Case Study – Value Companies – CERA
Valuing companies is a combination of art and science – CERA sanity ware is a fast growing consumer focussed bathroom solution company in India, which we will try to value in this post
Before valuing any company answer these basic questions, this will enrich your research
- Do you understand the business ? Is this an industry you are comfortable talking about ?
- What does the company do to make money ?
- Is company taking undue advantage of any of its stakeholder ?
- Will Company be in business for next 5 to 10 years ?
- What is the competitive advantage of the business ? (Moat)
- Does company has ability to raise prices ?
- Is the product differentiated ? Corollary to the above question ?
- Is management honest and competent ?
- Is the business capital-intensive ?
- Is the business doing mindless imitation of peers ?
- Are debt proportions for company meaningful ?
- Is it selling for substantially less than they’re worth, or B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory
Then equip yourself with various valuation methodologies to answer question 12, I use below as guide, and its evolving in my quest to be Tankrich
|Company Type||Valuation model||Basis||Driven by||Assumptions|
|Slow Growers||Average PE Value Method||The company is valued at its average PE for last 5 years||Earnings||Implicit assumptions that company would trade at it’s average PE|
|Economic Value Method||Current EPS is converted to perpetuity with model discount factor||Earnings||Share is treated as perpetual bond|
|Liquidating business/ Cyclical / No growth business||Graham Number||Theoretically, the maximum price that a defensive investor should pay for the given stock||Earnings||To be used in bear phase for cyclical business|
|Fast growth Companies||Graham Intrinsic Value||The formula as described by Graham in the 1962 edition of Security Analysis||Earnings||The formula’s inherent assumption|
|All Companies||Historical Earnings growth||Value of stock when existing EPS growth rate is extended||Earnings||Forward PE assumptions|
|All Companies||Sustainable Earnings Growth||Value of stock when existing ROE growth rate is extended||Earnings||Forward PE assumptions|
|All Companies||DCF||Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them with a discount rate to arrive at a present value, which is used to evaluate the potential for investment.||Cash Flow||Growth , discount assumptions & projections|
|All Companies||Reverse DCF||Gives view on market implied growth||Market Price||Market price is true reflector of growth expectations|
– For today’s post since we have picked CERA sanity ware a fast grower, I would cover Graham’s Intrinsic value , Historical Earnings growth, Sustainable earnings growth , DCF to try & value CERA
The operational word in above statement is try, one can’t get absolute value at best we can get the range of fair values
A. Graham Intrinsic Value
In his seminal work The Intelligent Investor, Ben Graham is credited with proposing his famous Ben Graham formula for calculating intrinsic value. The formula described by Ben Graham in the 1962 edition of Security Analysis , In 1974, Ben Graham revised his formula in order to more accurately account for changes in interest rates.
Value = [EPS X 4.4 X (8.5 + 2g)] / Y
V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company , Now 8.5 would signify an earnings yield of 11.76% so I would be comfortable with this number as this is close to what you will get if you invest in AA NCD / bond
g = reasonably expected 7 to 10 year growth rate ,Take industry growth rate or use reputed industry research to plug in this number, in case of no available material use =[GDP growth * 1.5] also I would edit 2 from g and re plug this with 1, I am happy to go wrong on higher growth
Y = the current yield on AAA corporate bonds = 13.5% (my assumption)
So edited formula would look like
Value = [EPS X 4.4 X (8.5 + g) ] /Y
Let’s plug in numbers for CERA
EPS Trailing = INR 45.79
Growth forecast by one of the leading research companies in India
Always take various multiple growth forecast to get a range of values which will make your analysis more in-depth, below are fair value ranges as per above formula
|Projected Growth (g)||12%||15%||18%|
|Value / Share
B. Historical Earnings growth
The historical earnings growth rate for a stock is a measure of how the stock’s earnings per share (EPS) has grown over the last few years. The historical earnings growth rate can tell investors how quickly a company’s profits are growing. A company may increase its earnings per share by increasing its sales, decreasing its costs, or reducing the number of shares outstanding in the marketplace. Last one artificially inflates EPS so watch out for those cases
