How to identify the fair price for a good company?

Published in The Hindu - Sunday Magazine on May 03, 2009

The right ‘price’ is what makes a good company a good investment…

My last few articles discussed how to spot a ‘good’ company by computing the return on capital that it generates for itself. Now that you have a shortlist of ‘good’ companies, how do you determine how much to pay for such a company? As a stock investor, at what price should one acquire the shares of such a company?

The Enterprise value

Before we get into this, let me tell you how to find out what is the price at which Mr. Market (the stock market) is valuing a company as a whole, at any point in time. The share price of any company traded in the stock market is the price of one share of a company (many might think this is obvious, but I don’t!). If you multiply this share price by the total number of shares issued by the company, you get the value of ‘all’ shares of the company (the number of shares issued by the company is disclosed in the balance sheet as part of the annual report, under ‘Shareholder’s funds’ or ‘Equity capital’ section). This amount is called the ‘market capitalization’ of the company. Add the Debt capital of the company (loans and other external borrowings) to the ‘market capitalization’ and you get the ‘Enterprise value’ of the company. (Sometimes companies issue certain special instruments such as preference shares or warrants - the value of which need to be added to ‘market capitalization’ while computing the ‘Enterprise value’)

Enterprise value (value of a listed company as per Mr. Market) = Market capitalization + Debt capital = Share price * total number of shares + Debt capital

In ‘English’, the above equation merely implies that if you want to buy a company, you need to buy all the shares of the company plus pay off (or takeover) the loans that the company has borrowed from banks etc. If the share price changes, the ‘Enterprise value’ of the company changes.

Having converted the share price of a company into its ‘Enterprise value’, the next step is to find out whether the ‘Enterprise value’ is cheap enough so that you could acquire the shares from Mr. Market and reap a minimum 15% annual ‘return on your investment’ over the long term. Please note that ‘Return on investment’ as stated here is what you would make in the form of dividends and appreciation in share price post investment in the company’s shares. ‘Return on capital’ on the other hand is the return that the company generates on its ‘total capital’ (you can refer my previous article for more on this). Though the two are different, they are linked. Here’s how – the long term return to a shareholder (the return on investment) tracks the ‘return on capital’ that the company generates despite short term fluctuations of Mr. Market. Investing in high ‘return on capital’ companies at a low price produces high ‘return on investment’ for you, over many years to come.

A Golden rule for computing the ‘right price’

Now, let’s put on the hat of a business owner in order to decide whether the ‘Enterprise value’ of a ‘good’ company (that generates 20%+ return on capital) is cheap enough for acquiring its shares. After all, every shareholder is a business owner. A shrewd and conservative business owner will want to recover the cost of his investment in a project (achieve breakeven) in 5-6 years. We could use the same criterion for deciding how much ‘Enterprise value’ to pay for a company. Imagine that you are a business owner and want to acquire a ‘listed’ company as a whole by buying all its shares and settling its bank loans.

The ‘Enterprise value’ of a ‘good’ company is typically more than the ‘total capital’ of the company (i.e. equity capital + debt capital). To help you recollect - ‘equity capital’ is the money contributed by shareholders to the company at the time of shares issue plus the re-invested profits of the company till date. Companies use both equity capital and debt capital to buy assets or retain as cash for running the business. The minute you acquire a company by paying its ‘Enterprise value’, you immediately earn a portion of this value in the form of the company’s assets (or ‘total capital’) that can be sold and disposed off if need be (presuming you would be the new owner!). The remaining portion should be recouped within 5 –6 years. How are you going to achieve this?

Here is where the ‘return on capital’ track record of the company comes into the picture. Every year, the return on capital of the company will determine the additional amount that the company would earn on its total capital. These earnings can either be reinvested in the company (by adding to total capital) or taken out as dividend for you the shareholder. Either ways this would bring you closer to break-even, at the end of every year – by bridging the gap between what you paid in the form of ‘Enterprise value’ and what you get in the form of the company’s total capital + dividends. At the end of 5 years, the company’s total capital + dividends (accreted over the period) would have compounded and will be equal to the original total capital of company at time of acquisition * (1+ average return on capital %)^5. Imagine the compound interest formula and you can easily relate to this. You could even use a 6-year time frame if the return on capital track record is higher than 20%.

Based on the conservative business owner logic, you need to ensure that the price at which you buy the company (or its shares in our case) is less than the compounded amount above so that you will be able to recoup your cost of investment within 5 years.

Ensure ‘Enterprise value’ paid at time of acquiring shares <
Total capital of company * (1+ average return on capital % over previous 5-10 years)^5

This rule ensures that you don’t over pay for a good company. As long as the price at which you invest pertains to the above rule, you can be confident of a return on your investment in excess of 15% over the long term.