Tuesday, May 26, 2015



Most often, the dilemma we face is in understanding a company. We invest in a stock so that we get benefits or gains in two ways- One is from the dividend stream and the second is from a favourable change in the stock price. To make both happen, it is obvious that the company has to do well. Even if there is a slippage in performance, the dividend may still come to us, but we could be disappointed with a decline in stock price.
Temporarary declines in stock prices do happen. It is part of the volatility of stock prices and only the nerds on the TV channels can give reasons for a rise in price one day and a fall the very next day, and so on. Volatility has no explanation. One day there are more people feeling good about the company and drive up the prices. Another day, they are outnumbered by people who feel bad about the price and sell it. And these are most often not caused by any underlying change but by transient sentiments of buyers and sellers who throng the market place with changing views every nano second.
I like to look at most companies from two perspectives, with a view to deciding an approximate ‘value’:
THE FIRST is a ‘balance sheet’ view. This is useful in case of companies that are in business with no entry barriers, no significant technology changes over time and just economies of scale matter.  Most commodity companies would fall in to this category. For instance a Cement or a Steel company or even an automobile company. All of them have replicable plants and we can estimate a ‘replacement’ value for these kind of businesses. For instance, we could say that it costs around $130 per tonne (of installed capacity) to set up a cement plant.  Very unlikely that any one player has any significant advantage over the other, except for one growing faster and another growing slower. The time I would like to buy these companies is when the Enterprise Value (market capitalisation plus total debt minus cash ) per share is higher than the market price of the share. In other words, I am willing to give a fair value which would just be the replacement cost. I know that the product is cyclical and will rebound in the not to distant future. Thus, I will buy aggressively when there is a steep discount to the fair value as I estimate it. That is my ‘margin of safety’.  I am not bothered about the change in EPS etc since every player will be doing the same.  Balance Sheet based valuation is more useful to find stocks that are more short term opportunities than long term investment value.

THE SECOND is a ‘profit & loss’ view. Here, the company is asset light. Has turnover that is several times its fixed assets. Earns a superior ROE as compared to the Balance Sheet earning company. This company has brands, earns super normal margins and is one of the first three in the industry or segment. The company has built a ‘moat’ round itself by building market size, brand pull, scale economies etc over time, which will ensure its continued dominance in the near term. Here we will find companies predominantly in the FMCG, pharma space. These shares trade at several times the ‘book value’. However, their ROE is several times the commodity company. Most grow at healthy rates and the shares always trade at what we could term as ‘expensive’.  If we go by our above hypothesis for valuation, we will never own a single stock of this kind. Here, what I would do is to look at the average ROE over the last few years. And then relate it to the Book Value. If the ROE is 25%, then I do not mind paying three to four times book value. I would also use what is called as ‘historical P/E Band” ( the range of P/E at which the stock traded in the past ten years) and see the pattern. I am happier buying closer to the lower end of the P/E Bankd and selling at the higher end of the P/E Band. For instance, if I find out that HUL has historically traded in a band of 20 to 50 times EPS, I will buy the stock at closer to twenty rather than 50.
Of course there is another type of share which I cannot value. Companies in the emerging space that are allergic to profits and get valued higher if they lose higher moneys.