc).
But this means that the opposite is also true. Take the case of Lupin, for instance. In the last five years, Lupin’s Sales has grown by 10.38%, but its Profits have decreased by 26% and change. This is because their Net Margins have fallen from 18% to 1% in the same period. In fact, Lupin has created very little value for someone who bought its stock 5 years back. It’s currently trading at almost the same level as it was half a decade back.
So while attempting to value a company, one has to ask the question “Will this company be able to charge more prices for the same kind of product/service in the future?” or “Will this company be able to spend less for producing the same kind of product/service in the future?” and depending on the answer (Based on research and groundwork), the Margin assumptions can be made.
2. Implicit Drivers
Implicit Drivers are those factors which are considered in line with the Explicit Drivers by good investors. They know for a fact that the Explicit Drivers are superficial if the Implicit Drivers are not up to the mark. Reinvestment and Risk are the two Implicit Drivers of a Stock’s Value.
Reinvestment
Remember earlier when I said ‘All growth is not good’? While a part of it has to do with the concept of the SGR, a bigger part of it lies with the concept of ‘Reinvestment’ or the amount of Assets a company has to reinvest to a certain level of growth.
Let me provide you with two investment opportunities. Company A, which may produce Rs. 100 in Profit, but has to reinvest Rs. 50 in order to end up with that profit. Company B, which may produce Rs. 10 in Profit, but has to reinvest Rs. 3 in order to end up with that profit. If you are a smart investor, you will choose Company B, because they are more productive, that is to say, they only require 30% of their profits to be ‘reinvested’, while Company A requires 50% of their profits.
The efficiency is Reinvestment is usually measured via the Return Ratios (Return on Capital Employed, Return on Invested Capital, Return on Equity).
Charlie Munger, Warren Buffet’s investing partner, loves companies with massive Returns on Invested Capital. It is almost guaranteed that for a stock to grow multi-fold, the company has to temporarily or permanently boost their productivity.
On the other hand, look at any company in a flailing industry (Say, Telecom) and you will realize that they haven’t created any value in the last decade because they found it more and more difficult to retain customers without investing in advertising or some sort of new technology.
Bharti Airtel has grown its Sales by 10% over the last decade, yet it has destroyed value for its shareholders over the same time (Imagine having to hold a stock for 10 years, only to end up with a loss). In fact, it took a massive disruption in Jio to make the entire industry re-think how they can invest better to create value.
Risk
Risk is very personal and it’s not quite easy to explain. In fact, I wrote an entire blog post attempting to explain the fact, but I am pretty sure I didn’t even scratch the surface with understanding Risk. Without getting into complex monsters such as the Capital Asset Pricing Model or the Fama-French Five-Factor Model, the most logical definition of ‘Risk’ is an opportunity foregone.
In Finance, ‘Risk’ is usually measured as an interest rate (Termed the ‘Discounting Rate’), because the Time Value of Money demands that we do. So when it comes to investing in stocks, one needs to ask “If I do not invest in this stock, what is my next best investing option and how much am I likely to earn from investing in that option over the long term?”
I personally use a Discounting Rate of 15% for most of my valuations, because that is the median long term returns on Mutual Funds investments in India (The actual figure is 14.88% if you are curious). So my ‘next best option’ to investing in any stock is investing in a Mutual Fund scheme.
This is where it gets ‘personal’. Some people may not consider investing in a Mutual Fund as their next best option. For a Hedge Fund specializing in Start-ups, 15% may be chump change, so they may demand anywhere between 50–60% on their investments.
At the same time, for a retired pensioner, even an 8% return from a Post Office scheme would look amazing. However, even a retired pensioner can invest in an index fund and earn close to 12–13% over the long term (In India). So it’s not wise for anyone to demand anything lesser than the long term index returns in their country (For instance, in the US, it is about 8–9%). But some academics consider the Risk-free Rate (Usually the 10-year local Government Bond yield) as the true Discounting Rate for any valuation.
3. Hidden Drivers
These are Value Drivers which can be ascertained only by master investors. They aren’t found in Management Commentary, Financial Statements or Analyst Reports. They require additional research to be uncovered.
Redundant Assets
These are mostly Real Estate or some sort of Patent/Right held by the company, which has been long since written off from the books. However, if they were actually sold in the market, they might fetch a fortune for the shareholders of the company.
In the Indian context, Wonderla would be a good example. The company is currently trading at about Rs. 1550 Crores, but the company has unused land parcels of around Rs. 1000 Crores. Of course, this doesn’t mean that the company automatically demands supreme valuation. It simply means that if an investor finds the company’s intrinsic value to be Rs. 600 Crores only, he can go ahead and purchase the stock, because the intrinsic value is actually Rs. 1600 Crores, thanks to the ‘Redundant Asset’ in unused land.
But finding this bare fact isn’t really useful all the time. Take the case of Binny Mills.
Binny Limited, the listed entity which holds Binny Mills, also holds several land parcels and real estate (Mills) in Chennai. But they hold these properties in North Chennai, which is crowded and used to be a trading hub decades back (When ‘street shopping’ was famous). Nobody wants these properties, because of them being located in an archaic trading community. If it was possible to sell these off, some rich investor would have bought out Binny Mills and sold it for parts. thereby netting himself a cool profit via a Special Dividend. The fact that this hasn’t happened tells us the follies of betting on companies simply because the company has a hidden “land bank”.
Competitive Advantage Period
I saved the best for the last. This relates to the most sought-after four-letter magic word in investing: Moat. Before giving my views on this, you should check out Michael Mauboussin’s paper on this topic. It’s bloody brilliant.
It is economic truth that if a specific kind of business is profitable, competitors will emerge to get their own piece of the pie. ‘CAP’ measures how long a company can fend off the competitors, while keeping most of the pie for themselves. This is often too difficult to measure or even see, because the beauty of a good moat is realized over very long time periods. Left unattended, some competitors will breach the moat and run off with a piece of the pie. Let unattended for a long time, the moat will dry up and the survival of the company itself will become a concern.
Once again in the Indian context, I think Eveready Industries would be a great example. Post its initial success as a battery-maker, Eveready’s profits started to dwindle from 2007–2012. But the company still had an amazing ‘Moat’—the brand name, which is known to almost every Indian who’s ever used battery-run appliances. Post 2012, the new management levered the brand name into several new divisions, especially the consumer electronics space, where their products have picked up with little to no investment, thanks to the company’s brand name. The profits in the last 5 years have ballooned at an amazing pace of 56% and more. One could argue that Eveready Industries’ CAP has been lengthened dramatically, which led to the sudden spike in their stock price.
I usually use a 10–20 year projection period, based on a company having no moat, having a thin moat or having a massive moat. The truth stands that very good moats can make companies have CAPs in excess of 20 years (Think Coca-Cola).
However, the Time Value of Money will make sure that profits earned 100 years from now aren’t as important as the ones earned, say, 15 years from now. I still adjust for this by demanding a lesser Margin of Safety for companies that have a proven operating model and a Moat.
In the end, this is just the theory behind why I do what I do when I Value a company. To put it lightly, Value is a marriage of numbers and stories. One cannot do without the other. Only when these ‘stories’ are grounded in reality using ‘numbers’, does the Valuation get complete?
