Anda di halaman 1dari 227

equitymasters

SECRETS
The Biggest Lessons From Our
Entire 20-Year Investing Journey

Equitymaster Agora Research Private Limited


All rights reserved. Any act of copying, reproducing or distributing the contents
of this Book whether wholly or in part, for any purpose without the permission
of Equitymaster is strictly prohibited and shall be deemed to be copyright
infringement.

Disclaimer
The information/content (including any charts/graphs) in this Book has been
compiled from sources we believe to be true and reliable, but we do not hold
ourselves responsible for its completeness or accuracy. Any omissions/errors
are accidental and not intentional. This is not an offer to sell or solicitation to buy
any securities in any jurisdiction. Equitymaster or its associates will not be liable
for any losses incurred or investment(s) made or decisions taken/or not taken
based on the information provided in this Book. Before acting on any information/
recommendation, readers should consider whether it is suitable for their particular
circumstances and, if necessary, seek professional advice. Equitymaster and
its affiliates, directors, officers, employees may or may not hold any securities
mentioned herein. Equitymaster and its affiliates may from time to time, have
a relationship with any company reported in this Book in the ordinary course
of business. All opinions/views, if any, are subject to change from time to time
without notice.

Equitymaster Agora Research Pvt. Ltd.


103, Regent Chambers, Above Status Restaurant, Nariman Point,
Mumbai - 400 021 Tel: (022) 6143 4055 Fax: (022) 2202 8550
E-mail: info@equitymaster.com www.equitymaster.com
CIN NO - U74999MH2007PTC175407
SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537

Table of Contents
Welcome to a New Chapter in Your Investing Journey

Business Models & Economic Moats


Chapter 1

Introduction to Value Investing...............................................

Chapter 2

Analyzing Business Models.....................................................

Chapter 3

Identifying Economic Moats I.................................................

23

Chapter 4

Identifying Economic Moats II................................................

33

Chapter 5

Identifying Economic Moats III...............................................

51

Accounting Basics & Financial Analysis


Chapter 6

Accounting Basics...................................................................

65

Chapter 7

Financial Ratio Analysis I.........................................................

69

Chapter 8

Financial Ratio Analysis II........................................................

81

Chapter 9

Identifying Accounting Red Flags..........................................

91

Separating Good Management from Bad


Chapter 10

Separating Good Management from Bad I........................

105

Chapter 11

Separating Good Management from Bad II.......................

113

Chapter 12

Separating Good Management from Bad III......................

127

Valuation Methods
Chapter 13

Introduction to Valuation..........................................................

141

Chapter 14

Earnings Power Value and Franchise Valuation................

155

Chapter 15

Franchise Valuation With


Growth & Multiple-based Valuation......................................

165

Stock Screeners
Chapter 16

Stock Screeners..........................................................................

181

Behavioral Finance
Chapter 17

Behavioral Finance....................................................................

195

Portfolio Analysis
Chapter 18
Portfolio Analysis........................................................................

209

Welcome to a New Chapter


in Your Investing Journey

Dear Reader,
When we launched Equitymaster in 1996 - Indias first financial
website - we could not have imagined we would emerge as one of
Indias most trusted research houses.
Our visionto empower the small investorto be investors best
friendhas guided us through many challenges these past two
decades.
And today, when we look back, we take immense pride in what
weve delivered. And how weve remained committed to delivering
clear, honest, and unbiased views.
This book, which commemorates our 20th anniversary, has the
potential to change the way you invest. Thats because these
pages include the culmination of our two decades of experience
picking out money-making opportunities.
In these pages, we reveal the complete Equitymaster Waythe
secrets weve run our business on for 20 years.
We hope you find these lessons richly rewarding in your wealthcreation journey.
Happy investing,
Rahul Shah & Tanushree Banerjee
Co-heads, Equitymaster Research Team

PS: Three years ago, we decided to put together the best investing
secrets, lessons, and experiences weve gathered over the years.
We wanted to keep it simple and practical for the lay investor. As
such, the examples explained in the book pertain to that period.
While some facts may have changed, the essence of the lessons is
timeless.
We have strived to present the book in a highly objective and
concise manner, and as a result, have used bullet points in many
chapters. We hope you find the reading experience easy and
enriching.

ii

Business
Models
&
Economic
Moats

Chapter 1

Introduction to Value Investing

Definition of Value Investing


An investment operation is one which, upon thorough
analysis, promises safety of principal and a satisfactory
return. Operations not meeting these requirements are
speculative.
- Benjamin Graham
Value investing is an investment approach that seeks to profit from
identifying undervalued stocks. It is based on the idea that each
stock has an intrinsic value, i.e. what it is truly worth.
Through fundamental analysis of a company, we can determine
what this intrinsic value is. The idea is to buy stocks that trade at
a significant discount to their intrinsic values (i.e. they are cheaper
than their true value).
Once we buy an undervalued stock, the stock price eventually rises
towards its intrinsic value, and makes a profit for us in the process.
Value investing is conceptually simple, though requires effort to
implement. Research process focuses on finding out the intrinsic
value of a company. Primary tool for researching a company is
called fundamental analysis.

Chapter 1: Introduction to Value Investing

Philosophy of Value Investing


Benjamin Graham - The founder of Value Investing
4 components that define the philosophy behind value investing:

First component: Mr Market


Imagine you are in a partnership with Mr Market, where you can
buy or sell shares. Each day, Mr. Market offers you prices for shares
depending on his mood. If Mr Market is in a very optimistic mood,
he will offer very high prices. In this case, an investor should cash
out of shares. If Mr Market is in a very pessimistic mood, he will
offer low prices, and this is the time to buy.

Second component: Intrinsic Value


Intrinsic value represents the true value of the company based on
fundamentals. In the short term, market prices deviate from their
intrinsic values due to changing market sentiments. In the long
term, market prices return to intrinsic values. This process allows us
to make profits, because we can buy stocks when they fall below
their intrinsic values. We then hold them until they return to their
intrinsic values in the long term.

Third component: Margin of Safety


Margin of safety is the difference between the current market price
and the intrinsic value.
A margin of safety is achieved when securities are
purchased at prices sufficiently below underlying value
to allow for human error, bad luck, or extreme volatility
in a complex, unpredictable and rapidly changing
world. - Seth Klarman
4

Equitymasters Secrets

Fourth component: Investment Horizon


In the short run, the market is a voting machine but in
the long run it is a weighing machine.
- Benjamin Graham
Value investing works in the long term, because that is when
prices return to their intrinsic value. Value investing does not aim
to predict what stock prices will do 2 days or 2 months from now.
Instead, it aims to pick undervalued businesses that will outperform
in the long term. This will eventually reflect in the stock price.

Evolution of Value Investing


Value investing started as a purely quantitative approach that
has now evolved to incorporate a qualitative approach. Benjamin
Grahams view was that one only needed to look at the financial
statements of a company in order to determine its value. There
was no need to analyze qualitative factors such as a companys
management, future product offerings, etc. The numbers told the
investor everything they needed to know about whether they
should invest in a company or not. This approach is known as the
cigar butt approach. The advantage of the quantitative approach
is that it is based on hard facts alone. The analysis is objective,
and less reliant on assumptions. Unfortunately, the quantitative
approach does not account for all the factors that determine a
companys true value. Qualitative factors such as the management
quality, industry dynamics, competition, future products, consumer
behavior, etc. are all relevant to a companys performance. Warren
Buffetts approach incorporated these qualitative factors into his
analysis, along with the quantitative factors.

Chapter 1: Introduction to Value Investing

Concept of Economic Moat


A companys ability to maintain competitive advantages over its
competitors to protect market share and long-term profitability.
If a company has a high economic moat, it means it has an edge
over its competitors. Warren Buffetts approach aims to identify
companies with a high moat that are trading at reasonable prices.
The moat is inherently a qualitative factor, and this represents the
difference between Buffetts and Grahams approaches.

Coca-Cola Company - A classic Buffett stock


One of Buffetts most successful investments. Exemplifies the
difference between the approaches of Graham and Buffett. Buffett
admired the company due to the presence of a strong economic
moat. He also analysed other factors like management quality,
consumer behaviour, scalability of business, long term growth
visibility, etc. He was able to conclude that Coca-Cola could earn
much more 10 years from now than today. Graham on the other
hand would have seen Coca-Cola as just another company. He
would have analysed it based on existing earnings and ignore
future growth potential. Graham was of the view that competition
does not allow any company to earn extra profits for a prolonged
period of time. Hence, he did not believe in paying any premium
price. Buffett, however, focused on just those companies that could
keep competition at bay for a prolonged period of time due to the
presence of a strong economic moat. He was also willing to pay a
slightly higher price for them.

Equitymasters Secrets

Warren Buffetts Four Filter Approach


Warren Buffetts four filter approach is a process by which we can
arrive at an investment decision. It is like a checklist that we apply
to any stock we are interested in. We identify companies that have:

1. A business we understand
A business we understand is critical because we need to know
what we are buying into.
We stay away from companies that have overly complicated
products and business models.

2. Favorable long-term economics


Favorable long-term economics means the company should have
a competitive advantage (economic moat) that we believe is
sustainable over the long-term.

3. Able and trustworthy management


Able and trustworthy management means that management
consistently demonstrates competence and works in the interest
of shareholders.

4. A sensible price tag


Finally, a sensible price tag is nothing more than having a margin
of safety.

Chapter 1: Introduction to Value Investing

Equitymasters Approach
Here at Equitymaster, we closely follow Warren Buffetts investing
approach for many of our recommendation services. We believe
in identifying companies that have a high moat and sell for
reasonable prices. Our investment philosophy can be summarized
as follows:
Dont try predicting where markets will go
tomorrow or 6 months from now...Dont lose
your calm over changing market sentiments...
Buy stocks as if you are buying businesses...only
the ones with solid long term fundamentals...
only when theyre selling cheap...
And stay invested for the long term...Period

Equitymasters Secrets

Chapter 2

Analyzing Business Models

Investing in a Business
When you invest in a stock, you become a part-owner of the
business. Would you ever put money in a business that you dont
understand? Understanding businesses thoroughly and investing
in only those businesses that you understand is the cornerstone of
value investing.

Analysis of Business Models


When we study a company, we start by analyzing its business
model and the industry structure. A companys business model
is a description of how a company operates within an industry/
economy and creates value for its shareholders. Porters Five
Forces is a very powerful framework that can help you analyze a
companys business model and the overall industry dynamics.

Porters Five Forces- Basics


Firms in an industry compete for profits. Competition is not limited
to direct competitors alone. Factors such as potential new entrants,
customers, suppliers and substitute products also impact an
industrys profitability. An analysis of Porters Five Forces gives us
a solid understanding of a companys business model, the industry
structure and the long term profitability.

Chapter 2: Analyzing Business Models

Porters Five Forces- Benefits


Helps analyze a companys business in the context of the
industry in which it operates
Helps filter away short term market trends and understand
root factors that affect long term profitability of firms in an
industry
Helps understand why some sectors command premium
valuations while others do not

Porters Five Forces


Threat of New
Entrants

Bargaining Power of
Suppliers

Competitve Rivalry

Bargaining Power of
Customers

Threat of Substitutes

1. Threat of New Entrants


The barriers to entry determine how likely it is that new firms will
enter the market. The threat of new entrants determines how long
high profitability in an industry can last. If a company is making high
profits, this will attract other firms into the market, ultimately driving
profits lower. Factors such as high fixed costs, distribution network,
network effects, use of patented technologies, brand loyalty,
government regulations, etc. tell us how easy it is for new firms to
enter the market.

10

Equitymasters Secrets

2. Bargaining Power of Customers


The bargaining power between a firm and its customers can
affect the companys profit margins. In particular, if buyers are
concentrated (i.e. a small number of buyers), they are likely to
have considerable bargaining power. Other factors include how
easy it is for buyers to switch suppliers, whether buyers are price
sensitive, whether they can afford not to buy temporarily, and how
dependent the firm is on individual customers.

3. Bargaining Power of Suppliers


The bargaining power between a firm and its suppliers also
significantly impacts the companys profitability. The concept is
similar to the analysis of the bargaining power of customers; the
difference is that the company is a customer of its inputs. If there
are a small number of suppliers, then they will hold considerable
bargaining power. Also important is how easy it is for the firm
to switch inputs and suppliers; the harder it is to so, the more
bargaining power the supplier has.

4. Threat of Substitutes
A company faces competition from not just other firms in the same
industry but also firms from other industries that have products that
offer the same benefits as the companys products. The threat of
substitute products determines whether profit margins can remain
high over long periods of time. The more likely a customer is to
switch to a substitute product, the lower the company has to keep
its prices (and thus profit margins) to attract the customer. If profit
margins are low, it is more difficult for a company to withstand
external shocks; e.g. a rise in the price of its inputs.

Chapter 2: Analyzing Business Models

11

5. Competitive Rivalry
Competitive rivalry looks at the way in which companies compete
with each other within the industry. If companies compete
heavily on price, this is likely to keep profit margins low; this
occurs primarily when the companies products are very similar.
Competitive rivalry is low if there is differentiation between
products and brand loyalty is significant. Competitive rivalry is also
low if exit barriers are low and vice versa.

Applying Porters Five Forces:


We have selected three companies - Arvind Ltd, Nestle India
Ltd, and Asian Paints Ltd, due to their distinct business models.
Let us see how they fare as per Porters Five Forces model. The
analysis is performed as of June 2013. Many of the facts come from
company websites, annual reports, data providers, etc.

Arvind Ltd

12

Worlds fourth largest denim manufacturer.

Indias largest denim exporter.

Annual capacity: 110 m metres of denim and over 72 m


metres of shirting fabric.

Vertical integration in garments, strong brand franchise and


a wide distribution network in branded apparels has placed
the company in a strong position in domestic as well as
global markets.

Well-known in-house brands like Flying Machine, Excalibur,


Newport University and Ruggers.

Licensed brands such as Geoffrey Beene, Cherokee, Elle, US

Equitymasters Secrets

Polo Association, Arrow, Izod, Energie, and Gant.


Master franchisee of Tommy Hilfiger through a joint venture


(JV).

Business-to-business clients include brands such as Miss


Sixty, Diesel, Gap and Zara for denim.

Despite having a leadership position in the denim industry,


company has failed to create value for shareholders. Once a large
cap stock, Arvind Ltd was part of the BSE-Sensex from 1996 to
1998. However, company has consistently lost value and today is a
mid cap stock. Porters analysis helps understand how the adverse
dynamics of the textile industry have impacted the companys long
term profitability.

Arvind Ltd - Porters Five Forces


1. Threat of New Entrants - Very high

Denim is a highly commoditised product and does not


require a lot of capital investment. It is easy for any new
player to enter the market and take away market share from
existing players.

Even in apparel retailing, threat of new entrants is high on


account of numerous Indian and global brands entering the
market across all price points.

2. Bargaining Power of Customers - High


Given that there are several players in the denim space


starting from those vending unbranded, low priced ones
and going up to higher priced branded ones, the bargaining
power of customers is especially high in the mid-market
segment, where Arvind operates.

Chapter 2: Analyzing Business Models

13

3. Bargaining Power of Suppliers - High


Cotton and power costs put together comprise nearly 40% of


Arvinds manufacturing expenses. The volatility in the prices
of cotton due to shortage in global markets has made the
bargaining power of suppliers very high. Also, the bargaining
power of the foreign licensee companies is very high.

4. Threat of Substitutes - Very High


Most other fabrics can act as substitute for denim.

Demand for denim tends to move as per fashion trends in


global markets.

5. Competitive Rivalry - High


There exists a huge unorganized market for both denim and


shirting in India.

In each of the product segments, there exist other players


that compete in both the premium end space as well as in
the economy space.

An apparel manufacturer without strong brand recall


amongst customers and a strong retail franchise has very
little pricing power.

Nestle India Ltd

14

Indian arm of Swiss MNC Nestle S.A.

Largest food company in India.

Third largest FMCG company in India.

Leader in branded processed foods.

Commands a large market share in products such as instant


coffee, weaning foods, instant foods, milk products.

Equitymasters Secrets

Nestle India has been among the best shareholder wealth creators
with over 2300% returns in 18 years (19% CAGR). Low capex model
with excellent return on capital. For nearly two decades, Nestle has
paid out on average 76 out of every 100 rupees of net profits as
dividends to shareholders. How has the company managed to do
this? Porters Analysis provides some useful insights

Nestle India - Porters Five Forces


1. Threat of New Entrants - Low

Although launching a product is relatively easier, making it a


success is based on establishing its brand presence.

The brand equity is built over a period of time through


promotions that develop a brand recall and a robust
distribution network to ensure availability.

Nestle with its 100 years presence and powerful brands,


enjoys a definitive advantage over entrants.

2. Bargaining Power of Customers - Moderate


In mass segments where volumes play a major role,


customers enjoy bargaining power.

Customers also benefit in well penetrated and mature


product categories that are relatively more price sensitive.

Barring instant noodles, majority of the companys products


are in the premium categories.

As such, the bargaining power of customers is moderate.

3. Bargaining Power of Suppliers - Low


Since there are no major suppliers of inputs, they do not


have considerable clout and hence have low bargaining
power.

Chapter 2: Analyzing Business Models

15

4. Threat of Substitutes - Low


Most of the food products do have readily available


substitutes but it is difficult to rid people of their deep rooted
habits.

Those who prefer coffee over tea or instant noodles over


any other snack will seldom give up their preferences.

Threat of substitutes, therefore, is low for companys


products.

5. Competitive Rivalry - Low


The competitive rivalry is low in all product categories such


as noodles, chocolates and milk & milk products.

This is borne by the companys dominant market share in


most of the categories it is present in.

In instant noodles, it enjoys a market share of about 80%.

Nestle is also the market leader in other categories like baby


food, instant coffee and milk products.

Asian Paints Ltd

16

Founded in 1942, market leader in paints since 1968.

Indias largest paint company and Asias third largest.

Nearly 4 times the size (in terms of FY13 sales and net profits)
of its biggest competitor in India.

Manufactures a wide range of paints for decorative and


industrial use.

Operates in 17 countries, has 24 paint manufacturing facilities


and services consumers in over 65 countries.

Equitymasters Secrets

Driven by its strong consumer-focus and innovative


strategies, it has several strong brands and has consistently
pioneered new concepts in the industry.

Asian Paints ranks among leading shareholder wealth creators with


over 3300% returns over 18 years (22% CAGR). It was included in
Forbes Asias Fab 50 list of Companies in Asia Pacific in 2011 and
2012. It has a low capex model with excellent return on capital.
Over last 12 years, Asian Paints has paid out on average 45 out of
every 100 rupees of net profits as dividends to shareholders. How
has the company managed to do? Porters Analysis provides some
useful insights...

Asian Paints - Porters Five Forces


1. Threat of New Entrants - Moderate

Since there are no major regulatory hurdles and relatively


low fixed costs, starting the business is easy.

However, scale, reach and brand are major barriers to entry.

Also, there is some element of technology involved in


industrial paint segment which may act as a barrier.

2. Bargaining Power of Customers - Low


Asian Paints is the largest player in the decorative segment.


Since individuals are typical customers here, they lack
bargaining power.

However, in the industrial segment, the customers have high


bargaining power since they buy in bulk.

The company has strong presence in the decorative


segment. Hence, bargaining power of customers could be
deemed as low.

Chapter 2: Analyzing Business Models

17

3. Bargaining Power of Suppliers - High


Major raw material inputs include crude-based derivatives


and certain solvents.

Crude prices move based on global demand-supply


dynamics.

Availability of titanium dioxide is also scarce.

Hence, bargaining power of suppliers is high.

4. Threat of Substitutes - Low


The use of limestone as a substitute is limited to rural


markets.

In urban markets there is no real substitute to paint.

As such, the threat of substitutes is virtually absent.

5. Competitive Rivalry - Moderate

18

There is stiff competition in organized market since there are


many players.

Advertising and distribution are the key to attract customers


as there is minimal product differentiation.

Asian Paints has certain advantages because it is the largest


player and also has the biggest distribution network.

But margins are not very lucrative and hence, the


competitive rivalry can be termed as moderate.

Equitymasters Secrets

Conclusion
Understanding businesses is fundamental to value investing.
Porters five forces is a powerful framework to analyze business
models & industry structures. The five forces are: Threat of New
Entrants, Bargaining Power of Customers, Bargaining Power of
Suppliers, Threat of Substitutes, and Competitive Rivalry. How
companies rank on the five forces impacts long term profitability
and shareholder returns.

Chapter 2: Analyzing Business Models

19

20

Equitymasters Secrets

0.0

Dividend Payout ratio (%)

1.5

9.8

Return on Equity (%)

Total Debt to Equity

5.3

1.6

17.2

10.1

5.5

1.6

0.0

9.2

5.7

1.7

0.0

1.5

0.7

Data Source: Ace Equity

1.4

25.5

6.3

3.8

2.3

0.0

-9.6

-4.0

1.8

0.0

4.9

1.6

Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

Net Profit margin (%)

(Consolidated)

Arvind Ltd.

Key Performance Indicators- 10 years

Appendix 1

1.6

0.0

12.8

4.0

Mar-11

1.2

5.8

27.9

8.7

Mar-12

1.2

17.1

13.4

4.6

Mar-13

Chapter 2: Analyzing Business Models

21

73.3

0.0

Dividend Payout ratio (%)

Total Debt to Equity

5.5

28.7

56.3

0.3

Net Profit margin (%)

Return on Equity (%)

Dividend Payout ratio (%)

Total Debt to Equity

(Consolidated)

0.0

93.8

77.0

10.6

0.0

78.0

84.8

10.7

0.0

76.9

102.5

11.3

Data Source: Ace Equity

0.0

77.9

91.9

11.7

0.0

76.7

119.8

11.9

0.0

71.4

124.2

12.5

0.4

52.3

33.0

6.2

0.4

44.4

39.8

6.9

0.3

39.9

48.6

8.7

Data Source: Ace Equity

0.4

56.5

34.7

6.1

0.3

42.2

38.4

6.9

0.1

31.0

60.7

12.4

Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

84.3

Return on Equity (%)

Asian Paints Ltd.

11.5

0.1

36.4

45.2

10.1

Mar-11

0.0

57.1

114.0

12.8

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Net Profit margin (%)

(Standalone)

Nestle India Ltd.

0.1

38.8

41.4

9.4

Mar-12

0.8

48.6

90.3

12.5

Dec-11

0.1

39.6

37.8

9.2

Mar-13

0.6

43.8

69.5

12.4

Dec-12

Chapter 3

Identifying Economic Moats I

The Way Capitalism Works


The dynamics of capitalism guarantee that competitors
will repeatedly assault any business castle that is
earning high returns.
Warren Buffett
Money flows where it sees the highest possible return. High
return on capital in an industry leads to entry of new players. As
competition intensifies, return on capital shrinks. However, some
companies do manage to earn high returns for long periods
of time. What is it that protects them from the onslaught of
competition? The answer is economic moat!

What is an Economic Moat?


The term economic moat coined by Warren Buffett refers to the
competitive advantage a firm has over its peers. It is a structural
feature that helps to ring-fence a firms profitability and enables it
to earn return on capital much higher than the cost of capital.
We can also think of moats as entry barriers that prevent
competitors from reducing the firms profitability. If there is no
moat, competition will eventually drive return on capital down to
the cost of capital or even lower.

Chapter 3: Identifying Economic Moats I

23

Why do Economic Moats Matter?


Assume two companies that are growing sales and profits at
the same rate employing the same amount of capital. The only
difference is that one company (A) has a moat while the other
(B) does not have one. While B will see its returns decline with
rising competition, A will manage to earn superior returns for
long periods of time. Economic moats show the durability of a
companys future earnings. Companies with wide moats are
the most resilient businesses and the best shareholder wealth
creators.

