Investment Principles and Equity Valuation

Investment Principles

Premises for Valuation

Efficient Market Theory

Almost all the time should not be confused with always.

Ultimately, human beings decide price of assets in the market and they are

subject to greed and fear.

At times, they price assets away from their intrinsic value.– Market is a pendulum that forever swings between unsustainable optimism and

unjustified pessimism. Intelligent investor is a realist, who sells to optimists and buys from pessimists. BG

However, prices of assets will converge with their intrinsic value over a

period of time.

To make money in the market, get greedy when others are fearful and be

fearful when other are greedy. WB

Investment Principles Stock represents ownership interest in an actual business, with

an underlying value that does not depend on its share price. Stocks are not worth buying at any price. Return on every investment is a function of its present price.

The higher the price you pay, the lower your return will be. No matter how careful you are, one risk no investor can ever

eliminate is the risk of being wrong. Only by insisting on “margin of safety” – never overpaying, no matter how exciting an investment seems to be –one can minimize odds of error.

Become a critical thinker, take no wall street “fact” on faith, invest with patience, develop discipline and courage, refuse to let other people’s mood swings govern your thoughts.

Investment Principles Obvious prospects for physical growth in a business do not

translate into obvious profits for investors. The experts do not have dependable ways of selecting and

concentrating on the most promising companies in the most promising industries.

Control the self-defeating behavior that keeps most investors from reaching their full potential.

How your investments behave is much less important than how you behave.

Intelligent investing has nothing to do with IQ or SAT/GMAT scores. It is about being patient, disciplined and eager to learn.


An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.– Thorough analysis– First safety– Then, return

Minimize the odds of suffering irreversible losses. Maximize the chances of achieving sustainable

gains.


Bull markets have a number of well-defined characteristics in common:

– Historical high price level– High P/E ratios– Low dividend yields as against bond yields– Many offerings of new common-stock issues of poor quality.

Bear markets also have a number of well-defined characteristics in common:

– Historical low price level– Low P/E ratios– High dividend yields as against bond yields– People are not willing to touch stocks. General fear among investors

about stocks.

Investment Principles Focus on buying an existing business Buy simple businesses in industries with an ultra-

slow rate of change– We see change as the enemy of investments. So we look

for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.W. B.

Buy businesses with a durable competitive advantage – The key to investing is not assessing how much an

industry is going to affect society or how much it will grow but rather determining the competitive advantage of any given company and above all, the durability of the advantage. W.B.

Investment Principles Focus on ROI. Look for businesses replacing capital

with creativity and imagination Buy businesses at big discounts to their underlying

intrinsic value– The function of the margin of safety is, in essence, that of

rendering unnecessary an accurate estimate of the future.– The bigger the discount to intrinsic value, the lower the

risk.– The bigger the discount to intrinsic value, the higher the

return.• Benjamin Graham

Better to buy copycat than an innovator Undertake few bets, big bets and infrequent bets


A lot of great fortunes in the world have been made by owning a single wonderful business. If you understand the business, you do not need to own very many of them.

Outstanding investment opportunities are rare..go at it when it comes around, and put a huge portion of your wealth into it.

Think of investment as though you have a punch card with 20 holes in it. You have to think extremely hard about each one, and in fact 20 (in a lifetime) is way more than you need to do extremely well as an investor.

Exist is as critical as entry


It requires a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it.

• Nathan Mayer Rothschild

Understanding Financials and Ratios

Business flow

Source - Investopedia

Sources of funds

Sources of long term funds Financing by Banks and Financial Institutions Capital Market Products

Equity Debt Preference shares Hybrids

• Sources of short term funds Financing by Banks and Financial Institutions Money Market Products

Commercial papers Public deposits Inter-corporate deposits Bill discounting Factoring

Equity

Equity capital is the risk capital, which represents ownership in a business entity.

Company’s perspective:– No fixed obligation of funds on equity.– It is perpetual in nature.

Investors’ perspective:– Dividend and capital appreciation, if any. No fixed return.– Voting right.– Claim over the residual assets at the time of liquidation of the company

(last claim).

Equity features

Face value per share Market value per share and Market capitalization Book value per share = Net worth/ number of

outstanding shares. New worth is equal to the share capital + reserves and surplus other than the Capital Reserves.