I’m the quintessential geek and a strong INTP-A. Saying ‘I am passionate about investing’ would be an understatement. I have been investing my own and my family’s money in the Indian markets since 2016. I’m also a voracious reader and listener of topics ranging from cattle rearing to particle physics. When I am not busy investing or reading, I blog about Valuations and Markets at Valuation in Motion. I believe that finance is as simple as knowing where your last dime went. And I hope to show you how.
A prominent question many people have about investing in stocks is, “Does the purchase price matter?” or “Should I value a stock before purchasing it”?
A lot of financial theory argues that you shouldn’t. They say, markets are always efficient in pricing securities and you should rather worry about decreasing frictional costs like brokerage charges, transaction charges, churn costs and so on.
But Mr. Charlie Munger, the business partner of the world’s richest investor Mr. Warren Buffett, has a different answer:
“It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets.
So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. The stock market is the same way – except that the house handle is so much lower.
If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking. To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”
Let’s say that you are about to bet $100 on a Horse Race. A total of ten horses are participating in the race and you are given the following statistics:
You are told that 100 people have laid down their bets (Let’s call them the ‘Horse Market’) and the total pool of bets is $4,050. Indirectly, you can assess how these 100 people have determined the probability of winning, or ‘Odds’ of winning, for each of these horses. In fact, Horse #6 seems to be an overwhelming favorite, with $1,700 bet for the horse.
But before blindly betting on Horse #6, you need to understand the most important thing about Parimutuel Betting. If Horse #6 indeed wins, everyone who bet on Horse #6 will get $4,050 i.e. Everyone will make roughly 2 times of their bet amount (For convenience, let’s just say the remaining 0.38 times is participation fee). Is that good?
Hold your horses (Pun intended)!
If you bet on Horse #5 or Horse #9 instead, you can make 81 times the money, instead of the paltry 2 times. Well, well, now is this a better bet? Logically speaking, these horses have had a very little bet on them because they may be poor to begin with. The 100 gamblers already know this. That’s why only 1-2 of them have placed bets for these horses.
Wait, this is confusing. Which horse should I bet on now? Let’s recount the statement made by Mr. Charlie Munger:
“We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble.”
A mispriced gamble. That’s where the trick lies. To summarize Mr. Munger’s thought process:
You shouldn’t bet blindly on Horse #6, because you will only make only 2 times the money, the lowest reward of the lot. Even when Horse #6 can be deemed the healthiest horse with the most skilled jockey, the payout is simply too low.
You shouldn’t bet blindly on Horses #5 or #9, even though they have an astronomical payout of 81 times. It is more likely that Horses #5 or #9 could be sick/weak or their jockeys inexperienced.
The sweet spot, therefore, is in a bet where you think there’s mispricing i.e. A bet where the ‘Odds’ have been miscalculated by the Horse Market people. Take Horse #1 for instance. The Odds here are 8:1 i.e. The Horse Market people think there’s only a 12.50% (1/8) Probability of this horse winning. If you believe that these Odds are somehow way wrong i.e. If you believe that this horse actually has a 25% (1/4) Probability of winning, then you should consider betting on this one. Of course, you should repeat this exercise for all the horses and figure out which one has the most mispriced Odds and bet on that one.
Sounds simple enough? Horse Betting is decidedly more complex than this. However, it proves to be an interesting lesson in investing. This system of Parimutuel Betting, Mr. Munger argues, also applies to the Stock Market. I would personally visualize it like this:
To put it in a words, then:
You shouldn’t invest blindly in the well-known, excellent company. Although these type of companies have the lowest probability of making a Capital Loss (i.e. Chance of not achieving the Average Returns) over the long term, they also have a low, 15% returns over the long term. Put together, they have an Expected Returns of 12%, which is neither too high, nor too low.
You shouldn’t invest blindly in the unknown, terrible company. Although these type of companies can become potential ‘multi-baggers’ over the long term, clocking a CAGR of 23%, they also come with a high 50% risk of a potential Capital Loss. Put together, they have an Expected Returns of 11.50%, the lowest of the lot.
The sweet spot, therefore, could be in the lesser-known, mediocre companies. These type of companies offer a decent 18% CAGR over the long term and also come with a moderate, 30% Capital Loss probability. Put together, they have an Expected Returns of 12.60%, the highest of the lot.
Of course, this is just an example. There are thousands of Stocks listed around the world and there might very well be numerous permutations and combinations of this in action at any given time. Instead of the 100 people from our horse betting example, the Stock Market consists of millions of people. They are pricing the odds for a stock every moment a trade is executed. It is an investor’s job to figure out the most mispriced bet and pick it up.
Just remember. You don’t make the most money-per-risk-taken by betting on the most favorite gamble. And you don’t make the most money-per-risk-taken by betting on the least favorite gamble, either. You make the most money-per-risk-taken by betting on the gamble where the odds are highly mispriced.
That’s it for today! I’ve used the word ‘Intrinsic Value’ several times in this post, without really letting on much what it is supposed to be. Think about what it means. Let’s explore this more in ‘Equity Valuation 102’, the next post.
I’m the quintessential geek and a strong INTP-A. Saying ‘I am passionate about investing’ would be an understatement. I have been investing my own and my family’s money in the Indian markets since 2016. I’m also a voracious reader and listener of topics ranging from cattle rearing to particle physics. When I am not busy investing or reading, I blog about Valuations and Markets at Valuation in Motion. I believe that finance is as simple as knowing where your last dime went. And I hope to show you how.
In the past two decades, we have seen countless companies which turned from zero to over billion rupees in market value with very limited inventories. It’s true that companies in the information sector (which only require a laptop and internet connection) doesn’t need a lot of inventories. After all, if the sole purpose of a company is running their mobile app (Android/iOS) and offering services through them, then what physical inventories they actually need apart from hosting, customer support and a few other development tools.
On the other hand, if you look into manufacturing companies which offer goods to the people/organization, inventory analysis plays a crucial role. The inventories of those companies are their most valuable current assets as they contribute directly to the source of revenue.
In this post, we’ll discuss what is an inventory and how to evaluate inventory on balance sheet.
What is an inventory?
Integratory can be defined as the goods available for sale and raw materials used to produce those goods. In other words, these can be the raw materials, goods in process and the finished goods.
There are a number of advantages of keeping sufficient inventories for a company. For example, if the company has the necessary inventories, it can quickly meet the customer orders. Stock in hand improves customer experiences. Moreover, in a few sectors, high inventories may make an attractive display and increase conversions.
On the other hand, delays in fulfilling orders, empty shelves and products out of stocks might drive away customers to the competitors. And therefore, inventory control is a key area for the company’s management to focus.
Excess Inventory
In case the company has excess inventories, it may be a little troublesome for them.
Too much inventories involve a higher cost of storage, damage issues, and insurance costs. It may also lead to increased wastage of goods if the inventories are perishable or the threat of obsolescence in case the products changes fast.
Moreover, if the company is spending a lot of money on excessive inventories, it is fixing that money which they could have used in other potentially rewarding opportunities. And that’s why excessive inventories should be controlled by the company.
How to Evaluate Inventory on Balance Sheet?