Now let us value CERA by using this method , the number required are before we begin are below
|Year Ending||Mar ’14||Mar ’13||Mar ’12||Mar ’11||Mar ’10||CAGR|
We will use average numbers to smoothed data , Note this has disadvantages for a fast grower the intrinsic value calculated will be on lower side
Growth rate is calculated as = ROE * (1-Payout)
Projections based on historical growth rate of EPS
|Projections Earnings||Year 0||1||2||3||4||5|
|Earnings after 5 years||144.47|
|Sum Of dividend paid||44.84|
We get projected price of INR 1311.44 which needs to be discounted to present value, before you do that one of the inherent problem with using average numbers is using average PE, do you think a scorching grower like CERA will be valued at 9 times earnings, we need to plug-in realistic value, I would put a PE of 15 to get projected value of INR 2167 at year 5
C. Sustainable Earnings Growth
In simple terms and with reference to a business, sustainable growth is the realistically attainable growth that a company could maintain without running into problems. A sustainable growth rate (SGR) is the maximum growth rate that a company can sustain without having to increase financial leverage
Growth rate is calculated as = ROE * (1-Payout)
Projections based on extending existing ROE on book value per share (BVPS)
|Projections BVPS||Year 0||1||2||3||4||5|
|Earnings after 5 years||115.99|
|Sum Of dividend paid||36.70|
We get projected price of INR 1311.44 which needs to be discounted to present value, before you do that one of the inherent problem with using average numbers is using average PE, do you think a scorching grower like CERA will be valued at 9 times earnings, we need to plug-in realistic value, I would put a PE of 15 to get projected value of INR 1739
Now discount both values by discount rate (10%) [again my assumption ] to get present value of CERA
D. Discounted cash flow
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them with a discount rate to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one
This is DCF formula
where, Free cash flow = Net earnings + depreciation – maintenance capex or
Free Cash Flow = Cash Flow from Operations – Capital Expenditure
Now let me throw some ancedote ,If company is earning ROE of 20%+ depreciation should take care of capex requirement
This I learnt from this brilliant post by Rohit Chauhan, excerpts below
Key point to remember – If the ROE is in excess of 15%, generally the depreciation will covers the maintenance capex and the Net profit will be almost equal to free cash flow.
Exception to the above can be seen in some companies such as Gujarat gas/ HLL etc where the Working capital throws off cash and hence the FCF is actually greater than the free cash flow.
So in response to the question above, I would say that some amount of the Fixed asset has to be adjusted , but I would not deduct all the addition. For ex: A company launches a very profitable product and due to volume growth puts up a new plant. The cash flow may be negative during that year and then become positive a few years later. If you focus on the cash flow based on actual capex, you may undervalue the company when it is investing in a profitable venture and over value a company which is not investing and just milking its assets.
So in CERA’s case wouldn’t it be wise to say FCF = Cash Flow from Operations
So we would calculate two DCF figures
|DCF with CFO as proxy for FCF
||INR 1405 / share
|DCF with Free cash flow as CFO (mar ’14) – Capital expenditure (mar’14)
||INR 550 / Share
Cross checked CRISIL DCF calculation as well this was very near to our CFO as proxy for FCF calculation
Now you have got your range of fair values with various methods imbibing multiple assumptions
|Valuation Method||Value INR / Share|
|Graham Intrinsic Value||1522 to 2283|
|Historical Earnings growth||1346|
|Sustainable Earnings Growth||1080|
|Discounted cash flow||550 to 1405|
We see a tremendous range of INR 550 to INR 2283, this is the precise reason why we have both buyers and sellers for CERA , the gamut of assumptions and multiple viewpoints make valuations such a fun experience
For high ROC / ROCE companies fair values grows at a fast clip so never be anchored to a price
Hope you liked this take on CERA, in our next post we will take up another business and give rest of valuations methods a go