Earning per share (EPS) = Profit after tax / number of outstanding shares.

Dividend per share (DPS) Dividend payout ratio = DPS/EPS Price earning ratio (P-E ratio) = Market price/ EPS

Debt Debt provides the business with the capital bearing a

fixed/floating cost obligation. Debt instruments represent lending rights not the

ownership rights. Debt can be secured or unsecured. Debt owners have :

– Interest – Payment of interest is an obligation on the company. – No voting right. – Claim over the assets of the company before the equity holders.

Different debt owners would have different priority claims on the assets of the company at the time of liquidation.

Debt features

Face value/ Par value Issue price (at face value or at discount/premium to

the face value) Redemption value (at face value or premium/

discount to the face value) Terms of the redemption – Bullet or otherwise Rate of interest (Coupon) – Fixed or floating Maturity of the instrument

Can we have perpetual debt?

Variety in the debt market

Step up bonds. Step down bonds. Amortization bonds. Perpetual Bonds (consol bonds). Principal protection Bonds. Payment in kind bond (PIK bonds). Deep discount bonds. Floating rate bonds. Treasury Inflation protection securities (TIPS).

Preference shares

Preference share holders have : Equity like features

Dividend, which is fixed and paid from profit. Dividend is not an obligation on the company. Tax treatment at par with ordinary equity.

Debt like features Fixed tenor of the instruments. Fixed dividend and paid before the equity holders. At liquidation, their claim is prior to the claim of ordinary

equity holders. No voting right originally. But acquire the voting rights in

certain circumstances. Preference shares are called quasi equity as they behave

partly like shares and partly like debt instruments.

Hybrid instruments

Convertible bonds are bonds to be converted into equity of Issuer Company.

Important considerations in convertible are:1. Whether conversion is compulsory or optional?

2. If it is optional, in whose hands?

3. What is the price at which equity shares would be issued? Is it a fixed price or floating price?

4. If it is floating price, what is the reference benchmark for determination of conversion price?

5. What time will the conversion take place?

Preference shares can also be convertible like debt instruments.

Sources of short term funds

Commercial papers – Issued at discount– Unsecured in nature

Public deposits– Generally issued at par– Unsecured in nature

Inter-corporate deposits Bill discounting – Financing against the commercial bills.

– Banks can discount the commercial bills (both demand and usance bills).

– Banks can approach other banks and institutions for rediscounting of the bills, discounted by them.

Sources of short term funds

Factoring – Sell off the commercial bills.– Factoring is a variant to the bill discounting.– It results in the sale of the bills to the other

party.– This sale of bills may be with recourse or

without recourse.

Considerations for sources of funds

Cost and tenor of funds Business risk Control considerations Tax considerations State of the market

Uses of funds

Fixed Assets– Land and building– Plant and Machinery– Others

Working Capital – Raw Material – Work in progress– Finished goods– Cash

Investments– Various avenues of investment

Basic Concepts of Accounting

Entity Concept Going Concern Concept Conservatism Concept Dual Aspect Concept (Asset = Lib. + equity) Accounting Period Concept Accrual Concept Realization Concept Matching Concept

Simple Illustration – ABC Inc. Promoter contributes $500,000 as equity. ABC pays $100,000 as deposit for hiring office premises. ABC buys furniture and fixtures for $300,000. ABC buys merchandise worth $300,000 on credit. ABC sells merchandise costing $100,000 for $120,000 on

cash basis. ABC sells merchandise costing $80,000 for $100,000 on

credit. ABC pays establishment expenses of $5000 in cash. ABC pays $9,000 as rent in cash. ABC depreciates the Furniture and Fixture by $10,000.

ABC Inc. B/S.

Liabilities + Equity– Capital 500,000– Reserves and Surplus 16,000– Trade Credit 300,000 Total 816,000

Assets– Bank Deposit 206,000– Premise Deposit 100,000– Furniture and fixture 290,000– Merchandise 120,000– Debtors 100,000 Total 816,000

ABC Inc. P/L

Revenues 220,000– Cash sale 120,000– Credit sale 100,000

Expenses 204,000– Merchandise cost 180,000– Establishment Exp. 5,000– Rent 9,000– Depreciation 10,000

Profit 16,000

Important Accounting Rules Every transaction has a bearing on at least two

accounts in B/S. Irrespective of the transaction B/S identity is

preserved i.e. Assets = Liab. + Equity. Transactions, which do not result in a revenue or

expense, have no bearing on the P/L (or Reserve and Surplus).