The Inventory level of a company can be evaluated by using the inventory to current asset ratio. This ratio reflects how much percentage of the current asset is kept as inventory.
Inventory to current asset=Inventory/(Current assets) ∗100
Although the ideal inventory to current asset ratio varies industry-to-industry as a few industries may require more inventories in their shelves for timely operations compared to other. However, as a thumb rule, this ratio should be less than 40%.
Moreover, try avoiding to invest in companies with inventory to current asset ratio greater than 60% as this might reflect too much inventories and the management’s inefficiency in inventory control.
For example, here is the balance sheet of Hindustan Unilever (HUL). Let’s calculate its inventory to current assets ratio.
For Hindustan Unilever, if you calculate the inventory to current assets ratio, you can find it equal to 21.23% for the year ending March 2018.
In the last 5 years, this ratio has been continuously decreasing- 30.75 (2014), 28.54%(2015), 26.87%(2016), 24.86%(2017), which means that HUL is spending less on their inventories. As the inventory to current assets ratio is still under a satisfactory level, this can be considered healthy for the company.
However, to get a better idea, you need to compare the inventory to current assets ratio of HUL with its competitors in the consumer goods segment.
Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course on Introduction to Financial Statements & Ratio Analysis.
Summary
Although inventories are often ignored while evaluating companies in many industries, however, they are still one of the most crucial assets of a company. And that’s why inventory control is an important area to focus.
A low inventory level may lead to delays in completing orders, empty shelves and out of stocks which are not a good experience for the customers. On the flip side, excess inventory might lead to higher cost of storage, damage issues, insurance costs, spoilage costs or the threat of obsolescence. In order for a company to work effectively, its necessary to have sufficient (but not excess) inventories.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
When I worked as a Trainee at Tata Motors, I got to know about the term payload. In easy words, it is simply the load carried by a vehicle. The payload helps the owner to determine how much they can fit in their vehicle and moreover how many trips they have to take to carry a specific load.
During that time, once I was walking with my manager and we were discussing a light truck – Tata 407, which could carry 2.25 tonnes of payload. And we started talking about its payload. My manager told me that most of the commercial vehicles in India are almost always overloaded and easily crosses the prescribed payload. I asked him why do the Tata trucks perform so well then and why it doesn’t break? Obviously, if you overload the truck with twice its capacity, it should snap. And his answer was Margin of safety!!
Before developing any new vehicle, there’s a comprehensive study done on consumer behavior. And the R&D team of Tata knew this Indian behavior of overloading the truck in order to reduce the total number of trips to carry out the goods. And that’s why the load capacity of the Tata trucks are always more than what specified in the manual.
Moreover, here having a safety is a must for Tata trucks as they are known for their strength and the brand image matters a lot while selling vehicles in the automobile segment. They couldn’t afford to get their brand image ruined by not having a margin on their vehicle’s load capacity.
A similar concept of safety is used in the investing world to reduce the risk and maximize the profit. In fact, it is the central concept of value investing.
What is the Margin of Safety?
The margin of safety means purchasing the stock when the market price of the company is significantly below its intrinsic value. Here, the difference in the intrinsic value and your purchase price is called the Margin of Safety (MOS).
The fundamental analysts believe that there is a true (intrinsic) value for all the company which can be found by reading financials of the company. Moreover, they also believe that the stocks do not trade at their true intrinsic value at most of the time because of speculations and other short term market behavior. A stock can be overvalued or undervalued at any moment of time. And that’s why Investors can make good profits by purchasing stocks when they are trading at a discount i.e. below their true value.
The margin of safety helps to safeguard the investments against calculation error, human error, judgment errors or any other unexpected occurrences concerning the market or stocks.
The margin of safety plays a significant role while purchasing stocks.
For example, if you think a stock is valued at Rs 100 per share (fairly). Then, there is no harm in giving yourself some benefit of the doubt that you may be wrong with your judgment and calculation. And hence, you should buy that stocks at Rs 70 or Rs 80 instead of Rs 100. Here, the difference in the calculated intrinsic amount and your final purchase price is your margin of safety.
The ideal margin of safety depends on the risk tolerance of an investor. The strict value investors may have a MOS of over 50% to minimize the downside risk. On the other hand, aggressive investors may choose a comfortable MOS of 10–15%. As a rule of thumb, always have a margin of safety of between 10–30% on the intrinsic value of the stock while making your investment decisions.
Moreover, apart from the risk tolerance of the investor, this margin of safety percentage also depends on how risky the investment is. If you are investing in a safe blue chip stock, this margin of safety can be comparatively lower than the MOS on high-growth riskier small-cap stocks.
Methods to find Intrinsic value:
The concept of Margin of safety was poularized by the legendary investor, Benjamin Graham (also known as the father of value investing). He used his ‘Graham formula’ to find the true value of companies, and if the stock was trading way below the intrinsic value, only then he would purchase them. This concept of MOS was later inherited by Warren Buffett, a student of Ben Graham.
There are different tools to find the intrinsic value of a company. While many prefer using PE or Book value to find if the stock is undervalued, one of the most popular method to find the true value of a company is the discounted cash flow. DCF analysis is a method of valuing a company using the concepts of the time value of money. Here, all future cash flows of a company are estimated and discounted by using the cost of capital to find their present values. (Read more here: How to value stocks using DCF Analysis?)
A few other methods to find the intrinsic value of a company is the dividend discount model (DDM), EPS valuation, relative valuation etc.
Having a margin of safety in the investments helps the investors to minimize the downside risk. However, an important point to highlight here is that having a MOS does not guarantee that the investment will always be profitable. Finding the intrinsic value of the company correctly also plays a crucial role here. And therefore, you should spend a significant amount of time valuing the stocks suitably.
Nevertheless, a meaningful discount on the purchase price compared to the intrinsic value can limit your losses and maximize the profits on your investments.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
Share market is a place where one can sell you a one-liter packet of milk for Rs 1,000 and if you might be even happy to purchase that. It’s completely impossible to decide whether a stock is overvalued or undervalued just by looking at the market price of the company.
And that’s why valuation is a crucial factor while deciding whether to invest in a stock or not. You do not want to purchase a stock at ten times its valuation. After all, a good company may not be a good investment if you are overpaying for it. It’s always preferable to invest in stocks when they are trading below their true (intrinsic) value.
In the words of the legendary investor Warren Buffett, the intrinsic value of a company can be defined as —
“The intrinsic value of a company is the discounted value of the cash that can be taken out of a business during its remaining life.” — Warren Buffett
Nevertheless, evaluating the value of a company using this definition is easier said than done. After all, finding the intrinsic value of a stock requires forecasting the future cash flows of a company which needs a lot of calculated assumptions like growth rate, discount rate, terminal value etc.
Anyways, one of the most popular approaches to find the intrinsic value of a company is the discounted cash flow (DCF) analysis. In this post, we are going to discuss the step-by-step explanation of how to find the true value of a stock using the DCF method. Further, we’ll also perform the DCF analysis on a real-life company listed in the Indian stock market to find its true value.
Quick note: I’ll try to keep the explanation as simple as possible so that you can easily understand the fundamentals. Let’s get started.