Types of Economic Moats


The two main factors that define a firms profitability are Price and
Cost. Firms can boost their profitability in two ways:
Increase product prices
Cut down costs
But not many firms can do this. The ones that can do so on a
sustainable basis can be said to be enjoying an economic moat. All
moats can be divided on the basis of price and cost advantages.
Let us discuss them in detail

Types of Moats: Price Advantages


Economic moats that allow a firm to charge a premium over its
competitors could be referred to as moats arising from price
advantages. The most important moats under this type:
I. Real Product Differentiation
II. Intangible assets

24

Equitymasters Secrets

Brands

Regulatory licenses

Patents & Intellectual Property

III. Switching Costs


IV. Network Effects

I. Real Product Differentiation


Real product differentiation refers to distinctive attributes in a
companys product that set it apart from competition. Differentiating
factors could include appearance, features, durability, performance
quality, technology, etc. Product differentiation enables a firm to
command a premium price over its competitors. Firms can earn
very high returns by staying ahead of competition in terms of
quality and innovation.
However, this kind of moat may not ensure long term durability
due to the following reasons:

Competitors will replicate the product and grab market


share.

Customers may be unwilling to pay a high premium if


competitors products are only slightly inferior and may be
selling at a significantly lower price.

It is pertinent to constantly innovate, improve the product


and add new features in order to stay ahead of competition.

Innovation requires substantial R&D expenditure.

A market leader today may be replaced by a competitor who


manages to offer better products at a lower price. Hence, a moat
arising out of product differentiation is not only difficult to sustain

Chapter 3: Identifying Economic Moats I

25

over the long term but also requires huge capital investments.
Example: Consumer electronics, technology sector, etc. Companies
such as Nokia and RIM were once ahead of the curve but later on
failed to adapt themselves to changing customer preferences and
needs.

II. a) Intangible Assets: Brands


A brand is a name (or other feature) that creates a perceived
product differentiation in the minds of the consumers. The
companys products may or may not be very distinct from those
offered by competitors. But the perceived superiority and
trustworthiness of the product allows the firm to charge a premium
price. Because customers have loyalty towards a particular brand,
they may be reluctant to switch to other similar products. Brands
tend to create a moat by not only making it difficult for new
competitors to enter the market, but also limiting the scope of
existing players to expand. But do all brands imply an economic
moat? A well-known brand does not imply an economic moat
unless it gives the company pricing power and brand loyalty
(repeat business).
Examples of brands that have an economic moat: Coke, Colgate,
Nestle, Titan, Cadbury etc. Examples of well-known brands that do
not have an economic moat: MakeMyTrip, Flipkart, Videocon, etc.

II. b) Intangible Assets: Regulatory Licenses


Regulatory licenses can create a strong moat as new players
cannot enter the market without the requisite approvals. As a
result, a few number of firms have control over the entire market.
This must, however, not give the impression that all sectors that
require regulatory licenses may enjoy a strong moat. The key
condition that makes regulation a strong moat is when only entry

26

Equitymasters Secrets

to the market is regulated, whereas there is no regulatory control


on pricing of products or services.
Take the case of state-run electricity boards and private banks.
Entry to both sectors is highly regulated. But most utility companies
are under heavy losses because they have no pricing power.
On the other hand, profitability in the private banking sector is
determined largely by market forces and as such, banks tend to
enjoy higher returns. However, the moat in case of regulatory
licenses is dependent on an external factor and as such any
adverse change in regulation could be a major risk.

II. c) Intangible Assets: Patents & Intellectual


Property
When a company innovates a new product, it can patent the
product so that no other firm is legally allowed to sell this product.
Think of a patent as the financial reward for creating a new
product, or as intellectual property the company can use. The
pharmaceutical industry makes heavy use of patents whenever
they create a new drug. The patent allows them to recoup the high
capital expenditure that goes into research and development of
new drugs. Companies that have a patent on a particular good are
immune from competition.
Patents provide a very strong moat and allow the firm to earn very
high returns. However, moats arising out of patents do not assure
long term durability because patents have a finite duration. Once
a patent expires, it brings in heavy competition in that market and
drives down the profitability. As such, a company has to keep
innovating new patented products to enjoy high returns. Patents
are often vulnerable to legal battles and could be revoked. As
such, the moat of firms that have just a few patented products may
lack long term durability.

Chapter 3: Identifying Economic Moats I

27

III. Switching Costs


Switching costs refer to factors that make it difficult or undesirable
for consumers to switch to the products/services of a competitor.
The factors include time, capital, convenience, etc. If the switching
costs are high, a firm is able to lock in its customers. It can
charge its existing customers higher prices because it knows the
customers are reluctant to switch to competitors.
Think about the difference between a bank and a retailer. Do
you change your bank account every time some bank offers
higher interest and lower fees? Would you continue to buy things
from the same retailer even if he charges more than his nextdoor competitor? Another example is Microsoft Office. Users are
reluctant to switch from Microsoft as learning a new product would
be inconvenient and time-consuming.

IV. Network Effects


Network effects refer to the fact that the value of a product or
service increases with the increase in the number of users. This
effect is largely observed in fields where businesses rely on
information sharing or linking users together. Consumers are
unlikely to move to a new competitor because there would be very
few people using the new product/service.
Take the example of the National Stock Exchange. The higher the
trading volumes on the exchange, the more efficient is the pricing
process. This creates a self-reinforcing pattern, bringing in more
volumes on the exchange.
Another example is Facebook. Facebook is valuable to a user
because many other people they know also use it, making it
difficult for new social networking sites to succeed in the market.

28

Equitymasters Secrets

Types of Moats: Cost Advantages


While price advantages refer to how a firm can charge a premium
to its customers, cost advantages refer to supply-side factors that
enable a firm to be a low cost player. The most important moats
under this type:
I. Economies of scale
II. Cheaper access to resources
III. Process-based cost advantages

I. Economies of Scale
In an industry where the fixed costs are relatively much higher
than the variable costs, the greater the size of the firm, the greater
are the cost benefits that it can enjoy over its peers. Due to high
fixed costs, new competitors are discouraged from entering the
market. The absolute size of a firm is not as important as its size
relative to its competitors. For instance, a small cap firm could be
a dominant player in a niche industry and enjoy scale advantage
within that industry.
Cost advantages based on economies of scale can be divided into
two main types:

a) Large distribution network


A firm that possesses an extensive distribution network
can enjoy a remarkable edge over competitors and new
entrants. The higher volumes and lower lead times thus
enable companies to cut costs. It can not only achieve
higher volumes but can also introduce various new products
through the same channel. Example: ITC Ltd

Chapter 3: Identifying Economic Moats I

29

b) Large scale operations


For a manufacturing firm with high fixed costs, the average
cost per unit decreases as the output increases. Example:
Maruti Suzuki
For a retailer, the cost advantages lie in its ability to procure
merchandise on a large scale at a price that is significantly
lower than what its competitors can get. Example: Wal-Mart

II. Cheaper Access to Resources


In many commodity businesses, the access to key raw materials
or assets is an important component of their success. Usually,
firms will buy/lease access to a land/onshore/offshore asset and
use that asset to access raw materials. Cheap access to a resource
or raw material can lead to significant cost savings and, in turn,
high profitability. Examples: oil, gas, mining companies. Energy
and mining companies can be very profitable due to their ability to
cheaply access raw materials.

III. Process-based Cost Advantages


Process-based cost advantages refer to cost savings occurring
due to efficient and cheaper production or supply processes.
By innovating and building better processes, a firm can produce
or supply its products more cheaply than other competitors.
Competitors may not have access to these processes, and cannot
necessarily implement it themselves. However, competitors could
catch up and erode the moat over time. Example: Amazon.com
(online retailer), Toyota (Total Quality Management), Dell (sold direct
to buyers) Tata Steel (low cost steel producer), etc.

30

Equitymasters Secrets

Determining a Moat
Has the company consistently earned high returns on
capital?
Does the company enjoy better profitability relative to its
competitors?
Identify the key factors that enable the company to earn such
high returns.
Can the company continue to enjoy these high returns for a
long time?
If the answer to these questions is in the affirmative, the company
under consideration does have an economic moat.
Note: Certain industries, by their very inherent structural
characteristics, offer economic moats to a relatively large number
of firms. Example: Consumer goods, pharma, etc.

Durability of a Moat
Once we identify a company with a moat, the next step is to
determine its long term durability. How long can the company earn
higher returns while keeping competitors at bay? Certain moats
tend to erode over time, while few get more durable over time. The
Buffett test: Can a well-financed competitor erode the companys
profitability?
Give me $10 billion dollars and how much can I hurt
Coca-Cola around the world? I cant do it.
Warren Buffett

Chapter 3: Identifying Economic Moats I

31

Avoiding False Moats


Temporary favourable economics should not be confused for
moats. Example: High profitability due to supply shortages
will end once new capacities come on stream.
Advantages that cannot be scaled up do not imply a moat.
Popular products, strong market share or technological
superiority do not guarantee a durable long term moat.
Never confuse a great management for a moat.
Go for a business that any idiot can run -- because
sooner or later, any idiot probably is going to run it.
Peter Lynch

Conclusion

32

Moats are entry barriers that prevent competitors from


eroding a firms profitability.

Economic moats are indicative of the durability of a


companys future earnings.

Price advantage moats are competitive advantages that


allow a firm to charge a premium price from its customers.

Cost advantage moats are supply-side factors that ensure a


firms high profitability.

It is important to determine durability of a moat & avoid


getting trapped by false moats.

Now that we have discussed the conceptual framework


of economic moats, the next two chapters will be entirely
dedicated to discussing practical examples of economic
moats in listed Indian companies.

Equitymasters Secrets

Chapter 4

Identifying Economic Moats II

Examples of Price Advantage Economic


Moats:

1. WABCO India Real Product


Differentiation
Company overview

WABCO India, a majority owned subsidiary of WABCO


Holdings Inc., is a leading manufacturer of air-assisted and
air brake systems for commercial vehicles in India.

It has about 85% market share in the original equipment


manufacturers (OEM) market.

It also enjoys a market share in excess of 75% in the


replacement market segment

The company has a strong aftermarket network with more


than 7,000 outlets and 320 service centers all over India.

Economic Moat- Real Product


Differentiation

WABCOs strength is the performance quality and the


technology behind its products that sets it apart from
competition.

Chapter 4: Identifying Economic Moats II

33

The companys parent has been a pioneer of breakthrough


electronic, mechanical and mechatronic technologies for
braking, stability and transmission automation systems for
over 140 years.

WABCOs track record of technology leadership features


many of the commercial vehicle industrys most important
innovations.

With intensive R&D efforts and high quality standards,


its products have found global acceptance. It exports to
countries such as Australia, Malaysia, UK, Singapore, South
Asia, North America, Venezuela and the Middle East.

It consistently tries to increase revenues per vehicle through


introduction of new products and upgradation to higher end
technologies.

Given the support of its parent company in terms of


technology and brand name, we believe it would not be so
easy for one to displace WABCO from its leadership position.

Financial performance

WABCO India has generated returns on equity (ROE) of


around 30% on average over the last five years.

It does not have any debt on its books.

Its profit margins are way higher than its peers in the
industry, indicating strong pricing power.
( Please see table in Appendix 2 on page 46 )

34

Equitymasters Secrets

2. Colgate-Palmolive (India) Brands


Company overview

Promoted by Colgate-Palmolive USA, the 51% subsidiary


company commenced its Indian operations in 1937.

Colgate manufactures and distributes oral care, personal


care & household care products.

In oral care, the company is the market leader with 55%


share in the Indian toothpaste market, and 42% share in
the toothbrush market.

The oral care segment contributes over 95% of the


companys total sales.

Colgate has a wide distribution network of 4.9 million


stores.

Its flagship brand, Colgate Dental Cream, is the largest


distributed product in the toothpaste market, and is available
in 4.1 m stores.

Economic Moat- Brands


Colgate has built an extremely powerful brand over its 75


years of existence. The brand is consistently ranked among
the most trusted brands in India.

Its products are approved by the Indian Dental Association


and this lends strong brand equity. Medically approved
dental products find greater acceptance and act as powerful
entry barrier for new launches.

The company has oral care products straddling price points


and catering to niche categories.

Chapter 4: Identifying Economic Moats II

35

The company partners with dentists and schools to increase


oral care awareness, thereby promoting its products.

Financial performance

Over last 10 years, Colgate has generated a return on net


worth (RONW, same as return on equity) of over 90% on
average.

As of year ended March 2013, Colgate had zero debt on its


balance sheet.

The company spends heavily on advertising and sales


promotion, averaging nearly 16% of sales over the last 10
years.

Colgates brand value coupled with one of the widest


distribution networks in the country has resulted in a strong
economic moat for the company and has led to significant
shareholder wealth creation over the long term.
( Please see table in Appendix 2 on page 47 )

3. Solar Industries - Regulatory Licenses


Company overview

36

The company is the largest and the fastest growing


manufacturer of industrial explosives and initiating
systems in India.

The company commands 29% market share in the domestic


explosives market. Apart from 17 manufacturing facilities
in India, Solar exports explosives to over 19 countries and
enjoys about 70% market share in exports from India.

Equitymasters Secrets

The company also has two overseas manufacturing units in


Zambia and Nigeria, Africa.

The company is also in the process of setting up a


manufacturing plant that would supply specialty chemicals to
the defence sector.

Economic Moat- Regulatory Licenses


Government regulations provide a strong moat. The


industrial explosives sector is one of the very few industries
that require industrial licenses. It is mandatory to get
clearance from the Home Ministry.

Given the hazardous nature of the product, clearance from


the Intelligence Bureau (IB) is required regarding safety of
location.

A lot of other permissions, NOCs (No Objection Certificates)


and licenses are required from various other government
agencies. This creates a strong barrier against new players
planning to enter this industry.

In addition, the pricing is not subject to regulatory


oversight. This allows the company to earn high returns on
capital.

Financial performance

Solar Industries robust financial performance is testimony of


its economic moat.

The companys return on capital has been robust, while


operating margins have remained within a stable range.
( Please see table in Appendix 2 on page 48 )

Chapter 4: Identifying Economic Moats II

37

4. Bosch Ltd Patents and Intellectual


Property
Company overview

Bosch Ltd is a subsidiary of German auto components firm


Robert Bosch GmbH.

It manufactures fuel injection systems with focus on both


diesel and gasoline.

It is the market leader in this field and has a share of around


70% in the diesel space.

Given the increasing dieselization in the country, the


company stands to benefit as diesel systems account for
around 85% of the companys total revenues.

It has supply contracts with most of the major players in


the commercial and passenger vehicles segment and even
caters to three wheelers.

Economic Moat- Patents and Intellectual


Property

38

Bosch Ltds strength is the patented technology of its


parent firm, the German auto components behemoth Robert
Bosch GmbH.

In terms of patent application numbers, Bosch occupies a


leading position in important markets.

Bosch Group associates had together filed 4,700 patent


applications in 2012 alone.

The Bosch Group spends over 8% of its sales revenue for


research & development. As the leader in the fuel injections

Equitymasters Secrets

space, Bosch Ltd has continuously improved technology and


introduced new products in this area.

The company has been working closely with most original


equipment manufacturers (OEMs) to introduce products that
will help smooth the transition to Bharat Stage 3 and Bharat
Stage 4 emission norms.

Given the support of its parent company in terms of patented


technology, we believe it would not be so easy for one to
displace Bosch Ltd from its leadership position.
( Please see table in Appendix 2 on page 48 )

Financial performance

Bosch Ltd has generated a return on equity (ROE) of over


25% on an average during the past 10 years.

This is commendable given the cyclical nature of the


industry.

It has ample cash and investments and virtually no debt on


its books.

Whatever capex requirements it has had in the past have all


been met through internal accruals with no recourse to debt.
( Please see table in Appendix 2 on page 49 )

Chapter 4: Identifying Economic Moats II

39

5. HDFC Bank Switching Costs


Company overview

Incorporated in 1994, HDFC Bank is the second largest


private sector bank in the country in terms of asset size.

HDFC Bank has very successfully merged with Times Bank


and much later acquired Centurion Bank of Punjab. On both
occasions the bank benefitted from the expansion of its
franchise.

Its group companies, HDFC Standard Life (insurance), HDFC


AMC (mutual funds) and HDFC Securities (equities) add
scalability to the banks offerings.

The bank is well-positioned in urban and rural markets with a


nationwide network. It is a leading player across retail loan
categories.

Besides the extensive branch network, the bank has made


significant headway in its multichannel servicing strategy,
such as ATMs, internet, phone and mobile banking to serve
their banking needs.

The bank boasts of a total customer base of 28.7 million.

Economic Moat- Switching Costs

40

HDFC Banks strength is its strong national network with


expanding semi-urban and rural footprint.

The bank at present has an enviable network of 3,062


branches and 10,743 ATMS spread across 1,845 cities. 88%
of the banks new branch setup is located in semi-urban and
rural areas.

Equitymasters Secrets

The bank enjoys a market share of 4.1% and 4.7% in total


banking system deposits and advances respectively, offering
competitive rates.

Given the market leadership, accessibility and wide range of


product offerings, it is very unlikely that the customers may
switch to the competition for a few more percentage points
on deposit rates.

Parent HDFC, which is a significant player in retail home


loans, distributes its loans through HDFC Bank. Hence the
customer stickiness tends to be high.

Additionally, the bank benefits from cross-selling


opportunities through its parents subsidiaries that are
into life and non-life insurance and broking services. This
provides a wide and sticky customer base. The variety and
quality offers competitive advantage.

Financial performance

HDFC Bank has demonstrated a proven ability to generate


shareholder value over the past 17 years of its operations.

With a healthy balance sheet and consistent profitability


growth, the banks return ratios are the highest in the
private sector space. For last 10 years, the bank has
recorded average return on assets (ROA) at around 1.5%, and
average return on equity (ROE) at above 15%.

Supported by a rich liability franchise, HDFC Bank enjoys


highest current and savings account (CASA) ratio of 47%
(FY2013) in the industry.

HDFC Bank has historically had higher net interest margins


between 4.0% to 4.4% over the last 5 years.

Chapter 4: Identifying Economic Moats II

41

The bank has, over the last 10 years, had net non-performing
assets (NPA) levels below 0.6% and has one of the most
conservative provisioning norms.

Note: The banking industry, due to its inherent structural


characteristics, tends to offer this economic moat to most of
the firms in the space. Evidently, HDFC Bank has managed to
capitalize well on this characteristic feature of the industry.
( Please see table in Appendix 2 on page 49 )

6. Info Edge (India) Ltd - Network Effects


Company overview

42

Established in 1995, Info Edge Ltd is Indias premier on-line


classifieds company in recruitment, matrimony, real estate,
education and related services.

The company runs Indias largest job site - Naukri.com. It is


the market leader in this field with over 60% traffic share.

Its matrimony website, Jeevansathi.com is currently ranked


at number 3 in the country.

The property listing service for real estate purchases, sales,


and rentals is conducted through the website 99acres.com.

Shiksha.com is the companys offering in the space of


education. It carries online education classifieds.

In recent times, the company has invested in different start


ups as well as new businesses that present opportunities for
scaling up. This includes leading names like Zomato.com,
mydala.com, Happily Unmarried, etc.

Equitymasters Secrets

Economic Moat- Network Effects


The network effect is significant in this business. Because


Info Edge has the maximum number of listed jobs, it is able
to attract the largest share of traffic.

As it is able to attract the largest share of traffic, its users get


the most responses.

Because they get the most responses, the company gets


more clients.

This virtuous cycle enables the company to make higher


profits and earn higher returns on capital than its peers
even through times of slowdown and economic recession.

The online portal is complemented by a strong sales force.

The company has a nationwide network through 57 branch


offices in 36 cities.

This makes it the only online (dot com) company with such a
strong sales force.

As other players do not have such a strong network, Naukri


has the largest database of both jobs as well as resumes.

The network helps it maintain a leadership over its peers.

The traffic gap with Monster India and Times Jobs (its closest
competitors) has widened from a mere 10% in 2007 (only
with Monster India) to 45% and 52% respectively in March
2013.

The companys increasing market share is the result of a


strong moat due to network effects.

Chapter 4: Identifying Economic Moats II

43

Financial performance

Info Edge has generated a return on equity (ROE) of around


18% on average over the past 6 years.

The company has been completely debt-free post its initial


public offering.

Its operating margins have averaged at over 30% during


the past 6 years.

As of year-ended March 2013, the company had a cash


balance of Rs 3.1 bn (cash + short term investments).

It has been investing a part of this cash in investee


companies which are predominantly startups or small but
powerful brands that present opportunities for scaling up.
Despite the investments, the cash balance remains strong.

With minimal capex requirements and negative working


capital, the cash pile is just set to grow. This provides
adequate safety to the company when the times get tough.
( Please see table in Appendix 2 on page 50 )

Conclusion

44

We discussed price advantage economic moats with


examples of listed Indian companies.

WABCO Indias moat is its superior technology.

Colgates moat arises from its strong brand and extensive


distribution network.

In case of Solar Industries, regulatory licenses deter new


player from entering the market.

For Bosch Ltd, the patented technology of its parent firm is

Equitymasters Secrets

the moat.

HDFC Bank enjoys the high switching costs that are inherent
in the banking sector. Its vast branch network further widens
the moat.

Info Edge benefits from the network effect on its online job
portal Naukri.com.

Companies that have multiple moats tend to enjoy much


higher return on capital.

In the next chapter, we will discuss examples of cost


advantage economic moats.

