Let's compare two friends – Sonia and Peter. Sonia starts saving Rs750 per year from the time she is 15. After 15 years, she stops investing money to her nest egg.
On the other hand, Peter starts investing Rs5,000 per year when he is 30 and continues investing this amount every year till he is 60.
If both earn 15% post-tax return per annum on their investments, who will have more wealth when they retire at age 60?
Sonia. Her Rs750 annual savings between age 15 and 30 will aggregate to Rs27.7 lakhs by age 60, whereas, Peter’s Rs5,000 annual savings between age 30 and 60 will aggregate Rs25 lakhs.
Both will have built up meaningful wealth (compared to their investments). BUT for Sonia to build her wealth, the difference in the annual investment amount and the fewer number of years required for making investments, highlight the importance of starting to invest early.
To summarise, the power of compounding is the single most important reason for you to start investing right now. Remember, every day that your money is invested, is a day that your money is working for you.
Monday, January 14, 2008
Saturday, January 12, 2008
Ratios II
PROFITABILITY RATIOS
If you decide to set up a business, the most important thing for you to know is the return you would earn on your investment. Say, you decide to invest Rs 15,000 in a business–Rs 10,000 from your own pocket and Rs 5,000 using borrowed funds. The two figures you should look at to gauge its viability are your profits after meeting all operational expenses (termed return on capital employed) and profits after meeting expenses and paying the interest on the loan (termed return on equity).
If you pay an annual interest of 12 per cent on the loan and your business generates a return on capital employed of 14 per cent, it earns more than the cost of debt–and is therefore a profitable proposition; if it earns less, it’s a losing proposition. Also, if your return on owned funds was less than 12 per cent, it wouldn’t be a sound investment, as you could get at least 12 per cent by lending out your money. Before buying a company’s stock, evaluate its business on these two counts–no point investing in a losing business.
Return on capital employed (RoCE).
The RoCE is a measure of the efficiency with which a company uses its funds. It’s also a useful tool for lenders to gauge a company’s ability to service its debt obligations. Mathematically, the RoCE is the profits generated from operations divided by the capital employed (normally, taken as the average of the past two years so as to smoothen the effect of a mid-year increase or decrease in equity or loans) in the business.
RoCE=Profit before interest, depreciation and taxes÷(equity+reserves+debt)
As a rule of thumb, a company’s RoCE should exceed the interest rate it pays on its borrowed funds. Obviously, the higher a company’s RoCE, the more profitable it is. Having said that, RoCEs vary across sectors. For instance, steel is a more capital-intensive business than FMCG (it requires more funds to support operations), and it is only to be expected that Hindustan Lever will have a higher RoCE than Tisco. Hence, always compare a company’s RoCE with that of its peers. Also look at its RoCE over the preceding three to five years. Look for consistency, especially the ability to maintain profitability during downturns in the sector.
Return on equity (RoE). The RoE is a measure of the returns generated on shareholder funds.
RoE=Net profit÷(equity+reserves)
Companies that generate high returns on shareholder’s equity have the ability to pay their shareholders handsomely and create incremental assets on each rupee invested. The RoE is also an indicator of financial strength–companies with high RoE are more likely to generate incremental cash to fund capital expenses and are better placed to raise debt at fine rates. As in the case of RoCE, to draw meaningful inferences from a company’s RoE, compare it with that of its peers and over time.
OPERATIONAL RATIOS
Next, you need to evaluate a company’s operational efficiencies–how well it manages various aspects of its operations. Here, we focus on three key ratios that shed light on three important areas of a company’s business.
Inventory turnover ratio.
Inventories are the sum total of finished goods, raw materials, stores and spares that a company holds at any point in time to ensure continuity in production and sales. The inventory turnover ratio indicates what proportion of sales are held as inventories.
Inventory turnover ratio=Sales÷Avg inventory
The average inventory is worked out by taking the average of inventories for two consecutive years, which is available in the balance sheet. A more understandable concept is the inventory turnover period–the number of days it takes the company to turn over its inventory.