Discounted cash flow valuation:
Before we start the actual calculations, let’s quickly discuss what exactly is discounted cash flow analysis.
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.
DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. (Source: Discounted Cash Flow (DCF)– Investopedia)
In other words, discounted cash flow analysis forecasts the future cash flow of a company and later discounts them back to their present value to find the true intrinsic value of the stock (at the time of calculation).
Further, I would also like to mention that valuing stocks using the DCF method requires a little knowledge of a few common financial terms like free cash flow, discount rate, growth rate, outstanding shares etc. Here is a quick walk through the key inputs required in the discounted cash flow analysis.
Key inputs of Discounted Cashflow Valuation:
1. Free cash flow (FCF): Free cash flow can be defined as the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings. Free cash flow of a company can be calculated by using the below formula:
FCF = Cash flow from operating activities — capital expenditures
2. Growth Rate: It is the expected rate at which the company may grow in the upcoming 5–10 years. It’s really important to use a realistic growth rate for efficient calculations. Else, the calculated intrinsic value might be misleading.
Different investors use different approaches to find the expected growth rate of a company. Few of the common ways are by looking at the historical growth rate for the earnings/profits, reading the analysts reports to find out what they are forecasting, peeking in the company’s annual report/latest news to find out what the management/CEO is saying regarding the company’s growth rate in upcoming years etc.
Quick Note: In the book- ‘The little book of valuation‘, the author Aswath Damodaran has used an interesting method to find the growth rate of a firm. He argues that for a firm to grow, it has to either manage its assets better (efficiency growth) or make new investments (new investment growth). He used the multiple of proportion invested and return on investment to arrive at the growth rate in earnings. If you haven’t read his book, it is a good place for the beginners to start learning valuation of stocks.
3. Discount rate: The discount rate is usually calculated by CAPM (Capital asset pricing model). However, you can also use the discount rate as the rate of return that they want to earn from the stock. For example, let’s say that you want an annual return rate of 12%, then you can use it as the discount rate.
As a thumb rule for the discount rate, use a higher value if the stock is riskier and a lower discount rate if the stock is safer (like blue chips). This rule is in accordance with the principle of the risk-reward which claims a higher reward for a higher risk.
4. Terminal Multiple Factor: This is the fourth input of the DCF calculation that is used to find the terminal value of the company. Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the DCF model as it typically makes up a large percentage of the total value of a business.
There are two approaches to the terminal value formula: (1) perpetual growth, and (2) exit multiple.
In this post, we are going to use the exit multiple approach. This approach is more common among industry professionals as they prefer to compare the value of a business to something they can observe in the market. The most commonly used terminal factor is EV / EBITDA. (Read more here).
Steps to value stocks using DCF Analysis:
Here are the steps required to value stocks using the discounted cash flow valuation method:
First, take the average of the last three years free cash flow (FCF) of the company.
Next, multiply this calculated FCF with the expected growth rate to estimate the free cash flows of future years.
Then, calculate the net present value of this cash flow by dividing it by the discount factor.
Repeat the same process for the next 10 years to find the net present value (NPV) of the future free cash flows. Add the NPV’s of the FCF for all the ten years.
Next, find the terminal value the stock by multiplying the final year FCF with a terminal multiple factor.
Add the values from step 4 and 5 and adjust the total cash and debt (mentioned in the balance sheet of the company) to arrive at the market value for the entire company.
Finally, divide the calculated number in step 6 by the total number of outstanding shares to arrive at the intrinsic value per share of the company.
If the final intrinsic value of the company is lower than the current market price of the share, then it can be considered undervalued (and a good time to invest in that stock assuming the quality of the stock is also amazing).
On the other hand, if the final intrinsic value of the company is greater than the current market value, then the stock might be over-valued. In such a scenario, it’s better to keep that stock in the watchlist and wait for the price to come down within the purchase range.
That’s all. This is the exact approach used to find the discounted cash flow value of any company.
In any case, if you are not comfortable in performing DCF valuation using excel sheets, you can also use the Trade Brains’ online DCF calculator to find the intrinsic value of a stock.
Real life example of valuing stocks from Indian stock market using DCF analysis.
Now, let’s calculate the Intrinsic value of Ashok Leyland (NSE: ASHOKLEY) using the Discounted Cashflow Valuation method. (Please note that all the data used here has been gathered from Annual reports.)
First, we will start by finding the free cash flow of Ashok Leyland. Here, we’ll take the FCF for the last 3 years and consider their average as a reasonable FCF. Now, free cash flow is equal to cash from operating activates minus the capital expenditures. The average FCF for the last three years turns out to be Rs 1715 Cr.
Next, we’ll project this FCF only for the upcoming ten years. Although, the company may continue for many more years after the tenth year, however predicting free cash flow for over 10 years is really difficult. Therefore, we assume that the company will sell off all its assets at the end of year ten at a ‘Sell off valuation’ (Terminal value). We’ll use a multiplier of 9 for the tenth year cash flow to simulate the value of these cash flows in the case company would sell all its assets (This is a necessary assumption that we need to make in order to find the value of the company).
Apart from the cash flows, the next important input is cash and cash equivalents which the company reflects on its balance sheet. For Ashok Leyland, this value is equal to Rs 993 Cr.
Besides cash, the next essential input is the debt (as debts have to be first paid off and shareholders are last in the line). Ashok Leyland has a total debt of Rs 515 Cr.
Next, we need to find the annual growth rate for Ashok Leyland. From the historical reports, we’ll consider a conservative growth rate of 12.75% per annum for our calculations of forecasted cash-flow.
Further, here we are considering a discount rate of 13.5% for discounting the future cash flows to their present value.
In addition, we need the total numbers of outstanding shares of Ashok Leyland. It is equal to 294 Crores.
Finally, let’s take a margin of safety of 10% on the overall calculated intrinsic value to give our calculations a benefit of doubt. (Higher the margin of safety, lower is the risk).
After placing the above values in the online DCF Calculator, the intrinsic value per share of Ashok Leyland turns out to be Rs 93.19 (after a margin of safety of 10% on the final intrinsic price). This is the true value estimate per share for Ashok Leyland at the time of writing using the DCF model.
The current stock price of Ashok Leyland is at Rs 105.55. This means that this stock is currently slightly overvalued compared to the calculated intrinsic price.
Quick Note: This intrinsic value is based on my calculations and assumptions. Although I’ve tried to be reasonably conservative in using the inputs, still no valuation should be considered precise as there is no guarantee that the company will grow at the assumed growth rate for the upcoming years. The key while performing DCF is to always consider rational inputs to arrive at a roughly correct intrinsic value.
Now that you have understood how to value stocks using the DCF analysis approach, let me give you a FAIR WARNING. DCF is a very powerful tool for valuing stocks. However, this methodology is only as good as the inputs.
For example, even a small change in inputs (like growth rate or discount rate) can bring large changes in the estimated value of the company. (Try changing these values by 1% or 2% and you can notice a significant change in the result). In short, if the inputs are not reasonable, the out will also not be correct -’Garbage in, garbage out’.
Therefore, fill all the inputs carefully as they all have the potential to erode the accuracy in the estimated intrinsic value.
Closing Thoughts:
DCF method is a very powerful method of valuing stocks. However, this method requires rational inputs.