Chapter 4: Identifying Economic Moats II

45

46

Equitymasters Secrets

FY09
15.2
9.8
9.8
FY09
19.5
4.4
6.3

Operating margin (EBITDA, %)

WABCO India

Rane Brake Linings

Sundaram Brake Linings

Return on Equity (ROE, %)

WABCO India

Rane Brake Linings

Sundaram Brake Linings

6.7

18.8

38.8

FY11

9.5

10.8

21.1

FY11

Data Source: Ace Equity

7.4

14.1

33.4

FY10

11.0

11.8

21.2

FY10

0.6

17.7

33.5

FY12

8.2

11.0

20.3

FY12

Comparison of Key Financial Ratios

Appendix 2

NA

9.2

22.2

FY13

2.7

8.5

19.4

FY13

5.2

12.8

29.5

5-Yr Avg

8.2

10.4

19.4

5-Yr Avg

Chapter 4: Identifying Economic Moats II

47

Advertising & Sales


Promotion/ Net Sales (%)

(EBITDA, %)

15.7

15.6

75.6

Dividend Payout ratio (%)

Operating Profit margin

44.2

Return on Net Worth (RONW, %)

FY04

14.2

18.0

84.1

45.3

FY05

16.0

16.1

80.7

57.1

FY07

FY09

FY10

FY11

FY12

FY13

17.4

17.0

75.0

16.0

16.8

71.7

15.3

22.2

63.1

15.3

20.3

75.0

15.3

19.4

75.0

15.5

18.2

76.7

140.9 132.2 130.5 104.8 102.5 100.1

FY08

Data Source: Ace Equity

17.6

17.3

74.1

50.8

FY06

Colgate Palmolive (India) Ltd - 10 Yr Key Financial Ratios

15.8

18.1

75.1

90.8

Avg

10-Yr

48

Equitymasters Secrets

12.2
16.2

Return on Equity (ROE, %)

Operating margins (EBITDA, %)

18.0

21.9

30.6

8.8

38,174

3,348

2009

Data Source: Company website

8.4

45,127

Sales Revenue

2008
3,810

R&D cost as a % of Sales

22.0

20.8

23.7

FY10

18.9

24.5

31.5

FY11

6.5

47,259

3,073

2010

Bosch Group - R&D Expenditure

Research & Development cost

(Figures in million euros)

15.2

Return on Capital Employed (ROCE, %)

FY09

Data Source: Ace Equity

FY08

(Consolidated)

4,190

2011

20.4

28.9

33.3

FY12

8.1

51,494

Solar Industries - Key Financial Ratios

9.1

52,464

4,787

2012

19.1

21.7

26.8

5-Yr Avg

Chapter 4: Identifying Economic Moats II

49

0.11

Total Debt to Equity ratio


(times)
0.10

30.5

13.8

0.10

26.5

12.8

Data Source: Ace Equity

0.11

24.5

10.4

0.09

22.4

12.5

0.08

18.2

11.6

0.07

23.0

12.1

CY10

3.9
54.7
20.6

CASA/ Total Deposits (%)

Return on Equity (%)

17.7

55.5

4.0

19.5

57.7

4.3

17.7

54.5

4.4

17.2

44.4

4.3

Data Source: Company website, Ace Equity

18.5

60.7

3.9

16.3

52.0

4.4

FY04 FY05 FY06 FY07 FY08 FY09 FY10

16.8

52.7

4.2

FY11

HDFC BANK - Key Financial Ratios

Net Interest Margins (NIMs, %)

(Standalone)

34.6

29.0

Return on Equity (ROE, %)


0.12

14.5

CY03 CY04 CY05 CY06 CY07 CY08 CY09

Profit after Tax margin (PAT, %) 11.20

(Standalone)

Bosch Ltd - Key Financial Ratios

0.04

18.6

10.2

CY12

18.7

48.4

4.1

20.3

47.4

4.0

FY12 FY13

0.06

25.4

12.8

CY11

18.3

52.8

4.2

10-Yr
Avg

0.09

25.3

12.1

Avg

10-Yr

50

Equitymasters Secrets

20.7
29.5
14.5

Return on Equity (ROE, %)

Operating margin (EBITDA, %)

Profit after Tax margin (PAT, %)

29.5

27.3

18.3

FY09

25.4

29.5

14.9

FY10

30.5

34.1

18.1

FY11

Data Source: Equitymaster Research, Ace Equity

FY08

(Standalone)

27.3

38.3

21.3

FY12

Info Edge (India) Ltd - Key Financial Ratios

28.2

34.3

15.4

FY13

25.9

32.2

18.1

6-Yr
Avg

Chapter 5

Identifying Economic Moats III

Examples of Cost Advantage Economic


Moats:

1. Container Corporation of India Ltd


Economies of Scale
Company overview

Container Corporation of India (Concor) is a public sector


undertaking under the Indian Ministry of Railways.

Primary business is transportation through containerization.


Also offers terminal and warehousing services in India.

Concor uses the Indian Railways network for its operations


for more than 90% of its inland transportation, and also
gets wagons and operational support.

Market leader in container rail business segment, with a


market share of 75%.

Huge network of around 62 terminals and over 9,600 high


speed wagons. The company does business through two
main segments EXIM (export-import) segment (80% of the
business) and the Domestic segment.

Economic Moat- Economies of Scale


Company has unmatched pan-India strategic assets and

Chapter 5: Identifying Economic Moats III

51

network of rail terminals that provide a strong moat.


High cargo volumes (75% market share) bring down average


cost per tonnage.

Before 2006, Concor had a monopoly in containerized train


transport. In 2006, the sector was opened up to private
players.

However, Concor continues to be the lowest cost operator


as the new players have not even achieved minimum
economies of scale.

Scale advantage and lower costs compared to peers allow


the company to dominate a market where competition is
mainly price-based.

Being the pioneer, it also has the benefit of getting Indian


Railways surplus land at key locations at very attractive
long-term lease rates.

Financial performance

The company is debt free and its average return on equity


(ROE) over the last 7 years is about 21%, signaling a strong
moat.

The competitors do not have such high returns, and they are
also highly leveraged.

The companys dominant market share gives it considerable


bargaining power.

Despite a tough macroeconomic environment, the


companys financials have not been very severely hit.
( Please see table in Appendix 3 on page 59 )

52

Equitymasters Secrets

2. Coal India
Cheaper Access to Resources
Company overview

Established in 1973, Coal India Ltd (CIL) is a state controlled


coal mining company in India.

It is the largest coal producing company in the world (based


on raw coal production).

Coal India has the largest reserves of coal in the world at


67 bn tonnes, with proved reserves of 52 bn tonnes (47% of
Indias proved reserves) and extractable reserves of 22 bn
tonnes.

CIL operates 471 mines in 21 major coal fields across


8 states in India, including 163 open cast mines, 273
underground mines and 35 mixed mines.

It is the primary supplier of coal in India, accounting for 82%


of the countrys coal production.

Economic MoatCheaper Access to Resources


Coal Indias cheap access to raw materials creates a strong


moat.

Given Indias abundant coal reserves and the absence of


other sustainable fuel sources, the company plays a strategic
role in meeting Indias energy requirements.

It has one of the lowest strip ratios at 1.69x. The strip


ratio refers to how much waste they have to mine per unit
of what they want to extract. The low strip ratio ensures

Chapter 5: Identifying Economic Moats III

53

easily extractable reserves and high margins due to lower


production costs.

Nearly 90% of the companys production is from open cast


mines. Most of these open cast mines have low stripping
ratios, which provide the company with a significant cost
advantage.

Coal India is expected to contribute 80% of the Indian coal


production in FY14, and thus maintain its dominant position.

Financial performance

Despite the economic slowdown, profit margins and ROE


remain high.

The company is almost debt free and has an average return


on equity of over 32% over the last 8 years, signifying a
strong moat.

The company makes further profits due to auction sales, as


they can sell at a much higher price than the reserve price of
coal.

Due to their monopolistic business model, high reserve to


production ratio, and cash rich balance sheet, they are well
poised for future success.
( Please see table in Appendix 3 on page 60 )

3. Ambuja Cements
Process-based Cost Advantages
Company overview

54

Founded in 1983, Ambuja Cements is today one of the

Equitymasters Secrets

leading cement manufacturers in India.


Ambuja has been a pioneer in the Indian cement industry


with several laurels to its credit. It is one of the most
profitable and innovative cement companies in India.

The company has grown at a rapid pace over the last three
decades and its cement capacity stands at 27.3 mtpa.

Ambuja has a pan-India with 5 integrated cement


manufacturing plants, 8 cement grinding units and 3 bulk
terminals.

The company is particularly strong in the northern and


western markets of India.

Economic MoatProcess-based Cost Advantages


Ambuja is one of the most efficient and low cost cement


manufacturers in the world.

Strong management focus on continually fine-tuning


efficiencies and upgrading facilities.

Ambuja Cements pioneered the concept of transport of


cement by sea. This has not only led to lower freight costs
but has also brought the coastal markets of India within its
reach.

Moves like owning ships for movement of cement within


India, early emphasis on captive power plants, captive jetties
and emphasis on branding have yielded rich dividends.

Swiss-based global cement major Holcim acquired


management control in 2006 and now holds a 50.6% stake
in the company. Post Holcim acquisition, Ambuja Cements
has benefited from the MNCs expertise in several areas

Chapter 5: Identifying Economic Moats III

55

including waste-based power generation.

Financial performance

Ambuja Cements is ahead of its competitors on some of


the most important financial parameters, indicating a strong
economic moat.
( Please see table in Appendix 3 on page 61 )

Example of a false moat:

Suzlon Energy
Company overview

Suzlon Group was ranked as the worlds fifth largest wind


turbine supplier, in terms of cumulative installed capacity, at
the end of 2011.

The company has over 21,500 MW of wind energy capacity


installed in 30 countries, across Asia, Australia, Europe,
Africa and North and South America

Suzlon has operations across 33 countries and a workforce


of over 13,000.

Regulatory mandates in the US, Europe and India for


investments in green energy projects were a huge positive
for Suzlon, which until a few years back had the first mover
advantage in wind energy capacities.

False Economic Moat


56

Suzlon Energys first mover advantage in being able to


capitalize on the worldwide regulatory support to the fast-

Equitymasters Secrets

growing wind energy sector was considered to be its


biggest moat.

The company, however, failed to deliver on quality and lost


customer trust. There were several legal cases filed against
the company over the poor quality of wind turbines.

Suzlon also went on to do big ticket acquisitions (Hansen


Transmission in 2007 and REpower Systems) which took its
debt to equity ratio to unreasonable levels.

Finally the stimulus packages awarded by governments


in the US, Europe and India to the wind energy sector
eventually dried out as the focus shifted towards the
economic crisis in 2009.

Financial performance

After earning healthy profits and return on capital, Suzlon


Energys fortune tumbled in the aftermath of the financial
crisis.

The company has been loss-making over the last four


financial years.

The companys debt to equity ratio has shot up substantially


over the years.

Despite the bleeding bottomline and negative return ratios


the management refused to restructure the businesses.

Finally Suzlon had to accept a corporate debt restructuring


package of Rs 95 bn from its bankers in April 2013.
( Please see table in Appendix 3 on page 62 )

Chapter 5: Identifying Economic Moats III

57

Conclusion

58

We discussed cost advantage economic moats with


examples of listed Indian companies.

Container Corporations moat is its scale of operations and


its extensive rail network.

In case of Coal India, the cheap access to vast reserves of


coal is the companys competitive advantage.

Ambuja Cements moat arises from its highly efficient low


cost processes and pan-India reach.

Suzlon Energy is a classic example of how first mover


advantage and market leadership are not sustainable moats.

All moats are not equally durable; it is important to evaluate


the quality of a companys moat.

Long term trends in the financial performance of a company


often indicate if the moat is eroding or strengthening over
time.

Equitymasters Secrets

Chapter 5: Identifying Economic Moats III

59

FY07
23.0
26.8
33.2

(Consolidated)

Profit after Tax margin (PAT, %)

Return on Equity (ROE)

Return on Capital Employed (ROCE)

29.1

22.6

22.6

FY09

Data Source: Ace Equity

31.8

25.3

21.8

FY08

24.7

19.4

20.8

FY10

22.8

19.0

22.5

FY11

22.2

16.5

21.1

FY12

19.4

15.0

20.9

FY13

Container Corporation of India - Key Financial ratios

Appendix 3

26.2

20.6

21.8

7-Yr
Avg

60

Equitymasters Secrets

FY06
23.6
41.3
0.2

(Consolidated)

Operating margin (EBITDA, %)

Return on Equity (ROE, %)

Total Debt to Equity ratio (times)

0.1

30.5

17.6

FY08

0.1

10.9

6.1

FY09

0.1

37.2

21.8

FY10

Data Source: Equitymaster Research

0.1

35.2

21.5

FY07

0.1

32.6

19.6

FY11

0.1

36.6

25.1

FY12

Coal India Ltd - Key Financial Ratios

0.1

35.8

26.5

FY13

0.1

32.5

20.2

8-Yr
Avg

Chapter 5: Identifying Economic Moats III

61

27.6
16.8
0.2
34.9

Operating margin (EBITDA, %)

Profit after tax margin (%)

Total Debt to Equity ratio (times)

Dividend payout ratio (%)

33.1

0.5

12.1

21.0

28.0

ACC Ltd**

8.1

0.8

9.3

20.7

22.3

UltraTech#

Data Source: Ace Equity


*Consolidated, Jun 2004 to Dec 2012; **Consolidated, Mar 2004 to Dec 2012; #Consolidate,
Mar 2004 to Mar 2013; ^Standalone, Mar 2004 to Mar 2013

30.7

Return on Capital Employed (ROCE, %)

Ambuja Cem*

16.7

1.6

10.3

24.9

19.2

Madras Cem^

Comparison of Key Financial Ratios - 10 Year Average

62

Equitymasters Secrets

FY03
15.9
14.3
15.0
15.2
0.4

(Consolidated)

Operating Profit margin


(EBITDA, %)

Profit afte Tax margin (PAT, %)

Return on Equity (ROE, %)

Return on capital employed


(ROCE, %)

Total Debt to Equity ratio


(times)
0.6

35.3

46.0

16.9

18.9

0.4

45.9

62.8

18.8

25.4

FY05

0.2

39.3

43.5

19.8

24.8

FY06

1.5

21.0

28.3

10.8

17.7

FY07

Data Source: Ace Equity

FY04

1.2

13.3

17.7

7.4

17.2

FY08

1.7

8.6

5.2

1.6

12.4

FY09

1.9

3.9

-13.1

-4.8

6.2

FY10

Suzlon Energy - Key 10-Yr Financial Ratios

1.9

1.3

-20.1

-7.3

6.4

FY11

2.7

8.0

-8.1

-2.2

9.1

FY12

Accounting
Basics
&
Financial
Analysis

Chapter 6

Accounting Basics

Accounting

Accounting is the reporting of the financial statements of a


company.

A companys accounts are a summary of all the transactions


conducted by the company. They provide us with a picture
of how the company is performing.

When we analyze a company, the first place to start is the


companys accounts. We use accounts to come up with a
valuation for the company.

All company accounts are audited, but sometimes they can


be misrepresented. A companys financial statements consist
of four elements.

The first is the Balance Sheet, the second is the Profit and
Loss Statement, the third is the Cash Flow Statement,
and the fourth is Notes to Financial Statements (including
changes in Equity).

Companies publish a summary of their accounts every


quarter, and a full set of accounts every year.

Balance Sheet

The Balance Sheet is a snapshot of the companys financial


balances at a particular point in time.

Chapter 6: Accounting Basics

65

It is composed of three parts: assets, liabilities, and


shareholders equity.

Assets represent items of economic value that can be


converted into cash. Assets are used to generate income.

Assets include current assets, long-term assets, and


intangible assets.

Liabilities represent the firms financial obligations that have


resulted from previous transactions.

These include current (short-term) and non-current (longterm) liabilities.

Shareholders Equity is equal to Assets minus Liabilities


and is the book value of the firm.

It consists of investment from shareholders and retained


earnings.

Profit and Loss Statement


The Profit and Loss statement summarizes the companys


revenues, expenditures, taxes, and profits over a particular
period of time.

They include non-cash transactions such as depreciation.

The Profit and Loss Statement is measured over a time


period (e.g. one year or one quarter), whereas the Balance
sheet is a snapshot and measured at a single point of time.

Cash Flow Statement


66

The Cash Flow statement is a summary of all the cash


inflows and outflows by the company over a particular
period of time.

Equitymasters Secrets

There are differences between cash flows and profits.

Revenues can be recorded before the actual cash is


received and vice versa.

Cash flow is more difficult to manipulate as compared with


earnings.

Cash versus Accrual Accounting


Method

Imagine being asked to run your Dads set up for one year.
You are a complete novice in accounting. This is how your
financial statements would look:

Business related cash flows


Cash received from customers ------------------ Rs 6,000,000
Cash paid to suppliers ---------------------------- Rs (3,000,000)
Tax outflow (this year plus some of last year) -- Rs (500,000)
Interest on working capital ------------------------- Rs (200,000)
Other expenses -------------------------------------- Rs (1,000,000)
Total cash inflow/ (outflow): -------------------- Rs 1,300,000

What we just saw was cash based financial reporting. It


is useful but suffers from a serious drawback. It records
transactions based on when cash was received or paid out.
It does not record it when the actual transaction happens.
For instance, in cash received from customers in the previous
slide, some of the cash could be from sales of previous year.
Also, the company must have bought raw materials on credit
which is not reflected in cash based accounting because
cash has not yet gone out.

Chapter 6: Accounting Basics

67

So, what to do in such a scenario? The answer is accrual


based accounting. In accrual based accounting, the
transaction is recorded when it actually happens and not
when cash is received or paid.

E.g. If a customer buys goods on credit, the company will


record it even though the cash has not been received for it.
Also, the company will also record expense related to sales
even if the cash has not gone out yet.

Cash based accounting suffers from a disadvantage that


it is not good at tracking historical growth. It is difficult to
compare quarter on quarter or year on year sales using this
approach. Accrual based accounting records transactions as
they happen and hence, is a better system of providing like
to like comparison.

A statement that is prepared based on accrual based


accounting and the one that shows whether a firm is making
profit or not is known as the income statement or the Profit
& Loss statement.

Notes to Financial Statements

68

Most companies usually have additional statements to


supplement the first three.

These include more detail on how certain items were


calculated, etc.

As a result, they are very important for valuation analysis.

Companies may also include a statement of changes in


equity within this.

Notes also include various provisions that the company has


made.

Equitymasters Secrets

Chapter 7

Financial Ratio Analysis I

Financial Ratios

Financial Ratios examine the relative magnitude of two or


more variables related to a company.

These can include accounting based variables (e.g.


earnings) and market based variables (e.g. stock price).

Financial ratios allow us to draw conclusions about a


companys stock that we are interested in analyzing.

We can think of them as summary statistics that paint a


picture of a particular company.

1. Profitability Ratios
Operating Profit Margin

Operating profit margin is the ratio of operating profit to total


revenue.

Operating profit is profit before depreciation, interest and


tax.

So from revenues, you deduct all expenses related to


operations, such as cost of raw materials, manufacturing,
salaries, marketing, logistics, etc.

Operating profit is the most important profitability ratio since


it gives a clear picture about the health of the companys
core business. It also reflects the managements efficiency.

Chapter 7: Financial Ratio Analysis I

69

It does not include expenses such as interest and taxes


which depend on external factors.

2. Profitability Ratios Net Profit Margin


Net profit margin is the ratio of net profit to total revenue.

Unlike operating profit margin, it takes into account all of a


companys costs.

Net Profit Margin = Profit after tax/Revenue

It measures the percentage of sales that the company keeps


in profits.

For both Operating and Net profit margin, higher numbers


are obviously better.

3. Profitability Ratios Effective Tax Rate


Effective tax rate is the average rate at which a companys


profits are taxed.

Effective Tax Rate = Tax Expenses/Profit before Tax

Marginal rates vary for companies, and there are many


deductions, tax incentives that can determine how much a
company pays in tax.

The effective tax rate is an easy way to summarize how much


tax a company pays.

4. Profitability Ratios (Banks) Net Interest Margin


70

Net interest margin examines how much a firm makes from


its investments relative to how much it pays on its debt.

Equitymasters Secrets

For a bank, it represents how much they earn from making


loans to borrowers, versus what they have to pay when
taking deposits from savers, and what they pay to their
creditors.

Net Interest Margin = (Interest Income Interest Expenses)/


Average Earning Assets

5. Profitability Ratios (Banks) Net NPA to Loans


NPA refers to non performing assets, which means loans


that may be in default.

From the perspective of a bank, they expect that these loans


they have made will not be repaid.

Net NPA to Loans = Net Value of Non Performing Assets/


Total Value of Loans.

If this ratio is high, the bank may have to write off bad loans,
and this will reduce its future profitability.

6. Return Ratios Return on Equity


Return on equity measures the net profit generated by the


company relative to the shareholders funds.

Return on Equity = Net Profit/Shareholders Funds.

It is another measure of profitability, and it measures how


productively a company uses its equity capital.

Limitation: The ratio does not take into account debt capital.
As such, if a companys growth is heavily funded by debt, it
will boost the ROE. Hence, one must consider other ratios as
well.

Chapter 7: Financial Ratio Analysis I

71

7. Return Ratios
Return on Capital Employed

Return on capital employed measures how much profit the


company has generated relative to the capital it uses.

Return on Capital Employed = Net Operating Profit After


Tax (NOPAT)/ Capital Employed

NOPAT= Profit before interest and tax (PBIT)*(1-tax rate)

Capital employed= Shareholders funds+ Total debt

ROCE provides a more complete assessment of how well a


management is deploying capital.

8. Return Ratios Return on Assets


Return on assets measures how much profit a company


generates relative to its total assets.

Return on Assets = Net Profit/Total Assets

We include all assets to calculate ROA, including productive


and non-productive ones.

For example, if a company has a large cash balance that it is


not investing, this will increase total assets and bring down
ROA.

9. Debt Ratios Debt to Equity

72

Debt to equity measures how much leverage a company has.

Equivalently, it measures what proportion of its assets are


financed with equity or debt.

Debt to Equity = Total Debt/Shareholders Equity

Equitymasters Secrets

Using higher levels of debt is more risky, as interest liabilities


go up.

However, debt can be cheaper due to the tax deductibility of


interest, as well as lower returns for investors as compared
to equity.

10. Debt Ratios - Interest Coverage


The interest coverage ratio measures how easy it is for a


company to meet its debt obligations.

Interest coverage = Earnings before Interest and Taxes/


Interest Expense

If this ratio is close to 1 (or below 1), then the company is


having problems meeting its debt obligations.

In general, companies with higher debt to equity ratios will


have lower interest coverage ratios.

11. Debt Ratios Free Cash Flow to Debt


Free cash flow is the cash a company generates after paying


for its capital expenditures.

It is the operating cash flow minus capital expenditures

Cash flow is more difficult to manipulate than earnings.

Free Cash Flow to Debt = FCF / Total Debt

FCF= Cash flow from Operations Minus Capex

The ratio measures the ability of a company to finance its


debt obligations from its cash flow.

Chapter 7: Financial Ratio Analysis I

73

12. Liquidity Ratios Current Ratio


The current ratio measures the ability of a company to meet


its short term obligations.

Current Ratio = Current Assets/Current Liabilities

If this ratio is less than 1, it indicates that the company would


be unable to meet its current obligations if they came due.

Short term usually refers to any obligations due in the next 12


months.

13. Asset Utilization Ratios


Fixed Asset Turnover

Fixed asset turnover measures the companys ability to


generate sales relative to its fixed assets.

Fixed assets include property, plant, and equipment.

Fixed Asset Turnover = Net Sales / Fixed Assets

A higher number indicates that the company is more


effective in using its assets to generate sales.

This is a common ratio used for manufacturing companies.

14. Asset Utilization Ratios Inventory Days

74

Inventory days represent the average number of days that a


companys goods remain

in inventory.

Inventory Days = (Inventory/Cost of Sales) *365 Days

In general, a lower figure is better, as it implies the company


can shift its stock quickly.

Equitymasters Secrets

We would usually use average inventory over the relevant


time period.

15. Asset Utilization Ratios


Receivables Days and Payables Days

Receivables days measures how long it takes for a company


to collect revenue after a sale has been made.

Receivables Days = (Accounts Receivable/ Revenue) *365


Days

Payables days measures how long it takes on average for a


company to pay its creditors for inputs purchased.

Payables Days = (Accounts Payable/Cost of Sales)*365 Days

16. Cash Flow Ratios


Operating Cash Flow to Sales

Operating cash flow to sales measures how well a company


is able to turn its sales into cash.

OCF/Sales = Operating Cash Flow/Revenue


If we see a rise in a companys sales, we should see a
corresponding rise in operating cash flow.

If this is not the case, then we need to understand why sales


are not converting into cash, and question how sustainable
their sales might be.

17. Cash Flow Ratios


Free Cash Flow to Operating Cash Flow

Free cash flow is equivalent to what is left over from


operating cash flow after capital expenditures.

Chapter 7: Financial Ratio Analysis I

75

FCF/OCF = (Operating Cash Flow Capital Expenditures)/


Operating Cash Flow

The higher the ratio, the greater the financial strength of the
company.

New businesses are likely to have high levels of capital


expenditure, pushing this ratio lower.

18. Cash Flow Ratios Dividend Payout


The dividend payout ratio measures the proportion of the


companys earnings that are paid out as dividends.

Dividend Payout = Total Dividend/Net Profit

Most companies like to maintain a steady dividend payout


ratio, and a fall in this ratio is often a bad sign for a company.

Falls in this ratio also hurt the stock price, as investors will
seek higher dividend paying stocks.

19. Valuation Ratios Price to Earnings

76

The price to earnings ratio measures the price of a


companys stock relative to the earnings per share.

P/E = Market Price per Share/Earnings per Share

From an investors perspective, it measures how much we


are paying for a given level of earnings.