Inventory turnover period=Number of days in a year (365)÷Inventory turnover ratio
So, if the inventory turnover ratio is 3, the inventory turnover period is 122 days (365/3). This shows the company sold its inventory 3 times in a year and, on an average, it took 122 days to sell that stock.
Broadly speaking, a lower inventory turnover period is positive, as it means faster liquidation of inventory–and therefore, lower working capital requirement. The less money a company has tied up in inventory, the more money it has to spend on other operational activities.
Inventory holdings vary across sectors, and need to be viewed in conjunction with the nature of the business. Hence, while comparing inventory management of two companies in the same sector is fair, inter-sector comparisons are not. Between two companies in a sector, the one turning over its inventories faster is managing its inventories better or is able to sell its products more easily. Also look at a company’s inventory management over a period of time. A pronounced decrease (or increase) in a company’s inventory turnover period would indicate an improvement (or deterioration) in its inventory management.
Debtors turnover ratio.
This ratio indicates how quickly a company is realising payments from customers. If a company is slow to convert receivables into cash, it indicates that the company is resorting increasingly to credit sales or that it is having a problem with recoveries. The company’s liquidity could be impaired and it may need to borrow more funds to meet its working capital needs.
The debtors ratio calculations are similar to the inventory ratio calculations.
· Debtors turnover ratio=Sales÷Average debtors
· Debtors turnover period=Number of days in a year (365)÷Debtors turnover ratio
If the debtors turnover ratio is 4, the debtors turnover period would be 91 days (365/4). This means that, on an average, the company takes 91 days to realise its payments.
Compare a company’s debtors turnover period with other companies in the same sector and over time. This will show which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.
Be wary of companies whose debtors turnover period exceeds that of its competitors by a big margin and whose debtors position is showing a rising trend. Such companies are probably overstating current sales by pushing stock to their distributors. This was, in fact, the case with many tractor companies in mid-2001. Around 100,000 tractors were lying unsold with dealers then, which is abnormally high given that around 260,000 tractors are sold annually. In other words, tractor companies had recorded these sales in their books, but there was a question mark over when this money would actually come into the company’s coffers.
Current ratio.
The current ratio shows how much liquidity a company has to meet its trade obligations. This ratio is calculated by dividing the company’s current assets (assets that can be easily converted into cash) by its current liabilities (short-term debts). Both figures are available in the balance sheet.
Current ratio=Current assets÷Current liabilities
As a general rule, a current ratio of 2:1 is considered comfortable, as it provides an adequate margin of safety for the company to meet its operating cash needs. A low current ratio suggests a company might need to raise funds from other sources (raise debt or issue fresh equity) to meet obligations. On the other hand, a high current ratio suggests that a company is hoarding assets instead of using them to grow the business–not the worst thing in the world, but potentially something that could impact long-term returns. Always check a company’s current ratio against that of its competitors. Certain industries have their own norms on current ratios.
VALUATION TOOLS
If you’re convinced a company is on a sound wicket, there’s only one decision left to make: at what price is the stock a good buy? A good company is not always a good investment; it’s a good investment only when its share price offers appreciation potential. These four valuation tools help you find the right price.
Price-to-earnings (PE) ratio. This is the most commonly used–and abused–valuation tool. It shows how many times a company’s earnings are discounted for by the market.
PE ratio=Share price÷Earnings per share
Since the market values companies on their future prospects, not past performance, the historic PE (based on the latest declared EPS) presents an inaccurate picture. Instead, use the forward PE–current market price divided by expected EPS for the coming years–to project the future value of a stock, and decide at what price it merits investment. Say, a company whose stock has traditionally traded in a PE band of 10 to 15 expects its EPS to increase from Rs 10 for the financial year ended March 2002 to Rs 15 in the year ending March 2003. Given the stock’s historic PE band, the stock should trade between Rs 150 and Rs 225 in a year’s time. If the stock is currently at Rs 100, you’re looking at a potential return of 50-125 per cent in a year.
