SENSEX fundamental valuation - Is it overpriced ?

                                    Is BSE-SENSEX over/undervalued as of Sep 30, 2009?

To download

Word document

http://www.scribd.com/full/20584628?access_key=key-di0w6tj1vuu7xxhn2f6


Excel valuation model

http://www.scribd.com/full/20584733?access_key=key-1r2z1jjbq2c0dlj43viq


Media is inundated with the news of expected correction in the markets, having rallied too high too quickly. Some say the rally is driven by liquidity, while others claim the optimism in the global market.

Without doing any more storytelling (abundant in media), I will delve into how much SENSEX is valued intrinsically. (Readers can do the similar exercise for NIFTY or any other index)



What do I mean by the intrinsic value of SENSEX?

Intrinsic value of any asset is the present value of future cash flows, generated by the asset. Therefore, SENSEX, backed by 30 stocks, should also have an intrinsic value derived from the future cash flows of its 30 constituent securities. If one can identify these future cash flows and calculate the present value, one can conclude the degree of SENSEX over/undervaluation based on fundamentals.

How is SENSEX CALCULATED?

There is enough literature on the web that does a good job of explaining. In summary, SENSEX is calculated using a free-floating market cap of its 30 stock constituents. Free-floating market cap is the product of stock price and the number of shares that can trade in the market (shares held by promoters or other strategic investors are not included in calculating the free floating market cap). One can download the free floating multiplier from BSE web site, to calculate free-floating market cap. I have used the excel file downloaded from BSE website to do the same.

Lastly, the free floating market cap is multiplied by a divisor that references it to the base year. But for our purpose of discussion, we will limit ourselves to the estimation of free-floating market cap, driving the value of SENSEX.

How do you calculate intrinsic value of an asset?

Before we jump into valuing SENSEX, I will run you through an example of calculating intrinsic value of a candle making company (started in 2009 with an investment of Rs. 370). The company plans to generate Net income of Rs. 100 next year (2010) and growing hence @15% for next 4 years. At the end of 4 years, we assume that the growth rate reduces to 4% forever.

Let us first identify the future Net Income of the company.

2010 : 100

2011: 100*(1+.15)=115

2012: 100*(1+.15)^2=132.25

2013: 100*(1+.15)^3=152.08

2014: 100*(1+.15)^4=174.9


After year 5(2014), Net income grows at 4% forever. Therefore, 2015 Net income will be 174.90*(1+.04) =181.89

                               2010   2011    2012    2013   2014   2015       2016

Net Income(Rs)      100     115       132.25 152.08 174.9 181.89   189.17

Growth (%)            15       15        15           15       15        4            4

(Net income will continue to grow@4% forever after 2015. In the interest of space, I omitted more years in the table)

Now that we have identified future Net income, let us bring in the concept of Return on capital. A candle company must invest in the business to drive growth. As mentioned above, the company started with an investment of Rs 370 in 2009 and is expected to generate Net income of Rs. 100 in 2010, resulting in return on capital of 100/370=27.00%. The return on capital (increase/decrease) may change in future years, driven by several factors such as competition and efficiency. But in our example, we will assume that the company manages to maintain same ROE forever. In 2011, company’s net income grows by 15% to 115, requiring reinvestment driven by the formula G=ROC*B

G – Growth in Net income

ROC – Return on capital

B – How much of Net income to retain/reinvest to generate G growth

In our example, G=.15 and ROC=.27 resulting in B of 55.55%. The owner should reinvest 55.55% of Net income every year in its business to generate 15% growth rate. So in year 2010, owner should re-invest 55.55% of 100 =Rs. 55.55 in business leaving a cash flow of Rs. 44.44 to owner. As mentioned above, after year 5 (2014), the growth rate decreases to 4%, resulting in B of .04/.27=14.81%. After 2014, owner should reinvest only 14.81% of Net income in the business to generate 4% growth. Now we can identify the cash flow available to owner after all the reinvestments.