Balance sheet provides readers with the static picture of the business on a specific day.

Profit and loss account (P/L) provides a dynamic picture of business over a period of time.

A typical Balance SheetLiabilities (Sources of Funds)

Share Capital Authorized Capital Issued Capital Subscribed Capital Paid up capital

Preference share capital Reserves and surplus

Revenue reserves Capital reserves

Secured Loans Unsecured Loans Current liabilities and Provisions

Bills Payable Sundry Creditors Advance Payments Various Provisions

Assets (Uses of Funds) Fixed Assets

– Land and building– Machinery– Fixture and Fittings– Others

Investments Current Assets, Loans and Advances

Inventories Sundry debtors Cash and bank balances Loans and advances

Miscellaneous Expenditures and losses

Preliminary expenses Discount allowed on issuance of

securities Other capitalized expenses

Profit and Loss AccountRevenues (Net Sales)

Less cost of goods sold

Gross Profit

Less Operating expenses

Operating profit

Add (deduct) non operating surplus (deficit)

Profit before depreciation, interest and taxes (PBDIT)

Less Depreciation

Profit before interest and taxes (PBIT)

Less Interest

Profit before taxes (PBT)

Less taxes

Profit after taxes (PAT)

First step to valuation

Simple P/L (in USD)

Net Sales 10,000,000COGS 6,000,000Gross Profit 4,000,000Other Expenses 2,000,000Operating Profit 2,000,000Taxes @ 30% 600,000PAT 1,400,000Share capital: 2,000,000 shares of $1 each.Would you buy this business?

Profitability check

Gross profit margin (40%) Operating profit margin (20%) Net profit margin (14%)

Forgot to tell you that keeping everything else constant, debtors in the books of company have gone up by $2,000,000.

Cash flow statement Generating Cash is critical for a firms’ long term survival. P/L and B/S do not focus on cash flows. Cash flow of a firm may be reflected as follows:

Picture source – Investopedia

•Looking at net cash flows could be deceptive

•One needs to analyze each of the cash flow streams independently

Cash flow statement

Objective is to focus on sustainable and recurring cash flowsIdentify and adjust for non recurring/extraordinary items

Picture source - Investopedia

Tata Steel’s cash flows in 07-08

Cash flows Mar ' 08

Net cash flow - operating activity 6,254.20

Net cash - investing activity -29,318.58

Net cash - financing activity 15,848.07

Net inc./dec. in cash and equivalent -7,216.31

Cash and equivalent - begin of year 7,681.35

Cash and equivalent - end of year 465.04

Source – money.rediff.com

Liquidity check - exercise Revenues 1st month : $100M Expenses 1st month : $70M 1st month expenses include purchase of a second hand car for $10M Revenues 2nd month : $150M Expenses 2nd month : $75M 2nd month revenues include sale of shares for $20M and expenses include

purchase of shares for $10M Revenues 3rd month : $125M Expenses 3rd month : $270M 3rd month revenues include sale of car purchased in 1st month for $10M and

expenses include purchase of a new car for $20M and purchase of a house for $200M

Pl prepare cash flows for three months independently and consolidated cash flow for the quarter.

Note : M stands for 1,000 and all the transactions are in cash

Liquidity check 1st monthOperating cash flows : +$40M (100 – 60)Investing cash flows : -$10MFinancing cash flows: NilNet cash flows: +$30M 2nd monthOperating cash flows : +$65M (130 – 65)Investing cash flows : +$10M (20 – 10)Financing cash flows: NilNet cash flows: +$75M 3rd monthOperating cash flows : +$65M (115 – 50)Investing cash flows : -$210M (10 – 20 - 200)Financing cash flows: ?Net cash flows: -$145M (65-210) ConsolidateOperating cash flows : +$170M (40+65+65)Investing cash flows : -$210M (-10 + 10 - 210)Financing cash flows: ?Net cash flows: -$40M (30+75-145) or (170-210)

Liquidity check

Liquidity refers to the ability of the firm to meet its obligations in short run.

