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

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 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 …

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

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

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

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

 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

 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

Sources of Economic Moats
Our
choice
of
moats
Difficult to acquire customers from existing competitors
Source: http://bit.ly/1hLvEJ1

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

 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

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

 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

 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

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

 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

In “How to value Great Business we will talk
moats are..
 No Earnings: Limited downside when
no earnings are there

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

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

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%

 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

 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

*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

 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

 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’

In “How to value Great Business we will talk
moats are
 No Earnings: Limited downside when
no earnings are there

 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).

 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.”

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

 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

• 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.

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

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

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

 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)

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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