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 ….
Wednesday, September 16, 2009
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.
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.
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.
Tuesday, September 15, 2009
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.
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.
Monday, September 14, 2009
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
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
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