Many investors who have already made up their mind to purchase a stock, can easily infiltrate the final result by assuming a higher growth rate/ terminal value or a lower discount rate. However, if you are choosing wrong or unrealistic inputs for growth rate, discount rate etc, the final intrinsic value per share may also be incorrect. Therefore, it is always recommended to use conservative inputs while performing DCF valuation.
That’s all for this post. I hope it is useful to you. If you have any questions, feel free to comment below. Happy Investing.
**Investing for Beginners**
If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
How to find intrinsic value of stocks using Graham formula?
Valuation is one of the most important aspects while investigating any stock for investing. A good business might not be a good investment if you overpay for it. However, most valuation methods like DCF analysis, EPS valuation, dividend discount model etc requires little assumptions and calculations.
Luckily, there are also a few valuation methods available that are pretty simple to use in order to find the true value of a company.
In this post, we are going to discuss one such valuation method which is really straightforward and simple to use. And this valuation method is known as Graham formula. Here are the topics that we are going to discuss today:
A brief introduction to Benjamin Graham
How to find the intrinsic value of stocks using Graham formula?
Pros and cons of graham formula.
Real life example of valuing stocks from Indian stock market using graham formula.
Closing thoughts.
Overall, this post is going to be really helpful for all the beginners who are stuck with the valuation of stocks and want to learn the easiest approach to find the true intrinsic value of companies. Therefore, make sure to read this post till the end.
Let’s get started.
1. A brief introduction to Benjamin Graham
Benjamin Graham was a British-born American investor and economist. He was a sincere value investor and often credited for popularizing the concept of value investing among the investing population. Graham was also:
Graham was a strict follower of value investing and preferred purchasing amazing businesses when they were trading at a significant discount.
In his book- Security analysis, Benjamin Graham mentioned his formula to pick stocks which become overly popular among stock market investors for valuing stocks since then.
2. How to find the intrinsic value of stocks using Graham formula?
The Original formula shared by Benjamin Graham to find the true value of a company was
V* = EPS x (8.5 + 2g)
Where,
V* = Intrinsic value of the stock
EPS = Trailing twelve-month earnings per share of the company
8.5 = PE of a stock at 0% growth rate
g = Growth rate of the company for the next 7-10 years
Anyways, this formula was published in 1962 and was revised later to meet the expected rate of return as a lot concerning the market and economy has changed since Graham’s time to present. The revised Graham formula is:
During 1962 in the United States, the risk-free rate of return was 4.4% (this can also be considered as the minimum required rate of return). However, to adjust the formula to the present, we divide 4.4 by the current AAA corporate bond yield (Y) to make the formula legit.
Presently, the AAA corporate bonds are yielding close to 4.22% in the United States. (Source: YCharts). In order to make an apple to apple comparison, we’ll consider the bond yield for 1962 and current yield- both for the United States. Therefore, you can consider the value of Y equal to 4.22% currently, which may be subjected to change in the future.
Quick note: You can also use the corporate bond yield of India in 1962 and current yield to normalize the equation for valuing Indian stocks. In such case, the value 4.4. will be replaced by the Indian corporate bond yield in 1962 and Y will be the current corporate bond yield in India. Make sure to use the correct values.
Note: The Adjusted Graham formula for conservative investors.
Many conservative investors have even modified the Graham formula further to reach a defensive intrinsic value of the stocks.
For example, Graham originally used 8.5 as the PE of the company with zero growth. However, many investors use this zero growth PE between 7 to 9, depending on the industry they are investigating and their own approach.
Further, Graham used a growth multiple of ‘2’ in his original equation. However, many investors argue that during Graham’s time, there were not many companies with a high growth rate, such as technology stocks which may grow at 15-25% per annum. Here, if you multiply this growth rate with a factor of ‘2’, the calculated intrinsic value can be quite aggressive. And hence, many investors use a factor of 1 or 1.5 for the growth rate multiple in their calculations.
Overall, the adjusted formula of conservative investors turns out to be:
V* = EPS x (7 + g) * (4.4/Y)
3. Pros and cons of Graham formula.
The biggest pros of Graham’s formula is its ease and straightforwardness. You do not require any difficult input or complex calculations to find the intrinsic value of a company using the Graham formula. In a few easy calculation steps, this method can help the investors to define the upper range of their purchase price in any stock.
However, as no valuation method is perfect, there are also a few cons of Graham formula. For example, one of the important inputs of Graham formula is EPS. Anyways, EPS can be manipulated a little by the companies using the different loopholes in the accounting principles, and it such scenarios the calculated intrinsic value might be misleading.
Another problem with Graham formula is that like most valuation methods, this formula also completely ignores the qualitative characteristics of a company like Industry characteristics, management quality, competitive advantage (moat) etc while calculating the true value of stocks.
4. Real life example of valuing stocks from Indian stock market using graham formula.
Now that you understood the basics of how you can value stocks using graham formula, let us use this formula to perform a basic stock valuation of a real-life example from the Indian stock market.
Here, we are taking the case study of HERO MOTOCORP (NSE: HEROMOTOCO) to find its true intrinsic value using the Graham formula. For Hero Motocorp,
EPS (TTM) = Rs 186.29
Expected growth (for the next 5 years) = 9.89%
(Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).
Now first, let us find the intrinsic value of Hero motocorp using the original Graham formula,
V* = EPS x (8.5 + 2g)
= 186.29 x (8.5 + 2*9.89) = Rs 5268. 28
Now, using the revised formula with conservative zero-growth PE of 7 and growth multiple of one, the intrinsic value of Hero motocorp turns out to be:
V* = EPS x (7 + g) x (4.4/4.22) = 186.29 x ( 7 + 9.89) x (4.4/4.22) =3280.65
At the time of writing this post, hero motocorp stock is trading at a market price of Rs 2961.90 and PE (TTM) of 15.90. Therefore, by using Graham formula, we can consider this stock to be currently undervalued.
Disclaimer: The case study used above is just for educational purpose and should not be considered as a stock advisory. Please research the company carefully before investing. After all, no one cares more about your money than you do.
You can also use Trade Brains’ online GRAHAM CALCULATOR to perform your calculations fast.
5. Closing thoughts.
An important point worth mentioned here is the concept of margin of safety that Benjamin Graham repeatedly taught in his books.
In simple words, according to the concept of margin of safety, if the calculated intrinsic price of a company turns out to be Rs 100, always give your calculations a little safety and purchase the stock at a 15-25% below that calculated value, i.e. when the stock trades below Rs 75-85.
Overall, Graham formula is a fast, simple and straightforward method to find the intrinsic value of stocks. If you haven’t tried it yet, you should definitely use this valuation approach while performing the fundamental analysis of any stock.
Investing for Beginners
If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!
Additional credits: Vasanth (for data inputs in Graham Formula)
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
What is the Internal Rate of Return (IRR)? And How Does it Works?
Hi readers. A lot has been covered in our blog since inception, we have written articles ranging from the basics of financial statements to concepts of valuation. A reader who has followed our blog from the beginning should now be able to perform a detailed analysis of a company and arrive at a valuation for investment.