Higher P/E ratios indicate that we pay more for a given level
of earnings, and vice versa.

However, a high P/E stock is not necessarily expensive and


vice versa. It is important to consider future earnings growth
while evaluating P/E.

Equitymasters Secrets

It is generally relevant to compare the P/E multiples of


companies within the same industry.

20. Valuation Ratios Price to Book Value


The price to book value measures the market price per share
relative to the book value per share.

The book value is equal to a companys net worth or


shareholders funds.

It is the value of the company that would remain if it were to


go bankrupt immediately.

P/BV = Market Price per share/Book Value per share

A higher P/B means we are paying more for the stock


relative to its book value.

21. Valuation Ratios EV to EBITDA


Enterprise Value (EV) is the sum of market capitalization,


debt, minority interest, and preferred shares, less cash.

It measures the takeover value of a company (i.e. how much


one would pay to takeover the company)

EBITDA is earnings before interest, taxes, depreciation, and


amortization.

EV/EBITDA ratio is used to determine the companys value,


in a similar way to the P/E ratio.

22. Valuation Ratios Price to Sales


The Price to Sales ratio the measures the price per share
relative to the sales per share of a company.

Chapter 7: Financial Ratio Analysis I

77

Price/Sales = Market Price per Share / Sales Per Share

It measures how much we are paying for a given level of


sales.

The P/S ratio is used as an alternative to the P/E ratio.

Sales are more difficult to manipulate than earnings, but


dont provide as much information.

23. Valuation Ratios Dividend Yield


The Dividend Yield measures the dividend per share relative


to the market price per share.

Dividend Yield = Dividend per Share / Market Price per


Share

It measures the dividend return from holding the stock.

Note the difference between the dividend yield and the


dividend payout. The first uses market prices, the other uses
net profit.

24. Valuation Ratios


Price to Free Cash Flow

78

The Price to Free Cash Flow measures the market price per
share relative to the free cash flow per share.

Price/FCF = Market Price per Share / FCF per Share

It tells us how much we are paying for a given amount of


Free Cash Flow.

It is used an alternative to the P/E ratio, primarily because


FCF is more difficult to manipulate and may be a better
representation of the company.

Equitymasters Secrets

Conclusion

In this chapter, we have discussed many different types of


financial ratios.

It is important to know that some ratios are more relevant for


certain companies and industries.

Also, ratios will vary a lot between industries.

Usually, these ratios are best used when comparing


companies in the same industry.

In the next chapter, we will give you an overview of DuPont


Analysis, a useful financial performance measure along with
some examples.

Chapter 7: Financial Ratio Analysis I

79

Chapter 8

Financial Ratio Analysis II

Return on Equity

Return on Equity measures how well a company uses the


shareholders funds to generate profits.

It is calculated as Net Income (Profit After Tax) divided by


shareholders equity (Share Capital + Reserves).

Return on Equity =

Net Income
Shareholders Equity

Keep in mind that shareholders equity is the book value of


equity, not the market value.

In general, a higher ROE implies that the company is better


at generating returns for a given book value.

DuPont Analysis

The DuPont identity breaks down ROE into three


components.

The purpose is to understand what exactly is driving the ROE


for a particular company.

ROE = Net Profit Margin * Asset Turnover * Financial


Leverage

ROE =

Net Income Sales


*
Sales
Assets

Chapter 8: Financial Ratio Analysis II

Assets
Equity

81

This is an accounting identity and always holds.

a) Net Profit Margin


Net Profit Margin measures a companys profits as a


percentage of total sales.

For example, if a company earns revenues of 100, and after


all its costs it has 15 left over, the net profit margin is 15%.

Net Income is listed on a companys financial statements,


and is the profit after interest, depreciation, and taxes.

Net Profit Margin =

Net Income
Sales

b) Asset Turnover

Asset turnover is equal to sales as a percentage of total


assets.

Asset Turnover =

Sales
Assets

It measures how well a company uses its assets to generate


sales.

It is often the case that companies with low profit margins


have high turnover (e.g. grocery shop) and vice versa.

In general, a higher asset turnover is better. We can use


average total assets to calculate this.

c) Financial Leverage

82

Financial leverage measures total assets over equity.

Equitymasters Secrets

Financial Leverage =

Assets
Equity

It is implicitly measuring how much debt a company has


relative to its total assets, since assets are equal to equity
plus debt.

When financial leverage is higher, it implies that the company


has higher debt levels. But this is not always true as we will
see in the case of Hindustan Unilever.

Higher leverage leads to a higher ROE.

Using DuPont Analysis


The purpose of DuPont analysis is to understand how


exactly a company is generating its return on equity.

What we will usually find is that there are stark differences


depending on the industry.

For example, retailers tend to generate ROE through high


asset turnover.

Luxury industries tend to generate ROE through high profit


margins.

Financial companies (i.e. banks) tend to generate ROE


through high leverage.

As a result, DuPont analysis is not very useful for comparing


companies across different industries.

However, it is very useful when comparing companies in the


same industry.

Higher ROE may not always be a good sign it depends on


what is generating it.

Chapter 8: Financial Ratio Analysis II

83

For example, if a companys ROE is higher as compared with


its industry peers due only to higher leverage it could be
interpreted as excessively risky.

Examples

Well look at three companies all in different industries, with


the aim of showing how they generate ROE in different ways.

The companies we will discuss are: HDFC Bank, Hindustan


Unilever, and National Mineral Development Corporation
(NMDC).

1. HDFC Bank

HDFC Bank is a financial services company, and one of the


largest in India.

They have operations in retail banking, wholesale banking,


and treasury services.

As a financial company, they generate their ROE primarily


through high leverage.

HDFC Banks 5-yr avg. financial leverage is 11.2 times.

This is not unusual for a bank.

Banks primarily receive deposits that they lend to their


customers, which means that most of their loans are funded
with liabilities rather than equity.
( Please see table in Appendix 4 on page 87 )

84

Equitymasters Secrets

2. Hindustan Unilever Ltd (HUL)


Hindustan Unilever is Indias largest consumer goods


company.

They sell foods, beverages, personal care products, and


cleaning agents.

As an FMCG business, their ROE is driven primarily by high


asset turnover.

Their 5-yr avg. asset turnover is 2.1, meaning that their total
sales is just over double their total assets.

However, if one considers just operating assets, this ratio


would be even higher

This type of number is typical for FMCG companies.

Another contributor to the high ROE is the companys


financial leverage.

The high financial leverage is not because of debt. In fact,


the company is virtually debt free.

The leverage is high on account of presence of large noninterest bearing liabilities.

The company is able to extract very favorable terms from its


creditors due to its high bargaining power. Thus, most of its
assets are funded by its creditors.

This is also an indication of the presence of a very strong


economic moat.
( Please see table in Appendix 4 on page 88 )

Chapter 8: Financial Ratio Analysis II

85

3. National Mineral Development


Corporation (NMDC)

National Mineral Development Corporation (NMDC) is a


state-run company involved in mining and producing various
minerals.

These include iron ore, copper, and many others.

They are Indias largest iron ore producers, and have high
exports in this area.

NMDC generates its ROE primarily through high profit


margins.

Their 5-yr avg. net profit margin is 58.8%, and this is due to
the fact that the cost of mining and producing the minerals is
much less than what they earn in revenues from selling them.
( Please see table in Appendix 4 on page 89 )

Conclusion

86

DuPont analysis breaks down ROE into the product of three


components: net profit margin, asset turnover, and financial
leverage.

The purpose of DuPont analysis is to understand the


factors that drive the ROE for a particular company.

The primary factors vary considerably depending on the


industry.

The next chapter is on Identifying Accounting Red Flags.

Equitymasters Secrets

Chapter 8: Financial Ratio Analysis II

87

14.9%
163,323
22,449

Return on Equity = (1)*(2)*(3)

Interest Earned

Profit After Tax

150,527

12.2

Financial Leverage (3)

Shareholder's Funds

0.1

Asset Turnover (2)

1,832,708

13.7%

Net Profit Margin (1)

Total Assets

Mar-09

DuPont Analysis

[INR-Millions]
Data Source: Ace Equity

215,225

2,224,586

29,487

161,727

13.7%

10.3

0.1

18.2%

Mar-10

253,793

2,773,526

39,264

199,282

15.5%

10.9

0.1

19.7%

Mar-11

HDFC Bank Ltd (Standalone)

Appendix 4

299,247

3,379,095

51,671

278,742

17.3%

11.3

0.1

18.5%

Mar-12

362,141

4,003,319

67,263

350,649

18.6%

11.1

0.1

19.2%

Mar-13

88

Equitymasters Secrets

78.8%

3.8
117.0%

Financial Leverage (3)

202,393
25,007
81,937
21,375

Net Sales

Profit After Tax

Total Assets

Shareholder's Funds

Return on Equity = (1)*(2)*(3)

3.5

2.5

Asset Turnover (2)

[INR-Millions]
Data Source: Ace Equity

26,689

92,580

21,027

175,238

1.9

12.0%

12.4%

Net Profit Margin (1)

Mar-10

Mar-09

DuPont Analysis

27,350

101,405

23,060

197,355

84.3%

3.7

1.9

11.7%

Mar-11

36,811

111,973

26,914

221,164

73.1%

3.0

2.0

12.2%

Mar-12

Hindustan Unilever Ltd (Standalone)

28,648

118,833

37,967

258,102

132.5%

4.1

2.2

14.7%

Mar-13

Chapter 8: Financial Ratio Analysis II

89

75,640
43,724
168,254
116,369

Profit After Tax

Total Assets

Shareholder's Funds

1.4

Financial Leverage (3)

Net Sales

0.4

Asset Turnover (2)

37.6%

57.8%

Net Profit Margin (1)

Return on Equity = (1)*(2)*(3)

Mar-09

DuPont Analysis

[INR-Millions]
Data Source: Ace Equity

142,724

213,976

34,473

62,391

24.2%

1.5

0.3

55.3%

Mar-10

192,145

283,429

64,996

113,693

33.8%

1.5

0.4

57.2%

Mar-11

244,064

351,588

72,656

112,619

29.8%

1.4

0.3

64.5%

Mar-12

275,110

407,978

63,405

107,043

23.0%

1.5

0.3

59.2%

Mar-13

National Mineral Development Corporation (Standalone)

Chapter 9

Identifying Accounting Red Flags

Accounting Red Flags - Introduction


Financial statements are a snapshot of the complex web of


financial activities of a business.

They help us understand how the company is earning its


revenue, incurring expenses, raising and allocating capital,
and what all it owns and owes.

But do financial statements always depict an appropriate and


transparent picture of the company?

Many corporates tend to exploit accounting loopholes to


misrepresent or manipulate their financial statements.

Accounting red flags are signs of potential trouble that


should draw the caution of investors.

These could be misrepresentation, omission of information


and aggressive accounting techniques that may be within
the purview of the accounting standards.

In certain cases, there could be outright financial fraud. But


these are usually difficult to detect well in advance.

However, by identifying potential red flags, investors could


do their best to keep away from dubious companies and
protect their capital.

Chapter 9: Identifying Accounting Red Flags

91

Why do Companies Distort


Financials?

The most basic factor that prompts corporates to resort to


financial misrepresentation is excessive greed and fear.

Senior managers often have bonuses and incentives linked


to sales and profits. This could lead them to inflate revenues
and profits.

Reporting favourable financial performance also helps


companies to get better terms from lenders and premium
valuations from investors.

In certain extreme cases, promoters may resort to fraudulent


practices to siphon off money from the company to their
personal accounts.

Let us discuss some of the key accounting red flags that


could help investors identify potential trouble.

1. Dubious Related Party Transactions


Every company, in its annual report, is required by securities


law to report all related party transactions (RPT). These are
transactions that have happened between the company
and its insiders.

The insiders are the promoters and their families, the top
executives of the firm, and the directors on the board.

Such transactions may include but are not restricted to:

92

Providing loans to insiders at favourable interest rates.

Providing grants or donations with the cash from the firm


to other firms controlled by the promoters.

Equitymasters Secrets

Using the companys cash to buy stakes in entities


promoted by the friends or families of the insiders.

An unusually large number of such transactions should be a


red flag to investors. It might indicate that all is not well within
the company.

Example: The Satyam Scam


The Satyam Computer Services scam provides a valuable


lesson to investors regarding the implications of related party
transactions.

The Satyam scam was Indias biggest corporate scandal.

It came to light in January 2009 when the then chairman of


Satyam, B Ramalinga Raju, confessed in a letter to the stock
exchanges, that the companys accounts had been falsified
by US$1.47 bn.

Let us discuss some of the fraudulent techniques employed


by Mr Raju

Numerous bank statements were created to advance the


fraud.

Bank accounts were falsified to inflate the balance sheet


with balances that did not exist.

The income statement was inflated by claiming interest


income from these fake bank accounts.

About 6,000 fake salary accounts were created over many


years and the money deposited in them by the company was
appropriated.

Fake customer identities and fake invoices to them were


created to inflate revenue.

Chapter 9: Identifying Accounting Red Flags

93

94

Board resolutions were forged to illegally obtain loans for the


company.

The cash raised through American Depository Receipts


(ADRs) in the United States was siphoned off.

The objective of this scam since it began in 2003 was to


divert large sums of money, to other firms that Mr Raju
owned.

Two such firms were Maytas Properties and Maytas


Infrastructure.

In December 2008, Satyams Board of Directors unanimously


approved the purchase of these two firms.

The reason provided to investors was that these companies


would provide Satyam with greater diversification.

These transactions were a blatant attempt to siphon money


out of Satyam and into the hands of Mr. Rajus family, since
they held a larger stake in these firms than in Satyam.

Satyams share price crashed resulting in the transactions


being aborted. But by then, the damage had been done.

Widespread fraud began to be suspected by analysts.

When the scam came to light, on 7th January, the stock fell
by 82%.

This carefully orchestrated fraud had only one purpose: to


enrich the promoters of Satyam.

Money was diverted to various firms promoted by Mr Raju


and his family, primarily Maytas Properties and Maytas
Infrastructure.

These firms used the funds to purchase or develop


infrastructure and real estate assets, mostly in the city of

Equitymasters Secrets

Hyderabad, obtained with the help of several politicians and


bureaucrats; contacts that Mr Raju had developed over the
years.

2. Distortive Depreciation Practices


There are assets like plant & equipment or proprietary


technology that have a long useful life.

Accounting laws allow expenses incurred towards the


purchase of these assets to be spread over few years
instead of expending all of it in the year the cost was
incurred.

However, some companies take this flexibility too far.

They stretch expenses too far into the future even if the
useful life of asset has long been over.

Or they take small depreciation charges every year and then


take a huge write off every few years.

This amounts to artificially inflating profits as depreciation


expenses are lower than required.

Example: Jet Airways


Jet Airways, one of Indias largest airline operators, once


showed operating losses of Rs 562 crore in 1QFY09.

However, during the same period, they showed a Net Profit


of Rs 143 crore.

This was courtesy of a write back of Rs 916 crore on


account of change in depreciation method.

The company moved to a more conservative method and


hence wrote back the extra depreciation charges of previous

Chapter 9: Identifying Accounting Red Flags

95

years.

Investors should be on the lookout for such examples and


view such companies with suspicion.

Other warning signs are revaluing assets every few years or


high fluctuations in the amount of depreciation charged.

3. Misrepresentation of Revenues & Costs

96

Engineering, Infrastructure and Real Estate companies widely


use the Percentage of Completion method for revenue
recognition.

It is used in the case of the execution of long-term projects


that span over more than one accounting period.

Revenue recognized = % of work completed (often on


milestone basis) / Total project value.

Revenue, cost and profits are recognized based on the


percentage of the completion of the contract activity at the
end of each accounting period.

The method can be exploited by companies to overstate


their revenues.

Companies may want to meet their quarterly/annual internal


targets or meet market expectations.

In this method, the companies can assess the work


completed at their own discretion and raise the bill on the
client.

At the same time, they recognize revenues in the books and


increase their debtors by the same amount.

However, approval of entire amount billed is dependent on


whether the work completed fulfills the clients milestone

Equitymasters Secrets

criteria.

In case of non-acceptance of the amount billed by the client,


the amount can be reversed.

However, this can be difficult to capture in the subsequent


accounting period, as companies may follow the same
practice with another client.

To recognize red flags, investors can keep a tab on


receivables, if they take too long to get converted into cash
(as per industry standards).

Other warning signs can be gauged from interaction with the


industry and company clients.

Also, cost over-run is quite rampant in the execution of large


projects, which can also lead to overstated revenues.

However, acceptance of claims for cost over-run takes long


and can only be settled when the project is complete.

Exceptions can be companies which recognize revenues


only when the client accepts the bill.

These companies can be said to be following conservative


revenue recognition policy.

4. Spurt in Debtors & Inventories


Spurt in debtors and inventory is a sign that the company is


facing working capital issues.

This can threaten the balance sheet as the company may


have to borrow to finance working capital.

However, viewing an increase in debtors and inventory in


isolation as a working capital concern is inaccurate.

Chapter 9: Identifying Accounting Red Flags

97

As the size of the business increases so will it sales. This will


lead to an increase in inventory and debtors.

Effectively, investors need to focus on inventory and debtor


turnover to gauge whether there is a build up in either of
them.

Inventory turnover = Net sales/Inventory

Debtor turnover = Net sales/Account receivable

A decrease in these ratios over time indicates build up. This


is a sign of working capital concern.

Example: Reebok India

98

Reebok India (not listed), one of the largest retailers, faced


a build up in receivables. In short, customers were holding
back payments to the company.

While this is a normal business practice when liquidity is tight


it was later discovered that sales and debtors were inflated.

A proper analysis of receivables management could have


enabled in detecting the fraud earlier.

The debtor turnover ratio declined between FY08 to FY10


signifying a build up. However, a perfect warning sign came
up in FY10.

In FY10, debtors stood at Rs 699 cr and were 90% of its


sales. Now this figure in FY09 was at 42% of its sales (The
company later restated this figure)

A combination of increase in debtors and collection period


(in excess of 300 days) should have raised alarm bells.

Investors should look out for such instances and view them
with suspicion.

Equitymasters Secrets

They should also be careful in analyzing working capital


position of infra & engineering companies where cycles are
generally long.

5. Contingent liabilities

Investopedia defines contingent liabilities as liabilities based


on the outcome of a future event.

These are not really recorded as a part of balance sheet


liabilities as the exact outcome is not clearly defined.

You can find them in the notes to the accounts.

As such, if a company has provided for contingent liabilities


or has adequate funds in place to cover them if and when
the liability arises, then there is no problem.

However, if they dont, or if the contingent liability itself is


dubious, it warrants further investigation.

Example: Shree Ganesh Jewellery


House Ltd

Shree Ganesh Jewellery House Ltd manufactures and


exports hand crafted jewellery.

On the face of it, the company seems to have good financial


numbers. It has delivered healthy returns on equity. At the
same time it has been continuously paying off its debt.

Standalone (nos)

FY09

FY10

FY11

FY12

FY13

Return on Equity (ROE) 33.3%

30.9%

24.6%

22.2%

15.7%

0.72

0.51

0.57

0.37

Debt to Equity (x)

1.01

Data Source: Equitymaster Research

Chapter 9: Identifying Accounting Red Flags

99

A deeper look into the companys accounts presents a


different story.

The company has contingent liabilities of around Rs 19.6


bn in FY13. Of this nearly Rs 14.9 bn were on account of bills
discounted.

Bills discounted essentially mean that the customers owe


some money to the company which they will pay at a later
date.

Rather than accounting for these as receivables/debtors, the


company discounts the bill with the bank and takes the
money on a date earlier than the due date.

The contingency is that on the due date if the customer


defaults, then the bank will recover this money from the
company.

If this is a normal practice, then the companys debtors and


therefore its debtor days should be coming down right?

But if you look at the trend of the same over the past 5 years,
you get a completely different picture.

While contingent liabilities have been going up largely due


to increasing amount of bills discounted; at the same time,
debtors and therefore the debtors days have been on the
rise as well.
( Please see table in Appendix 5 on page 102 )

100

Investors should view such companies with suspicion.

Equitymasters Secrets

Concentrate on Cash

Cash flow from operations (CFO) depicts the amount of cash


that a company is generating from its business operations.

Ideally, increasing profits (as per the Profit & Loss Statement)
should broadly result in corresponding increase in cash flow
from operations over time.

If the increase in profits is corresponded by a decrease


(or maybe significantly slower growth) in cash flow from
operations, it could be seen as a potential red flag. This
could indicate one of the following scenarios:

Company is aggressively propping up revenues by


selling products on credit without collecting payments
from customers.

Company is boosting other income by selling


investments and assets.

Conclusion

Financial misrepresentation is widely prevalent in India


because of the weak regulatory environment.

Keeping a vigil eye on the Cash Flow Statements & Notes


to Financial Accounts can be useful in spotting potential red
flags.

One must also look out for any qualified or adverse opinions
by auditors in Auditors Report (included in Annual Report).

It is best to avoid companies that do not make sufficient


disclosures and display aggressive accounting methods.

Identifying accounting red flags is not always easy. It comes


with study and experience.

Chapter 9: Identifying Accounting Red Flags

101

102

Equitymasters Secrets

5,415

Bills discounted

21,485
1,754
30

Revenue

Debtors

Debtor days

73

5,898

29,499

92.5%

57.5%

8,526

9,217

FY10

Data Source: Equitymaster Research

89.8%

Bills discounted as % of contingent liabilities

6,032

Contingent Liabilities

YoY (%)

FY09

Standalone (Rs m)

78

11,250

52,432

90.6%

10.1%

9,391

10,362

FY11

Shree Ganesh Jewellery House Ltd

Appendix 5

117

21,147

65,936

72.3%

22.9%

11,545

15,966

FY12

140

35,463

92,223

76.0%

29.6%

14,965

19,695

FY13

Separating
Good
Management
from Bad

Chapter 10

Separating Good
Management from Bad I

What is Management?

Management refers to the control and oversight of running


a company.

When we talk about management, we mean the people


involved in running the company.

There are many levels of management.

At the top end, we have CEOs, high level executives,


directors, etc.

Throughout the company there are upper, middle, and lower


level managers.

The Importance of Management


The management type we are most interested in analyzing is


at the CEO and executive level.

Those individuals are responsible for looking after the


operations of the entire company have the biggest impact on
the companys performance.

They take decisions on how much to invest, what products to


sell, how to sell it, how many people to hire, etc.

Management is important because it is a significant

Chapter 10: Separating Good Management from Bad I

105

determinant of how well the company performs.


Since management is a critical factor in a companys


performance, we need to consider it when we are evaluating
a company.

Two companies that look identical on paper may perform


very differently if they have different management.

When the industry or the economy goes through a rough


patch, it is up to the management to see the company
through this successfully.

And so, management is a huge factor in a companys


performance and ultimately their stock price, and that is
why we will spend time learning about it.

Analyzing Management

Analyzing management is different to most of the other


analysis we do.

When we analyze companies, we typically look at their


financials, and perform quantitative analysis.

When we analyze management, the analysis is more


qualitative.

The Management Discussion and Analysis section in an


annual report is a clue to how the management operates and
their future plans.

Reading up on the news also helps us learn what a


companys management is doing.

Role of Management

106

What is the role of management in a company?

Equitymasters Secrets

Creating a business model


Formulating a long term strategy and vision
Determining the growth rate of the the business
Employing the right people and aligning their goals to
the overall goal of the management
Taking capital allocation decisions

Lets examine each of these in turn.

1. Creating a Business Model


A business model is a blueprint for how the company will


operate.

It includes what products to sell, how much to charge for


the products, how to sell the products, how to make the
products, etc.

It is managements job to create the companys business


model.

A good business model is critical to the success of a


company.

2. Formulating a Long Term Strategy and


Vision

This is closely aligned to determining the future growth rate


of the business.