                                      2010 2011 2012 2013 2014 2015 2016

Net Income(Rs)              100 115 132.25 152.08 174.9 181.89 189.17

Re-investment rate (%)    55.55 55.55 55.55 55.55 55.55 14.8 14.8

Re-investment(Rs)           55.55 63.82 73.39 84.40 97.06 26.92 27.99

Available cash(Rs)          44.5 51.17 58.85 67.67 77.83 154.97 161.17

(Available cash row is the cash flow available to the owner that he/she can withdraw from business. This cash flow is also called at times free cash flow)

To estimate the intrinsic/fundamental value of candle business, we need to calculate the present value of all future cash flows. Let us assume that the discount rate for this business is 12%. (Discount rate is driven by the riskiness of business, identified by Beta). The discount factor for 2010 will be 1/(1.12) and for 2011 be 1/(1.12)^2 and so on.

Putting back the discount rate into the table, the table looks like:



                                       2010 2011 2012 2013 2014 2015 2016

Net Income(Rs)              100 115 132.25 152.08 174.9 181.89 189.17

Re-investment rate (%)    55.55 55.55 55.55 55.55 55.55 14.8 14.8

Re-investment(Rs)          55.55 63.82 73.39 84.40 97.06 26.92 27.99

Available cash(Rs)         44.5 51.17 58.85 67.67 77.83 154.97 161.17

Discount factor              0.89 0.79    0.71   0.63    0.56   0.50      0.45

PV (available cash*disc) 39.73 40.79 41.88 43.01 44.16

(Omitted years after 2016)


Let us introduce the concept of terminal value. As mentioned above, it is assumed that starting 2015, Net income will grow @4% forever. The value of such annuity in year 2014 is:

(annuity cash flow in 2015)/(discount rate – annuity growth rate) ---- This is formula of infinite Geometric progression series

Annuity cash flow in 2015=154.97

Discount rate=12%=.12

Annuity growth rate=4%=.04

Annuity value in 2014=154.97/(.12-.04)=1937.19

This annuity value is also referred to as Terminal Value.

We need to discount terminal value to calculate its PV today (2009), so we will multiply by 0.56 resulting in 1099.21 . This is the present value of annuity, starting in 2015.

Therefore, the intrinsic value of candle business is the sum of terminal value( 1099.21) and the present value of first 5 years cash values.

Intrinsic value=39.73+40.79+41.88+43.01+44.16+1099.21=1308.81

Assuming owner has no debt and there are 100 shares in the company, the price of 1 share=1308.81/100=Rs.13.08

Intrinsic valuation of BSE SENSEX

Because SENSEX is composed of 30 stocks, we will need to identify future cash flows resulting from these 30 stocks, adjusted for free floating factor. (SENSEX is calculated using free-floating method).

We need to identify below mentioned parameters to calculate present value of SENSEX:

- Growth rate for next 10 years and Terminal growth rate.

- Return on Equity during next 10 years and in Terminal growth period.

Growth rate for next 10 years

There are 2 ways one can identify the next 10 years growth rate:

1. Using predictions for Indian economy growth rate – Mckinsey in its recent research report estimated Indian economy to grow at a CAGR of 10-12% in the next 10 years. Because SENSEX represents the Indian market, Indian growth rate can be a good substitute for SENSEX growth rate.

2. Using analyst EPS growth rate estimates of SENSEX companies - Analysts estimate the long term growth of public listed companies. Using the weighted average of such estimates, one can derive the SENSEX long term/10 year growth rate. For example, let us assume that SENSEX is composed of only 2 stocks: A(100 stocks traded) and B(200 stocks traded). EPS for A and B is 10 and 12 respectively. Also, analysts’ long term growth rate estimates for A and B are 10% and 12% respectively. The growth rate of SENSEX will be (10*100*0.1+12*200*0.12) /(10*100+12*200)=11.4%.



If one does the similar exercise for 30 SENSEX stocks using estimated forward EPS for next year and their long term growth rates, SENSEX long term growth rate comes out to 13.72 %.