But what PE should a stock get? Two good benchmarks to use are the stock’s historical PE band (the high and low PE it has got over the years) and the PE of its peers. While a stock’s historical PE band is a good benchmark to apply for future valuations, keep an eye out for developments that necessitate a re-rating of the stock–upward (giving it a higher PE) or downward (giving it a lower PE). On the positive side, these could take the nature of increased visibility in earnings for a pharma company from new drug launches, or, more generally speaking, a restructuring that makes the company more focussed and efficient. On the negative side, these could be a perceived decline in business prospects and lower growth.
Discounted cash flows (DCF).
The most comprehensive valuation method, it involves forecasting a company’s future cash flows and discounting them at your desired rate of return from the stock to today’s value.
DCF value=Cash flow Year 1/d+cash flow Year 2/d +...+cash flow Year n+residual value/d
where n=time period; d=(1+r/100)y; r=rate of return desired; y=year
While doing a DCF analysis, be careful about the four assumptions you make:
· Cash flows: Ideally, one should use free cash flows. But since this is a complex calculation, we advise you to use net cash from operating activities generated by the company in the latest year as the base. This figure is available in the cash flow statement in the annual report. Then, you need to make realistic projections of the rate at which you expect the company to grow, and work out the cash flows for the coming years.
· Discount rate: This is the return you desire from the stock. But again, keep it realistic. A 15 per cent annual return from equity is almost twice the risk-free rate of return, and a reasonable benchmark to go with given the risk involved.
· Number of years: Theoretically, you should do a DCF valuation based on the life expectancy of the business or the expected payback period from the business (by when you would like to recover your investment and desired rate of return). If you are unsure on both counts, use an evaluation period of five to 10 years.
· Residual value: Most businesses last for more than just 5 to 10 years (the time period indicated above), and you need to assign a value to the residual life of the business. The simplistic thing to do is to add the company’s present net worth (asset value) to the cash flows in the last year of your calculation.
After running the numbers on an Excel sheet, you’ll get a figure of how much net cash the company’s shareholders will earn from the business during the period under study. From this discounted value, current debt (an outflow) is deducted. The figure derived is divided by the company’s equity to arrive at the fair present value per share of the company. If this DCF price exceeds the current price of the stock, buy; if it’s less, sell.
Price-to-book value (P/BV) ratio.
The P/BV ratio illustrates how adequately or inadequately the share price of a
company reflects the shareholders’ share of assets in the business (total assets minus external liabilities).
P/BV ratio=Share price÷Book value per share
Theoretically, a P/BV of below 1 indicates that the shareholders’ interest in the company is undervalued–if all its assets were to be sold and the proceeds distributed to shareholders proportionately, each shareholder would get back more than the current price of the share. Therefore, there’s a case for the share price to rise.
In reality, though, assets are not easy to sell, more so at book value. A company is said to be an asset play when the difference between its share price and book value is significant and its assets can be sold easily at or above book value. This tool is best used for companies that could be targeted for a takeover or where there is a possibility of liquidation of these assets.
The P/BV ratio is relevant for companies in commodity-based businesses that have significant tangible assets like factories and depots. But don’t apply it to companies in sectors such as FMCG and pharma, which have brands or other intangible assets such as patent rights that are not reflected in their books.
Enterprise value-to-operating profit ratio.
This is another indicator of how attractive a company is to buyers. Unlike the P/BV ratio, which looks at the company purely as an asset play, this places emphasis on the company’s earning potential and how this is valued.
Enterprise value-to-op. profit ratio=(Mkt. cap+debt —liquid assets)÷Operating profit
From the perspective of a buyer, the cost of acquiring a company (the enterprise value, or EV) is the market value of its stock (market capitalisation) plus debt (which he’s likely to take on) minus cash and liquid assets (over which he has control, post-acquisition). This enterprise value now needs to be looked at in relation to the operating profit (or the profit before interest, depreciation and tax, or PBIDT) generated by the company. Depreciation is not accounted for, as it is a book provision. Likewise for interest, which is the cost attributable to borrowed capital (already accounted for in the acquisition cost).
