Professional Documents
Culture Documents
SECRETS
The Biggest Lessons From Our
Entire 20-Year Investing Journey
Disclaimer
The information/content (including any charts/graphs) in this Book has been
compiled from sources we believe to be true and reliable, but we do not hold
ourselves responsible for its completeness or accuracy. Any omissions/errors
are accidental and not intentional. This is not an offer to sell or solicitation to buy
any securities in any jurisdiction. Equitymaster or its associates will not be liable
for any losses incurred or investment(s) made or decisions taken/or not taken
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recommendation, readers should consider whether it is suitable for their particular
circumstances and, if necessary, seek professional advice. Equitymaster and
its affiliates, directors, officers, employees may or may not hold any securities
mentioned herein. Equitymaster and its affiliates may from time to time, have
a relationship with any company reported in this Book in the ordinary course
of business. All opinions/views, if any, are subject to change from time to time
without notice.
Table of Contents
Welcome to a New Chapter in Your Investing Journey
Chapter 2
Chapter 3
23
Chapter 4
33
Chapter 5
51
Accounting Basics...................................................................
65
Chapter 7
69
Chapter 8
81
Chapter 9
91
105
Chapter 11
113
Chapter 12
127
Valuation Methods
Chapter 13
Introduction to Valuation..........................................................
141
Chapter 14
155
Chapter 15
165
Stock Screeners
Chapter 16
Stock Screeners..........................................................................
181
Behavioral Finance
Chapter 17
Behavioral Finance....................................................................
195
Portfolio Analysis
Chapter 18
Portfolio Analysis........................................................................
209
Dear Reader,
When we launched Equitymaster in 1996 - Indias first financial
website - we could not have imagined we would emerge as one of
Indias most trusted research houses.
Our visionto empower the small investorto be investors best
friendhas guided us through many challenges these past two
decades.
And today, when we look back, we take immense pride in what
weve delivered. And how weve remained committed to delivering
clear, honest, and unbiased views.
This book, which commemorates our 20th anniversary, has the
potential to change the way you invest. Thats because these
pages include the culmination of our two decades of experience
picking out money-making opportunities.
In these pages, we reveal the complete Equitymaster Waythe
secrets weve run our business on for 20 years.
We hope you find these lessons richly rewarding in your wealthcreation journey.
Happy investing,
Rahul Shah & Tanushree Banerjee
Co-heads, Equitymaster Research Team
PS: Three years ago, we decided to put together the best investing
secrets, lessons, and experiences weve gathered over the years.
We wanted to keep it simple and practical for the lay investor. As
such, the examples explained in the book pertain to that period.
While some facts may have changed, the essence of the lessons is
timeless.
We have strived to present the book in a highly objective and
concise manner, and as a result, have used bullet points in many
chapters. We hope you find the reading experience easy and
enriching.
ii
Business
Models
&
Economic
Moats
Chapter 1
Equitymasters Secrets
Equitymasters Secrets
1. A business we understand
A business we understand is critical because we need to know
what we are buying into.
We stay away from companies that have overly complicated
products and business models.
Equitymasters Approach
Here at Equitymaster, we closely follow Warren Buffetts investing
approach for many of our recommendation services. We believe
in identifying companies that have a high moat and sell for
reasonable prices. Our investment philosophy can be summarized
as follows:
Dont try predicting where markets will go
tomorrow or 6 months from now...Dont lose
your calm over changing market sentiments...
Buy stocks as if you are buying businesses...only
the ones with solid long term fundamentals...
only when theyre selling cheap...
And stay invested for the long term...Period
Equitymasters Secrets
Chapter 2
Investing in a Business
When you invest in a stock, you become a part-owner of the
business. Would you ever put money in a business that you dont
understand? Understanding businesses thoroughly and investing
in only those businesses that you understand is the cornerstone of
value investing.
Bargaining Power of
Suppliers
Competitve Rivalry
Bargaining Power of
Customers
Threat of Substitutes
10
Equitymasters Secrets
4. Threat of Substitutes
A company faces competition from not just other firms in the same
industry but also firms from other industries that have products that
offer the same benefits as the companys products. The threat of
substitute products determines whether profit margins can remain
high over long periods of time. The more likely a customer is to
switch to a substitute product, the lower the company has to keep
its prices (and thus profit margins) to attract the customer. If profit
margins are low, it is more difficult for a company to withstand
external shocks; e.g. a rise in the price of its inputs.
