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Why standard valuation matrix is not the best
way to value great businesses
Ashish Kila
Perfect Research
 Our Chairman - Mr. R.A. Kila
 Perfect Research Team
My Profile
 CA
 MBA from MDI, Gurgaon
 Worked with - Goldman Sachs &
Religare Securities & Morgan Stanley
 Currently w...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
Return per unit of stress.(Link)
 Reinvestment risk.
 Power of compounding.
 Missing out on quality businesses(Large op...
Source: http://bit.ly/1iHghY7
Past Process
• First run screeners for
cheapness (e.g. IFB Ind.)
• Understand and see if the
business is sound
• Illusion ...
Comparison with running own business:
 Owning equity is like owning a business where a hired CEO is working
for us. He wi...
 As Tim Ferris says, “Be neither the boss nor employee, but the
owner. To own the trains, and have someone else ensure th...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
 For expensive stocks valuations in the near term one can either wait or
look for some opportunities as temporary underpe...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
Sources of Economic Moats
Our
choice
of
moats
Difficult to acquire customers from existing competitors
Source: http://bit....
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
Implied Growth rate
Company Name P/E As on date
10 Yrs
Implied
Growth Rate
20 Yrs Implied
Growth Rate
Gillette India ltd....
 Use of P/E multiple: In the above examples if we look at P/E
multiple then we might not invest in any company out of
abo...
In “How to value Great Business” we will talk
about three important aspects
 Moats: How durable and Wide the
moats are..
...
 It is important to judge the depth and longevity or durability of moat and if
the moat shrinks and disappears, a buy and...
 A high return on capital in the past is a necessary, but not a sufficient
condition to demonstrate the presence of a moa...
ROE
PATM(%)
SALES/TOTAL
ASSET
ASSET TO
EQUITY
Intangible Brands
-Invite
competition e.g.
Zydus Wellness
Example :
Relaxo
F...
 Sold 100 million pairs of branded footwear at an average price
of just INR 100 per pair & making profit of only INR 4.48...
In “How to value Great Business we will talk
about three important aspects
 Moats: How durable and Wide the
moats are..
...
0
50,000
100,000
150,000
200,000
250,000
300,000
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
net...
Source: Google.com/finance, Yahoo Finance, Ace Equity
ConAgra
Foods, Inc.
Unilever Plc.
Difference in no. of
times
Mcap
(2...
Product
SameSame
DATE:- 31/03/2015
Banking is all about its management quality and Risk
management practices
Banks M.CAP(In Rs. Cr.) P/B RO...
 HDFC Bank management run by Deepak Parekh.
 IDFC Management previously run by Deepak Parekh and now by his protégé
Raji...
 Here, first we do the DCF valuation of Gillette, in which we
have assumed the growth rate of 10% for the first 10 years
...
*Price as on 1st April 2015
CMP 4904
10-years expected Growth rate 51%
20-years expected growth rate 29%
Year FCF Growth P...
 If the FCF are to grow by 51%, then sales should grow by at least 25-
30%. Assuming, even if sales grow by 25% then also...
 In the nutshell, for a great business we see how wide
and durable the moat is (that can sustain for 10/20/30
yrs)
 Then...
In “How to value Great Business we will talk
about three important aspects
 Moats: How durable and Wide the
moats are
 S...
 We may have missed Kaya if we had our investment thesis based on
numbers only.
 Where there are no earnings- We look at...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
 In tough businesses and businesses which are prone to black swan
events like financials, backing up of a fanatic managem...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
Source: http://bit.ly/1Ijklb3
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
 Some companies doesn’t have capacity to reinvest so we used
to avoid them earlier e.g. Rating agencies, Exchanges
 The ...
Why Great Businesses
Why the need to think differently
Ranking Moats
How to value Great Businesses
Tough business/Capacity...
• Reasonable Valuation/ Expensive Valuation
1. AAA businesses-Businesses which can reinvest capital at high
ROE’s- Atul Au...
Stock
Business
Quality
Fanatic and
Intelligent
Management
Capacity
to reinvest
Capacity to
Suffer
Corporate
Disclosures
Ca...
Stock Business Quality
Fanatic and
Intelligent
Management
Capacity to
reinvest
Capacity to
Suffer
Corporate
Disclosures
Ca...
Holdings at T0
Price in
July 2014
Allocations
in Rs term
Allocation
in %term
Price in
July 2015
Allocation in
Rs. Term
Alo...
 Marico Kaya had become a larger part of the portfolio
after price appreciation.
 Portfolio composition becomes skewed, ...
Perfect Research
T-24A Green Park Extn.
New Delhi – 16
Blog: http://perfectresearch.blogspot.in
Twitter: @ashishkila
Pleas...
why standard valuation matrix is not the best way to value great businesses
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why standard valuation matrix is not the best way to value great businesses