The management is in charge of deciding the companys


future path.

How will they improve their profitability and performance in


the future?

Chapter 10: Separating Good Management from Bad I

107

How do they intend to grow the business?

How will they deal with perceived future threats?

All these fundamental questions need to be answered by the


management.

3. Employing the right people


In many businesses, the quality of the individuals employed


has a significant impact on the companys performance.

Management must hire the right people and create working


conditions that encourage high productivity and success.

Capital allocation decisions


Management must decide how to raise funds for future


projects.

This involves deciding how much debt or equity to issue,


and how to raise the funds from them.

Qualities a Management Should Have


Now that we know what a management is supposed to do,


lets look at what are the qualities they should have.

Ideally, the more they possess these qualities, the better they
will fulfill their roles and deliver strong results.
Qualities include:
A strong understanding and knowledge of the business
under consideration.
Honesty and transparency in dealing with stakeholders.
Passion for the business.

108

Equitymasters Secrets

1. Understanding and knowledge of the


business

This is more critical that we might first imagine.

When working in an industry, one develops knowledge and


expertise over time relevant for that industry.

If a management attempts to grow the business in an area


completely unrelated to what they know well, this can be a
problem.

Management should expand where they have knowledge


and understanding of the business.

2. Honesty and transparency in dealing with


stakeholders

A stakeholder is anyone that is impacted by the companys


actions.

This includes stockholders, bondholders, employees, clients,


customers, regulatory authorities, etc.

It is important for a management to deal with stakeholders


correctly, and build up trust between themselves and their
stakeholders.

Management that tries to deceive others can end up hurting


the company in the long run (e.g. accounting scandals).

3. Passion for the business


This is another quality that is easily overlooked but is


nonetheless extremely important.

If you are passionate about your work, you will do a better

Chapter 10: Separating Good Management from Bad I

109

job at it as compared with if you disliked your work.


Likewise, a management that is passionate about the


business will end up more profitable as compared with if
they were not passionate.

Management Background Inspection


A management background inspection means that we look


closer at the individuals running the company and examine
their credentials.
Some factor we consider are:
Is the owner also the CEO or are they separate?
Is the CEO from within the organization or outside?
If the CEO is from outside, do they have relevant
experience?

1. Is the owner also the CEO?


The CEO is the person in charge of running the company,


while the owner is someone who has shares in the company.

Ideally, we want a situation where the CEO is also an owner


in the company.

If they own shares in the company, their interests are more


aligned with those of other shareholders.

They want the stock price to go up just like investors do.

If they dont have shares, this reduces their incentive to


work for shareholders benefit.

110

Equitymasters Secrets

2. Is the CEO from within or outside the


organization?

It is not always clear whether an inside or outside CEO is


better for the job.

A CEO from the inside has much better knowledge of


how the company is run, and it that sense is well place to
perform well.

However, if a company is performing poorly, it can be


beneficial to hire a new CEO from outside.

They can bring new ideas to the company that insiders may
not have had.

We must analyze this on a case by case basis for a company


as to whether one is better or not.

3. If the CEO is from outside, do they have


relevant experience?

If a company does hire a CEO from outside, we should check


their credentials to determine whether they will do a good
job.

Ideally, we would like them to have experience in the


industry, as this would help them run the company more
effectively.

A CEO that is completely new to the industry is more likely to


struggle.

We inspect managements background to make a forecast of


how they will perform.

Chapter 10: Separating Good Management from Bad I

111

Conclusion

In this chapter, we started our discussion on how to separate


good management from bad.

Some of the points we discussed are:


The importance of management
Role of management
Qualities a management should have
Management background inspection

112

In the next chapter, well continue our discussion on


management, and move to case studies.

Equitymasters Secrets

Chapter 11

Separating Good
Management from Bad II
Management Compensation

Management compensation refers to how much the


management is paid for their services, and crucially how
they are paid.

It is natural to expect that CEOs will earn more than anyone


else in the company.

Some important issues include:


Is management pay linked to performance?
Do they receive a high fixed salary, or do they mostly
earn variable pay?
How much do they earn when the business does
poorly?

Management compensation comes down to whether they


are incentivized to behave in the long term interests of
shareholders.

The first issue is whether their compensation is linked to the


overall performance of the company.

Chapter 11: Separating Good Management from Bad II

113

If we owned a copper-mining company in its entirety,


wed base compensation on costs of production, which
management has control over, rather than things based
on market prices, which they dont control. Costs wont
fluctuate a lot. Compensation should tie to what is
under the control of management. Try to understand
what management can have impact on.
-Warren Buffett on management compensation

The next important issue is the composition of total pay, i.e.


how much is variable and how much is fixed?

A good scenario for shareholders is to have a low fixed


salary with a higher variable component that is based on
long term performance.

If the fixed component is relatively too high, management


has less incentive to improve the performance of the
business.

It is also important for the compensation structure to punish


poor performance.

In some companies, we will often find large pay packages for


CEOs even when the company is doing poorly.

Executive Pay - Jindal Steel & Power Ltd


Jindal Steel & Power Ltd is a steel and energy company


based in Delhi, and is a division of Jindal Group
Conglomerate.

They were founded in 1952 and they are the third largest
steel producer in India.

They also have operations related to mining, oil, gas, and


infrastructure.

114

Equitymasters Secrets

In addition, they have investments outside India.

The company is headed by Mr Naveen Jindal, son of the


founder O. P. Jindal.

This case study is about excessive executive pay.

Naveen Jindal earned nearly Rs 550 m in FY 2013.

This was among the highest compensations for CEOs in


India.

Naveen Jindal - Chairman, JSPL


(Rs m)

FY11

FY12

FY13

Salary

106

120

121

0.04

0.04

Shares in Profit / Incentives

566

615

429

Total Compensation

672

734

550

Consolidated Net Profit

37,539

39,649

29,101

Total Salary / Net Profit

1.8%

1.9%

1.9%

Perquisites

Data Source: Equitymaster Research, Ace Equity

His pay was roughly 10 times the pay of the Managing


Director of Tata Steel, Indias most efficient steel producer.

Ideally, there should be some parity between the


compensation packages of top management of companies
from the same industry.

However, in most companies where promoters control the


companys management, the executive compensation tends
to be typically high.

Chapter 11: Separating Good Management from Bad II

115

H M Nerurkar - Managing Direction, Tata Steel


(Rs m)

FY11

FY12

FY13

Salary

11

13

Perquisites

Commission

28

48

38

Total Compensation

42

64

57

68,657

66,964

50,630

0.1%

0.1%

0.1%

Standalone Net Profit


Total Salary / Net Profit

Data Source: Equitymaster Research, Ace Equity

In the case of Tata Steel, they have much lower


compensation for their top management, yet better
corporate results.

Managements Way of Running the


Business

Managements way of running the business refers primarily


to how the company operates internally. Some important
questions include:
Are all the interests of stakeholders taken into
account?
Management that considers all its stakeholders is likely
to make better decisions.
Is the management hands-on or primarily involved in
the big picture?
The more hands on they are, the more they will
understand the needs of the business. However, it is
also important for management be be involved in the big

116

Equitymasters Secrets

picture, i.e. have a long term strategic vision and plan for
the company.

Other questions include:


Does management give quarterly and yearly earnings
estimates?
This type of information is useful for investors when
we try and forecast the companys earnings and value
their stock. Of course, we have to keep in mind that
management may wish to inflate or deflate their
estimated earnings for various reasons.
Is there too much bureaucracy in the company?
High levels of bureaucracy are obviously bad as they
slow down business. A de-centralized structure is usually
more effective.

Some final questions:


What is the hiring policy of the management?
For example, do they like to promote people within the
company to executive positions, or prefer to hire from
outside?
How does the management allocate capital?
What kind of projects do they tend to invest in, and how
are these decisions made?

For many of these questions, there are no right or wrong


answers. The purpose is to build an overall picture of the
management of the company we are interested in investing.

Chapter 11: Separating Good Management from Bad II

117

Bureaucratic Culture - Government


Owned Companies

Most of us have witnessed or experienced the bureaucratic


culture in the government, and the slow results it produces.

A bureaucratic culture is one where there are many layers of


management, with a top down control mechanism.

Each individual generally has a specific role and function,


and they do not deviate from it.

In theory this may not be a problem.

However, in practice it is associated with high levels


of inefficiency, lack of flexibility or creativity, too many
unnecessary rules, and lots of red tape.

Government owned companies are good examples of


bureaucratic culture. We can compare government vs. non
government companies in the same sector to get an idea of
the impact.

For example, in the banking sector, we have State Bank of


India and HDFC.

Over the years, HDFC has consistently outperformed SBI,


both in share price and company performance.

SBIs bureaucratic culture means they respond more slowly


to new opportunities, and fall behind the competition over
time.

Another example exists in the Steel Sector.

We can compare Steel Authority of India Ltd (SAIL) with Tata


Steel.

SAIL has an inherent advantage due to their large size.

118

Equitymasters Secrets

Despite this, Tata Steel is way ahead in terms of efficiency


and expansion.

Bureaucratic culture is primarily found in government owned


companies, but this need not be the case.

Private sector companies can also be run in a bureaucratic


way.

In general, we should avoid stocks where a companys


bureaucratic culture is significantly hurting their performance.

Extravagant Use of Company Funds


Next, we will consider some other issues that are important


when analyzing management.

Does the management lead an extravagant lifestyle or does


it care more about the business?

For example, spending money on private jets to travel may


not be the best use of the companys capital.

It indicates that management is happy to waste the


companys money for their own private benefit.

It is important that the actions that the management takes


are consistent with the overall goal of increasing shareholder
value.

This next case study will give an example of management


living an extravagant lifestyle at the expense of shareholders.

Most of us accept that managers should be well


compensated for good performance, but there is a limit to
this.

Sometimes, managers can use company money to fund


extravagant lifestyles, and call it business expenditures.

Chapter 11: Separating Good Management from Bad II

119

We will discuss a company named Crompton Greaves that


has been guilty of this type of behavior.

What is an example of using business expenses to fund an


extravagant lifestyle?

For example, when someone goes on a business trip, they


could fly economy or business class, and each would cost a
different amount to the company.

If a business executive flies business class, we would be


unlikely to view this as a waste of money.

But Crompton Greaves took this to a whole new level.

In 2011, the company spent Rs 270 crore on their own


private jet for use by management to travel.

This was at a time when the companys profits were under


pressure.

This was a large expense, and the sole purpose was to fund
the extravagant lifestyle of the management.

If an individual uses their own personal fortune for these


types of expenses, we may not bother if there is a genuine
need for the same.

But when this is done using company funds and that too
without a genuine need, it is clearly not correct.

It is a poor use of the companys capital that should instead


be used to make investments that generate returns for
shareholders.

In the end, Crompton Greaves was forced to sell their


private jet after pressure from large institutional
shareholders.

When the jet purchase was noticed by investors, profits were

120

Equitymasters Secrets

falling, and the companys stock price fell 44% over the
course of a month.

When management misuses a companys funds, this is a big


red flag.

It is a clear violation of the job of management, which is to


maximize value for shareholders.

In this case, it was good that shareholders protested this


move, and the company had to sell the jet.

Does management fall prey to herd


mentality?
How does management communicate with shareholders?
Do they regularly address shareholders concerns?
Are they transparent in their dealings with shareholders?
As an investor, you own a piece of this company, and you are
entitled to a management that deals with you in the correct way.
Does the management get easily influenced by herd mentality, or
do they make independent decisions?
The best managers think independently and creatively, and arent
distracted by undue outside influence.

Not Going by Herd Mentality HDFC Bank


This next case study is on management not following Herd


Mentality, and the company benefiting as a result.

Herd mentality refers to people getting influenced by what


others around them do, and then following what they do.

Chapter 11: Separating Good Management from Bad II

121

Often, it is easier to just follow the crowd.

If things turn sour, everyone is negatively affected and not


just you.

If things go well, then you benefit.

Though following the crowd is easier, that does not make


it the best course of action.

We admire a management that is bold enough and smart


enough to make the right decisions rather than follow
everyone else.

HDFC Bank is an example of a bank that has significantly


outperformed its peers, and this is due to its management
not going by herd mentality.

HDFC bank is more conservative than its peers when


it comes to making loans, and as a result has the lowest
percentage of non performing loans compared to other
banks.

They have generally avoided many risky investments


that their peers made, especially exotic and risky financial
instruments/products.

While the rest of the industry chases high yields by taking


too much additional risk, HDFC Bank has not done so.

They have done a much better job assessing the potential


risk of borrowers and of investment projects.

Their investors have been handsomely rewarded as a result.

From January 2008 levels, HDFC Bank shares have nearly


doubled while their rival ICICI Banks shares are still lower
by about 8%.

HDFC Bank trades at nearly 4 times its book value, and

122

Equitymasters Secrets

a result is one of the most expensive banks traded in the


world.

When management follows herd mentality too often, it is


a sign that they are not capable of making good decisions
themselves.

They would rather do what the rest of the industry does, so


that there is less responsibility on their shoulders should
anything go wrong.

HDFC Bank is an example of a company whose management


has done a stellar job by not following what everyone else
does, and making good independent decisions instead.

When analyzing companies, we should look for signs of


independent thinking and action.

Strong corporate culture or Superstar CEO?


Does the CEO focus excessively on himself?

Is the CEO making himself the brand rather than the


company?

The CEO should work hard and focus on improving the


companys brand and performance.

With any management related questions, we should always


come back to one central question:

Are the managements actions consistent with maximizing


shareholders long term value?

If so, then they are doing the right thing. If not, then they are
doing the wrong thing.

Chapter 11: Separating Good Management from Bad II

123

Process Oriented Culture - Tata Group


Our last case study is on a company following a process


oriented culture, and its success as a result of it.

A process oriented culture means the company takes great


care in doing things the correct way.

There is a high focus on teamwork, accountability, and


customer satisfaction. In addition, process oriented
companies take measured risks, and stick to what they know
works well.

The opposite of a process oriented culture is a results


oriented culture. A result-oriented culture is highly focused
on the bottom line (i.e. profits) without much attention the
process of making those profits.

Tata Group is one of the most successful companies in India.

Today, they are a large multinational organization with


operations in 80 countries.

They produce cars, consultancy services, software, steel, tea,


coffee, chemicals, hotels, among others.

A large reason for Tatas success is its reliance on its


process oriented culture.

By focusing on the correct processes, rather than short term


earnings goals, they end up doing better over the long term.

For example, they place a strong emphasis on fostering


innovation. One such example is frugal innovation
creating products that appeal to poorer people and the rising
middle class.

The Tata Nano car & the Tata Swach water purifier are
examples of frugal innovation.

124

Equitymasters Secrets

Their process oriented culture also means that they are


much less prone to corruption and scandals that can bring
down a company.

The management practices of Tata are a big reason for their


success, and continued strong returns for shareholders.

We want to avoid companies that do the opposite, i.e. focus


purely on meeting earnings targets.

Results oriented companies may do well in the short term,


but are much riskier in the long term.

Conclusion

Excessive management compensation relative to peers and


poor linkage between pay and performance is a sign of bad
management.

How a management runs the business has a significant


impact on operational efficiency and long term profitability.

Management extravagance at the cost of companys funds


should be seen as a red flag.

Avoid companies that follow herd mentality and are too


focussed on the bottomline.

Chapter 11: Separating Good Management from Bad II

125

Chapter 12

Separating Good
Management from Bad III
Treatment of Minority Shareholders MNCs and Subsidiaries

A subsidiary is a company that is partly or wholly owned, and


partly or wholly controlled by the parent company.

Many multinational corporations (MNCs) have subsidiaries


around the world.

These subsidiaries may be separately listed on local stock


markets.

Minority shareholders are investors who own less than


50% of a companys shares.

This case study is about the treatment of these shareholders


by the management of the parent companies (the MNCs).

It is sometimes the case that parent companies will find a


way to transfer profits to themselves, at the expense of the
subsidiary.

For example, the parent can sell products to the subsidiary at


inflated prices, or purchase finished goods at very low prices.

MNCs often engage in this type of behavior to reduce their


overall tax burden (i.e. shift profits to countries where tax
rates are lower). This is known as transfer pricing.

Chapter 12: Separating Good Management from Bad III

127

In addition, subsidiaries of MNCs are often obliged to pay


royalty payments to the parent firm for use of brands,
trademark licenses, technology, technical know-how, etc.

Other examples include mergers and restructuring done


between parent and subsidiary companies in ways that
clearly benefit the parent at the expense of the subsidiary.

When analyzing a company that has a foreign MNC parent,


we should examine how the foreign management treats the
minority shareholders of the Indian subsidiary.

Treatment of Minority Shareholders Royalty Payments to MNCs


Earlier, the royalty payments to overseas parent firms were


capped by the Indian government.

However, effective December 2009 onwards, the govt.


removed all caps on royalty payments by Indian firms to
overseas parents.

This has resulted in almost all domestic subsidiaries doling


out higher royalty payments to the foreign parent.

While minority shareholders resist unreasonable increases in


royalty payments, the MNCs tend to have their way because
of their controlling stake in the company.

Higher royalty payments not only impact the subsidiarys


profits but also eat into the dividends of minority
shareholders.

Lets examine the trend in sales, royalty payments and


dividends of some of the leading Indian companies that are
subsidiaries of foreign MNCs.

128

Equitymasters Secrets

Treatment of Minority Shareholders - HUL


( Please see table in Appendix 6 on page 136 )

Royalty payments have continuously increased over the last


five years.

Dividends to shareholders have grown by less than half the


rate during the same period.

Starting Feb 2013, HUL has announced that it will increase


its royalty payments in a phased manner to 3.15% of annual
sales by March 2018. This will further eat into the companys
earnings and dividends of minority shareholders.

Treatment of Minority Shareholders Maruti Suzuki


( Please see table in Appendix 6 on page 137 )

Royalty payments to Suzuki Motor Corporation have


increased at a compound annual rate of 38% since FY08.

Dividends to shareholders have grown at just 10% CAGR


during the same period.

Treatment of Minority Shareholders Whirlpool & Asahi India Glass


Another example is two MNCs, Whirlpool of India and Asahi


India Glass.

Both the companies remit significant sums to their parent


companies in royalty payments.

Asahi and Whirlpool have paid on average Rs 200 m

Chapter 12: Separating Good Management from Bad III

129

and Rs 321 m per annum, respectively, as royalty to their


respective parent firms over the last five years.

However, both of these companies do not pay any


dividends to their Indian shareholders.

This clearly shows the parent MNCs care more about


their own investors than the minority investors of their
subsidiaries.

How promoters greed & recklessness


can ruin a great business

In the previous chapter, we discussed process oriented


corporates with the example of Tata Group.

We will now discuss the management failure of Ranbaxy


Laboratories, a leading corporate entity, and how the shortsighted and opportunistic approach of its top management
adversely impacted the companys reputation and fortunes.

Case study - Ranbaxy Laboratories


Incorporated in 1961, Ranbaxy Laboratories is one of the


leading Indian pharmaceutical companies.

It was among the first few early entrants into the lucrative
US market.

The company sells products in over 150 countries and has an


expanding international portfolio of affiliates, joint ventures
and alliances, and ground operations in 43 countries.

In 2008, Ranbaxys Indian promoters sold their entire stake


to Daiichi Sankyo of Japan, which now holds a 62% stake in
Ranbaxy.

130

Equitymasters Secrets

Ranbaxys claim to success


For Ranbaxy, the US market has been a focus area and also
forms a major revenue contributor.

It is worthwhile to note that Ranbaxy was among very few


generic companies to identify the importance of Para IVs
and thus had made filings in most of the mega blockbuster
products.

A generic company that challenges the patents of the


innovator with an intention to launch the drug before the
expiry of the patent is called a Para IV filer. The company
that makes the first successful filing is entitled to 180 days
exclusivity.

Ranbaxy was quite successful in taking advantage of first to


file (FTF) 180-days exclusivity.

Ranbaxys fall of fortune


After having been so successful, what went wrong?

The golden days of Ranbaxy came to end when two of its


facilities received warning letters and import alerts from
United States Food and Drug Administration (USFDA).

A Warning letter means that the company can continue


manufacturing but new approvals are not given clearance.

An Import alert is considered even more severe as the


company cannot export medicines manufactured in those
facilities to the US market.

These adverse events resulted in delay to get approvals


for the drugs and thus, the company had no option but to
enter into deals that trimmed away a significant share of their

Chapter 12: Separating Good Management from Bad III

131

revenues and profits.


In addition, even the existing revenues were impacted on


account of the import ban.

Erosion of shareholder wealth


How was the companys overall business impacted? The


irregularities in Ranbaxys facilities resulted in huge
penalties worth US$ 500 m.

The company has hired consultants to whom huge fees


are paid to resolve the issues in manufacturing facilities
and take corrective measures. This has been impacting the
companys margins. All this has resulted in great overhang
on shareholder wealth.

The table below shows the change in market cap of Ranbaxy


and its Indian peers since 2008.

Change in Market Capitalisation: 2008 to present


1-Jan-2008

18-Nov2013

Change

Ranbaxy Lab

157,753

181,295

14.9%

Sun Pharma

41,444

1,263,410

423.3%

Lupin Ltd

51,283

386,953

654.5%

Dr Reddy's Lab

121,316

419,117

245.5%

Rs million

Data Source: Ace Equity

132

Equitymasters Secrets

What was wrong with Ranbaxys management?


The organizational culture of any corporate flows from top to


bottom.

The behaviour and aspirations of the top management have


a significant influence on how the organization conducts its
business.

In its pursuit of quick profits, Ranbaxys top management


compromised on critical corporate processes and good
governance.

The following brief excerpt from Fortune magazine about


Malvinder Singh (Managing Director & CEO from 2006 to
2008) gives a clear view of the promoters attitude: I want
profit! he would yell in meetings, two former
employees recall. Among the staff, he was known
for being preoccupied with his ranking on the
Forbes list of Indias 40 richest people. When he
and his brother Shivinder fell from No. 9 in 2004
to No. 19 in 2005, despite $1.6 billion in assets,
Singh seemed to blame the decline on a lack of
employee loyalty, a former employee recalls.

This is a clear sign of bad management.

Managements negligence takes a toll


The top management did not respond to alarms raised by a


senior employee about the issues at its manufacturing units.
As per whistleblower Dinesh Thakur, the company used
fraudulent data to get USFDA approvals.

Various instances of non-adherence to good manufacturing


practices (GMP) were also observed.

Chapter 12: Separating Good Management from Bad III

133

The management did not take conscious steps to keep the


facilities up to the mark.

If the company had kept its facilities up to the mark, it would


have been able to run its US business smoothly.

The margins, too, would not have been impacted.

More importantly, the company would have been able to take


advantage of lucrative Para IVs it had filed, without sharing
the same with other players.

Managements short-sighted approach


ruined long term prospects

The managements focus on short term profits may have


helped in saving some near-term costs. However, in the long
term the company has incurred huge costs to resolve the
issues.

The Indian promoters bailed themselves out by selling off


their entire stake to Japanese pharma firm Daiichi Sankyo
before the irregularities came to the fore.

The troubles for Ranbaxy havent ended with exit of the


Indian promoters. A third plant has received an import ban
from the US drug regulator over quality concerns.

This seems to reflect that the culture of negligence has


become so ingrained in the companys DNA that even
the new promoters havent been able to put an end to the
companys troubles.

All in all, shareholders have had to suffer due to the


managements greed, brashness and negligence.

134

Equitymasters Secrets

Management and Valuation


We have seen many examples of how good management


can lead to a companys success, and how bad management
can cause its failure.

One of the difficulties with analyzing management is


translating the impact onto its stock valuation.

Imagine there were two identical companies except that


one had a good management and the other had a bad
management.

How would we value one companys stock relative to the


other companys stock?