To our ever growing list of posts, today we shall add one that seeks to provide a method for calculating the rate of return of a portfolio. This method is called as Internal Rate of Return (IRR).
The IRR method to measure the portfolio performance has become a lot popular in recent days because of its effectiveness over CAGR measurements. That’s why you need to get acquainted with what actually is IRR and how to quickly calculate it.
The topics we shall read about in today’s post are as follows.
What is the Internal Rate of Return (IRR)?
How is IRR different from CAGR and how is it more useful?
Application of IRR method of return calculation with an example.
It’s going to be a very informative post. So, let’s get started.
1. What is the Internal Rate of Return (IRR)?
Theoretically speaking, IRR is the rate at which the net cash flows (both inflow as well as outflow) from an investment would be equal to zero. Better said, it is the rate of return to be achieved by all the money invested to give back all the cash received.
2. How is IRR different from CAGR and how is it more useful for investors?
Although CAGR is a classic investment metric for calculating investment returns and makes a better representation of performance than average returns since it assumes the investment capital to be compounded over time.
But it makes a couple of assumptions which may hinder its practical use. Firstly, it assumes that the compounding process is a smooth one over time with steady returns being made every year. Secondly, it assumes that a portfolio incurs cashflow only two times during its lifetime. One at the very beginning when an investment is made and the second when the investment is sold and cash is returned to the investor.
In practice rarely do we come across such scenarios where an investment is made only once, most of us happen to make regular investments over time and hence the overall return may actually be different than what the CAGR method of calculation may usually project it to be.
In such cases of multiple or uneven investment periods and cash flows, the CAGR method of calculation becomes futile and using the Internal Rate of Return method would better serve the purpose. Mathematically, the IRR calculation is represented by the following expression.
Where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; And, IRR equals the investment’s internal rate of return.
3. Application of IRR method of return calculation with an example.
Assume we bought a stock ₹3,00,000. Also, assume that we bought an additional ₹1,00,000 worth of stock one year later and another ₹50,000 in the two years later.
Let us make one more assumption that we hold the stock for 2 more years before selling the stock for a total cash return of ₹7,50,000 Here is how the IRR equation looks in this scenario:
Mathematically speaking IRR cannot be computed analytically, but thanks to calculators and spreadsheets today this task can be done fairly easily.
Using the XIRR function in an excel we get the IRR for this scenario as 11.80%, which is the rate that makes the present value of the investment’s cash flows equal to zero.
If we were to calculate the CAGR for the example for an initial investment of ₹4,50,000 and final cash return of ₹7,50,000 over a period of 5 years we would get a but the incorrect return of 10.8%.
Quick Note: If you want to learn how to perform fundamental analysis of stocks from scratch, feel free to check out this online course- HOW TO PICK WINNING STOCKS. Enroll now and start your journey is the Indian stock market today!!
Closing thoughts
Although initially, the IRR method found applications in the capital budgeting projects of companies, recently it has become a favored method among investors to calculate the capital allocation efficiency of their portfolio.
We advise our readers to add this to their ever-growing investing toolkit. Happy Investing.
Enterprise Value and Equity Value are two terms that have confused investors and sometimes professionals alike through the years. In this post, I shall try to clear some air on both the terms and help our readers figure out the one they need to use during their analysis of companies.
Here are the topics that we will cover in this post:
Who are the different stakeholders in a firm?
What is the level of risk associated with the level of ownership?
What is Enterprise Value and Equity Value and how are they calculated?
Enterprise Value and Equity Value Multiples
Methods of analysis using Enterprise Value and Equity Value
Closing thoughts
On a broad level, this will be long, but an easy read and we would really appreciate that our readers leave comments in case of any doubts.
1. Who are the different stakeholders in a firm?
To understand the concept of Enterprise Value and Equity Value, it would first be necessary to understand the different players in the capital markets and their claims on a company’s capital and income.
To understand this, picture a company like a big country with different religious and social groups with each group seeking to pursue their own interest but somehow still manage to operate under the common banner of a company.
These interest groups from the perspective of a company include those who have contributed capital to the firm. Since a company can generate capital from debt and equity the top-level classification of the mentioned interest groups comprises of Debt Holders and Equity Holders
Note that the two groups can be further divided into subgroups depending on the priorities of each subgroup.
2. What is the level of risk and return associated with the level of ownership?
In corporate finance, when an asset is sold the debt holders get a priority to the funds generated from the sale and then the different classes of equity holders.
Since debt holders normally take fixed payments at the regular periods regardless of the profit-generating capacity of a company, their position tends to be the one of minimum risk in the company’s capital structure.
The equity holders, on the other hand, get dividends only when the company makes a profit (in most cases) and also happen to pledge their money as owners of the firm without the promise of returns. This makes their position the riskiest within the capital structure.
The below infographic should summarise the relationship between capital and relevant risk and payments for different equity and debt holders.
3. What is Enterprise Value and Equity Value and how are they calculated?
Now to address the crux of this post, assume that a big financial investor wants to buy a company. Let us say he wants to get 100% control of the firm and also 100% of the earnings generated by the firm.
To achieve the first goal, he would just have to buy the stakes of equity holders of the firm, these equity holders could include the Minority Interest, the Preferred Shareholders, and the Common Shareholders. The money the buyer would have to expend to acquire the complete equity of all the above-mentioned groups is what is known as the Equity Value.
Now since the equity holders are of the picture, the buyer now turns his eyes towards the debt holders. To make the debt holders give up claims to the company’s earnings (in the form of interest and principal payments), our buyer would have to pay them cash equivalent to the debt they hold in the company. A lot of the times, the buyers use the cash and cash equivalents of the company they bought to pay off the debt outstanding on the balance sheet. In finance, the term used for the is called the Net Debt.
Net Debt = Total Debt – Cash and Cash Equivalents
And further, the formula for Enterprise value becomes
Enterprise value = Equity Value + Net Debt
Assuming the company has also got minority interest, preferred shareholders and affiliates/associates the formula gets modified as
Enterprise Value = Equity Value + Preferred Shares + Minority Interests – Value of Associates + Net debt
4. What are the Enterprise Value and Equity Value multiples?
The key difference between Enterprise Value and Equity Value is the inclusion of the Net Debt figure in the calculation. So when we think of multiples only terms which have the payments related to debt (interest) should be included with Enterprise Value and the metrics devoid of debt payments (interest) should be included with Equity Value.
The following figure should give the summary of the financial statement components used with both Enterprise Value and Equity Value.
As mentioned earlier, please note in the income statement that all metrics which include interest is included with the Enterprise Value calculation.
The corresponding ratios are summarised in the following figure
5. Methods of analysis using Enterprise Value and Equity Value
The multiples of Enterprise Value and Equity Value can be used extensively in the valuation analysis of a company. The two methods of valuation that are commonly used are relative valuation and historical valuation.
The limitation of using the relative valuation method is that during the period of elevated valuations- during a bull market all our comparable companies may be trading at a premium, this may sometimes make our target company seem cheap when it is only less expensive.
Similarly, during periods of depressed valuations, our target company may look expensive compared to our comparables when it is actually only slightly less cheap.
Although a lot of retail investors do not use Enterprise Value multiples in their valuations to could be useful to do so since the resulting valuations are inclusive of the leverage the companies have employed in their business activities.
