2                                 1                  D           6                                             4      e   ...
“Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimatin...
“We believe the process is in many  respects closely related to creditanalysis as we are seeking collateral net worth in e...
Type 1 Securities
How do High Grade Bonds  contrast with Equity?
In Bonds, focus is onAVOIDANCE OF LOSSIn equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS
What’s the best case scenario for  a high-grade bond buyer?
Downside risk in bonds                                                  NO offsetting trades                              ...
You are SACRIFICINGProfit SharingIn Exchange OfA PRIOR CLAIM and DEFINITE   PROMISE Bad exchange
High Grade Bond Selection is a NEGATIVE artFocus on exclusion
“The first chance you have, to avoid a  loss from a foolishloan is by refusing to make it. There is no    second chance.”
Graham’s Principles of  High GradeBond selection
1. Safety is measured  not by specific lien orother contractual rights   but by the ability of the issuer to meet ALL      ...
1. Lien unreliable                                                               form of safety                           ...
Shrinkage of                                                           property                                           ...
http://fundooprofessor.wordpress.com/2012/10/19/virginity/
2. This ability                                                        should be                                          ...
3. Deficient safety                                      cannot be compensated                                       for by...
4.The selection of all  high grade bondsshould be subject to  rules of exclusion   and to specific  quantitative tests.
“What’s fascinating . . . is that you could  now have a business that might have  been selling for $10 billion where the b...
“But the owners of that business, because its                                public, could borrow many billions of dollars...
Two Sources of safety: A. The character of the industry(the particular business is immune     from drastic shrinkage of   ...
B. The amount of protection (themargin of safety is so large that   the company can undergo a  drastic shrinkage of earnin...
4. Quantitative Tests    The selection of all seniorsecurities for investment should be subject to rules of exclusionand t...
“The past ability of   the borrower to   earn in excess ofinterest requirements   is counted on to protect the investor  a...
“The bond investor does    not expect future    earnings to be the same as in the past. If   he was sure of that,  the mar...
“ If he did that, he would have to measurehis margin in terms of a   carefully projected profit and loss account instead of...
Factors in Bond Selection1.   The nature of the      6. The relation of the         business           value of the proper...
Fixed                                                       Charges                                                       ...
Graham’s Version of   Debt-equity ratio Market Value of Enterprise/         Debt ratio:What is the logic of using this    ...
“Before paying                                                  standard prices for                                       ...
“The market valueof stock is generally   recognized as abetter index of the fair going concern value of a businessrather t...
“The presence of a  stock equity with market value many  times as large as    the total debt   carries a strong  assurance...
“Conversely, an                               exceedingly small                                 stock equity at           ...
The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should  be at least 75% of total debt.  Thi...
Interest coverage and   debt-equity ratios   Do you see any similarity? What does interest-coverage        ratio measure?C...
They are very similar, therefore,    they should produce similar             conclusions.i.e. if a company is creditworthy...
Suppose, the minimum standard for interest-coverage ratio is barely metbut the stock-value ratio is considerably higher th...
But what if they producecontradictory conclusions?
If interest coverage ratio is ample but the stock-value ratio is substantially     below the minimum required.    “Under s...
Good Reason: Stock market is right  you fool! - there are bad daysahead, the earnings are suspect, or      there may be a ...
Bad reason: Stock market is wrong -   the stock is a bargain - buy it  instead! - its cheaper and safer! In either case, t...
Time for some backward thinkingLets do some reverse engineering
Recall The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should  be at least 75% of total deb...
For Graham, if a company is  creditworthy, then its stockshould be worth at least 75% of      the value of its debt.(Busin...
A Valuation Rule  “An equity share representing the  entire business cannot be less safe[and less valuable] than a bond ha...
“There are instances   where an equity     share may be   considered sound because it enjoys amargin of safety as  large a...
“This will occur, forexample, when a company   has outstanding onlyequity shares that underdepression conditions are selli...
“In such instances theinvestor can obtain the     margin of safetyassociated with a bond,plus all the chances of    larger...
“Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimatin...
“We believe the process is in many  respects closely related to creditanalysis as we are seeking collateral net worth in e...
“A bondholder can enjoy noright or protection which the full owner of the business, without bonds ahead of him, does not a...
VST’s “Bonus Debentures”
Hidden inside the stock of a credit-    worthy company is a bond...