Unfortunately, this is not an easy question to answer.

The impact of management is difficult to quantify.

Instead, we should think of good management as


something that can sustain a companys success over the
long run.

When we value a company, we have to make assumptions


about their future earnings and performance.

Companies with good management are much more likely to


sustain strong performance over time.

Companies with bad management become increasingly


risky over time.

Chapter 12: Separating Good Management from Bad III

135

136

Equitymasters Secrets

138,711

772

0.6%
9.0

Revenue from Operations

Total Royalty Payments

Royalty as % of Net Sales

Dividend per share

7.5

0.6%

1,184

205,011

FY09*

6.5

0.9%

1,579

177,643

FY10

6.5

1.4%

2,689

196,910

FY11

Data Source: Equitymaster Research, Ace Equity

CY07

Rs million (Consolidated)

Hindustan Unilever Ltd

Appendix 6

7.5

1.3%

3,072

34,363

FY12

18.5

1.5%

3,923

70,040

FY13

16%

38%

14%

5-Yr CAGR

Chapter 12: Separating Good Management from Bad III

137

2.7%
5.0

Royalty as % of Net Sales

Dividend per share

3.5

3.3%

6,777

205,579

FY09

6.0

3.5%

10,168

293,028

FY10

7.5

5.2%

18,925

366,112

FY11

Data Source: Equitymaster Research, Ace Equity

4,931

180,208

Net Sales

Royalty Payments

FY08

Rs million (Consolidated)

FY12

7.5

5.1%

18,031

351,972

Maruti Suzuki India Ltd.

8.0

5.7%

24,540

432,159

FY13

10%

38%

19%

5-Yr CAGR

Valuation
Methods

Chapter 13

Introduction to Valuation

Time Value of Money


Renowned Greek story teller Aesop (600 BC) had once said,
A bird in hand is worth two in the bush.

Warren Buffett has often referred to this line as the basis for
valuing all assets.

Investing is about laying out a bird now to get two or more


out of the bush. The birds refer to money and the bush
refers to the underlying asset.

In the investment context, Aesops axiom translates as the


Time Value of Money concept

In simple words, Time Value of Money means that you can


make people part with their money only if you promise to
repay more money in the future.

How much more? Well, that depends on the rent that the
money earns. This rent is nothing but what we popularly
know as the interest rate.

Say you are asked to choose either of the two: Rs 10 million


(m) today OR Rs 10 m three years from today. Which one
would you choose?

It goes without saying that you would go for option 1.

Lets assume you take Rs 10 m today and invest it in a fixed


income security. Lets say the rent or the interest rate is 8%.

Chapter 13: Introduction to Valuation

141

Compounded annually, you would get Rs 12.6 m at the end


of three years.

10*(1+0.08)^3 = 12.6

In other words, Rs 10 m today has a future value (FV) of Rs


12.6 m three years from now.

Alternatively, you could use the same interest rate to find out
the present value (PV) of Rs 10 m that is offered 3 years from
today. This is called discounting.

By discounting the future payment of Rs 10 m at 8% interest


rate, you arrive at a present value of Rs 7.9 m.

10/(1+0.08)^3 = 7.9

Discount rate is nothing but interest rate in reverse.

The concept of time value of money is the most fundamental


principle of finance. It forms the bedrock on which the values
of almost all the assets are based.

These values are nothing but what we call the intrinsic


value.

Determining Intrinsic Value


A financial asset is something that generates cash flows.

Thus, intrinsic value of any asset can be defined as the


present value of all the distributable cash flows that the
asset generates during its lifetime.

Please note we used the term present value above.


This means that all cash flows in the future have to be
discounted by an appropriate discount rate.

The formula for intrinsic value applies to any kind of asset

142

Equitymasters Secrets

whether its a farmland, a coal mine, an office, a bond or a


companys equity.

Warren Buffett expands Aesops a bird in hand concept


by adding three very relevant questions that can help an
investor find the intrinsic value of any investment asset:
1) How certain are you that there are indeed birds in
the bush?
2) When will they emerge and how many will there be?
3) What is the risk free rate?

Intrinsic Value of a Bond


Lets apply the 3 questions to find the intrinsic value of bond.

Lets say a 10-year government bond has face value of Rs


1,000 and 8% coupon rate.
1) How certain are you that there are indeed birds in the
bush?
2) When will they emerge and how many will there be?
3) What is the risk free rate?

In the case of this bond, these three questions have clear


and definite answers.

Bonds are fixed income securities. The tenor is fixed


and the interest rate is known. Government bonds are
presumed to be risk-free. As such, the coupon rate offered
on the bond is also the risk free rate.

In this case, the intrinsic value of the bond is the same as


its face value.

Chapter 13: Introduction to Valuation

143

Intrinsic Value of Equities


Can we extend the analogy of a bond to equity?

Like a bond, the intrinsic value of a companys equity


(or stock) can also be seen as the present value of all
the future net cash flows that the company is likely to
generate during its remaining life.

Lets ask the same three questions for equity.


1) How certain are you that there are indeed birds in the
bush?
2) When will they emerge and how many will there be?
3) What is the risk-free rate (or discount rate)?

Discounted Cash Flow Method


One of the most widely taught valuation methods is the


discounted cash flow (DCF) method.

The DCF Method attempts to determine the intrinsic value


of a companys equity by forecasting the future cash flows
that the company will generate during its lifetime and
then discounting them to arrive at the present value of the
companys equity.

Let us first broadly explain how this method really works.

There are 2 key elements in the DCF method:

1) Forecasting future cash flows


Under the DCF method, you first forecast cash flows for the
current and future periods out to a reasonable date.

So the general practice is to forecast yearly cash flows for a


period of 5 to 10 years.

144

Equitymasters Secrets

2) Determining the discount rate


The next step is to determine the discount rate or cost of


capital that reflects the riskiness of the asset.

In essence, the discount rate is the required annual return


on investment.

Now, there is one limitation with forecasting for a limited


period of around 10 years.

A fundamentally sound company would typically have a


fairly longer life.

How do you account for those years?

To remedy this shortcoming we have the concept of


Terminal Value.

The terminal value is calculated by assuming that beyond


year 10, the cash flow grows perpetually at a constant rate.

Limitations of DCF Method


Theoretically, the DCF method sounds quite appropriate.

However, the problem lies in its practical application.

Here are some limitations that make the DCF method less
reliable.

DCF valuations rely too heavily on future forecasts.

For most businesses it is impossible to forecast 10 years into


the future with any degree of certainty.

Several factors such as changes in technology, higher


competition, etc. can completely derail your estimates.

Moreover, even slight changes in assumptions pertaining to

Chapter 13: Introduction to Valuation

145

discount rate and perpetual growth rate (for terminal value)


can substantially alter the valuations.

As such, DCF method may not be of great use to value


investors.

Asset Based Valuation


As we just saw, there are quite a few flaws with DCF


valuation.

Therefore, it is necessary that we look at other methods of


valuation.

Here, we will study one such method called as the asset


based valuation (ABV).

Unlike DCF that uses too many assumptions, asset


based valuation approach relies on currently available
information

It is more realistic and does not involve making future


estimates.

It is useful for firms that have hardly any competitive


advantage.

It does not take into account future growth.

The approach assumes that intrinsic value comes merely


from investment in the assets of the firm and does not
generate any positive cash flow for investors thus creating
no value for them.

This valuation approach is useful under two scenarios.

Scenario 1: The company to be valued is making losses


and generating negative cash flows.

If the industry to which the firm belongs is in serious decline

146

Equitymasters Secrets

phase, assets should be valued on what they will bring when


sold (Liquidation value method).

Scenario 2: The company to be valued is earning just


enough to pay for the cost of capital it employs.

In other words, there is no competitive advantage that


enables the firm to earn more than its cost of capital.

Thus, if the industry is stable and profitable but with no


competitive advantage then assets can be valued based on
reproduction cost method.

Thus, we have two methods under asset based valuation,


liquidation value and reproduction cost method.

Liquidation Value Method


This method can be applied in cases when the industry


is failing, or when the firms profits have collapsed and
are unlikely to improve or when the firm is facing financial
bankruptcy.

Assets are valued based on the funds they will bring in


when sold.

Specific assets (that serve the particular industry) will not


have any market; hence they are valued (sold) at scrap.

Goodwill /intangibles are worth nothing.

Deferred tax assets can be offset against deferred taxes


owed.

Cash/accounts receivables can be more or less fully


valued.

Chapter 13: Introduction to Valuation

147

Reproduction Cost Method


It can be defined as the value a firms competitor would


have to pay to replace it today at the currently most efficient
way of production.

In other words, it is the amount of money an investor or


business has to lay out to acquire/replicate competitors
assets.

It is applicable when the industry is stable/growing but the


firm enjoys no or limited competitive advantage in the
industry.

Relevant when industry enjoys free entry (no competitive


advantage, no entry barriers and offers level playing field).

As such, the company is worth identifiable value, unless


mismanagement impairs their worth or the industry is
suffering from over capacity.

Reliability of Information

Reproduction value is calculated as assets net of liabilities


for the latest period.

Net Asset Value (NAV) = Assets Liabilities.

Since accounting values for assets and liabilities will not


always be accurate/unambiguous, they should be adjusted
to arrive at realistic valuations where accounting values cant
be relied upon.

Reliability issue depends on how far in the balance sheet


one goes.

For example, cash and current assets, expected to convert


into cash within a year are likely to be recorded close to

148

Equitymasters Secrets

reproduction value.

However, as one goes down the balance sheet, with items


like intangibles and fixed assets, the margin of error is
wider.

As such, these items need some adjustment, based on


industry knowledge, judgement and experience.

Adjusting Items with Wider Error Band


Heres a short summary on how one can go about valuing


various assets:

Property/Land: Will be reproduced at more than book value,


at current market value adjusted for any advantage the
competitor may have in acquiring land (if competitor can get
a similar land at lesser prices).

Plant: Includes office buildings, oil refineries, etc. Here,


the gap between recorded cost and reproduction cost
is likely to be high. The different rules of depreciation
and depreciation rate applied on historical asset values
(ignores inflation) does not reflect economic value of the
asset. In some cases, plants may have been depreciated
down to zero while they still remain the basis of all
business operations of the firm. As such, it needs massive
adjustments.

Equipment: Since it is depreciated over the useful economic


life, the adjustments are unlikely to be huge and will depend
on a case to case basis, on the basis of specific knowledge
of the firm and industry.

Goodwill: This can be a bit tricky and treatment will depend


on case to case basis. For example, while calculating
reproduction cost of a firm like Coca Cola, one cannot

Chapter 13: Introduction to Valuation

149

ignore the goodwill, loyalty and the distribution network


that the brand enjoys. That said, in cases where goodwill
has no economic value (assuming the acquirer overpaid for
no good reason), goodwill should be ignored.

Licenses: For instance, to sell alcoholic beverages one


needs license. To assign a value, one needs to see what
similar rights have sold for in the private market to a
knowledgeable buyer who is paying for the entire business.

Other items: Other items that need to be considered include


aspects such as developing customer relationships. While
this may never appear as assets, some multiple of selling,
general and administrative expenses (SGA) line should be
added to value it.

Reproduction Value of Liabilities


Liabilities and equity are the sources that fund the assets.

As we saw before, Asset Based Value = Assets Liabilities.


Thus, we will have to subtract all the liabilities from the asset
value.

Liabilities can be grouped into three main classes :


1) Spontaneous liabilities (SL): For example, accounts
payable, wage costs due, etc. These arise intrinsically from
normal business, are due within a year and are like a credit
for which a company need not pay interest. The larger these
spontaneous liabilities are, the less investment a company
needs to fund its assets.

Reproduction value of net assets = Reproduction value of


total assets less book value of spontaneous liabilities
2) Circumstantial liabilities (CSL): These arise from

150

Equitymasters Secrets

circumstances not relevant for the new entrant. For example,


deferred tax liabilities incurred due to adverse legal
judgements against the firm. These should be subtracted
from asset value to see what a firm is worth to investors,
though they dont reduce the investment a potential entrant
might have to make.
3) Outstanding formal debt of the company: This is most
relevant for someone who is looking to make an equity
investment. Once we reduce SL and CSL from reproduction
cost of assets, what is left is enterprise value to which debt
holders and equity holders have the claim. An equity investor
needs to reduce the value of debt to know the equity value.

Beware of highly leveraged firms


A slight error in estimating asset value for highly leveraged


firms can lead to huge errors. Let us understand this by the
following example of a highly leveraged firm:
Estimated asset value of company less SL (Adj AV) = Rs 100 m
Debt (D) = Rs 80 m
Resultant value of equity (E) = Adj. AV D = Rs 100 m Rs 80
m = Rs 20 m

In case we are 5% off in estimating asset value, let us see


how it affects resultant equity value.
Estimated asset value of company less SL (Adj AV) = Rs 95 m
Debt (D) = Rs 80 m
Resultant value of equity (E) = Rs 15 m

Hence, a 5% error in estimating asset value can lead to


25% error in estimating equity value.

Chapter 13: Introduction to Valuation

151

No wonder investors like to stay away from highly leveraged


companies as margin of safety gets completely wiped out.

When to invest based on Asset Based


Valuation

First find out Asset Based Value (ABV) as discussed earlier


by subtracting liabilities from values of all assets put
together.

Now find out the market cap plus the value of debt of the
firm under consideration. Call this the market enterprise
value.

Compare market enterprise value (EV) (market value of


equity + market value of debt less cash) with ABV.

If EV < ABV, its a good investment opportunity.

This approach is more relevant when new comers enter an


industry to take advantage of overvaluation.

Limitations of Asset Based Valuation


Does not differentiate between good management/bad


management (franchise value).

In cases of overcapacity in the industry/poor management,


asset value will be on the higher side.

Resultant value can be biased depending upon industry


knowledge/experience as it involves estimating/adjusting
asset values to some extent.

Does not take into account earnings, cash flows or growth


rates.

152

Equitymasters Secrets

Conclusion
In this chapter, we discussed the time value of money concept and
its importance in determining intrinsic value.
While the DCF Method is a sound theoretical framework, its
practical application has too many limitations.
For companies that do not enjoy any economic moat, future growth
has no value and hence are well-suited for asset based valuation.
In the next chapter, we will discuss valuation methods for
companies that have an economic moat.

Chapter 13: Introduction to Valuation

153

Chapter 14

Earnings Power Value


and Franchise Valuation
Earnings Power Valuation

In the last chapter, we saw Asset Based Valuation (ABV), the


first of our three valuation methods.

ABV can be used where firms either earn less than their
cost of capital or are just about able to match their cost of
capital.

For e.g. if the cost of capital is 12% and if the ROE or ROIC of
the firm is around 10%-12% on a sustainable basis, it makes
more sense to use asset based valuation than any of the
others.

ABVs entire focus is on the valuation of assets on the


balance sheet.

It does not aim to value the earnings or the cash flows of the
company.

But what if the firm consistently earns above its cost of


capital?

For such cases, we use what is known as the earnings


power value method.

For e.g. if the cost of capital is 12% and if the ROE or ROIC of
the firm is around 15%-20% then the earnings power value
method can be used.

Chapter 14: Earnings Power Value and Franchise Valuation

155

What does EPV mean?


Earnings power value (EPV) is determined using the


current earnings of the company after making all the
adjustments.

Since it considers current earnings, future earnings and


cash flows do not enter the picture.

The adjustments to earnings would mean not including one


time charges, adjusting for maintenance depreciation etc.

Further, for companies in a cyclical industry, there would be


wide swings in earnings during the peak and the downturn
in the business cycle. Hence, in such cases earnings would
have to be considered on a normalized basis.

Assumptions for EPV


Graham and Dodd have made certain assumptions with


respect to EPV.

First, current earnings, properly adjusted, are considered to


be nearly the same as the cash flows to shareholders.

Second, this method is more suited for firms where


earnings remain constant and are not likely to increase by
much in the indefinite future.

By making these assumptions, we arrive at the following


formula for the valuation of a firm using EPV:
EPV = Adjusted Earnings * 1/R

Over here, R refers to the current cost of capital.

Since the earnings/ cash flow is assumed to be constant, the


growth rate (G) would be zero.

156

Equitymasters Secrets

How does one interpret EPV?


There is a close connection between EPV and the ABV we


studied in the previous chapter.

This connection can be evaluated by considering three


scenarios.

In the first scenario, let us assume that a companys EPV


is substantially below the reproduction cost of the assets.
This implies the management is not using the assets to the
maximum potential to earn the kind of returns that it should.
What this means is that the management will have to change
the way it is doing things.

In the second scenario, let us assume that a companys EPV


is equal to the reproduction cost of the assets. This situation
typically arises in highly competitive industries.

Let us assume, that company A operating in a particular


industry has earnings, properly adjusted of Rs 10 m a year.

If the cost of capital is 10%, then applying the earlier


mentioned formula, the EPV comes to Rs 100 m.

If the cost of the assets using the reproduction cost method


of the previous chapter is Rs 30 m, then there is a differential
of Rs 70 m. What this means is that investing Rs 30 m in
assets has the potential to generate earnings of Rs 100 m.

This would naturally attract other players. So let us assume


that Company B enters the fray.

Naturally, with two players now present, Company A would


see its earnings reduce to Rs 8 m per year.

As long as the differential exists, more players will enter the


field till the EPV equates the reproduction cost of assets.

Chapter 14: Earnings Power Value and Franchise Valuation

157

This phenomenon is typically seen in commodity type


businesses or industries where the barriers to entry are quite
low.

Here competitors enter the industry and drive down the


excess returns to the same level as the cost of capital.

In the third scenario, let us assume that the EPV is


significantly higher than the reproduction cost of the
assets.

More importantly, it is likely to stay this way for the company


for some time.

This means that the company is operating in an industry


where the barriers to entry are high and where competitors
are not able to drive down returns to the cost of capital.

And for the EPV to remain higher, the barriers to entry must
be sustainable at the current level for the indefinite future.

Importance of a Franchise

The difference between the EPV and the asset value is the
value of the franchise enjoyed by the company.

The defining character of a franchise is that it allows


the company to earn more than it needs to pay for the
investments that fund its assets.

For this, the company should have a strong competitive


advantage and this also needs to be sustainable.

It should be noted that the franchise concept is nothing


but the economic moat of a company that helps it to earn
significantly higher than the cost of capital.

Thus, if EPV is much greater than reproduction cost and

158

Equitymasters Secrets

this difference is sustainable, the firm is said to have a


sustainable competitive advantage with its value being the
difference between the two.

Advantages & Limitations of EPV


The main advantage of EPV is that it considers current


information without having to make predictions for the
future.

This means that it can be considered more reliable than


assuming the rate of growth and cost of capital many years
into the future.

However, the limitation is that assumptions are based on


earnings which are less reliable than the value of assets.

Summary of EPV

In this chapter so far, we discussed the concept of earnings


power value (EPV) and its importance as a measure of a
firms intrinsic value.

Since, it takes into account current earnings, it is more


reliable than estimating earnings and cash flows into the
future.

If the EPV is substantially higher than the asset value for a


company, then it means that it enjoys what is known as a
franchise.

Therefore we now have two methods of valuation. One


where the firms return on capital is less than or equal to
its cost of capital. Here, we used the asset based valuation
method where we valued the assets. The assets were
valued using the liquidation method or the reproduction cost
method.

Chapter 14: Earnings Power Value and Franchise Valuation

159

The second method considered the case where the return


on capital is greater than the cost of capital but there is no
growth in the earnings/cash flows of the firm.

How to Value a Franchise?


Franchise value is simply the difference between the asset


value and EPV of any company.

As highlighted earlier, EPV = Adjusted earnings*1/R, where R


is current cost of capital.

Lets assume that adjusted earnings for XYZ Ltd are Rs 25 m.


Assuming cost of capital at 8% we get EPV value of Rs 313 m.

The next step is to estimate the asset value or the


reproduction cost of assets.

The asset value is simply the book value of assets with


some adjustments.

Lets assume that total assets (tangible + intangible) of XYZ


Ltd are Rs 70 m.

The next step is to find reproduction cost of assets which


includes some adjustments.

Lets assume that XYZ Ltd has a strong brand and is a highly
profitable company. Hence, competitors are lured to enter
into the industry.

This would entail even higher advertising and promotion


(A&P) expenses for competitors as XYZ Ltd is already a brand
in the eyes of consumers.

Thus, in correctly estimating the reproduction cost of assets


A&P expenses have to be capitalized.

Though recurring in nature the benefit of these expenses is

160

Equitymasters Secrets

realized in future years in terms of increased market share.


Hence, they can be considered as off balance sheet assets.

Within one year a competitor cannot pose any material threat


to XYZ Ltd. Hence, we need to decide the period (number of
years) over which the expenses have to be capitalized.

Deciding on the number of years depends upon your


judgment as to how long the competition will take to build
a brand as strong as XYZ Ltd and replicate its distribution
pipeline.

For the sake of simplicity we assume a period of 3 years and


total A&P capitalization cost of Rs 50 m.

Our total reproduction cost of assets now stands at Rs 70


m + Rs 50 m = Rs 120 m.

From this we reduce the spontaneous liabilities like


advances from suppliers, workers etc (Rs 20 m).

We can also deduct cash in excess of what the company


needs to run the business (Rs 10 m).

Spontaneous liabilities are reduced as it reduces the outgo


of competitors. For instance, advances from suppliers
reduce the investment in working capital.

Excess cash is reduced as competitors can invest the same


in other profitable areas.

Adjusting for these items total reproduction cost of assets


would be:Total Assets: Rs 70 m
Add-Three years of A&P expenses capitalized: Rs 50 m
Less- Advances from suppliers: Rs 20 m

Chapter 14: Earnings Power Value and Franchise Valuation

161

Less- Excess cash: Rs 10 m


Total net reproduction cost = Rs 90 m

Our initial EPV estimate was Rs 313 m. Thus, franchise value


is equal to Rs 313 m (EPV value) Rs 90 m (net reproduction
cost) = Rs 223 m

Please note that the firms franchise value would have been
zero if its EPV were equal to reproduction cost of assets.
But since it is much higher, the firm has some sort of strong
competitive advantage or a franchise.

The franchise exists because the firms return on capital is


much higher than cost of capital.

On reproduction assets of Rs 90 m, it earned Rs 25 m. This


translates into a return on capital of around 28%. Since this
is much higher than cost of capital that we assumed of 8%, it
signals the existence of a strong franchise.

Key Points about Franchise Value


Franchise value increases if EPV increases and vice-versa.

EPV increases if profitability of XYZ Ltd increases. This can


happen when competitors are unable to make any inroads
into the market share of XYZ Ltd.

However, if competitors cut their price and spend heavily


on marketing they would be able to garner market share at
XYZs expense. This will reduce XYZs profitability and thus
its EPV and hence franchise value.

As such, franchise value is dependent upon how


successfully the company is able to maintain its market
share and profitability.

162

Equitymasters Secrets

For that to happen the company should have a strong


competitive advantage. It should also be sustainable. If not,
EPV will erode and franchise value will fall.

Advantages and Limitations of Franchise


Value

The main advantage of franchise value is that it involves


inputs which are less subjective in nature.

Most figures like earnings, book value of assets are readily


available. The limitation is that franchise value is susceptible
to changing values in cost of capital.

For instance, in our earlier example if we increase the cost of


capital to 10% instead of 8%, the value of franchise will fall.

Also, if companies frequently change their accounting


techniques to record transactions, franchise value estimate
may not be accurate.

Conclusion

In the second part of this chapter, we discussed the concept


of franchise value and what it indicates.

Since, it takes into account book values, it is less reliable for


companies that fudge books or change accounting methods
frequently.

If the franchise value is substantially higher, then one must


find out the competitive advantage the company enjoys. If
the advantage is sustainable franchise value will sustain or
else it will deplete.