In case retail investors find the concept of Enterprise value confusing, it should not deter them from performing a good analysis of companies if they use other leverage evaluation methods in their research and analysis process.
We hope our readers continue to embrace an objective approach to their valuation processes while performing stringent quality checks on the stocks they invest in. Happy Investing.
How to use the Treasury Stock Method to Calculate Diluted Shares?
Hi Investors. We earlier published an article detailing how dilution affects our ownership position in the company and how it affects the calculations for PE ratio and Earnings Yield ( 1/ PE). (You can read that article here: How Dilution Affects the Company’s Valuation?)
In this post, we will cover how employee stock options are converted into common stock and learn how to calculate the incremental contribution to a number of outstanding shares (NOSH).
Here are the topics that we will discuss today:
Why stock options?
What is the common term associated with stock options?
Main kinds of stock options given to employees and management?
What is the treasury stock method and why is it called so?
Closing thoughts – the good, the bad and the ugly
It’s going to a little lengthier post. However, it will definitely be worth reading if you want to learn the dilution basics. So, let’s get started.
1. Why stock options?
Companies are increasingly rewarding their employees using stock options this provides multiple benefits:
It helps align the management actions in line with the interests of the shareholders or better said managers of a business become shareholders themselves and are rewarded when their decisions in the operating activities deliver value to the shareholders
Employees and managers who are rewarded stock options get the twin benefit of capital appreciation of the stock in the market and also of the lower capital gains tax for investments held over the period of 1 year.
2. What are the common terms associated with stock options?
Although there are a lot of terms we may come across when we read about stock options, almost always it will suffice to know just the meaning and relevance of a handful of terms when assessing options. Some of the most relevant that we feel will be useful for our readers are as follows:
Issue date: this corresponds to the date on which the underlying stock option was issued to the holder
Exercise date: represents the date on which the holder of the stock gains the right to exercise the option
Exercise price: represents the minimum price required to be attained by the shares of the company before the options can be converted into common stocks
Vested and non-vested shares: When a stock option is owned by an individual and he/she retains the right to exercise them when they wish so, the option is said to be vested. Non-vested shares options, on the other hand, represent those which are still owned by the company and the transfer of ownership to the individual hasn’t occurred yet.
In-the-money / out-the-money: When the trading price of a stock above the exercise price of the option is then said to be the in-the-money option, while it is said to out-the-money when the share price is below the exercise price (and then rendering the exercising such options useless).
3. What are the main kinds of stock options given to employees and management?
In most annual reports investors may come across different types of stock options, the common ones are (but not limited to) ESOPs or employee stock options, Restricted Stock Units (RSUs), Performance Stock Units (PSUs).
Employee Stock Options (ESOPs)
In almost all cases these represent the options offered to individuals by companies as a part of their equity compensation plans. These are usually reported by companies with relevant details like issue date, exercise date, the and exercise price. The primary catch for the employees here is that their options do not become exercisable unless and until the stock price of the company trades above the mentioned exercise price
Restricted Stock Shares (RSSs)
These are awards that entitle individuals to ownership rights to a company’s stock. Normally, these are subject to restrictions with regard to the sale of the stock or option until they become vested. The vesting event is determined by minimum service or performance conditions set by the company for the employee. However, during the restricted period, the individuals may have voting rights and the right to the dividends owed to restricted shares.
Performance Stock Shares (PSSs)
Performance Stock Shares are restricted stock shares that vest upon the achievement of performance conditions specified by the company. These shares are generally subject to sale restrictions and/or risk of forfeiture until a specific performance measurement is satisfied. Performance measurements are set by your company. During the restricted period you may have voting rights and the right to dividends paid on the restricted shares, which may be paid to you in cash or may be reinvested in additional performance shares. Once vested, the performance shares are usually no longer subject to restriction.
4. What is the treasury stock method and why is it called so?
The most commonly used method within the finance industry to calculate the net additional shares (from exercising the in-the-money options and warrants) is the treasury stock method (TSM).
Here, it is important to note that the TSM makes an assumption that the proceeds the company receives from in-the-money option exercises are subsequently used to repurchase common shares in the market. Repurchasing those shares turns them into shares held in the company’s treasury, hence the eponymous title.
Implementing the treasury stock method
The broad assumptions in the TSM are as follows. Firstly, it assumes that the options and warrants are exercised at the start of the reporting period and that a company uses the proceeds to purchase common shares at the average market price during the period. This is clearly implied within the TSM formula. Treasury stock method formula:
Additional shares outstanding = Shares from exercise – repurchased shares
Example:
Imagine a scenario where a company has an outstanding total of in-the-money options and warrants for 15,000 shares. Assume that the exercise price of each of these options is around ₹400. The average market price of the stock, however, for the reporting period is ₹550.
Assuming all the options and warrants outstanding are exercised, the company will generate 15,000 x ₹400 = ₹60,000 in proceeds. Using these proceeds, the company can buy ₹6,000,000 / ₹550 = ~10909 shares at the average market price. Thus, the net increase in shares outstanding is 15,000 – 10,909 = 4,091 shares. This can also be found by simply using the last formula provided above. The net increase in shares outstanding is 15,000 (1 – 400/550) = 4,091.
Although options can be a force used for good as described at the beginning of this post it is not always a very innocuous tool. Since almost always, options are more complicated than cash payments there arises a potential for companies to manipulative the rewarding scheme to incentivize the management too much (beyond what is considered acceptable) at the expense of the shareholders.
Another problem can sometimes arise when a firm holds options or convertible debt offerings in another publicly traded company, there have been cases in the stock market history where such firms have gained majority control in the publicly traded company and subsequently initiated multiple activist campaigns against the management and in extreme cases have ended up owning the company entirely (a lot of the times at the expense of minority shareholders).
An argument which is sometimes overseen but nonetheless is credible when understanding options are that options incentive management to undertake risky decisions. These could sometime come in the ugly form of management cutting corners to influence the stock prices in the short term so that the options they hold may become exercisable. It is also not uncommon to see situations where management undertakes short-term risks that may eventually outweigh long-term gains for the shareholders.
In view of the above scenarios, a retail investor when assessing companies should look at the state of the options and the rewarding schemes when studying the management of their target company. Normally the two main things an investor needs to look for to be able to make a reasonably informed judgment include the following:
The period for the options are awarded: here longer is better, something more than 3 years should be considered as satisfactory
The number of options which are awarded: make sure that excessive amounts in addition to the existing cash packages are not paid out to the management and employees unless deserved.
That’s all for this post. I hope it was useful to the readers. Happy Investing.
When you are investing for the long-term, it can be sensibly concluded that the only cash flow that you will receive from a publicly traded company will be the dividends, till you sell the stock.
Therefore, before investing it may be justifiable to calculate the dividends cash flow that you’ll receive while holding the stock. Dividend discount model (DDM) uses the same approach to find the worth of a stock.
In financial words, dividend discount model is a valuation method used to find the intrinsic value of a company by discounting the predicted dividends that the company will be giving (to its shareholders in future) to its present value.
Once, this value is calculated, it can be compared with the current market price of the stock to find whether the stock is overvalued or decently valued.