11
5. Competitive Rivalry
Competitive rivalry looks at the way in which companies compete
with each other within the industry. If companies compete
heavily on price, this is likely to keep profit margins low; this
occurs primarily when the companies products are very similar.
Competitive rivalry is low if there is differentiation between
products and brand loyalty is significant. Competitive rivalry is also
low if exit barriers are low and vice versa.
Arvind Ltd
12
Equitymasters Secrets
13
14
Equitymasters Secrets
Nestle India has been among the best shareholder wealth creators
with over 2300% returns in 18 years (19% CAGR). Low capex model
with excellent return on capital. For nearly two decades, Nestle has
paid out on average 76 out of every 100 rupees of net profits as
dividends to shareholders. How has the company managed to do
this? Porters Analysis provides some useful insights
15
16
Nearly 4 times the size (in terms of FY13 sales and net profits)
of its biggest competitor in India.
Equitymasters Secrets
17
18
Equitymasters Secrets
Conclusion
Understanding businesses is fundamental to value investing.
Porters five forces is a powerful framework to analyze business
models & industry structures. The five forces are: Threat of New
Entrants, Bargaining Power of Customers, Bargaining Power of
Suppliers, Threat of Substitutes, and Competitive Rivalry. How
companies rank on the five forces impacts long term profitability
and shareholder returns.
19
20
Equitymasters Secrets
0.0
1.5
9.8
5.3
1.6
17.2
10.1
5.5
1.6
0.0
9.2
5.7
1.7
0.0
1.5
0.7
1.4
25.5
6.3
3.8
2.3
0.0
-9.6
-4.0
1.8
0.0
4.9
1.6
(Consolidated)
Arvind Ltd.
Appendix 1
1.6
0.0
12.8
4.0
Mar-11
1.2
5.8
27.9
8.7
Mar-12
1.2
17.1
13.4
4.6
Mar-13
21
73.3
0.0
5.5
28.7
56.3
0.3
(Consolidated)
0.0
93.8
77.0
10.6
0.0
78.0
84.8
10.7
0.0
76.9
102.5
11.3
0.0
77.9
91.9
11.7
0.0
76.7
119.8
11.9
0.0
71.4
124.2
12.5
0.4
52.3
33.0
6.2
0.4
44.4
39.8
6.9
0.3
39.9
48.6
8.7
0.4
56.5
34.7
6.1
0.3
42.2
38.4
6.9
0.1
31.0
60.7
12.4
84.3
11.5
0.1
36.4
45.2
10.1
Mar-11
0.0
57.1
114.0
12.8
(Standalone)
0.1
38.8
41.4
9.4
Mar-12
0.8
48.6
90.3
12.5
Dec-11
0.1
39.6
37.8
9.2
Mar-13
0.6
43.8
69.5
12.4
Dec-12
Chapter 3
23
24
Equitymasters Secrets
Brands
Regulatory licenses
25
over the long term but also requires huge capital investments.
Example: Consumer electronics, technology sector, etc. Companies
such as Nokia and RIM were once ahead of the curve but later on
failed to adapt themselves to changing customer preferences and
needs.
26
Equitymasters Secrets
27
28
Equitymasters Secrets
I. Economies of Scale
In an industry where the fixed costs are relatively much higher
than the variable costs, the greater the size of the firm, the greater
are the cost benefits that it can enjoy over its peers. Due to high
fixed costs, new competitors are discouraged from entering the
market. The absolute size of a firm is not as important as its size
relative to its competitors. For instance, a small cap firm could be
a dominant player in a niche industry and enjoy scale advantage
within that industry.
Cost advantages based on economies of scale can be divided into
two main types:
29
30
Equitymasters Secrets
Determining a Moat
Has the company consistently earned high returns on
capital?
Does the company enjoy better profitability relative to its
competitors?
Identify the key factors that enable the company to earn such
high returns.
Can the company continue to enjoy these high returns for a
long time?
If the answer to these questions is in the affirmative, the company
under consideration does have an economic moat.
Note: Certain industries, by their very inherent structural
characteristics, offer economic moats to a relatively large number
of firms. Example: Consumer goods, pharma, etc.