Does the company have sustainable positive operating cash flows?

Do current assets show continuous coverage of current liabilities with good margin ?

Do current assets (excluding inventory) show continuous coverage of current liabilities with good margin ?

Simple P/L (in USD)

Unleveraged Leveraged (1:1)Net Sales 10,000,000 10,000,000COGS 6,000,000 6,000,000Gross Profit 4,000,000 4,000,000Other Expenses 2,000,000 2,000,000EBIT 2,000,000 2,000,000Interest - 100,000EBT 2,000,000 1,900,000Taxes @ 30% 600,000 570,000PAT 1,400,000 1,330,000EPS $.70 $1.33 Leverage does magic in terms of improving EPS and Return on equity. Let us make it leverage 3:1 (debt/equity), EPS turns to $2.59. Appreciate that nothing comes free.. Accordingly, enhanced leverage

increases the financial risk in the firm. Logically, should not we look at return (EBIT) on capital employed

irrespective of mode of financing ? That no. is same for both the firms.

Financial risk check

Leverage is equally important to both lenders and equity owners

Financial leverage refers to the use of debt component in Capital Structure

Important checks are:– Coverage of debt by equity– Coverage of interest by EBIT– Coverage of interest by operating cash flow – Coverage of debt service by operating cash flow

Forgot to tell you that company also has revenue reserves of $2,000,000.

Simple P/L (in USD)

No reserves With reserves Net Sales 10,000,000 10,000,000COGS 6,000,000 6,000,000Gross Profit 4,000,000 4,000,000Other Expenses 2,000,000 2,000,000EBIT 2,000,000 2,000,000Interest - -EBT 2,000,000 2,000,000Taxes @ 30% 600,000 600,000PAT 1,400,000 1,400,000EPS $.70 $.70ROE 70% 35%

Should not we look at return on Equity (both capital + reserves) rather than only capital.

Indeed, including the debt if any…which takes us to Return on Investment employed in the business.

Return of capital check

Return on Equity Return on Investment Return to be taken as EBIT to make it free

from influence from financing decision

Efficiency check

Inventory churn Receivables churn Fixed Assets churn Total Assets churn

Valuation parameters

Price Earning Ratio Market Price to Book Value Ratio Beta of a stock and cost of capital

– Cost of equity– Cost of debt

Coloring financials

True and fair view…not essentially a correct view What is critical is consistency and not a specific

methodology of accounting Past financials help you understand revenues/cost dynamics

and assets/liability dynamics Future, anyway, is uncertain Work of an analyst starts when work of CA is over Management discussion and notes to accounts are more

important than accounts themselves Closely scrutinize off-balance sheet items (financing ,

liabilities – guarantees, MTM on outstanding derivatives etc.)

Coloring Financials

Accounting future revenues in the previous year. Postponing expenditure – Capitalization of the expenses

like R&D expenses, Brand building expenses (Advertisements and sales force cost).

Change in the depreciation policy Extra provisions in the good years and writing them back in

the difficult years. Not providing sufficiently for the known and contingent

liabilities. Revaluation of assets to create impression of hefty reserves.

Valuation models

Valuation principles

Ability to differentiate between value and price is key to success in investments

Price is what you pay and value is what you get Understanding what an asset is worth and what

determines that value is a pre-requisite for intelligent decision making

Value must be supported by potential sustainable cash flows

Valuation pre-supposes knowledge about the assets

and the ability to estimate cash flows there from

Valuation models Net Asset Value Approach Discounted Cash Flow Valuation Relative Valuation Contingent claim Valuation

These models can yield significantly different estimates of value.

One needs to understand these valuation models in detail and pick right model to use in a specific situation.

Even the best valuation comes with a substantial margin for error

Net Asset Value

Net Asset Value is computed as:

Total Assets – Current Liabilities & Provision – Total Debt – Contingent Liabilities

Used in valuation of sectors such as Shipping, Real Estate and Airlines

Discounted Cash Flow Valuation

Value of an asset is the present value of expected cash flows on it.