Recent Cases of Debt Capacity Bargains
Satyam Effect
At Rs 60 in march 2009, market cap was R 190 cr.             Surpus cash = Rs 70 cr.Rs 120 cr for a business which generat...
At Rs 60 in March 2009, market cap was Rs592 cr Surplus cash = 100 cr. Rs 492 cr for a business    which generated Rs 120 ...
India’s largest provider of inland transport by rail                  using containers.
Midterm Exam Question
Exercise done in Oct 2011Total cash flow for five years = Rs 4,896 cr.Average = Rs 979 cr.Interest expense = 979cr/3 = Rs 32...
At 560, stock  was a debt-capacity bargain
Average cash flow from operations after W/C changes: Rs 1,000 cr.Interest expense = 1000cr/3 = Rs 333cr.Debt business can e...
Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 crMinimum intrinsic value of equity = Rs 7,...
At 560, stock                 was a debt-               capacity bargainTHIS is what we mean by FAVORABLE ODDS
Value Investing in Las VegasThe casino is a value investor because of:1. Favorable odds on each bet2. Lots of play (divers...
In American roulette there are 38 slotsnumbered 1-36, 0, and 00. Pay-out is 35:1
If you bet Re 1 on your lucky # 8 and if theba" lands on # 8, you win Rs 35, otherwise                you lose Re 1.
You wager Rs 1,000 on a single number, say                 number 7.Probability of ba" landing on 7 = 1/38 = 2.63%.Probabi...
Event                     Payoff       Probability Expected Value                         Ball lands on 7             36,0...
Suppose you bet Rs 1000/38 or Rs 26.32 on                         each of the 38 numbers to “spread your risk”What happens...
Event                           Payoff        Probability         Expected Value                          Ball will land o...
Thank you
Debt capacity
Debt capacity
Debt capacity
Debt capacity
Debt capacity
Debt capacity
Debt capacity
Debt capacity
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Debt capacity

  1. 1. 2 1 D 6 4 e b t 2 C 7 a p a c 3 i 8 5 t y 1Debt capacity is a very useful mental construct in valuation.
  2. 2. “Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimating the collateral value of its assets and/or cash flow.
  3. 3. “We believe the process is in many respects closely related to creditanalysis as we are seeking collateral net worth in excess of the cost of our investment.”
  4. 4. Type 1 Securities
  5. 5. How do High Grade Bonds contrast with Equity?
  6. 6. In Bonds, focus is onAVOIDANCE OF LOSSIn equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS
  7. 7. What’s the best case scenario for a high-grade bond buyer?
  8. 8. Downside risk in bonds NO offsetting trades So It’s better to be safe than sorryIn stocks, being loss averse can be costly. You have to take calculated risks...
  9. 9. You are SACRIFICINGProfit SharingIn Exchange OfA PRIOR CLAIM and DEFINITE PROMISE Bad exchange
  10. 10. High Grade Bond Selection is a NEGATIVE artFocus on exclusion
  11. 11. “The first chance you have, to avoid a loss from a foolishloan is by refusing to make it. There is no second chance.”
  12. 12. Graham’s Principles of High GradeBond selection
  13. 13. 1. Safety is measured not by specific lien orother contractual rights but by the ability of the issuer to meet ALL its obligations.
  14. 14. 1. Lien unreliable form of safety 1. Lien vs. AbilitySafety is measured not by specific lien or other contractual rights but by the ability of the issuer to meet allits obligations.The idea that a lien on the assets is a guarantee of protection independent of the success of the businessitself is in most cases a complete fallacy.In the typical case, the value of the pledged property is vitally dependent on the earning power of theenterprise.Example: ITCRailroads - lien on property not adaptable to other uses.Indian Banks NPAs - emphasis on security rather than ability.
  15. 15. Shrinkage of property values when a business fails.Difficulty of asserting the bondholders supposed legal rights.Delays and other disadvantages incident to a receivership or bankruptcy.
  16. 16. http://fundooprofessor.wordpress.com/2012/10/19/virginity/
  17. 17. 2. This ability should be measured under conditions of depression rather than prosperity.Any bond can do well when conditions are favorable.e.g. FCCB issues
  18. 18. 3. Deficient safety cannot be compensated for by an abnormally high coupon rate.Yield TrapReturn ON money vs. Return OF money
  19. 19. 4.The selection of all high grade bondsshould be subject to rules of exclusion and to specific quantitative tests.