Terminal growth rate

This is determined by the risk free rate or GDP growth rate in the terminal period. Indian 10 year yield on Sep 30, 2009 is 7% and the country holds a BBB- Moody’s credit rating, resulting in country risk premium of ~3.5%. This results in Indian risk free rate of 7-3.5=3.5%, or the terminal growth rate of 3.5%.

Return on Equity for next 10 years

We calculate ROE of SENSEX for last 5 years and use the median ROE in the last 5 years as an estimate of ROE for the next 10 years. The max ROE for SENSEX is 23.06% in 2007.

ROE for SENSEX is calculated using the Book Value weighted average of ROE of index components.

2009 (Until-Mar) 2008 2007 2006 2005

SENSEX-ROE (%) 18.32 20.36 23.06 22.42 21.00

ROE in terminal period

No company can continue to maintain excess returns forever, as it will encourage competition and hence whittle away the excess returns. Similarly, Indian markets can’t continue to maintain excess returns forever, as it will encourage more FIIs to invest in India, increasing the valuations and reducing the excess returns. According to Mckinsey school of thought, terminal excess return should be zero, resulting in ROE equal to cost of equity. The SENSEX valuation will assume terminal excess return of zero, resulting in terminal ROE of 10% equal to cost of Equity.

Cost of Equity

This is determined by the Indian risk free rate, Indian country risk premium and the equity market risk premium. India holds a BBB- Moody’s rating corresponding to 3.5% country risk premium. The Indian 10 year yield at the time is 7% and the average historical market risk premium is 5%. Because SENSEX beta is 1, the cost of equity=7+5=12%.

It is estimated that India’s Moody’s rating will improve 10 years from now, attributed to improved country’s economy. In terminal period, India’s risk premium will reduce by 200bp resulting in cost of equity of 10%.

SENSEX forward EPS- 2010

Using analysts estimates of 30 index components, free-floating weighted average of forward EPS is calculated resulting in next year earnings of Rs. 628264.71m. (Free-floating earnings= fwd EPS*free-floating-multiplier*shares-outstanding)

Retention ratio

Earnings are not the free cash flow because growth is driven by reinvestment. Using G=ROE*B, we can calculate the retention ratio for high growth phase and terminal growth period. Using growth rate of 13.72% and ROE of 23.06% in high growth phase, SENSEX needs to retain 60% of its earnings resulting in a payout ratio of 40%. In terminal growth phase, payout ratio is 65%.

Intrinsic valuation of SENSEX

With future EPS, growth rates and pay-out ratio of SENSEX, we can calculate the Free-cash flow to equity generated by SENSEX. Calculating the present value of these cash flows will give us the intrinsic value of SENSEX, indicating SENSEX is overvalued by 14.10%

Cash on BS

Cash on Balance Sheets of Sensex companies should be weight adjusted and added to intrinsic value calculated above.


I couldn't get the table for DCF formatted correctly, please either donwload word doc http://www.scribd.com/full/20584628?access_key=key-di0w6tj1vuu7xxhn2f6 

Are low P/E stocks cheap ?

We have already discussed how to calculate P/E for wipro and Infosys. Now lets go one step further and see what actually drives P/E - either low or high.


We often hear people saying stock ‘X’ is cheap because it is trading at lower multiple or is expensive because its trading at a very high multiple compared to industry average. Is that really true? I hope after reading this you should have necessary tools at your disposal to be informed investor and ask back your financial advisor with the necessary information.

Drivers of P/E

Last time we calculated wipro and Infosys P/E to be 20.15 and 22.8 respectively. Before we jump to conclude which is cheap or expensive, we should understand what drives the P/E of an asset.

You will be surprised that there are only 3 parameters that drive P/E and you have heard about them:

1. Payout ratio – This determines how much a company is required to retain cash from its earnings for reinvestment purpose. Keeping other things constant, if a company needs to retain more capital relative to its competitor to achieve similar growth, the company is relatively inefficient.

2. Cost of equity – This is the return that equity investor expects from a stock. How do we determine this? Every stock is associated with a beta, which determines the riskiness of that stock. And as the saying goes higher the risk higher is the return investor expects. This implies higher beta is associated with higher cost of equity.