The lower the EV/PBIDT ratio, the more attractive the valuation. So, a company with an enterprise value of Rs 1,000 crore and generating an operating profit of Rs 500 crore (EV/PBIDT of 2) is more attractive than a company available for Rs 1,500 crore and earning an operating profit of Rs 600 crore (EV/EBITDA of 2.5). A comparison with peers on this parameter can direct you towards the undervalued business.
If you decide to set up a business, the most important thing for you to know is the return you would earn on your investment. Say, you decide to invest Rs 15,000 in a business–Rs 10,000 from your own pocket and Rs 5,000 using borrowed funds. The two figures you should look at to gauge its viability are your profits after meeting all operational expenses (termed return on capital employed) and profits after meeting expenses and paying the interest on the loan (termed return on equity).
If you pay an annual interest of 12 per cent on the loan and your business generates a return on capital employed of 14 per cent, it earns more than the cost of debt–and is therefore a profitable proposition; if it earns less, it’s a losing proposition. Also, if your return on owned funds was less than 12 per cent, it wouldn’t be a sound investment, as you could get at least 12 per cent by lending out your money. Before buying a company’s stock, evaluate its business on these two counts–no point investing in a losing business.
Return on capital employed (RoCE).
The RoCE is a measure of the efficiency with which a company uses its funds. It’s also a useful tool for lenders to gauge a company’s ability to service its debt obligations. Mathematically, the RoCE is the profits generated from operations divided by the capital employed (normally, taken as the average of the past two years so as to smoothen the effect of a mid-year increase or decrease in equity or loans) in the business.
RoCE=Profit before interest, depreciation and taxes÷(equity+reserves+debt)
As a rule of thumb, a company’s RoCE should exceed the interest rate it pays on its borrowed funds. Obviously, the higher a company’s RoCE, the more profitable it is. Having said that, RoCEs vary across sectors. For instance, steel is a more capital-intensive business than FMCG (it requires more funds to support operations), and it is only to be expected that Hindustan Lever will have a higher RoCE than Tisco. Hence, always compare a company’s RoCE with that of its peers. Also look at its RoCE over the preceding three to five years. Look for consistency, especially the ability to maintain profitability during downturns in the sector.
Return on equity (RoE). The RoE is a measure of the returns generated on shareholder funds.
RoE=Net profit÷(equity+reserves)
Companies that generate high returns on shareholder’s equity have the ability to pay their shareholders handsomely and create incremental assets on each rupee invested. The RoE is also an indicator of financial strength–companies with high RoE are more likely to generate incremental cash to fund capital expenses and are better placed to raise debt at fine rates. As in the case of RoCE, to draw meaningful inferences from a company’s RoE, compare it with that of its peers and over time.
OPERATIONAL RATIOS
Next, you need to evaluate a company’s operational efficiencies–how well it manages various aspects of its operations. Here, we focus on three key ratios that shed light on three important areas of a company’s business.
Inventory turnover ratio.
Inventories are the sum total of finished goods, raw materials, stores and spares that a company holds at any point in time to ensure continuity in production and sales. The inventory turnover ratio indicates what proportion of sales are held as inventories.
Inventory turnover ratio=Sales÷Avg inventory
The average inventory is worked out by taking the average of inventories for two consecutive years, which is available in the balance sheet. A more understandable concept is the inventory turnover period–the number of days it takes the company to turn over its inventory.
Inventory turnover period=Number of days in a year (365)÷Inventory turnover ratio
So, if the inventory turnover ratio is 3, the inventory turnover period is 122 days (365/3). This shows the company sold its inventory 3 times in a year and, on an average, it took 122 days to sell that stock.
Broadly speaking, a lower inventory turnover period is positive, as it means faster liquidation of inventory–and therefore, lower working capital requirement. The less money a company has tied up in inventory, the more money it has to spend on other operational activities.