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The presentation is an attempt to collate thoughts on the investment process we follow from the Gurus, Mentors and Friends we follow along with our own experience in this field.

*Disclaimer*

1. We are not SEBI registered analysts

2. Educational post only and not a stock recommendation

3. We take no responsibility to keep updating about the business being discussed

4. We may or may not own a position in any of the businesses being discussed and even if we do own a position, we may change our mind due to change in any facts or circumstances

5. Plz consider this post only as a framework to keep tracking businesses and understanding them

Published in: Economy & Finance

why standard valuation matrix is not the best way to value great businesses

  1. 1. Why standard valuation matrix is not the best way to value great businesses Ashish Kila Perfect Research
  2. 2.  Our Chairman - Mr. R.A. Kila  Perfect Research Team
  3. 3. My Profile  CA  MBA from MDI, Gurgaon  Worked with - Goldman Sachs & Religare Securities & Morgan Stanley  Currently working as • Director, Perfect Group • CIO, Perfect Research With Mr. Ashish Dhawan With Mr. Basant Maheshwari With Prof. Aswath Damodaran Blessed to have got Vicarious Learnings from my Role Models …
  4. 4. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to Suffer/Capacity to reinvest Illustrative Model Portfolio
  5. 5. Return per unit of stress.(Link)  Reinvestment risk.  Power of compounding.  Missing out on quality businesses(Large opportunity cost).  Gives freedom to pursue other business, family and personal interests   Ultimately it all boils down to hurdle rate …. Comfortable in this zone
  6. 6. Source: http://bit.ly/1iHghY7
  7. 7. Past Process • First run screeners for cheapness (e.g. IFB Ind.) • Understand and see if the business is sound • Illusion of Quality Bias – try to justify quality where there is none Present Process • Now we start with great business models (e.g. ATFL) • Then look for reasonable returns over very long periods • Margin of safety is more in quality than in price • Mistakes tend to be more of opportunity cost rather than loss of capital
  8. 8. Comparison with running own business:  Owning equity is like owning a business where a hired CEO is working for us. He will quarterly report to us by con calls and investor presentations. Points to Ponder Owning Equity Running Own Business Emotional Attachment Minimal, You don’t define yourself with the business you run Very high, you might continue running business despite low returns Diversification Yes, buy shares in multiple industries Not easy to manage Regulatory Requirements You can own stake in existing players with licenses/approvals Not possible to start certain businesses like liquor, banks etc. Succession Planning for Underlying Business Professional management is possible Children/Family may not be competent/interested Ability to Close/Change Business Easy, Just Sell the Shares Very Difficult Scalability Extremely Scalable, managing a 1000 Cr. portfolio might require a few people only Not Easy Minimum Capital Requirement You can start with a few thousand Rupees as well High amount of capital is required
  9. 9.  As Tim Ferris says, “Be neither the boss nor employee, but the owner. To own the trains, and have someone else ensure they run on time.”  Meaning owners of business are not limited by the amount of time they put in the business  The best doctor can also work not more than 16 hours a day  But in Business you can multiply man hours by delegating
  10. 10. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to Suffer/Capacity to reinvest Illustrative Model Portfolio
  11. 11.  For expensive stocks valuations in the near term one can either wait or look for some opportunities as temporary underperformance corrects the stock.  When you wait there is a chance you might miss the stocks  Looking at durability of moat etc..start allocating some amount Source: https://dl.dropboxusercontent.com/u/28494399/Blog%20Links/ October_Quest_2013.pdf