In the next chapter, we will discuss another variant of the EPV


approach.

Chapter 14: Earnings Power Value and Franchise Valuation

163

Chapter 15

Franchise Valuation With


Growth & Multiple-based Valuation
Recap of ABV Method - Liquidation Value

In the previous two chapters, we discussed the Asset-based


Valuation and Earning Power Value method.

In both the methods, we did not lay any emphasis on growth


in future earnings.

In fact, in the liquidation method, growth in earnings


destroys value. If your cost of capital is 12% and return on
capital is 10%, you are earning Rs 10 and paying back Rs 12
as cost of capital. This is a straight loss of Rs 2 per Rs 100 of
invested capital.

This way the more you invest, the more you will lose.

As a result, the best way to buy companies like these is to


buy them at a huge discount to their asset values.

Recap of ABV Method - Replacement Cost


For replacement cost method, we had assumed cost of


capital to be the same as return on capital.

Here, every extra Re 1 invested in the business will be valued


at exactly that, Re 1. Consequently, the intrinsic value will
increase at the same rate at which capital invested in the
business increases.

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

165

If the capital base of the company increases by 100, its


intrinsic value will also increase by Rs 100.

Contrast this with the liquidation method where every Rs 100


invested is valued at Rs 80 or thereabouts.

Recap of EPV Method


The third method we discussed was the EPV method. Here


we assumed the return on capital to be higher than the
cost of capital.

But what we did not take into account was the growth in
earnings.

We assumed no growth in earnings and then derived a


formula to value such firms.

The intrinsic value using EPV method gives a value higher


than the ABV method for the same capital base.

This is because of the presence of a franchise. It is this same


franchise that enables the firm to earn greater than the cost
of capital.

With this, let us now move on to our last valuation method.

Franchise Valuation With Growth


Imagine a business that has a franchise as well as growth in


earnings.

In other words, imagine a business that has a return on


capital comfortably higher than its cost and is also seeing
its earnings grow at a decent rate.

Such a business will certainly be valued higher than the one


with franchise but with no earnings growth.

166

Equitymasters Secrets

This is because growth requires investment and on this


investment, the return on capital will be higher than the cost
of capital.

As a result, the companys capital base will go on increasing


leading it to be valued higher than the firm with no growth or
the EPV method.

Let us try and arrive at a valuation method for a firm with a


franchise as well as growth in earnings.

For this, let us go back to the formula we used for the EPV
method and build on it.

If you remember we had the following formula:

EPV = Adjusted Earnings * 1/R (R refers to the current cost of


capital)

Now, let us introduce three more variables in the equation C,


ROIC and G

C is the capital base of the company. In other words, it is the


total tangible invested capital of the business.

ROIC is the return on invested capital of the business and


can be calculated as: ROIC = EBIT (1-tax rate)/C

Please note that the EBIT (1-tax rate) is the adjusted earnings
we used in the EPV formula.

And lastly, G is the expected growth rate of the business


from now until perpetuity.

Now, we are sure our readers are familiar with two of the
most basic formulas in finance.

These are the perpetuity and perpetuity with growth formula.


These are CF/R and CF1/(R-G) respectively.

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

167

In the first, the numerator stays constant or does not grow for
an infinite period of time.

In the second, the numerator grows at a fixed rate every year


for an infinite period of time.

Now, for the EPV, we used a formula similar to the perpetuity


method because there was no growth.

But since for franchise with growth method, we are assuming


a fixed growth rate G, our denominator for the formula will
be (R-G). Of course, R here is the cost of capital and G
the expected growth rate of the business from now until
perpetuity.

Now, let us move on to the numerator of the valuation


equation.

In the EPV formula, we had the adjusted earnings as the


numerator. This was after tax and it also took into account
the maintenance depreciation outgoings for the company.

This adjusted earnings can also be written as C*ROIC. It is


the capital base of the company multiplied by its ROIC.

Therefore if capital base is Rs 100 and ROIC is 15%, the


adjusted earnings equal 100 times 0.15 i.e. Rs 15. As a
matter of fact, ROIC, C and adjusted earnings are the three
variables in the equation and the third can be easily found
out if the first two are given.

Its time to bring growth into the equation now.

C*ROIC will remain the numerator for an equation with no


growth as we saw in the EPV formula. But what happens
when we bring growth into the picture?

Please note that growth requires investment in the capital


base of the company. If ROIC remains constant, for a 10%

168

Equitymasters Secrets

growth in adjusted earnings, capital base will also have to


increase by 10%.

This investment in growth will essentially have to come from


the cash flow that the company generates. And this cash
flow is nothing but the adjusted earnings for the company.

As a consequence, the funds for growth will come from the


adjusted earnings of the company. We can get the funds
that we required for growth by the formula C*G.

Please note that we have taken ROIC to be constant.


Therefore for a 10% growth, 10% more capital is required. So
if the capital base is Rs 100 and expected growth is 10%, the
extra capital required will be Rs 10 which we calculate from
the formula C*G.

Similarly, if the capital base is Rs 500 and expected growth is


15%, the extra capital for growth under a constant ROIC will
be Rs 75 (500*15%).

As a result, the numerator of the valuation formula will no


longer have the adjusted earnings.

It will now have the equation (C*ROIC) (C*G)

This is the cash that will remain after investing for growth.

If we recall, (C*ROIC) is nothing but the adjusted earnings of


the firm or the cash flow for a no growth firm. (C*G) on the
other hand is the extra capital required for growth. Thus,
the formula is nothing but cash generated minus cash
invested. The difference between the two gives us the final
distributable cash flow.

Putting it all together, in the numerator we now have a


distributable cash flow which under constant ROIC is growing
at a fixed rate G every year and in the denominator we have

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

169

a perpetuity thats growing at the same fixed rate G.


The final formula will thus look like this:

PV = ((C*ROIC) (C*G))/(R-G)

This can be further reduced to PV = C*(ROIC-G)/(R-G)

We have borrowed this terminology and most of our


discussion on valuation from Prof. Bruce Greenwalds famous
book Value Investing. PV refers to the present value of the
future cash flows and hence the term.

The formula for PV shows us the way in evaluating firms


that not only have competitive advantage but also have
strong earnings growth going for them.

Imagine a hypothetical scenario where we have two firms


having the same capital base, return on capital as well
as cost of capital. The only difference is the growth rate
between the two.

While firm A is not able to grow its earnings, firm B has a


sustainable, constant growth rate of around 5% for many
years into the future.

Now let us try plugging these numbers in the two formulas


for EPV and PV respectively.

Let us assume the ROIC to be 20% for both companies,


capital base as Rs 100 and R to be around 12%.

For the no growth firm, we will have to substitute the


respective values in the following formula C*ROIC/R (Please
remember that C*ROC is nothing but the adjusted earnings).
This gives us 100*0.2/0.12 = Rs 167. Thus, the EPV of the firm
is Rs 167 with no growth in earnings.

Now, let us calculate the intrinsic value of the firm with

170

Equitymasters Secrets

growth in earnings assumed at 5% per annum. For this, we


will use the equation we just developed.
PV = C*(ROIC-G)/(R-G)

Putting in the values, we get 100*(0.2-0.05)/(0.12-0.05). This


results into an intrinsic value of the firm of Rs 214.

For a firm that has a franchise or in other words where the


return on capital is higher than the cost of capital, growth in
earnings will create a value greater than where there is no
growth.

In the case we just studied, the intrinsic value of the firm


where there is a franchise as well as growth is nearly 30%
higher than the firm with franchise but no growth.

Now, heres another interesting observation. If one takes


the ROIC down to just 10% and everything else remaining
constant, then both the EPV as well as PV change to Rs 83
and Rs 71 respectively!

Did you see what just happened here? PV, which takes into
account growth came in lower than EPV where there is no
growth.

This leads us to a very important conclusion. Growth adds


value only when return on capital is greater than cost
of capital or where there is a sustainable competitive
advantage. If the same is not there, growth destroys value as
we just saw.

So next time you see a firm that is growing earnings at a


strong pace but does not have a competitive advantage, we
think it will be better to give it a miss unless it is trading at a
significant discount to its asset value.

So how will the ratio of PV/EPV look like at different levels

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

171

ROIC, R and G. We have a table below that will give you


some idea about the same.
G/R

ROIC / R
1.0

1.5

2.0

2.5

3.0

25%

1.0

1.1

1.2

1.2

1.2

50%

1.0

1.3

1.5

1.6

1.7

75%

1.0

2.0

2.5

2.8

3.0

G = Growth Rate, R = Cost of Capital, ROIC = Return on Invested Capital

As can be seen, even with a very high ROIC and growth


rates in relation to cost of capital, the maximum one should
pay for a firm over its EPV is 3x.

In fact very few companies on the face of this earth are able
to command even that high a valuation. For competition
constantly chips away, trying to bring both growth rates and
ROIC down in the process.

This brings us to the end of our discussion of the third and


the final method of valuation.

Summary of the 3 Valuation Methods


Just to recap, we now have three methods of valuation.

The first is the asset based valuation where we value the


stock based on its liquidation value or replacement value.

The second method is the earnings power value or the EPV


method where we value a company having a franchise but
with practically no growth in earnings.

And finally we saw the present value method or the PV

172

Equitymasters Secrets

method whereby we valued a company having both a strong


franchise as well as witnessing a growth in earnings.

We believe the three methods will be best demonstrated by


the image below. It nicely summarizes the three approaches
with the help of slices of value.

Value of Growth:
Only if the growth is within
advantage
Earnings Power Value:
Franchise value from current

Asset Value:
Free entry

cost of assets

We would also like to use a great Warren Buffett analogy


to describe the three different types of businesses we
discussed using the three valuation methods

As per him, a Gruesome business is a kind of a savings


account which pays an inadequate interest rate.

This is the business that can be valued using mostly the


asset based valuation method as the return on capital is less
than cost of capital.

On the other hand, a Good business is a one that pays an


attractive interest rate. This is the business that can be
valued using the EPV method.

And finally, Warren Buffett talks about a Great business

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

173

as a type of savings account that pays an extraordinarily


high interest rate that will rise as the years pass. This is the
business we discussed in the current chapter that not only
has a franchise but also a growth in earnings.

As per Buffett, the more sure money tends to be made in


the first kind of business when it is bought at a significant
discount to the companys liquidation value or the
replacement cost value.

However, the big money tends to be made in the third


kind of business where the company has a sustainable
competitive advantage or a franchise which is backed by
growth in earnings for many years to come.

Multiple-based Valuation Approach


Despite their practical utility, the valuation methods we talked


about seldom get quoted in company research reports.

Instead, what we see is nothing else but multiple based


valuations like Price to Earnings, Enterprise Value / EBITDA
or Price to Book Value.

Please note that like our three approaches, these multiple


based methods are not another set of independent methods
of valuation.

On the contrary, these are nothing but a variation of the


three approaches we just discussed with some assumptions
and simplifications thrown in.

Therefore, if we are familiar with the original approaches


to valuation, we can easily derive the multiples that can be
assigned to companies in the multiple based approaches.

With this background, let us discuss one of the most

174

Equitymasters Secrets

common methods of valuing companies i.e. the P/E (price to


earnings) method.

Price to Earnings Multiple Approach


What should be the ideal P/E multiple for a stock? Let us try
and answer this question using our three valuation methods.

We know that asset based valuation method values a


company based on its assets. Here, earnings do not enter
the picture.

However, the P/E method requires that one give a certain


multiple to the earnings of a company. Consequently, we
cannot use the asset based valuation method to arrive at an
ideal P/E multiple for a firm.

Now, let us turn our attention to the second of the three


methods i.e. EPV method.

You would recall that here we assume the companys return


on capital to be greater than the cost of capital. Also, the
company under consideration has a stable earnings profile
with no growth.

You would also recall the formula i.e. EPV = Adj. Earnings*
1/R

Therefore, in order to arrive at a P/E for such kind of firms, all


you need to know is the cost of capital of the firm and also
calculate the adjusted earnings.

So say if the cost of capital of the firm is 12%, then the


maximum P/E multiple you should give to such stocks is
1/12% i.e. 8.3 times. And if the cost of capital is say 15%, the
maximum P/E would drop to 6.7x. And if it is 10%, then the
P/E would come to 10x.

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

175

You would notice all that one needs to do is find out if


the companys return on capital is higher than its cost on
a sustainable basis and if this is true then the maximum
earnings multiple one should give the stock is 1 / Cost of
Capital.

Some assumptions are in order. One, the PAT or the


earnings of the firm under consideration is the same as
adjusted earnings.

Two, the company is either debt free or its cost of debt


is the same as its cost of equity with the interest expense
being non-tax deductible.

Thus, once youve factored in these two assumptions, the


expected P/E of a stock with stable earnings and with its
return on capital higher than cost of capital is nothing but a
very simple formula as we just saw.

So, this was about a firm with earnings staying constant.


But what about the case where the firm has a competitive
advantage as well as growth in earnings?

To find an ideal P/E multiple for such stocks, we will have to


turn to our last of the three methods of valuation viz. the PV
method.

We will reproduce the formula here again for easy reference.


The formula was: PV = C*(ROIC-G)/(R-G)

Now, by plugging in the observed values of ROIC, R, G, we


get the intrinsic value PV of the firm in the form of a multiple
of C.

And invested capital C can be expressed in terms of adjusted


earnings by the formula E/ROIC. Please recall that E was
nothing but C*ROIC i.e. capital base multiplied by the return
on the same invested capital base.

176

Equitymasters Secrets

Thus, what we now have is the intrinsic value of the firm


expressed in multiple of its earnings, E.

Price to Earnings: Example


An example will help make things clearer. Say there is a firm


with an ROIC of 20%, G of 6% and the cost of capital being
12%. Substituting these values in the PV equation, we get PV
= C (0.2-0.06)/(0.12-0.06). Simplifying this further, we get PV =
2.33 C.

Now, we need to go one step further and replace C with E/


ROIC. Therefore the final equation in terms of E will now be
PV = 11.7 E.

Consequently, an ideal P/E for a firm with the characteristics


we just outlined is approximately 11.7x or about 12x.

Thus, if you know the long term expected ROICs, Gs of the


firms you are studying, one can calculate the approximate
P/E that the stock can command after taking into account a
suitable cost of capital

Please note that this formula will not work for G>ROIC. But
this is not much of a problem because for most firms, long
term growth on a sustainable basis is lower than its ROIC.

Summary of Multiple-based Valuation


The beauty of the Present Value (PV) formula is that it can be


used to arrive at not just an approximate earnings multiple
but also multiples like price to book value and EV/EBIT.

If the company under consideration is debt free then


effectively C becomes the book value of the company and
ROIC becomes RONW.

Chapter 15: Franchise Valuation With Growth & Multiple-based Valuation

177

Therefore the PV that we get is nothing but an intrinsic


value by way of a book value multiple of the stock.

This now brings us to the conclusion of the chapter on


franchise with growth as well as multiple-based approach to
valuations.

Conclusion

We discussed a formula that needs to be brought into use


when the firm under consideration has both growth as well
as some form of sustainable competitive advantage.

We then saw the PV varies with different combinations of


ROIC/R and R/G with valuations getting higher and higher
as both ROIC and G increase.

Subsequently, we arrived at the multiple based approaches


to valuation using the same PV formula we studied in the first
part of the chapter.

We now have approaches to value practically all kinds of


firms. These are firms that earn less than or equal to their
cost of capital, firms that earn more than the cost of capital
but with a stable earnings profile and lastly, firms that not
only earn more than their cost of capital but also witness
stable, long term growth in earnings.

Of course, it must be remembered that firms that grow their


earnings at a strong pace but do not earn more than cost
of capital do nothing but destroy value over a long term
period. Consequently, such companies are best avoided
unless available at a significant discount to their asset value.

178

Equitymasters Secrets

Stock
Screeners

Chapter 16

Stock Screeners

What is a Stock Screener?


In the book so far, we have covered the qualitative and


quantitative aspects of value investing that will enable you to
evaluate a potential investment.

With this, you would now be in a position to apply the


principles of value investing for your own stock portfolio.

At this point, you may have a question: How to get started?

There are two broad approaches to fundamental investing top-down approach and bottom-up approach.

The Top-Down Approach


The top-down approach lays greater emphasis on the


macro factors.

An investor would first evaluate the macro economy.

Based on the analysis of macro trends, he would pick up a


sector or sectors that would be likely beneficiaries.

And then from within those sectors, an investor would pick


up fundamentally-sound companies.

Chapter 16: Stock Screeners

181

The Bottom-Up Approach


While the top-down approach is logically sound, it depends


on certain macroeconomic assumptions that may or may not
materialise.

On the other hand, the bottom-up approach has a more


company-specific focus.

An investors investment decision would be primarily based


on the individual merits and demerits of a stock.

Some of the most successful value investors including Mr


Buffett have followed this investment approach.

This, however, does not mean that one should ignore the
larger sectoral and macro trends. The idea is to be wary of
risks from top-down perspective but invest bottom up.

The Need for a Stock Screener


If an investor were to follow the bottom-up approach, how


should he go about selecting companies that he would like
to research on?

There are more than 5,000 companies listed on the BSE.

It is humanly impossible to peruse through the business and


financials of every company.

To remedy this, one can take the help of stock screeners.

Stock screeners are financial and valuation filters that can


help you zero down on companies that could be prospective
investment candidates.

This can be useful to eliminate all the companies that dont fit
the prerequisite financial criteria.

182

Equitymasters Secrets

Types of Stock Screener


The next question is: How do you choose the right stock
screener? Ideally, the choice of the screener must reflect
your investment philosophy.

The various parameters that you use in a stock screener


are business and performance attributes that you expect a
prospective stock to possess.

You can create your own stock screener based on factors


that you believe are critical in a sound business.

We will discuss some important stock screeners based on


the principles of some noteworthy value investors.

Benjamin Graham Stock Screeners


Benjamin Graham, known as the Father of Value Investing,


largely focused his stock picking approach on finding deep
bargains.

During his earlier years, his investment strategy was to buy


stocks that were available at a price below their net current
asset value. This methodology produced very good results.

However, after the long bull-run commenced in 1949 such


bargain opportunities became increasingly rare.

In 1973, just three years before he passed away, he


presented an elaborate study which showed that in every
two-year period between 1958 and 1971, stocks had either
risen or fallen by at least 33%.

This finding encouraged him to find a quantitative framework


that would be able to take advantage of such volatility in the
stock markets.

Chapter 16: Stock Screeners

183

As per Graham, such a quantitative system would have to


be logical, easy to implement and capable of producing
satisfactory financial returns.

Which financial criteria would be able to fulfill all three


conditions across time periods?

Based on the principles and criteria laid down by Graham,


we will discuss three stock screeners that could help you
pick value stocks trading at a steep discount.

Benjamin Graham - Stock Screener #1


The first stock screener has two parameters- Price to Book


Value ratio and Debt to Equity ratio.

The conditions are as follows:


1) Stock price must be less than two-third the book value
per share;
2) Debt to Equity ratio less than 1.

Please note that in addition to the above conditions, P/BV


ratio must be greater than zero and D/E ratio must be greater
than or equal to zero.

This will ensure that you eliminate companies with negative


net worth.

As you saw, the first parameter in this stock screener is Price


to Book Value ratio.

This ratio shows the relationship between the stock price


and the balance sheet.

Book Value is what remains for the equity holders if the


company were to go for liquidation (Total Assets - Total
Liabilities).

184

Equitymasters Secrets

Book Value = Net Worth = Shareholders Funds

By setting a condition to screen stocks that are trading at


less than two-third their book value, you would get stocks
that are trading at a deep discount to their net worth.

The Debt to Equity condition ensures that you avoid highly


leveraged companies.

Benjamin Graham - Stock Screener #2


The second stock screener has two parameters: Price to


Dividend Yield ratio and Debt to Equity ratio.

The conditions are as follows:


1) Dividend yield must be at least two-thirds of the bond
yield or greater;
2) Debt to Equity ratio less than 1 (and greater than or equal
to zero as mentioned previously).

Dividend yield is a financial parameter that shows the returns


earned on a stock investment from dividends.

Dividend yield = Dividend per share / Stock price

Say you bought stock X at Rs 100 per share with dividend


per share of Rs 8, the dividend yield on the stock is said to
be 8%.

Why is dividend yield important?

Dividend yield ensures that investors earn a return on their


investment even in the absence of stock price appreciation.

It provides a steady stream of income for long term investors


without them having to sell their stocks.

Going back to the screener, the first condition said that the

Chapter 16: Stock Screeners

185

dividend yield of a stock must be at least two-third of the


bond yield or greater.

The corporate bond yield in India is close to 10%.

So assuming a bond yield of 10%, the dividend yield must


be 6.7% or greater.

Benjamin Graham - Stock Screener #3


The third stock screener has two parameters: Earnings to


Price ratio and Debt to Equity ratio.

The conditions are as follows:


1) Earnings to Price ratio must be at least twice the
bond yield;
2) Debt to Equity ratio less than 1 (and greater than or
equal to zero).

Earnings to Price ratio (also known as Earnings Yield) is


nothing but the inverse of Price to Earnings ratio.

The first condition of the screener said that the Earnings to


Price ratio must be at least twice the bond yield.

So if the bond yield is 10%, the earnings yield must be at


least 20%.

A 20% earning yield means that if the stock price is 100,


earnings per share is 20.

Taking an inverse of the Earnings to Price ratio, you get a


Price to Earnings multiple of 5x (100/20).

Hence, you could rephrase the first condition as Price to


Earnings ratio of 5 or less.

186

Equitymasters Secrets

Warren Buffett Stock Screener


Benjamin Grahams most astute student Warren Buffett kept


the principles of value investing taught by his mentor intact.

However, he redefined his approach to focus more on


quality.

He focuses on companies that have a very durable


economic moat and are trading at fair valuations.

This is in contrast with his mentors focus on deep discount


stocks without much emphasis on a firms qualitative factors.

Let us try and understand the typical qualities of a stock that


Warren Buffett would buy and how an investor could create a
screener to find such companies.

We have identified some key parameters that can help you


zero down on stocks that possess the attributes that a typical
Warren Buffett stock is likely to possess:

High return on equity

Strong Dividend payout ratio

Low debt to equity ratio

Fair price to earnings ratio

Magic Formula Stock Screener


We just went through a stock screener that was derived on


the basis of Warren Buffetts value investing principles.

However, it must be noted that it was just one of the various


ways of finding a quantitative interpretation of Buffetts stock
picking approach.

We will now go through Joel Greenblatts Magic Formula

Chapter 16: Stock Screeners

187

stock screener.

In his stock screener, Greenblatt has tried to arrive at a


quantitative translation of Buffetts investment strategy of
buying a great business at a fair price.

As you can see, there are two key factors in Buffetts


approach - Great business and fair price.

How can these qualitative factors be defined in quantitative


terms?

Greenblatt uses the following algorithm to arrive at a


financial metric that would be an approximate translation of
the two qualitative terms.
1) Great business: As per Buffett, a great business is one that
earns a high return on capital (ROC).

Now, there are various ways to look at a companys ROC.

Let us see how Greenblatt defines the ROC

Return on Capital = Earnings Before Interest & Tax (EBIT) /


Capital

As per Greenblatt, Capital = Net Plant, Property and Equity +


Net Working Capital

It is noteworthy that he has excluded excess cash and


interest-bearing assets.

In other words, he has included only those assets in his


definition of Capital that are actually used in the business to
generate a return.
2) Fair price: Buffett prefers a great business at a fair price
than a fair business at a bargain price.

188

Let us see how Greenblatt defines the financial parameter

Equitymasters Secrets

that would determine a companys fair price.


For this second factor, he uses earnings yield. As we have


noted earlier, earnings yield is nothing but the inverse of
price to earnings ratio.