Inventory holdings vary across sectors, and need to be viewed in conjunction with the nature of the business. Hence, while comparing inventory management of two companies in the same sector is fair, inter-sector comparisons are not. Between two companies in a sector, the one turning over its inventories faster is managing its inventories better or is able to sell its products more easily. Also look at a company’s inventory management over a period of time. A pronounced decrease (or increase) in a company’s inventory turnover period would indicate an improvement (or deterioration) in its inventory management.
Debtors turnover ratio.
This ratio indicates how quickly a company is realising payments from customers. If a company is slow to convert receivables into cash, it indicates that the company is resorting increasingly to credit sales or that it is having a problem with recoveries. The company’s liquidity could be impaired and it may need to borrow more funds to meet its working capital needs.
The debtors ratio calculations are similar to the inventory ratio calculations.
· Debtors turnover ratio=Sales÷Average debtors
· Debtors turnover period=Number of days in a year (365)÷Debtors turnover ratio
If the debtors turnover ratio is 4, the debtors turnover period would be 91 days (365/4). This means that, on an average, the company takes 91 days to realise its payments.
Compare a company’s debtors turnover period with other companies in the same sector and over time. This will show which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.
Be wary of companies whose debtors turnover period exceeds that of its competitors by a big margin and whose debtors position is showing a rising trend. Such companies are probably overstating current sales by pushing stock to their distributors. This was, in fact, the case with many tractor companies in mid-2001. Around 100,000 tractors were lying unsold with dealers then, which is abnormally high given that around 260,000 tractors are sold annually. In other words, tractor companies had recorded these sales in their books, but there was a question mark over when this money would actually come into the company’s coffers.
Current ratio.
The current ratio shows how much liquidity a company has to meet its trade obligations. This ratio is calculated by dividing the company’s current assets (assets that can be easily converted into cash) by its current liabilities (short-term debts). Both figures are available in the balance sheet.
Current ratio=Current assets÷Current liabilities
As a general rule, a current ratio of 2:1 is considered comfortable, as it provides an adequate margin of safety for the company to meet its operating cash needs. A low current ratio suggests a company might need to raise funds from other sources (raise debt or issue fresh equity) to meet obligations. On the other hand, a high current ratio suggests that a company is hoarding assets instead of using them to grow the business–not the worst thing in the world, but potentially something that could impact long-term returns. Always check a company’s current ratio against that of its competitors. Certain industries have their own norms on current ratios.
VALUATION TOOLS
If you’re convinced a company is on a sound wicket, there’s only one decision left to make: at what price is the stock a good buy? A good company is not always a good investment; it’s a good investment only when its share price offers appreciation potential. These four valuation tools help you find the right price.
Price-to-earnings (PE) ratio. This is the most commonly used–and abused–valuation tool. It shows how many times a company’s earnings are discounted for by the market.
PE ratio=Share price÷Earnings per share
Since the market values companies on their future prospects, not past performance, the historic PE (based on the latest declared EPS) presents an inaccurate picture. Instead, use the forward PE–current market price divided by expected EPS for the coming years–to project the future value of a stock, and decide at what price it merits investment. Say, a company whose stock has traditionally traded in a PE band of 10 to 15 expects its EPS to increase from Rs 10 for the financial year ended March 2002 to Rs 15 in the year ending March 2003. Given the stock’s historic PE band, the stock should trade between Rs 150 and Rs 225 in a year’s time. If the stock is currently at Rs 100, you’re looking at a potential return of 50-125 per cent in a year.
But what PE should a stock get? Two good benchmarks to use are the stock’s historical PE band (the high and low PE it has got over the years) and the PE of its peers. While a stock’s historical PE band is a good benchmark to apply for future valuations, keep an eye out for developments that necessitate a re-rating of the stock–upward (giving it a higher PE) or downward (giving it a lower PE). On the positive side, these could take the nature of increased visibility in earnings for a pharma company from new drug launches, or, more generally speaking, a restructuring that makes the company more focussed and efficient. On the negative side, these could be a perceived decline in business prospects and lower growth.