  12. 12. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to Suffer/Capacity to reinvest Illustrative Model Portfolio
  13. 13. Sources of Economic Moats Our choice of moats Difficult to acquire customers from existing competitors Source: http://bit.ly/1hLvEJ1
  14. 14. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to Suffer/Capacity to reinvest Illustrative Model Portfolio
  15. 15. Implied Growth rate Company Name P/E As on date 10 Yrs Implied Growth Rate 20 Yrs Implied Growth Rate Gillette India ltd. 154 31-Mar-15 56% 31% Symphony ltd. 71 31-Mar-15 56% 31% Agro Tech foods ltd. 43 31-Mar-15 25% 16% Kaya ltd*(listed on June 30, 2014) NA(Negative EPS) 31-Mar-14 NA NA
  16. 16.  Use of P/E multiple: In the above examples if we look at P/E multiple then we might not invest in any company out of above four because they all look so expensive.  Not using P/E multiple: If we don’t look at P/E and we say that I buy all great businesses then we might end up buying Gillette also which is extremely overvalued (will discuss more on it later).  If we face such problems, then what is the solution.  There are 3 aspects – Moats, Size and Limited downside
  17. 17. In “How to value Great Business” we will talk about three important aspects  Moats: How durable and Wide the moats are..  Size: Small size in relation to the addressable size of opportunity  No Earnings: Limited downside when no earnings are there
  18. 18.  It is important to judge the depth and longevity or durability of moat and if the moat shrinks and disappears, a buy and hold strategy will not save you.  In a nutshell, can you visualize whether company’s product/services shall be in demand 10/20yrs down the line. Warren Buffet on Economic Moats  Look for the durability of franchise. The most thing to me is figuring out how big a moat there is around the business. ~ Linda Grant, “Striking out at Wall Street”  All economic moats are either widening or narrowing – even though you can’t see it. ~ Outstanding Investor Digest, June 30, 1993 source: http://bit.ly/1ODHiZV
  19. 19.  A high return on capital in the past is a necessary, but not a sufficient condition to demonstrate the presence of a moat.  It is also important to judge the depth and longevity or durability of moat.  If your estimate is correct and turns out to be higher than that of the market, then you will excess returns. If not, be prepared to lose money or at best make market level returns .  As a corollary a buy and hold works only if you get the durability aspect correct. If the moat shrinks and disappears, a buy and hold strategy will not save you.  In a nutshell, can you visualize whether company’s product/services shall be in demand 10/20yrs down the line. source: http://bit.ly/1ODHiZV
  20. 20. ROE PATM(%) SALES/TOTAL ASSET ASSET TO EQUITY Intangible Brands -Invite competition e.g. Zydus Wellness Example : Relaxo Footwears ltd Low cost moat looks stronger than Intangible assets
  21. 21.  Sold 100 million pairs of branded footwear at an average price of just INR 100 per pair & making profit of only INR 4.48 per pair  Low cost advantage arising out of large scale. For example o Ad spend of INR 550 million (a fixed cost) spread over 100 million pairs translates into only INR 5.50 per pair. o But for a new entrant with scale of, say, 10 million pairs, translates into a unviable INR 55 per pair.  Ability to sell large volume enables the company to exert influence over its customers and suppliers Source: http://bit.ly/1KNibwU
  22. 22. In “How to value Great Business we will talk about three important aspects  Moats: How durable and Wide the moats are..  Size: Small size in relation to the addressable size of opportunity  No Earnings: Limited downside when no earnings are there
  23. 23. 0 50,000 100,000 150,000 200,000 250,000 300,000 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 net sales mkt cap (cr) PE=32 PE=24 PE=32 PE=27 Source: annual reports Years C R O R E S