We need future cash flows series and discount rate to arrive at DCF Valuation

As Valuation time horizon is < Asset time horizon, we need terminal value.

As significant value comes from terminal value, wrong estimations can infuse substantial error in valuation.

Discounted Cash Flow Valuation

Dividend Discount Models

Free cash flow to equity Discount Model - Value

equity based on free cash flows to equity (cash flow

after debt payments and reinvestment needs)

Free Cash Flow to Firm Discount Model - Value the

entire business based on free cash flows to the firm

(cash flow before debt payments and after

reinvestment needs)

Cost of funds Cost of equity to come from CAPM model:

COE = Rf + β * (Rm –Rf)– Determining Market Return-What historical period to consider-

longer the better– Higher leverage results in higher risk. Hence must be reflected in

higher beta Cost of debt is always the marginal cost of borrowing. Cost of preference share will be observed yield - Pref. Div. /

Market Price of Pref. Share. For non quoted equity/debt/preference shares, comparative

values will be used. WACC is the cost of each component weighted by its

percentage to total capital.


Value per share = Present Value of Expected Dividends Two fundamental inputs required-Expected dividends over

the years and cost of equity for discounting. As per Gordon Model (constant growth model), value of

Stock = DPS1

r-g Where, r is the required rate of return and g is the growth rate in

dividends.

To reflect different stages of growth, we can expand the model to two stages or three stages Dividend Discount Model


Useful tool of valuation only in case of limited

number of stable high dividend paying companies

Could undervalue companies that pay no

dividends or low dividends.

In a world where the entire amount available for

distribution is not declared in dividends, FCFE is a

better approach.

Free cash flow to equity Discount Models

This is similar to the dividend discount models with the Free cash flows to equity substituting for dividends

Free Cash Flow to Equity is the cash flows to common stockholders

Quick/Crude way to calculate FCFE

FCFE = EBITDA – Cash Interest – Cash Tax - Capex – Change in Working Capital –– Principal Repayments + New Debt Issues

Free Cash Flow to Firm Discount Models

In a leveraged world, Enterprise Value rather than equity value would be more relevant.

Accordingly, we can price the firm, using Free Cash Flows to Firm (FCFF) as future cash flows.

Free Cash Flow to Firm is the sum of cash flows to all stake holders - common stockholders, preferred stockholders and bondholders

Quick/Crude way to calculate FCFF

FCFF = EBITDA – Cash Tax – Capex – Change in Working Capital

Difficulties with Discount Models

• Future projections

• Sensitivity of the result to the Terminal Value

• Need to determine an appropriate discount rate

Relative Valuation

Relative valuation is basically intuitive.

We do this all the time in our personal life

The relative valuation methods are an extension of

natural habits of comparison to the field of

finance.

Value an asset looking at how the market prices

similar/comparable assets.– Trading Multiples– Transaction Multiples

Relative Valuation – Trading Multiples

Choose the appropriate valuation driver – Revenue, EBITDA, Net Profit, Book Value and Sector Specific

Calculate the valuation multiple of the company’s peers (Domestic or International)

Adjust the Multiple – Size, Operating/Net Margins, Growth Rate and ROCE

Apply the multiple to the valuation driver of the company to derive the company valuation

Widely used trading multiples– Price/Earnings– Price/Book Value– Price/Revenue– Sector Specific

Relative Valuation – Transaction Multiples

Multiples at which the similar transactions happened in the industry form the basis for valuation

Does not necessarily provide the correct valuation

Generally used for negotiations

Uses of Relative Valuation

Highly useful for quick estimates of value

Enables one to quickly identify potential baggers

in a market

Limited computations and assumptions.

Reflects current market mood

Good to appreciate parameters like max, min,

average etc.

Relative Valuation - Pitfalls

Inconsistent estimate of value - Key value

parameters like risk, growth and cash flow

potential are ignored

Values move with market moods

Vulnerable to manipulation and biases

Contingent claim valuation

Equity holders of the firm may be treated as having an option on the firm – either call or put, and so can be priced on option pricing basis.

Equity as an option

Stock holders

Stock holders have sold the asset to bond holders for loan amount, and

stock holders own call option on the firm.