  20. 20. “What’s fascinating . . . is that you could now have a business that might have been selling for $10 billion where the business itself could probably not have borrowed even $100 million.
  21. 21. “But the owners of that business, because its public, could borrow many billions of dollars on their little pieces of paper- because they had these market valuations. But as a private business, the company itself couldn’t borrow even 1/20th of what the individuals could borrow.”Promoters aren’t borrowing. They are selling.A sale in the garb of a loan.
  22. 22. Two Sources of safety: A. The character of the industry(the particular business is immune from drastic shrinkage of earnings).
  23. 23. B. The amount of protection (themargin of safety is so large that the company can undergo a drastic shrinkage of earnings without resultant danger).
  24. 24. 4. Quantitative Tests The selection of all seniorsecurities for investment should be subject to rules of exclusionand to specific quantitative tests.
  25. 25. “The past ability of the borrower to earn in excess ofinterest requirements is counted on to protect the investor against loss in theevent of some future decline in net income.”
  26. 26. “The bond investor does not expect future earnings to be the same as in the past. If he was sure of that, the margin demanded might be small. Nor does the bond investor predicts whetherfuture earnings will be materially better or poorer than the past.”
  27. 27. “ If he did that, he would have to measurehis margin in terms of a carefully projected profit and loss account instead of emphasizingthe margin shown in thepast record. The role of the margin of safety, therefore, to render it unnecessary to make accurate predictions about the future.”
  28. 28. Factors in Bond Selection1. The nature of the 6. The relation of the business value of the property to2. The size of the debt enterprise 7. The relation of stock3.The terms of the issue capitalization to debt4. The record of solvency Debt/Equity and dividend payments Average Market Value of5. The relation of Enterprise/Debt earnings to interest requirements Interest Cover
  29. 29. Fixed Charges CoverageFixed charges vs. InterestExample of leased vs owned outlets in retail operations. Rent is like interest.Why Fixed charges cover instead of Debt service?1. Cover demanded is high2. Assumption of going concern - ability to refinance
  30. 30. Graham’s Version of Debt-equity ratio Market Value of Enterprise/ Debt ratio:What is the logic of using this ratio?
  31. 31. “Before paying standard prices for bonds of any enterprise, the investor must be convinced that the business is worth a great deal more than what it owes.”Key term: Business worth a lot more than what it owes.In this respect the bond buyer must take the same attitude as the lender of money on a house ora diamond ring, with the important difference that it is the value of the business as an entitywhich the investor must usually consider, and not that of the separate assets.Why not use the conventional Debt/Equity ratio?What about the silly Mr. Market??
  32. 32. “The market valueof stock is generally recognized as abetter index of the fair going concern value of a businessrather than balance sheet figures.”
  33. 33. “The presence of a stock equity with market value many times as large as the total debt carries a strong assurance of thesafety of the bond.”
  34. 34. “Conversely, an exceedingly small stock equity at market prices must call the soundness of the bond into serious question.”Why is this very important?
  35. 35. The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should be at least 75% of total debt. This test must be passed both currently and over the average of last five years.”
  36. 36. Interest coverage and debt-equity ratios Do you see any similarity? What does interest-coverage ratio measure?Cash flow available for interest/ Interest
  37. 37. They are very similar, therefore, they should produce similar conclusions.i.e. if a company is creditworthy,it must be a lot more than what it owes. EV should be several times its debt
  38. 38. Suppose, the minimum standard for interest-coverage ratio is barely metbut the stock-value ratio is considerably higher than the minimum prescribed. Under such circumstances, the bond should be accepted as investment. Why?
  39. 39. But what if they producecontradictory conclusions?
  40. 40. If interest coverage ratio is ample but the stock-value ratio is substantially below the minimum required. “Under such circumstances, the purchaser of the bonds will have toassume that the price of the stock is too low.” This could happen for good or bad reasons
  41. 41. Good Reason: Stock market is right you fool! - there are bad daysahead, the earnings are suspect, or there may be a fraud!Credit rating agencies vs. the stock market as predictors of distress.