  24. 24. Source: Google.com/finance, Yahoo Finance, Ace Equity ConAgra Foods, Inc. Unilever Plc. Difference in no. of times Mcap (26 Oct 2015) (in Billion $) 17 135 8x Revenue (in Billion $) 16 (Year ended May 2015) 60 (Year ended Dec 2014) ~4x Agro Tech Foods Ltd. Hindustan Unilever Ltd. Difference in no. of times M.cap(in Billion $) 0.25 29 115x Revenue(in Billion $) 0.1 5 50x Globally In India Scope of opportunity  ConAgra is present in 99% of American Households while ATFL has just scratched the surface
  25. 25. Product SameSame
  26. 26. DATE:- 31/03/2015 Banking is all about its management quality and Risk management practices Banks M.CAP(In Rs. Cr.) P/B ROE 2,56,000 4.1 16.9% 26,600 1.3 10.1% 3,137 2.5 12.4%
  27. 27.  HDFC Bank management run by Deepak Parekh.  IDFC Management previously run by Deepak Parekh and now by his protégé Rajiv Lal IDFC: Why not be next HDFC?  IDFC has performed well despite being constrained to lend to Infra Sector  Now, IDFC has got banking license…. DESCRIPTION Mar-14 Mar-13 Mar-12 Mar-11 Mar-10 Mar-09 Mar-08 Gross NPAs to Gross Advances (%) 0.60 0.15 0.30 0.20 0.31 0.37 0.17 Net NPAs (funded) to Net Advances (%) 0.40 0.05 0.15 0.10 0.17 0.21 0.03
  28. 28.  Here, first we do the DCF valuation of Gillette, in which we have assumed the growth rate of 10% for the first 10 years and then a terminal growth rate of 4%. Discount rate is assumed to be 12%.  To calculate the FCF, we have taken the CFO- Capex for last three years and then the average of the three. (Capex is after adding back the Capex of Oral). In this way we arrive at the Intrinsic value of the Gillette by discounting the FCFs for next 10 years back to the present.  We then use Reverse DCF by using the Intrinsic value calculated in the DCF on it to determine what is the growth rate implied in the Free Cash Flow (FCF) by the market in the current valuation of the company
  29. 29. *Price as on 1st April 2015 CMP 4904 10-years expected Growth rate 51% 20-years expected growth rate 29% Year FCF Growth Present Value (PV) 2016E 73 51% 65 2017E 110 88 2018E 166 118 2019E 250 159 2020E 376 214 2021E 568 288 2022E 856 387 2023E 1291 521 2024E 1946 702 2025E 2935 945
  30. 30.  If the FCF are to grow by 51%, then sales should grow by at least 25- 30%. Assuming, even if sales grow by 25% then also it will surpass the market size itself. Source: http://bit.ly/1ODFVKR * Grooming represents about 70-75% of the sales of Gillette. Blade & Razor Present Sales(Rs Cr) (2015) CAGR% Projected Sales 10Yrs(Rs. Cr) Gillette(Grooming)* 1385 25% 12898 Market 3683 9% 8719
  31. 31.  In the nutshell, for a great business we see how wide and durable the moat is (that can sustain for 10/20/30 yrs)  Then, we calculate the implied growth rate.  We then project market share of the company vis-à-vis size of the market  Then we can take a call whether the implied gain in market share figure looks possible. E.g. ‘Gillette’
  32. 32. In “How to value Great Business we will talk about three important aspects  Moats: How durable and Wide the moats are  Size: Small size in relation to the addressable size of opportunity  No Earnings: Limited downside when no earnings are there
  33. 33.  We may have missed Kaya if we had our investment thesis based on numbers only.  Where there are no earnings- We look at how much downside risk exists  Marico Kaya Total Mcap.~300Cr. at the time of Listing & 180 Cr. Of Cash & Cash Equivalent in its Balance Sheet.  Reputed Marico Brand at this M.cap & a 13 yrs history of the company, at the verge of turnaround, the size of opportunity is huge w.r.t its EV.  Management started buying shares from open market  Active management role taken by Harsh Mariwala in the new company who has a history of scaling up Marico to a size of Rs 26,000 cr (Sept 2015) from Rs approx 426 cr (Dec 1997).
  34. 34. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to Suffer/Capacity to reinvest Illustrative Model Portfolio
