Archive for the ‘Valuation’ Category.

 

I was recently chatting with sandesh and he asked me a question – Why don’t you invest in US based companies? Is it due to the fact that you consider them outside your circle of competence or some other reason ?

My response was – As an indian resident, I cannot invest out of india and that is the main reason for not looking at US companies.

So much for due diligence ! It seems one can invest abroad through ICICI direct and this facility has been available for some time. I do not know if there are some restrictions on the type of stocks one can buy and so would appreciate if some one can leave a comment on it.

I have been following a few companies in the US, mainly out of curiosity and as a learning experience. The one company I would like to own is Berkshire hathaway. This company is run by warren buffett and as most of the readers of this blog would know, I am a Buffett fan.

Warren buffett has been the chairman and CEO of this company since 1967 or 68 (don’t have the exact date). The company stock price and intrsinic value has grown by 20%+ since he took over the management of the company (you do the math of what 1000$ invested then would be worth now after almost 40 years of compounding at 20%+ per annum).

The core business of the company is insurance. In addition Buffett has invested capital by accquiring a collection of good companies or by investing in stocks. The company is a major shareholder in companies such as Cocacola, Amex, washington post etc and a 100% owner of companies such as See’s candies, DQ, GIECO etc.

It is diffcult to analyse the company in a short post and I will do a detailed post later if I can confirm that an Indian investor can invest in this company. However irrespective of the outcome, I would recommend everyone to read Buffett’s letter to shareholders (download here) and analyse the company. I have read these letters multiple times and I can tell you from personal experience that these letters are the best education in economics, finance and investing.

I have analysed the company to understand the economics of an insurance company and also to see the disclosure a shareholder friendly management (Buffett is known for his shareholder orientation and ‘really’ considers them as partners).

I am uploading the valuation of the company (BRK valuation.xls) in google groups (see here). The company is undervalued from my perspective. I would encourage you to download the annual report and read through it. It is a big report and takes effort to understand it, but it is worth it.

Caution: The company is undervalued, but the stock is not cheap. The ‘A’ stock is worth around 100000 usd (50 lacs per share) and the ‘B’ stock (which is 1/30 of A stock) is worth around 3200 usd (1.6-1.7 lacs per share). The reason for this high price is that buffett has not split the stock for the last 40 years (read the owners manual in the AR for the reason).

 
 

I received a list of companies to analyse based on my earlier post. In order to do a better analysis, I am trying to club all the stocks from the same industry. As there are several cement companies in the list, I decided to take a stab at the cement stocks first.

My earlier analysis of the cement industry is here and here. In addition I have analysed the industry and updated my analysis in the file business analysis in the google group. Please have a look under the column commodity – cement.

The cement industry is a cyclical commodity industry where the profit and return on capital is dependent on the demand cycle picture. From the mid 90’s to 2002-2003 period, there was an excess of supply and hence prices were depressed. Most companies had poor to non-existent profits and accordingly the stock prices suffered. Since 2003, the demand has increased rapidly and so have the prices . The profit margins are now in excess of 20% for some companies and ROE in excess of 40% for companies such as ambuja cements. I personally think these are fairly high returns for this industry and the best of the companies in the industry would earn around a max of 20% over a business cycle.

Valuation of cement companies should not be done on the basis of peak earnings alone. This holds true for most commodity companies. Case in point – sugar companies. In 2006-2007, these companies appeared cheap based on their peak earnings. However when the cycle turned downwards, the stock prices got wacked. The economics of the cement industry are not as bad (there is lesser government intervention), however the valuation approach should be similar to the sugar industry. One has to be careful in extrapolating the peak earnings and assuming that the stock is undervalued.

Due to the cyclicality and commodity nature of the industry, analysis and valuation of  cement companies is more diffcult as one has to figure out where the industry stands in terms of the business cycle . High returns can be made if one can predict the key turnaround points in the business cycle.

Mysore cement –
This is an interesting company. The company was taken over by the heidelberg group and made a tender offer to buy shares from the public at 54 Rs/ share in 2006 . SEBI directed the group to set the price at 72.5 per share. This was recently overturned by SAT and the heidelberg group can now initiate a tender offer to buy the shares from the public at Rs54 per share.

In addition the company alloted 66.5 Million shares at Rs 54 per share in 2006 to the group. This capital was used to pay off the accumulated debts and wipe out the accumulated losses. The company has also become profitable from 2007 since the new management took over.

In addition a recent news, indicates that indorama cement would be merging with mysore cement taking the capacity to 2.8 Million tonnes. The company further plans to expand the capacity to 5.9 Million tonnes.

The financials look good, with the company solidly in the black, no debt and cash of almost 180 crs on the books. The impact of the new management can clearly be seen from the P&L account, balance sheet improvement and aggressive plans of the company to expand capacity through mergers and greenfield projects.