Discounted cash flows (DCF).
The most comprehensive valuation method, it involves forecasting a company’s future cash flows and discounting them at your desired rate of return from the stock to today’s value.
DCF value=Cash flow Year 1/d+cash flow Year 2/d +...+cash flow Year n+residual value/d
where n=time period; d=(1+r/100)y; r=rate of return desired; y=year
While doing a DCF analysis, be careful about the four assumptions you make:
· Cash flows: Ideally, one should use free cash flows. But since this is a complex calculation, we advise you to use net cash from operating activities generated by the company in the latest year as the base. This figure is available in the cash flow statement in the annual report. Then, you need to make realistic projections of the rate at which you expect the company to grow, and work out the cash flows for the coming years.
· Discount rate: This is the return you desire from the stock. But again, keep it realistic. A 15 per cent annual return from equity is almost twice the risk-free rate of return, and a reasonable benchmark to go with given the risk involved.
· Number of years: Theoretically, you should do a DCF valuation based on the life expectancy of the business or the expected payback period from the business (by when you would like to recover your investment and desired rate of return). If you are unsure on both counts, use an evaluation period of five to 10 years.
· Residual value: Most businesses last for more than just 5 to 10 years (the time period indicated above), and you need to assign a value to the residual life of the business. The simplistic thing to do is to add the company’s present net worth (asset value) to the cash flows in the last year of your calculation.
After running the numbers on an Excel sheet, you’ll get a figure of how much net cash the company’s shareholders will earn from the business during the period under study. From this discounted value, current debt (an outflow) is deducted. The figure derived is divided by the company’s equity to arrive at the fair present value per share of the company. If this DCF price exceeds the current price of the stock, buy; if it’s less, sell.
Price-to-book value (P/BV) ratio.
The P/BV ratio illustrates how adequately or inadequately the share price of a
company reflects the shareholders’ share of assets in the business (total assets minus external liabilities).
P/BV ratio=Share price÷Book value per share
Theoretically, a P/BV of below 1 indicates that the shareholders’ interest in the company is undervalued–if all its assets were to be sold and the proceeds distributed to shareholders proportionately, each shareholder would get back more than the current price of the share. Therefore, there’s a case for the share price to rise.
In reality, though, assets are not easy to sell, more so at book value. A company is said to be an asset play when the difference between its share price and book value is significant and its assets can be sold easily at or above book value. This tool is best used for companies that could be targeted for a takeover or where there is a possibility of liquidation of these assets.
The P/BV ratio is relevant for companies in commodity-based businesses that have significant tangible assets like factories and depots. But don’t apply it to companies in sectors such as FMCG and pharma, which have brands or other intangible assets such as patent rights that are not reflected in their books.
Enterprise value-to-operating profit ratio.
This is another indicator of how attractive a company is to buyers. Unlike the P/BV ratio, which looks at the company purely as an asset play, this places emphasis on the company’s earning potential and how this is valued.
Enterprise value-to-op. profit ratio=(Mkt. cap+debt —liquid assets)÷Operating profit
From the perspective of a buyer, the cost of acquiring a company (the enterprise value, or EV) is the market value of its stock (market capitalisation) plus debt (which he’s likely to take on) minus cash and liquid assets (over which he has control, post-acquisition). This enterprise value now needs to be looked at in relation to the operating profit (or the profit before interest, depreciation and tax, or PBIDT) generated by the company. Depreciation is not accounted for, as it is a book provision. Likewise for interest, which is the cost attributable to borrowed capital (already accounted for in the acquisition cost).
The lower the EV/PBIDT ratio, the more attractive the valuation. So, a company with an enterprise value of Rs 1,000 crore and generating an operating profit of Rs 500 crore (EV/PBIDT of 2) is more attractive than a company available for Rs 1,500 crore and earning an operating profit of Rs 600 crore (EV/EBITDA of 2.5). A comparison with peers on this parameter can direct you towards the undervalued business.
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