3. Lastly, the growth of its earnings. I think I don’t need to do any explanation on this.

Relationship between drivers and P/E

P/E = (payout-ratio)/(cost of equity-growth)

So what an investor should look for:

1. Payout ratio: Keeping others constant (meaning cost of equity and growth are same), companies with higher payout ratio should trade at a higher multiple and vice versa.

2. Cost of equity: Keeping others constant (meaning payout ratio and growth are same), higher cost of equity stocks should trade at a lower multiple.

3. Growth: Keeping others constant (payout and cost of equity are same), companies with high growth should trade at a higher multiple.

As an example, we will run this model through wipro and Infosys example.

Infosys drivers

(Source: in.reuters.com)

Beta: 0.54

Payout ratio: 22.46

Growth: 11

Wipro

Beta: 0.92

Payout ratio: 15.03

Growth: 9.31 (go to estimates and look for mean of long term growth)

So what do you observe comparing 3 drivers?

Wipro has lower growth, lower payout ratio and higher beta(high cost of equity), resulting in all drivers favoring Infosys to have higher multiple. Therefore Wipro deserves to be trading at lower multiple than Infosys.

But there exist stocks stocks which are cheap and do trade at lower multiple. The point is that now you have the tools required to discern between stock being cheap or deserving to be trading at lower multiple.

So is this the end of story. Not really… Even if we identify wipro deserves to be lower than Infosys, the question is by how much. I have seen analysts randomly slapping a multiple, with no justification.

A good analyst is expected to quantify all such details before recommending any stock to be cheap or expensive. I will try to address this issue later in the series.

But for now you may want to run this model through stocks you know. Happy P/E ….

Explanation of common financial terms that confuse investors

I will be covering most common asked questions. Feel free to ask if I missed any and I will continue to add o the list.

What is non-cash item?
Any item that doesn't impact cash flow. For example depreciation is a non-cash item or the interest expense of zero coupon bond.

What is capital expense?
Any expense that is needed for company to continue growing is called capital expenditure. This may include setting up new plants, R&D, acquitions or anything you can think of company is investing money that is for growth and not for operational purpose is categorized as capex.

What is Free cash flow ?
Any cash flow left after taking away any reinvestment needs is called free cash flow. Remember this cash flow is before any interest expense. So lets take example of Wipro.

Source http://in.reuters.com/money/quotes/incomeStatement?symbol=WIPR.BO

For year ending Mar-09

Operating income=45196
But remeber operating expense includes interest expense of 2400.
So add this back to operating income resulting in
EBIT (earnings before interest and tax)=45196+2400=47596

Now lets calculate the tax rate for wipro in this year.
Provision for taxes=6460
Net Income Before taxes=45196
Tax rate=6460/45196=14.29%

EBIT=47596
taxes(@14.29%)=6803
EBI=47596-6803=40792

Now We will add any non cash items in EBI. The major item is depreciation.
Depreciation=497

How much was wipro's capital expenditure.
Lets look into its cash flow statement for Mar-09
http://in.reuters.com/money/quotes/incomeStatement?stmtType=CAS&perType=ANN&symbol=WIPR.BO

Look under cash from investing activities. There is a capex of 16746.
Well i don't know what other investing is but lets take for argument sake just the capex.
Although there are several other items that company expense like R&D etc which one needs to account for capex.

So what we have is:
EBI=40792
+Dep=497
-Capex=16746

This equals Free cash flow=40792+497-16746=24543

This is the cash flow available to the firm(available to debt holders and equity holders).

We also call it cash flow available at the firm level


What is Enterprise Value

I am sure you can find the formula for EV from google to be

EV= marketcap+Net debt-minority interest

What does it actually mean ?

It represents the present value of all  future free cash flows. (see above what is free cash flow)

Also, you can say it is the value of the company attributed to its operational activities. So does that mean there is value coming from non-operational activities. Yes, some of them are :

1. cash
2. minority interest in other companies

Wipro for example has cash of Rs.41 billion as of June-09, so computing the total company value(available to debt and equity holders) will be sum of enterprise value and Rs.41 billion. If it holds any minority interest in other companies we will also add that at the market value to the above number.