  42. 42. Bad reason: Stock market is wrong - the stock is a bargain - buy it instead! - its cheaper and safer! In either case, the investor should not buy the bond as a type-I security.
  43. 43. Time for some backward thinkingLets do some reverse engineering
  44. 44. Recall The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should be at least 75% of total debt. This test must be passed both currently and over the average of last five years.”
  45. 45. For Graham, if a company is creditworthy, then its stockshould be worth at least 75% of the value of its debt.(Business is worth at least 175% of debt) Equity Value > 0.75 x Debt Capacity
  46. 46. A Valuation Rule “An equity share representing the entire business cannot be less safe[and less valuable] than a bond having a claim to only a part thereof.”
  47. 47. “There are instances where an equity share may be considered sound because it enjoys amargin of safety as large as that of a good bond.
  48. 48. “This will occur, forexample, when a company has outstanding onlyequity shares that underdepression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power.
  49. 49. “In such instances theinvestor can obtain the margin of safetyassociated with a bond,plus all the chances of larger income and principal appreciation inherent in an equity share.”
  50. 50. “Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimating the collateral value of its assets and/or cash flow.
  51. 51. “We believe the process is in many respects closely related to creditanalysis as we are seeking collateral net worth in excess of the cost of our investment.”
  52. 52. “A bondholder can enjoy noright or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, theowner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”
  53. 53. VST’s “Bonus Debentures”
  54. 54. Hidden inside the stock of a credit- worthy company is a bond...
  55. 55. Recent Cases of Debt Capacity Bargains
  56. 56. Satyam Effect
  57. 57. At Rs 60 in march 2009, market cap was R 190 cr. Surpus cash = Rs 70 cr.Rs 120 cr for a business which generated average operating cash flow of Rs 56 cr. p.a. over last 4 years.
  58. 58. At Rs 60 in March 2009, market cap was Rs592 cr Surplus cash = 100 cr. Rs 492 cr for a business which generated Rs 120 cr. average annual operating cash flow over last 5 years.
  59. 59. India’s largest provider of inland transport by rail using containers.
  60. 60. Midterm Exam Question
  61. 61. Exercise done in Oct 2011Total cash flow for five years = Rs 4,896 cr.Average = Rs 979 cr.Interest expense = 979cr/3 = Rs 326cr.Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.Minimum intrinsic value of the company = 5,705+2,000 cr= Rs 7,705 crMinimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per shareDid it fall to this level?
  62. 62. At 560, stock was a debt-capacity bargain
  63. 63. Average cash flow from operations after W/C changes: Rs 1,000 cr.Interest expense = 1000cr/3 = Rs 333cr.Debt business can easily support = Rs 333 cr./0.10 = Rs 3,333 cr.Minimum value of business = Rs 3,333*1.75=Rs 5,833 cr.
  64. 64. Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 crMinimum intrinsic value of equity = Rs 7,333cr/13cr shares = Rs 564per shareNow let’s get REALLY creative
  65. 65. At 560, stock was a debt- capacity bargainTHIS is what we mean by FAVORABLE ODDS
  66. 66. Value Investing in Las VegasThe casino is a value investor because of:1. Favorable odds on each bet2. Lots of play (diversification)3. Cap on maximum bet (protection from negative black swan)
  67. 67. In American roulette there are 38 slotsnumbered 1-36, 0, and 00. Pay-out is 35:1
  68. 68. If you bet Re 1 on your lucky # 8 and if theba" lands on # 8, you win Rs 35, otherwise you lose Re 1.
  69. 69. You wager Rs 1,000 on a single number, say number 7.Probability of ba" landing on 7 = 1/38 = 2.63%.Probability of not landing on 7 = 37/38 = 97.37%
  70. 70. Event Payoff Probability Expected Value Ball lands on 7 36,000 2.63% 947.37 Ball does not land on 7 0 97.37% 0 947.37 Amount Bet -1,000 NPV -52.63What happens when Margin of Safety is -ve and you practice wide diversification?Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”
  71. 71. Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”What happens when Margin of Safety is -ve and you practice wide diversification?
  72. 72. Event Payoff Probability Expected Value Ball will land on one of your 947.37 100% 947.37 numbers (=26.32*36) Amount Bet -1,000.00 NPV -52.63Lesson: Diversification does not work when Margin of Safety is absent.
  73. 73. Thank you
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