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.

The God Ratio in Finance

Published in The Hindu - Sunday Magazine on Apr 12, 2009

If there were one metric to measure a company’s performance that would be its return-on-capital.

In my previous article I had discussed about the Buffett philosophy of investing in high return-on-capital companies and how a high return-on-capital is a reflection of a company’s superior business model (assuming the company’s reported numbers are correct!). Here’s how to calculate the ratio and use it as a metric for choosing companies to invest-in for the long-term.

In simple terms the return-on-capital is the amount that the company generates in a year expressed as a % of the total capital that it uses. In practice, companies use a combination of equity capital and debt capital. Equity capital is the money contributed by promoters and other shareholders in return for shares in the company plus the portion of past profits that are retained in the company over the years. Since shareholders are the owners of a company, the company’s retained profits belong to shareholders and are considered part of equity capital. (Beginners, please note that companies typically retain a portion of the profits that they earn every year (for expansion) while distributing the remaining through dividends etc.).

Debt capital is the money borrowed from the bank or from other investors by issuing them bonds that carries interest charges. The ‘Total capital’ in a company is the sum of ‘Equity capital’ and ‘Debt capital’. This value can be got from the Balance Sheet of a company under ‘Source of Funds’. The ‘Source of Funds’ is split between ‘Shareholders funds’ (i.e. Equity Capital) and ‘Loan funds’ (i.e. Debt Capital).

The calculation

Return on capital (or Return on Total capital) for a company in a particular year (in %) = (Net Profit + Interest Charges) for the year *100/ (Equity capital + Debt capital) at end of previous year

For a company with zero debt, the Return on Total capital becomes equal to Return on Equity capital (in %) =
Net Profit for the year *100 / Equity capital at end of previous year

Now that you got the ‘Source of funds’ value (i.e. Total capital that the company possesses for doing business), you know what goes into the denominator of the Return-on-capital formula. Next is the numerator, which is the amount that the company generates on the total capital that it owns. The numerator, just like the denominator consists of two parts – one part is the amount that the company generates on the equity capital and the other the amount that the company pays on debt capital. The former is nothing but what we commonly see reported as the ‘Net Profit’ (otherwise known as Profit after tax) of the company. The latter is the ‘Interest charges’, which is the interest amount that the company pays to those who have lent money to the firm. The Net Profit and Total interest charges during any particular year can again be looked up from the company’s annual report, but this time not in the Balance Sheet but in the Profit & Loss (P&L) Statement.

Debt can distort true picture of company’s profitability

If you have really understood whatever I have explained so far, you must have a nagging question that must have popped up. As shareholders (who contribute to Equity capital) why should we be bothered about ‘Debt capital’ and ‘Interest charges’? Should we just not calculate Return on ‘Equity capital’ i.e. Net Profit/ Equity capital? The answer to this is that we want to know how effectively and efficiently the company is utilizing its ‘Total’ capital, so that we can decide if it is a good business or a poor business. In a way we are saying there is no color of money, when evaluating how well the company is using its money. Some companies borrow a lot of money (in financial parlance – they use “leverage”) in order to increase Return on Equity capital. But this is cheating, because all they are doing is changing the capital structure, which in no way impacts the intrinsic profitability of the business.

To understand this better, let me give you an example - say you buy a property for Rs 1 cr using your savings. After a year your property has appreciated and is worth Rs 1.2 cr. Your return on capital is 20% p.a. (no mean feat). Now imagine your friend also bought a property at the same time you did. But he did something different, along with Rs 1 cr of his equity, he borrowed Rs 4 cr from the bank at 10% p.a. interest rate and bought a property worth Rs 5 cr. At the end of the first year his property is worth Rs 5.75 cr and he decides to sell his property. After repaying his 4 cr loan with interest of Rs 40 lks, he pockets a cool Rs 35 lks. i.e. a return on ‘equity capital’ of 35%. Whose property performed better? Just looking at returns on ‘equity capital’ would give an impression that your friend’s property performed better. But look closer and you will find that the Return on ‘Total capital’ that it generated was Rs 75 lks(35 lks + 40 lks)/ 5 cr = 15%, which incidentally is poorer than the 20% that your own property generated! Your friend’s additional returns did not come from superior property selection but high leverage (or use of debt). You may ask - so what if he used leverage? He still generated better returns on his money (his equity). Yes, but he also assumed a lot of risk. What if his property did not appreciate at all, then he would have recorded a loss for the year due to the interest charges.

Incase you have drifted…this is not an article about real estate investment strategies. What I mean to say is that- for identifying superior businesses (or companies) you need to look at Return on ‘Total capital’ and not just Return on ‘equity capital’, because the latter does not clearly reflect the actual performance of the business. Why? Because, by using a lot of borrowed money one can easily boost the Return on ‘equity capital’. Good businesses do well by generating high return on ‘total’ capital – meaning they don’t have to depend on capital structure for oomph (just like how your property did in the above example).