However, Greenblatt differs in his approach in that he


uses EBIT instead of net profit in the numerator and Total
Enterprise Value (TEV) instead of just market capitalisation in
the denominator.

As per Greenblatts equation,

Earnings Yield = EBIT/TEV

Let us understand what Total Enterprise Value is and why


Greenblatt chooses to compare EBIT/TEV instead of P/E.

Total Enterprise Value is the cost an acquirer would have to


pay to buy out the entire company.
TEV = Market Cap. + Total Debt - Cash & Cash Equivalents
+ Minority Interest + Preferred stock

The reason Greenblatt uses EBIT/TEV instead of P/E is


to facilitate a like-for-like comparison between all stocks
irrespective of their capital structure.

When you use the P/E ratio, you compare a companys net
profits to its market capitalization.

However, market capitalization does not provide you


any clue about a companys capital structure and how it
finances its business.

This would make it difficult to compare debt-fee and debtladen companies.

On the contrary, when you use Greenblatts formula, youre


comparing EBIT with the entire value of the company.

Chapter 16: Stock Screeners

189

So when youre comparing the valuations of a large number


of companies using a screener, this formula can prove to be
more effective.

So as we discussed, Greenblatts Magic Formula has two


metrics:
1) Return on Capital (EBIT/ [Net Fixed Assets + Net Current
Assets])
2) Earnings Yield (EBIT/ TEV)

You run these two metrics on all the companies in your set.

Arrange the companies in the descending order of their


ROC. Assign the rank 1 to the company with the highest ROC
and go on assigning ranks in that order.

Carry out the same process for Earnings Yield.

Once you have all the companies with two respective ranks,
then next step is to do a combined ranking.

Greenblatt assigns equal weightage to both ROC and


Earnings Yield. Hence, you simply have to do the summation
of the two ranks to arrive at the combined rank.

As per Greenblatt, the lower the combined ranking, the


better the stock.

Things to Keep In Mind


While stock screeners are great stock picking tools, there are
some things that investors must bear in mind.
1) Stock screeners are statistical tools. They may not always
be reliable indicators a companys quality and intrinsic value.
2) Stock screeners indicate a companys past performance.

190

Equitymasters Secrets

They provide no input about a companys future prospects.


3) The results of a stock screener must not be taken at face
value. Investors can take the results as a starting point for
further research and analysis.

Conclusion

Stock screeners are excellent tools to scan the entire


universe of stocks and to find stocks that possess the
attributes that you are looking for.

They are effective tools to filter away undesirable stocks.

In the chapter so far, we discussed 5 different stock


screeners based on the principles of Benjamin Graham and
Warren Buffett.

If used diligently stock screeners can yield great results.

In the next chapter on Behavioral Finance, we will discuss


the psychological aspects of investing and how investors can
minimize biases and thinking errors from their investment
decision-making process.

Chapter 16: Stock Screeners

191

Behavioral
Finance

Chapter 17

Behavioral Finance

Are Stock Markets Efficient?


Normally, an investor buys a stock believing that it is worth


more than the price that he pays for it.

When he sells it, he assumes that the worth of the stock is


less than the price at which he is selling it.

But as per one investment theory, this is just a myth.

The Efficient Market Hypothesis, put forth by Nobel laureate


Eugene Fama in 1970, states that it is impossible to beat the
market.

This is because it assumes that stock prices fully


incorporate and reflect all relevant information at any
given point in time.

In other words, stock prices are always trading at a fair value


and hence, stock selection and market timing have no value
in the long run.

If markets were truly efficient, then how would it be possible


for value investors such as Warren Buffett to consistently and
substantially outperform the markets for decades?

In our view, the Efficient Market Hypothesis has several


flawed assumptions.

It presumes that investors are perfectly rational in their


behavior and that they are acting on the same public

Chapter 17: Behavioral Finance

195

information.

In making these assumptions, the Efficient Market


Hypothesis ignores the crucial element of human behavior
and its impact on the markets as well as the economic
landscape at large.

This brings us to Behavioral Finance, a field of study that


argues that human behavior is not as rational as presumed
by the traditional finance theories.

What is Behavioral Finance?


Behavioral Finance is an interdisciplinary field of study that


integrates finance, economics, psychology and sociology
to offer a holistic understanding of human behavior in
financial markets.

While traditional economics and finance theories presume


perfectly rational behaviour and eliminate irrationality and
bias as noise, behavioral finance puts forth that human
emotions and biases play a critical role in economic activity
and stock price movements.

Let us understand why it is critical to have a basic grasp of


behavioral finance in the context of stock investing.

Natural Science v/s Social Science


At the outset, let us understand the basic differences


between natural sciences and social sciences.

Natural science looks for explanations of the various


phenomena in the world around us.

It studies events that consist of a sequence of facts.

The chain of events leads directly from fact to fact.

196

Equitymasters Secrets

In social science, events have thinking participants.

This means that in natural science what a person or a group


thinks does not have an impact on the final outcome. In
social science, however, we can influence the very outcome
we are thinking about.

This particular characteristic feature of social science means


that we cannot come to a definite conclusion as we do in
natural science.

The conclusion in social science will always be colored by


what the participants think about it.

Thus there can be no generalizations, predictions and


explanations in social science like the kind we see in natural
science.

Behavioral Finance: Stock Markets


In the context of social science, let us understand two


important behavioral concepts fallibility and reflexivity espoused by legendary hedge fund manager George Soros.

The world is so complex that no individual can understand it


fully.

Hence, one can say that in situations that have thinking


participants, the participants view of the world is always
partial and distorted.

This is known as the principle of fallibility. It means that


human perception is inherently flawed and biased.

In theory, stock prices attempt to continuously incorporate


and reflect all available news, information and future
expectation.

Chapter 17: Behavioral Finance

197

But both ongoing as well as future economic events are


highly dynamic, variable and impacted by a large set of
factors.

It is humanly impossible to fully comprehend and


appropriately price in all the information and news.

So effectively, market participants base their buying and


selling decisions not on objective conditions but on their
limited and imperfect interpretation of those conditions.

The concept of reflexivity applies only in situations that have


thinking participants.

There are two key functions that the participants thinking


serves.

The first is the cognitive function which is to understand the


situation.

The second is the participating function which involves


action aimed at changing the situation to ones benefit.

In the cognitive function, the outside reality (news,


information, stock price movements, etc.) is supposed to
determine the investors view.

In short, the direction of causation is from the outside world


to the human mind.

But in the participating function, the direction of causation


reverses as the actions and decisions of the investors have
an impact on the outside reality (stock markets).

Since both the cognitive and participating functions operate


simultaneously, they tend to interfere with each other.

The actual course of events influences the participants


views.

198

Equitymasters Secrets

At the same time, the participants views also shape the


actual course of events.

This is easier to understand in the context of stock markets.

The markets tend to shape the investors views. But


the markets are not an independent variable. They are
simultaneous being shaped by the investors views.

This results in a two-way reflexive feedback loop between


the participants views and the actual course of events.

Since the participants perception is inherently biased and


there exists a reflexive relationship between the participants
and the market, it follows that market prices present a
biased view of the future.

This, effectively, debunks the premise that stock markets are


efficient.

Behavioral Finance & Value Investing


In the chapter so far, we discussed some characteristic


features of social sciences, and stock markets in particular.

The presence of thinking participants in the market makes


stock price movements less than a perfectly rational process.

The allegory of Mr Market was coined by Benjamin Graham


on exactly this premise.

Mr Market is nothing but a collective embodiment of


collective behavior of the market participants.

The manic-depressive tendencies of Mr Market often result


in markets swinging between the extremes of optimism (bull
market) and pessimism (bear market).

The value investing approach is designed to take

Chapter 17: Behavioral Finance

199

advantage of opportunities that arise because of Mr


Markets often irrational and emotion-driven behavior.

To be able to take advantage of the inefficiencies in the


market, participants need to not only recognize the mood
swings of Mr Market but also to take steps to minimize their
own thinking errors and biases in their investment decisionmaking process.

Inside the Human Mind


We will now shift our focus from market behavior to the mind
of an individual.

First, we will try and understand why human thinking is


inherently biased and partial.

The human brain is constantly stormed by millions of sensory


impulses.

However, our consciousness can only process a few


subjects at a time.

The impulses need to be condensed, ordered and


interpreted under huge time constraints.

As a result, thinking errors and distortions are direct


consequences of the brains limited capacity to process the
flood of sensory impulses.

It is clear, then, that it is practically impossible to eliminate


thinking errors and biases.

But with greater understanding and self-awareness, one


can certainly minimize the negative consequences of such
biases.

200

Equitymasters Secrets

Four Quadrants of Awareness


Our awareness can be broadly categorized into four


quadrants.

1. We know what we know


2. We know what we do not know
3. We do not know what we know
4. We do not know what we do not know

This is a useful mental framework that can help increase selfawareness, and, thereby minimize thinking errors.

We will briefly discuss each of these four quadrants and how


they affect our investment decision.

First Quadrant
We know what we know

Most of our waking conscious self we live in this quadrant.

This quadrant includes all the things that we think are


consciously known to us.

But sometimes, our ego tends to artificially inflate this


quadrant by including things that we dont really know.

For instance, simply possessing an academic degree in a


certain field does not make one an expert.

But people often confuse academic qualifications with actual


internalized knowledge.

How does this impact stock investing?

Chapter 17: Behavioral Finance

201

The maximum investment mistakes happen in this


quadrant.

People do not fail because of what they do not know,


but because of their failure to understand their circle of
competence.

One of the biggest reasons for Warren Buffetts immense


investing success has been his ability to clearly understand
his circle of competence and to stay strictly within it.

Second Quadrant
We know what we do not know

This quadrant relates to the state of awareness that pertains


to learning and enquiry.

All good investors reside largely in this quadrant as they


understand the limitations of their knowledge.

Just like it is important to know ones circle of competence, it


is also important to clearly know what lies outside that circle.

For instance, Buffett never invested in Microsoft despite


having been a long-time friend of Bill Gates, the billionaire
founder of Microsoft.

The fact I could have made billions of dollars from


Microsoft doesnt mean anything because I never could
understand Microsoft. Were willing to trade away a big
payoff for a certain payoff. Warren Buffett

202

Equitymasters Secrets

Third Quadrant
We do not know what we know

This quadrant relates to our subconscious self.

It includes genetic and socio-cultural learning.

People belonging to a certain social unit usually tend to bear


certain common behavioral characteristics.

Example: Characteristics that we generally describe as


exuding Indianness.

These characteristics are passed on from generation to


generation and become integral to ones psyche and often
determine our instinctive responses to various situations.

In the investing context, this quadrant is responsible for the


instinctive responses that we apply to economic situations
without knowing why we do what we do.

From an evolutionary perspective, the brain does not have


the mechanism to deal with stock markets.

Stock markets came into existence just a few hundred years


ago.

That is too trivial a period for the brain to evolve a


mechanism to deal with it.

So the brain uses the reward centre in the brain, the


amygdala, which was developed to deal with food (satiation)
and sex (drive) to deal with money and markets.

It goes without saying that it is this response-mechanism that


is responsible for all the chaos in financial markets.

This is the reason why investors get lured to buy when

Chapter 17: Behavioral Finance

203

markets are rising and when everyone else is buying.


This is also why investors confuse volatility as a risk in stock


investing rather than focusing on the risk of fundamentals
going bad.

There is another human instinct that causes investors to


make big mistakes.

As a self-preservation instinct, each individual believes in his


own uniqueness.

It leads us to believe in the uniqueness of our thoughts and


ideas.

It may prevent us from assessing whether others too hold


the same belief.

This instinct proves to be dangerous when a person is


susceptible to herd mentality.

It could so happen that an investor may think that his


thoughts are independent and unique.

He may fail to recognize that other investors too are thinking


along similar lines.

The history of bubbles and crashes shows the dangers of


ignoring this quadrant of ones awareness.

Fourth Quadrant
We do not know what we do not know

This quadrant of awareness relates to the realm that is


beyond all knowns.

Our knowledge of the world is distorted, limited and


incomplete.

204

Equitymasters Secrets

As such, all our thoughts, ideas and beliefs exist as mere


possibilities as we do not know enough to be absolutely
certain.

This quadrant is not only the largest but also the least
understood.

Let us discuss this quadrant in the context of investing.

In the investing business, it is impossible to be right all the


time. As such, a successful bout in stock markets can be
dangerous if it creates an illusion of genius.

Great investors tend to recognize the limits of their


knowledge and understand that humility is the best way to
survive unexpected outcomes.

Once we realize that imperfect understanding is the


human condition there is no shame in being wrong, only
in failing to correct our mistakes. George Soros

Conclusion

In this chapter, we studied how the presence of thinking


participants in social science gives rise to different set of
conditions that are not generally seen in natural science.

Market participants base their buying and selling decisions


not on objective conditions but on their limited and imperfect
interpretation of those conditions.

The value investing approach is designed to take


advantage of opportunities that arise because of Mr
Markets often irrational and emotion-driven behavior.

An understanding of the four quadrants of awareness


can help an investor in developing self-awareness, a key
ingredient to achieving success in stock investing.

Chapter 17: Behavioral Finance

205

Portfolio
Analysis

Chapter 18

Portfolio Analysis

Need for Portfolio Analysis & Asset


Allocation

In the chapters so far, we have mainly focused on evaluating


individual stocks based on the strength of their business
fundamentals and attractiveness of the valuation.

But how should you go about building your investment


portfolio? How many stocks should you own? How can you
minimize risk? When should you sell a stock?

In this chapter, we will focus on all the above mentioned


factors.

We believe this will be helpful in managing your investment


portfolio and maximizing the risk-reward equation.

Say you find a stock that has the attributes of a great


business and is available at a bargain valuation.

How much should you invest in such a stock? Should you put
all your money into it?

Intuitively, putting all eggs in the same basket may seem


risky.

A risk-averse investor may want to spread out his


investments across a portfolio of stocks and other assets
so that risks arising from any single investment would not
significantly impact the overall portfolio returns.

Chapter 18: Portfolio Analysis

209

What he is actually trying to do is maximize his chances of


reward while at the same time minimizing the risks.

What is Modern Portfolio Theory?


Pioneered by Harry Markowitz in 1952, the Modern Portfolio


Theory (MPT) is an investment framework for the selection
and construction of investment portfolios.

The theory is based on the maximization of expected


portfolio returns and simultaneous minimization of
investment risk.

It aims at constructing a portfolio of diverse investments


whose collective risk is lower than that of each individual
investment.

As per MPT, an investor must not select assets in his


investment portfolio based on their individual merits.

Rather, he must consider price behavior of each asset


relative to that of every other asset in the portfolio.

For instance, different types of assets such as stocks, bonds


and gold are known to respond differently to different
economic cues.

As such, a portfolio that has an optimal mix of different types


of assets would bear lower risk than a portfolio consisting of
only one type of asset.

MPT puts forth that investing is a tradeoff between risk and


expected return.

It shows how to build an investment portfolio with an optimal


risk-expected return equation.

At the core, MPT is nothing but a mathematical formulation of

210

Equitymasters Secrets

the concept of diversification.


It attempts to show how an investor can achieve the best


possible diversification strategy.

Modern Portfolio Theory- Assumptions


Lets go through some of the key assumptions of MPT:


All investors aim to maximize profit and minimize risk.

All investors are risk-averse and act rationally.

The correlations between various assets are always


fixed and constant.

The returns on assets follow a normal distribution.

Investors have a very clear and precise idea of expected


returns.

MPT - Risk and Expected Return


As we saw, MPT assumes that all investors are risk-averse


and they are trying to achieve profit maximization and risk
minimization.

In other words, it puts forth that there is direct correlation


between risk and return and that investors are willing to
accept more risk for higher payoffs and will accept lower
returns for a less risky investment.

So broadly, there are two important factors that an investor


needs to balance and optimize: 1) the expected portfolio
return, and 2) the portfolio risk.

Lets delve a bit into how Markowtiz looked at risk and


return

Chapter 18: Portfolio Analysis

211

As per MPT, risk is the same as volatility, a measure for


variation of returns of an investment over a period of time.

But MPT does not look at the risk of individual investment in


isolation.

It considers how each investment contributes to the risk of


the aggregate portfolio.

Hence, the greater the portfolio volatility, the greater the risk.

On the other hand, the expected return on an investment is


based on the average return it has offered investors over
some historical time period.

The risk therefore, is the deviation away from expected


historical returns during a certain period.

Why is the Modern Portfolio Theory flawed?


Like the Efficient Market Hypothesis that we discussed in


the previous chapter, Modern Portfolio Theory too has some
serious flaws.

It must be noted that both the theories have several common


assumptions.

Firstly, both the theories are based on a simple assumption


that risk is defined by volatility.

But is volatility a good measure of risk?

Investors are very concerned by downside volatility.

But would you call a portfolio that is going up a risky one?

The answer is no. But volatility regards upside and


downside movements as equally bad.

The other misconception that the theory suffers from is the

212

Equitymasters Secrets

assumption that there is direct relation between risk and


return.

But in reality, high volatility does not necessarily produce


better results, nor does low volatility produce poor results.

Moreover, volatility measures do not remain constant over


time.

So while MPTs basic idea of diversification is reasonable, it


fails miserably when it attempts to theorize it and to create a
mathematical formulation for portfolio selection.

The philosophical premise of MPT is in sharp contrast to


value investing and behavioral finance.

Let us now understand the views of value investors such as


Warren Buffett and Benjamin Graham on aspects such as
portfolio selection, risk, diversification and when to sell.

Portfolio Management
Graham Approach

Mathematics is ordinarily considered as producing


precise, dependable results. But in the stock market, the
more elaborate and obtuse the mathematics, the more
uncertain and speculative the conclusions we draw
therefrom. Whenever calculus is brought in, or higher
algebra, you can take it as a warning signal that the
operator is trying to substitute theory for experience.
Benjamin Graham

The above mentioned quote from Benjamin Graham is a


good indicator of his philosophy in both stock selection as
well as portfolio management.

As per him, simple, easy to follow rules are all that one

Chapter 18: Portfolio Analysis

213

requires in order to beat the markets over the long term.


As a result, concepts like the modern portfolio theory, CAPM


or Beta are not likely to find a place in his book.

He firmly believed that risk to an investor comes not from


the volatility in stock price but from a permanent loss of
capital.

It turned out that Benjamin Graham was indeed right.

We just saw that the modern portfolio theory has one


important assumption at its core. It argues that returns go
hand in hand with risk.

Therefore, if this was true, high beta which is a measure of


risk would automatically mean high returns.

However, this theory has been proven wrong on numerous


occasions.

It has usually been observed that growth stocks (stocks with


high P/E and high P/BV) are the ones with high betas.

But they have invariably ended up giving lower returns


than low beta value stocks.

The Modern Portfolio Theory thus stands proven wrong.

Thus, if modern portfolio theory is of little use in constructing


a market beating portfolio, what method should an investor
use?

Graham was of the view that trying to exploit the behavioral


deficiencies of humans would serve an investor much
better in portfolio construction as well as management
than theoretical concepts like modern portfolio theory.

He therefore greatly promoted the idea of buying beaten


down stocks that are trading at a significant discount to their

214

Equitymasters Secrets

readily ascertainable intrinsic values and ignoring stocks that


have a great deal of growth priced into them.

Successful portfolio management then is not a function of


higher order mathematics or calculus as per Graham.

It is all about having considerable will power so that the


temptation of following the crowd can be minimized.

And what is the number of stocks one should have in the


portfolio? No more than 20-30 as per Graham.

And the moment a stock reaches its predetermined


intrinsic value, it should be sold and replaced by another
stock that trades at huge discount to readily ascertainable
intrinsic value.

If no such opportunities are found, one should simply invest


in liquid bonds and wait till enough such opportunities show
up again.

To conclude, if you think about it, Grahams views on portfolio


management do make a lot of sense.

After all, how can one produce a superior performance


unless one does something different from the rest of the
crowd. And Benjamin Graham has tried to inculcate exactly
this philosophy through his teachings about value investing
and portfolio management.

Portfolio Management - Buffett Approach


Buffetts investing philosophy has been largely influenced by


Grahams ideas.

However, he has evolved his own investing style to focus


more on qualitative factors.

So how does Buffett select stocks and build a portfolio?

Chapter 18: Portfolio Analysis

215

He focuses on the merits of an individual stock and does


not bother about its volatility or correlation with other
asset classes.

He prefers to buy great businesses with a durable economic


moat that are available at attractive valuations.

As per Buffett, volatility (or price fluctuation) is not a risk at all.

On the contrary, volatility throws up great investment


opportunities for value investors.

The stock market is there to serve you and not to


instruct you. Thats a key to owning a good business and
getting rid of the risk that would otherwise exist in the
market. Warren Buffett

What is real risk to investing then?

Buffett focuses only on business-specific risks.

Business risks could arise from various avenues.

For instance, for a highly leveraged company, insolvency


could be a risk. For a commodity business, the risk arises
from intense competition.

From an investors point of view, paying too much for a stock


could be a risk.

What does Buffett do to mitigate risk?

Firstly, he invests in businesses that are inherently low risk


and do not have too much debt.

The second thing is to buy stocks only when the price tag
looks attractive.

The next question is: How many stocks should an investor


own? How much should one diversify?

216

Equitymasters Secrets

For lay investors who do not have much time to focus


on investing, Buffett suggests total diversification. He
suggests investing in a low-cost index fund.

But for avid investors who have confidence in their research,


he suggests having a concentrated portfolio of about 5-6
stocks.

As per him, if you have been able to identify great


businesses at a fair price, then there is no need for further
diversification.

Instead of trying to find more investment ideas, invest more


in your best investments and you are likely to be wellrewarded.

Charlie and I operated mostly with 5 positions. If I


were running 50, 100, 200 million, I would have 80%
in 5 positions, with 25% for the largest. In 1964 I found
a position I was willing to go heavier into, up to 40%.
I told investors they could pull their money out. None
did. The position was American Express after the Salad
Oil Scandal. In 1951 I put the bulk of my net worth into
GEICO.
Warren Buffett

Lastly, the most important question: When should you sell a


stock?

Buffett is famous for often emphasizing that his preferred


holding period is forever.

It means that once he has bought a great business at a good


price, he does not bother about where the stock price goes.

As long as the business fundamentals are intact, he prefers


holding the stock for a fairly long period of time.

Chapter 18: Portfolio Analysis

217

In other words, he would sell off an investment if he sees the


long term business fundamentals deteriorating.

It is worth noting that he does not focus much on the stock


price movement.

He buys a stock like he is buying a business and follows


the same approach when it comes to selling it.

In some cases, he would consider selling when the stock


valuations are way overstretched.

If you own great businesses, you should just hold


on most of the time, maybe sell if the valuations get
extremely high and buy more if they get really cheap.
Warren Buffett

Conclusion

Despite being a sophisticated mathematical formulation,


Modern Portfolio Theory is based on the flawed premise that
risk arises from volatility.

We then studied Graham and Buffetts views on stock


selection, investment risk, portfolio diversification and when
to sell stocks. We would like to end with one of Buffetts
famous quotes which very aptly lays down the roadmap that
we would like you to pursue hereafter:

You should approach investing like you have


a punch card with 20 punch-outs, one for each
trade in your life. I think people would be better
off if they only had 10 opportunities to buy
stocks throughout their lifetime. You know what
would happen? They would make sure that each
buy was a good one. They would do lots and lots
of research before they made the buy.

218

Equitymasters Secrets

Heres Why You Should Trust Equitymaster!


For more than 20 years weve worked hard to publish honest,
unbiased and reliable research for Indian investors to benefit
from.
And were proud to share that more than one and a half million
valued readers across the globe have joined us over the years.
But thats just one of the reasons why you should trust us
Go ahead, read full details of The Equitymaster Story here