Durability of a Moat
Once we identify a company with a moat, the next step is to
determine its long term durability. How long can the company earn
higher returns while keeping competitors at bay? Certain moats
tend to erode over time, while few get more durable over time. The
Buffett test: Can a well-financed competitor erode the companys
profitability?
Give me $10 billion dollars and how much can I hurt
Coca-Cola around the world? I cant do it.
Warren Buffett
31
Conclusion
32
Equitymasters Secrets
Chapter 4
33
Financial performance
Its profit margins are way higher than its peers in the
industry, indicating strong pricing power.
( Please see table in Appendix 2 on page 46 )
34
Equitymasters Secrets
35
Financial performance
36
Equitymasters Secrets
Financial performance
37
38
Equitymasters Secrets
Financial performance
39
40
Equitymasters Secrets
Financial performance
41
The bank has, over the last 10 years, had net non-performing
assets (NPA) levels below 0.6% and has one of the most
conservative provisioning norms.
42
Equitymasters Secrets
This makes it the only online (dot com) company with such a
strong sales force.
The traffic gap with Monster India and Times Jobs (its closest
competitors) has widened from a mere 10% in 2007 (only
with Monster India) to 45% and 52% respectively in March
2013.
43
Financial performance
Conclusion
44
Equitymasters Secrets
the moat.
HDFC Bank enjoys the high switching costs that are inherent
in the banking sector. Its vast branch network further widens
the moat.
Info Edge benefits from the network effect on its online job
portal Naukri.com.
45
46
Equitymasters Secrets
FY09
15.2
9.8
9.8
FY09
19.5
4.4
6.3
WABCO India
WABCO India
6.7
18.8
38.8
FY11
9.5
10.8
21.1
FY11
7.4
14.1
33.4
FY10
11.0
11.8
21.2
FY10
0.6
17.7
33.5
FY12
8.2
11.0
20.3
FY12
Appendix 2
NA
9.2
22.2
FY13
2.7
8.5
19.4
FY13
5.2
12.8
29.5
5-Yr Avg
8.2
10.4
19.4
5-Yr Avg
47
(EBITDA, %)
15.7
15.6
75.6
44.2
FY04
14.2
18.0
84.1
45.3
FY05
16.0
16.1
80.7
57.1
FY07
FY09
FY10
FY11
FY12
FY13
17.4
17.0
75.0
16.0
16.8
71.7
15.3
22.2
63.1
15.3
20.3
75.0
15.3
19.4
75.0
15.5
18.2
76.7
FY08
17.6
17.3
74.1
50.8
FY06
15.8
18.1
75.1
90.8
Avg
10-Yr
48
Equitymasters Secrets
12.2
16.2
18.0
21.9
30.6
8.8
38,174
3,348
2009
8.4
45,127
Sales Revenue
2008
3,810
22.0
20.8
23.7
FY10
18.9
24.5
31.5
FY11
6.5
47,259
3,073
2010
15.2
FY09
FY08
(Consolidated)
4,190
2011
20.4
28.9
33.3
FY12
8.1
51,494
9.1
52,464
4,787
2012
19.1
21.7
26.8
5-Yr Avg
49
0.11
30.5
13.8
0.10
26.5
12.8
0.11
24.5
10.4
0.09
22.4
12.5
0.08
18.2
11.6
0.07
23.0
12.1
CY10
3.9
54.7
20.6
17.7
55.5
4.0
19.5
57.7
4.3
17.7
54.5
4.4
17.2
44.4
4.3
18.5
60.7
3.9
16.3
52.0
4.4
16.8
52.7
4.2
FY11
(Standalone)
34.6
29.0
14.5
(Standalone)
0.04
18.6
10.2
CY12
18.7
48.4
4.1
20.3
47.4
4.0
FY12 FY13
0.06
25.4
12.8
CY11
18.3
52.8
4.2
10-Yr
Avg
0.09
25.3
12.1
Avg
10-Yr
50
Equitymasters Secrets
20.7
29.5
14.5
29.5
27.3
18.3
FY09
25.4
29.5
14.9
FY10
30.5
34.1
18.1
FY11
FY08
(Standalone)
27.3
38.3
21.3
FY12
28.2
34.3
15.4
FY13
25.9
32.2
18.1
6-Yr
Avg
Chapter 5
51
Financial performance
The competitors do not have such high returns, and they are
also highly leveraged.