Don’t worry if you find this concept a little difficult to grasp right now. Read the post until the very end and this model will become crystal clear to you.
What is Dividend Discount Model (DDM)?
Dividend discount model aims to find the intrinsic value of a stock by estimating the expected value of the cash flow it generates in future through dividends. This valuation model is derived from the net present value (NPV) and time value of money (TVM) concept.
Dividend discount model uses this simple formula:
Here,
P= value of stock
D= Dividend per share
r= Discount rate (also known as required rate of return or cost of equity)
g= expected dividend growth rate.
Assumptions: While calculating the value of a stock using dividend discount model, the two big assumptions made are future dividend payments and growth rate.
Limitations: Dividend discount model (DDM) does not work for companies that do not provide dividends.
The dividend growth rate (g) can be found using the company’s historical dividend growth.
Further, the dividend growth rate can also be calculated using return on equity (ROE) and retention rate values. Here’s a simple formula to calculate dividend growth rate:
Dividend growth rate = ROE * Retention rate
{Where, retention rate = (Net income – dividends)/ Net income = (1 – payout ratio) }
ROE and payout ratio can be determined using company’s financial statements. An easier approach would be to refer financial websites like Money control, investing etc. You can find these values on most of the financial websites.
In the dividend discount model, if you want to get an annual return of 10% for your investment, then you should consider the rate of return (r) as 0.10 or 10%.
Further, r can also be calculated using Capital asset pricing model (CAPM). Under this model, the discount rate is equal to the sum of risk-free rate and risk premium. The risk premium is calculated as the difference between the market rate of return and the risk-free rate of return, multiplied by the beta.
For example, for a company, if the beta is 1.5, the risk-free rate is 3% and the market rate of return is 7%.
Now that you have understood the basics of Dividend Discount Model, let us move forward and learn three types of Dividend Discount Models.
Zero Growth Dividend Discount Model
Constant Growth Dividend Discount Model
Variable Growth Dividend Discount Model
1. Zero Growth Dividend Discount Model
The Zero growth dividend discount model assumes that all the dividends that are paid by the company remain same forever (until infinity).
Therefore, here the dividend growth rate (g) is zero.
As dividend is constant throughout the company life
The dividend is first year= dividend in second year = dividend in the third year…
Div1= Div2= Div3 = Div4 …. =Div
Here is the share value formula for the zero growth dividend discount model:
Or Value of stock (P) = Div /r
Let us understand this further with the help of an example.
Example 1: Assume company ABC gives a constant annual dividend of Rs 1 per share till perpetuity (lasting forever). The required rate of return on the stock is 5%. Then what should be the purchasing price of the stock of company ABC?
Here, Expected return/ required rate of return (r) = 5%
Dividend (Div) = Rs 1 = Constant
Value of stock (P) = Div/r =1/0.05 = Rs 20.
Therefore, the purchasing price of the stock ABC should be less than Rs 20 to get the required rate of return of 5% per annum.
Limitations of Zero growth dividend discount model:
As the company grows bigger, it is expected to increase company’s dividend per share. The dividend cannot be constant till perpetuity.
This dividend discount model assumes that dividends grow at a fixed percentage annually. They are not variable and are constant throughout the life of the company. The most common model used in the constant growth dividend discount model is Gordon growth model (GGM)
Gordon Growth Model (GGM):
The Gordon growth model for DCF is quite simple and straightforward. Here are the three values required to calculate the share value of a company:
Div= Dividend at the zeroth year.
r = company’s cost of capital/ required rate of return
g=constant growth rate of dividends till perpetuity
Here, Div1= Dividend per share expected to be received at the end of first year = Div (1+g)
For the constant growth dividend discount model,
Note: If you want to learn how the derive the above formula, you can find it here.
Let us solve an example to find the share price of a company with Gordon growth model.
Example 2: Assume a company QPR has a constant dividend growth rate of 4% per annum for perpetuity. This year the company has given a dividend of Rs 5 per share. Further, the required rate of return for the company is 10% per annum. Then, what should be the purchase price for a share of company QPR?
Here,
Div= Dividend at zeroth year = Rs 5
r = required rate of return = 10%
g= constant growth rate of dividends till perpetuity= 4%
Div1= Dividend per share expected to be received at the end of first year = Div (1+g) = 5 (1+0.04) = Rs 5.2
Value of share (P) = Div1/ (r-g) = 5.2 / (0.1 -0.04) = 5.2/0.06 = Rs 86.67
Therefore, you should purchase the stock at a price below Rs 86.67 to get a required rate of return of 10% per annum.
Limitations of Gordon Growth Model:
Here are few genuine limitations to Gordon growth model while performing constant growth dividend discount model
The constant growth rate for perpetuity is not valid for most of the companies. Moreover, Newer companies have fluctuating dividend growth rate in the initial years.
The calculation is sensitive to the inputs. Even a small change in the input assumption can greatly alter expected value of the share.
High growth problem. If the dividend growth rate becomes higher than the required rate of return i.e. g>r, then the value of the share price will become negative, which is not feasible.
3. The multi-level/Variable Growth Dividend Discount Model:
The multi-level growth rate for dividends model may divide the growth rate into two or three phases (according to the assumption).
In the two-stage growth rate DDM Model, the dividends grow at a high rate initially followed by a lower constant rate for later years. (Also read: Supernormal dividend growth model)
Further, in the three-stage growth DDM Model, the first stage will be a fast initial phase, then a slower transition phase an then ultimately ends with a lower rate for the infinite period. For example- A company XYZ’s dividend may grow at 5% rate for the first 7 years, 3% rate for the next 4 years and finally 2% rate in perpetuity.
If you are interested to read more, here is an amazing source to learn the multi-level growth rate dividend discount model.
Limitation:
The biggest drawback with the multi-level growth rate of dividend discount model is that’s it’s really difficult to assume the growth rate in small specific periods. There are a lot of uncertainties involved while making these assumptions when the growth is distributed at multiple levels.
Problems of forecasting value using DDM:
Here are few of the common limitations of forecasting share value using the dividend discount model:
Plenty of assumptions about the dividend growth and company’s future.
This valuation model is good only as far the assumptions are good.
Most of the inputs of DDM model keeps on changing and susceptible to error.
Not feasible for few categories of stocks like Growth stocks. These stocks pay little or no dividends but rather use the company profit in their growth. DDM might never find these stock suitable for investment no matter how good the stock is.
Most of the analysts ignore dividend discount model while valuing the stock price because of its limitations as discussed above.
However, for few specific stocks (like stable dividend paying stocks), DDM remains a useful tool for evaluating stocks. Dividend discount model is a simple and straightforward method of stock valuation. It demonstrates how the stock value can be calculated by a simple approach of discounting future cash flows.
Anyways, I will highly recommend to never invest in a stock based on just DDM valuation. Use other financial tools like ROE, PE etc to cross-verify the conclusions before investing.
In the end, I would like to add that although DDM is criticised for the limited use, however, it has proved useful in the past. In addition, here is an amazing quote regarding valuation by one of the greatest investor of all time, Warren Buffett.
“It is better to be approximately right than precisely wrong.” -Warren Buffett
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting
In case the company has excess inventories, it may be a little troublesome for them.