This is how we compute the total firm/company value and you must have seen it may be greater than the enterprise value depending on other non-operational value items like cash or minority interest.

So how do we deduce equity value from above.

We know the total firm value= EV+cash+minority interest
Also we know firm is composed of Debt holders and equity holders so
We can say firm value=debt value+equity value

Lets assume that book value is same as market value for debt. We can read off balance sheet the existing debt. For wipro in this example, looking at interim balance sheet for June-09, we see
Short-term-debt=9433
Total long term debt=47986
So total debt=9433+47986=57419 or 57 billion

So for wipro:
debt value+equity value=EV+cash+minority interest

Lets assume wipro has no minority interest and from DCF model EV comes out to be 835billion

Therefore equity value(or market cap)=EV+cash-debt value= 835+41-57=819billion

You may be wondering how did I get the exact same market cap, actually I cheated to derive EV from today'smarket cap. But thats not the point .

Hope now you understand what are the different value components of firm and what is enterprise value.

Secrets about P/E and other multiples

I will address the easies valuation – relative valuation.


As discussed earlier on my blog, relative valuation doesn’t get into fundamental analysis, although you will be surprised that indirectly it is driven by the same fundamentals (explained later)

Various multiples used in market are-

1. p/e

2. EV/EBITDA

3. p/bv

4. p/sales

5. EV/EBIT

6. You can of-course make up your own.



Sanity check for any multiple:

Always ensure that any multiple you are dealing with is consistent. What I mean is whatever is in numerator is consistent with denominator. For example in P/E, numerator is price which is at equity level and denominator is EPS which is also at equity level. In EV/EBITDA, numerator is enterprise value which is at firm level and denominator is EBITDA, which is also at firm level. If you come up with a multiple in which numerator and denominator violates this principle, the multiple is no good. I am sure you should be able to identify the flaw to Price/EBIT multiple is someone throws at you.Try running these checks across other multiples and see if it passes.

In essence, either both numerator and denominator has to be at firm level(see my blog for further details) or at equity level.

Lots of people asked me what is Enterprise value, so not deviating into those details, I would suggest you refer to my blog for the explanation of Enterprise value and what drives it.

Price/Earnings

Sanity check: Both the numerator and denominator are at equity level so it passes our sanity check.

Numerator is price which can either be substituted by marketcap(in that case denominator will be Net income) or the stock price(denominator will be Earnings per share)

Now is EPS/Net Income for last 12 months(a.k.a ttm) or it’s a projection by analysts for next year(FY+1) or FY+2. This result in different versions of P/E – trailing P/E or forward P/E. Trailing P/E is where EPS/Net income is for last 12 months and Forward P/E is where EPS is for FY+1 or FY+2. So when some analyst says the stock is trading at 10x its 2011 earnings he/she is talking for forward P/E multiple of FY+2.

So which one is preferable : TTM P/E or forward. As long as you are comparing two stock on similar multiple, meaning either comparing both on TTM or forward, it doesn’t matter which multiple to use. They both will give you same results.

I am sure you will be anxious to see how to calculate P/E.

Lets do this exercise for Infosys and Wipro. All data I use is from in.reuters.com because I hate those pop up ads whenever I go to moneycontrol and others.

(Source: in.reuters.com)

We will be calculating forward P/E (see above what forward means)

Infosys

Price =2317

Estimated next year earning (go to estimates and look for mean EPS for 2010) =101.56

P/E=22.8

Now there are several issues like accounting for cash and other extra-ordinary items that I will address later.

Wipro

Lets do same exercise for wipro.

Price=554

EPS for 2010 mean=27.49

P/E=20.15

Ok so now we see wipro is trading at a lower multiple than Infosys. What would you intuitively think if some one tells you this. Wipro is cheap?

Think about it and I will return back with further insights and answer next week.

What is valuation

What is valuation?