Bond holders

Bond holders own the firm, and

Bond holders have sold a call option, on firm, to the stock holder.

Position of stock holders and bond holders in terms of call option:

Equity as an option

Stock holders

Stock holder own the firm,

Stock holders owe money to bond holders, and

Stock holders own a put option on the firm.

Bond holders

Bond holders have landed money to the equity holders, and

Bond holders have sold a put option, on the firm, to the stock holders.

Position of stock holders and bond holders in terms of put option:

Important considerations

Valuation is objective:– This may appear so but inputs required in the model are

subjective.– Inputs may be biased and there is a need to eliminate

bias.– Analyst’s stake in the firm under valuation might impact

conclusions. Valuation is not timeless. It can change if

circumstances or information change There is no precise estimate of value Complicated quantitative models need not mean the

valuation is better

Corporate Actions and Valuation

Corporate actions

Cash dividend Dividend in kind (stock dividend/bonus

shares) Stock split Stock consolidation Rights Equity carve out Buyback of shares

Corporate actions

Dividend decision PAT money is available for equity holders.

Following three things can be done with this money:

Distribute to equity holders as dividend. Retain the whole money and channelize that

towards the business, if opportunities exist. Distribute part of the money and retain part of the

money.

Corporate actions

Dividend decision

– Need of fresh funds in the company.

– Liquidity position of the company.

– Expectations of the shareholders.

– Management philosophy.

ROE along with retention ratio determines the growth rate

of the earnings

Corporate actions

Bonus shares– This is another form of paying dividend and so bonus

shares are also called stock dividend.

– Some fresh shares are given for the existing shares at no extra charges.

– Stock market prices fall down after bonus shares.

– In the books of company, general reserves become share capital (Capitalizing reserves).

– Shareholders’ proportionate ownership remains unchanged.

Corporate actions

Split of shares– Each shares is split in more number of shares.

– Par value per share goes down.

– Stock market prices fall down Ex-split to adjust for increased number of shares.

– In the books of company, there is no impact other than the change in outstanding number of shares (become more).

Comparison between bonus issue an stock split

Bonus Issue Par value of share remains

same. A part of reserves is

capitalized. Shareholders’

proportionate ownership remains unchanged.

Book value per share, EPS and market value per share decline.

Stock split Par value of share goes

down. No capitalization of

reserve takes place. Shareholders’

proportionate ownership remains unchanged.

Book value per share, EPS and market value per share decline.

Corporate actions

Consolidation of shares– This is exactly opposite to the split of shares.– Shares are consolidated and existing shares are

exchanged for lesser number of shares.– Par value per share goes up.– Stock market prices go up immediately.– In the books of company, there is no impact

other than the change in outstanding number of shares (become less).

Corporate actions

Right shares– At the time of raising further capital, first offer is made

to the existing share holders by the company.– Additional shares are offered to existing share holders on

priority basis to ensure that their shareholding does not get diluted.

– Shares are generally offered at a discount to market price of the share.

– Stock prices (Ex-rights) fall.– In the books of company, capital changes.

What about trading of rights on the exchange platforms ?

Corporate actions

Equity Carve-Out

– Offer for sale.– Seller raises new funds. – Seller generally maintains controlling interest in

business.– 100% equity carve-out is “divestiture IPO”

Corporate actions

Buyback of shares

Motives Management thinks that the stock is undervalued. Excess cash and lack of profitable investment opportunities. As a confidence building measure. As a defensive strategy against a potential takeover To increase leverage in the company.

– For treasury operations.– For extinction

Corporate actions

Buyback of shares

Modes of buy back Fixed price buy back.

– Proportionate right is offered to the investors to sell their shares back to company.

– Buy back of shares is done generally at a price higher than the market price.

Book built buy back Open market purchase

Corporate actions

Buyback of shares

– In the books of company, capital changes (it goes down).

– Buy back of equity shares in any financial year shall not exceed twenty five percent of the company’s total paid up capital and free reserves.

– D/E ratio should not exceed 2 after such buy back.

Thank you. Please feel free to reach me at:

[email protected]+91 98924 86751

Investment Principles and Equity Valuation

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