So if everything is so good, then one should go and buy the stock? I would hold on that before I can figure out the following
–        Cement is a cyclical industry. Currently the industry is on an upswing and hence all cement companies are making good money. How will mysore cement fare when the cycle turns south (supply exceeds demand)
–        What is the cost structure for mysore cement? Cost is critical in a commodity industry such as cement.
–        Future plans of the management. Scale is important in the industry. Mysore cement is still at 2.8 Million tonnes and even after capacity expansion would still be one of the smaller companies

One interesting development is the tender offer. The stock is quoting at around 30 Rs and the tender offer should be around 54 Rs. The stock may be a good arbitrage opportunity, even if the long term prospects of the company needs a more thorough analysis.

Ambuja cements
Ambuja cements has been one of most profitable cement companies in india and has made money even during the downturns. They have the highest net profit margins in the industry at 30% and ROE of almost 40%. Net profit margins have grown from 10% to around 30% and the profit as a result has grown by 8 times in the last 5 years.

The company sells at around 560 Crs/ Million tons of capacity compared to say 170 Crs/ Million tons of capacity for Mysore cement. The difference is high and understandable as Ambuja cement is a well run company with huge capacity and a very efficient cost structure.

The company is currently selling at a PE of 7 based on last year’s net profit numbers. Based on normalised profit margins of around 12-15%, the company is selling at a PE of around 12-13. I would say the company is undervalued by 20-25% at best.

If you believe that the net margins are sustainable, consider the following fact : Net margins in 2003 and before were around 10% and have expanded to around 30% in the last 2 years.

Grasim, ACC, Ultratech etc
Grasim has a blend of cement, VSF and other businesses. The cement business seems to be doing well in line with industry. The other companies such as ACC and ultratech have also been performing well in the last 2-3 years. Most of the top cement companies now have margins in the range of 18-22%, ROE in excess of 30% and high profit growth rates in excess of 20-30%.

The valuations of these companies are fairly close. Most of these tier I companies are selling at 7-8 times profit in comparison to the smaller companies which are selling at 4-5 times or lesser.

I am reaching the following conclusions after looking at the complete sector

–  The cement industry has enjoyed very high growth rates and great profits for the last few years. The profits margins are not sustainable. New capacity, cost pressure and competition are bound to drive the margins to long term averages of around 10-12% in the next few years

–  Most of the companies appear undervalued in terms of the last 2 years profits. However on the basis of normalized profits they are selling at 12-13 times earnings. At best, these companies appear undervalued by 20-25%. There may be a bit of undervaluation, but not by a huge amount.

–  Considering the level of undervaluation in some sectors such as pharma, IT etc and the better economics enjoyed by those industries compared to Cement, I am personally not too keen on investing in the cement sector. If I had to pick up one cement company to put my money in for the long term, I would prefer ambuja cement (if I had to that is !!)

 
 

In all my posts on investment ideas, I typically refer to the instrinsic value of the company. The definition and concept is deceptively simple, application takes a lifetime.

What is intrinsic value – It is the total free cash flow the company will produce from now to closure of the firm. Discounting these cash flows gives the intrinsic value.

I will not be able to give a complete rundown on the DCF (discounted cash flow) computation. That could be another post, when I am really in mood to bore everyone to tears 🙂 . However the formuale for the computations is present in my valuation template – see the tab ‘DCF’

You can find the formulae here. The key parameters are free cash flow, discount rate, terminal values and growth rate. There are volumes written on each parameter and I will not get into the pros and cons of it. Let me give you how I calculate each. You can find the mechanics for each in my worksheets for companies.

Free cash flow = Net profit (after adjusting for all one time gains / losses)+ depreciation – maintenance capex

Discount rate = around 12-13 %. That’s the hurdle rate for me. I don’t use any risk premium above that. Discount rate is a research topic in itself. I prefer to use a rough approach though and not tie myself up in academic acrobatics.

Growth – self-explainatory

Terminal value – It is the value of the company from the nth year ( n-1 year are the no. of CAP years) onwards. I would suggest looking at some textbook for more details as it is difficult to explain it in a short post.

 I take it as 12 times Free cash flow of the previous year. Simple formulae for terminal value is NOPAT (net operating profit after tax)/ WACC (weighted average cost of capital).  However let me warn you that the DCF calculations are very sensitive to the terminal value and it is important to be conservative on this parameter.

Once you have worked these numbers, you can plug them into a spreadsheet and get the intrinsic value. As you can see all these numbers are estimate and hence intrinsic value is an estimate too. The trick is in the assumptions you make. You have to be careful in making conservative assumptions, otherwise the DCF calculation could give you inflated numbers. That’s why a good valuation requires an indepth understanding of the company and its economics.

Discounted cash flow (DCF) analysis is the most fundamental way of calculating the instrinsic value. The other approaches such as PE, relative valuation which depends on comparing the valuation with other companies in the same industry etc are indirect valuation approaches. They can be used an input into the valuation process, but should not be the sole approach