Valuation determines how much an asset is worth. One can determine the worth either through market mechanisms such as what similar items are selling for in the market or if the asset has a defined cash flow stream, discounting them to calculate present value. The former approach is called relative valuation and the latter, fundamental valuation. But not all assets have a defined cash flow stream. You buy a piece of land at a price others are willing to pay for – example of relative valuation. But one can’t value using fundamental analysis as it doesn’t have any future cash flows.

Security like stock or a bond can be associated with future cash flows; hence can be valued using fundamental valuation.

Different kinds of valuation approaches

There are primarily 2 valuation approaches:

- Valuation driven by fundamentals like future cash flows – Fundamental valuation.

A Government Bond with a cash flow of Rs. 10 year from now is worth PV(10,discount-rare) – Present value of Rs. 10 today calculated by discounting 10 @ 1 year Indian Govt. interest rate. This is a very simple cash flow and a simple discounting without taking into account risk premium, capital structure and calculation of cash flows. Valuing a company requires zillion of assumptions in determining its present value, but the principle behind valuing a company is similar to one for bond in the example, albeit the degree of complexity is very high. Although this valuation approach is the most difficult to implement, if done correctly, and requires a long term horizon, it is market agnostic (fundamental valuation will continue to give you same valuation irrespective of market’s mood swings)

- Valuation driven by market moods such as degree of risk aversion (high risk aversion in recent crisis) or liking for a particular sector (IT in dot com bubble) – Relative valuation. If you have to buy a property, you will see what people are willing to pay for similar property in similar neighborhood and that will be its price. This is an example of relative valuation where you compare the prices of relatively similar assets. This valuation is driven by market mood swings – for example if market’s appetite for risk is high like in dot com or in 2007 before financial meltdown, people will be willing to pay higher prices for same asset than during 2009, characterized by high risk aversion. This approach is similar, but at the same time, suffers from the drawback that valuation changes with market moods.



Note: There is another valuation approach for depressed companies which are driven by the option component in the equity value. This one is for advanced readers and I may try to address this at the end.



Technical analysis, on the other hand, is driven by market demand and supply rather than fundamentals. (It can be argued that demand/supply may be indirectly driven by fundamentals)





In the future sections, I plan to take fundamental and relative valuation and get into greater detail taking a real company example.

Intrinsic valuation of Mahindra Satyam

Click below for complete valuation report

http://www.scribd.com/doc/19739503/Satyam-Post-Crisis-Valuation


Don't want to generalize, but felt that Indian investors follow/discuss more technical analysis than any other valuation. May be its quick way to make money and loose money, because no one can predict how market changes its mood.

Discussed with few analysts and their view point about fundamental analysis - most believe one can manipulate growth rates and other parameters to come up with any valuation. Is that really true if one does in a consistent and correct manner? People say one can fiddle with the terminal growth rate to generate any valuation. Well, I don't know how can one slap any terminal growth rate when it is range bound by long term GDP growth rates. Absolutely, projecting 10 year cash flows is a challenging task, and therefore is a more comprehensive approach to valuing companies in a market agnostic manner. Fundamental valuations doesn't change if particular sector gets over/underpriced.

From a retail investor view point, I think fundamental valuation is the most intutive approach. Its easier for a Relationship manager to make a finacial-unsavvy investor understand poor/good fundamentals(low/high excess returns due to low/high margins or high/low cost) than explaining a 14 PE multiple or stock breaking any barrier.

Below is my first link to Satyam fundamental valuation and hope to do more for Indian market.

Summary

Satyam investors have witnessed a massive wipe-out of their wealth, with its market cap nose-diving by 50 % since Dec, 08. Typical of any financial scam ridden company, Satyam stock got punished once its Chairman Mr. Ramalinga Raju jolted the market with the news of billion dollars financial irregularities. The acquisition by Tech-Mahindra infused confidence among investors community, reflected in the 300% stock appreciation since approval by India Law Board. The valuation report conducted the fundamental analysis of Satyam and valued it at Rs. 214.49, with 75% of its value coming from terminal phase.

Click below for complete valuation report

http://www.scribd.com/doc/19739503/Satyam-Post-Crisis-Valuation