  35. 35.  In tough businesses and businesses which are prone to black swan events like financials, backing up of a fanatic management is required.  In his 1990 letter, Mr. Buffett articulated his rationale for investing in Wells Fargo. o He wrote:“The banking business is no favourite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. o We have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well- managed banks at fair prices.”
  36. 36. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to suffer/Capacity to reinvest Illustrative Model Portfolio
  37. 37. Source: http://bit.ly/1Ijklb3
  38. 38. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to suffer/Capacity to reinvest Illustrative Model Portfolio
  39. 39.  Some companies doesn’t have capacity to reinvest so we used to avoid them earlier e.g. Rating agencies, Exchanges  The money thrown by these businesses can be used to reinvest in these companies alone or can be used to invest in other great businesses in the portfolio or other high value accretive businesses
  40. 40. Why Great Businesses Why the need to think differently Ranking Moats How to value Great Businesses Tough business/Capacity to suffer/Capacity to reinvest Illustrative Model Portfolio
  41. 41. • Reasonable Valuation/ Expensive Valuation 1. AAA businesses-Businesses which can reinvest capital at high ROE’s- Atul Auto, ITC etc. 2. AA businesses-Businesses which can reinvest capital at reasonable ROE’s – ATFL 3. A businesses-Good growth but not much reinvestment opportunity - Kaya, MCX, Crisil 4. Tough businesses, but with great management’s – DCB, IDFC, Wonderla etc.
  42. 42. Stock Business Quality Fanatic and Intelligent Management Capacity to reinvest Capacity to Suffer Corporate Disclosures Capital Allocation Trailing P/E* 10Yrs Implied Growth Rate Atul Auto Yes Yes Quarterly Concalls 5% 21X 27% ITC Yes Yes Annual PPT 3% 28X 22% Agro Tech Foods Yes Yes Yes Quarterly Concalls 10% 40X 25% MCX Quarterly PPT 2% 45X 39% DCB Bank Tough Yes Yes Yes Quarterly Concall and PPT 5% 2.2X NA IDFC Tough Yes Yes Yes Quarterly Concall and PPT 3% 14.1X NA Wonderla Tough Yes Yes Yes Quarterly Concall and PPT 5% 30X 32% Kaya Yes Yes Quarterly Concall 3% 55X 20% Source: ace-equity, annual reports
  43. 43. Stock Business Quality Fanatic and Intelligent Management Capacity to reinvest Capacity to Suffer Corporate Disclosures Capital Allocation Trailing P/E* 10 yr implied growthrate Cera Sanitaryware Yes Quarterly Concall 2% 40X NA Symphony Yes Yes Quarterly Concall 3% 55X 56% Nestle Yes 1.50% 48X 23% Relaxo Yes Yes Quarterly PPT 1.50% 50X 35% Asian Paints Yes Yes Quarterly Concall 1% 55X 32% Crisil Yes NO Concallor PPT 3% 45X 25% AccelyaKale 5% 17X 8% Thomas Cook Yes Yes Yes 5% 70X 27% Source: ace-equity, annual reports
  44. 44. Holdings at T0 Price in July 2014 Allocations in Rs term Allocation in %term Price in July 2015 Allocation in Rs. Term Alocation in %term Atul Auto 300 8 8% 450 12 6% ITC 320 5 5% 320 5 2% Agro Tech Foods 600 5 5% 600 5 2% MCX 700 4 4% 1050 6 3% DCB 70 2 2% 140 4 2% IDFC 160 6 6% 160 6 3% Wonderla 200 5 5% 250 6.25 3% Thomas Cook 110 5 5% 220 10 5% Cera Sanitaryware 1200 4 4% 2200 7.2 3% Symphony 1100 6 6% 2200 12 6% Nestle 5000 5 5% 6000 6 3% Relaxo 200 3 3% 500 7.5 4% Asian Paints 550 5 5% 825 7.5 4% Acceleya Kale 700 7 7% 1050 10.5 5% Marico Kaya 300 10 10% 1545 70 33% Cash 20 20% 35 17% Started Amount 100 209.95
  45. 45.  Marico Kaya had become a larger part of the portfolio after price appreciation.  Portfolio composition becomes skewed, as other winning ideas like Agro Tech and IDFC have become close to 2%.  For some stocks we are using blue sky scenario and for some we are not willing to give reasonable scenario consideration.  Analogy - If we have 10 sons and one has performed very well, then we don’t stop feeding our other sons. The same thing applies here – so we reallocate the food (capital)
  46. 46. Perfect Research T-24A Green Park Extn. New Delhi – 16 Blog: http://perfectresearch.blogspot.in Twitter: @ashishkila Please feel free to contact me with any unanswered questions, suggestions & ideas.  ashishkila@gmail.com  +91-9999751327

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