52
Equitymasters Secrets
2. Coal India
Cheaper Access to Resources
Company overview
53
Financial performance
3. Ambuja Cements
Process-based Cost Advantages
Company overview
54
Equitymasters Secrets
The company has grown at a rapid pace over the last three
decades and its cement capacity stands at 27.3 mtpa.
55
Financial performance
Suzlon Energy
Company overview
56
Equitymasters Secrets
Financial performance
57
Conclusion
58
Equitymasters Secrets
59
FY07
23.0
26.8
33.2
(Consolidated)
29.1
22.6
22.6
FY09
31.8
25.3
21.8
FY08
24.7
19.4
20.8
FY10
22.8
19.0
22.5
FY11
22.2
16.5
21.1
FY12
19.4
15.0
20.9
FY13
Appendix 3
26.2
20.6
21.8
7-Yr
Avg
60
Equitymasters Secrets
FY06
23.6
41.3
0.2
(Consolidated)
0.1
30.5
17.6
FY08
0.1
10.9
6.1
FY09
0.1
37.2
21.8
FY10
0.1
35.2
21.5
FY07
0.1
32.6
19.6
FY11
0.1
36.6
25.1
FY12
0.1
35.8
26.5
FY13
0.1
32.5
20.2
8-Yr
Avg
61
27.6
16.8
0.2
34.9
33.1
0.5
12.1
21.0
28.0
ACC Ltd**
8.1
0.8
9.3
20.7
22.3
UltraTech#
30.7
Ambuja Cem*
16.7
1.6
10.3
24.9
19.2
Madras Cem^
62
Equitymasters Secrets
FY03
15.9
14.3
15.0
15.2
0.4
(Consolidated)
35.3
46.0
16.9
18.9
0.4
45.9
62.8
18.8
25.4
FY05
0.2
39.3
43.5
19.8
24.8
FY06
1.5
21.0
28.3
10.8
17.7
FY07
FY04
1.2
13.3
17.7
7.4
17.2
FY08
1.7
8.6
5.2
1.6
12.4
FY09
1.9
3.9
-13.1
-4.8
6.2
FY10
1.9
1.3
-20.1
-7.3
6.4
FY11
2.7
8.0
-8.1
-2.2
9.1
FY12
Accounting
Basics
&
Financial
Analysis
Chapter 6
Accounting Basics
Accounting
The first is the Balance Sheet, the second is the Profit and
Loss Statement, the third is the Cash Flow Statement,
and the fourth is Notes to Financial Statements (including
changes in Equity).
Balance Sheet
65
66
Equitymasters Secrets
Imagine being asked to run your Dads set up for one year.
You are a complete novice in accounting. This is how your
financial statements would look:
67
68
Equitymasters Secrets
Chapter 7
Financial Ratios
1. Profitability Ratios
Operating Profit Margin
69
70
Equitymasters Secrets
If this ratio is high, the bank may have to write off bad loans,
and this will reduce its future profitability.
Limitation: The ratio does not take into account debt capital.
As such, if a companys growth is heavily funded by debt, it
will boost the ROE. Hence, one must consider other ratios as
well.
71
7. Return Ratios
Return on Capital Employed
72
Equitymasters Secrets
73
74
in inventory.
Equitymasters Secrets
75
The higher the ratio, the greater the financial strength of the
company.
Falls in this ratio also hurt the stock price, as investors will
seek higher dividend paying stocks.
76
Higher P/E ratios indicate that we pay more for a given level
of earnings, and vice versa.
Equitymasters Secrets
The price to book value measures the market price per share
relative to the book value per share.
The Price to Sales ratio the measures the price per share
relative to the sales per share of a company.
77
78
The Price to Free Cash Flow measures the market price per
share relative to the free cash flow per share.
Equitymasters Secrets
Conclusion
79
Chapter 8
Return on Equity
Return on Equity =
Net Income
Shareholders Equity
DuPont Analysis
ROE =
Assets
Equity
81
Net Income
Sales
b) Asset Turnover
Asset Turnover =
Sales
Assets
c) Financial Leverage
82
Equitymasters Secrets
Financial Leverage =
Assets
Equity
83
Examples
1. HDFC Bank
84
Equitymasters Secrets
Their 5-yr avg. asset turnover is 2.1, meaning that their total
sales is just over double their total assets.
85
They are Indias largest iron ore producers, and have high
exports in this area.
Their 5-yr avg. net profit margin is 58.8%, and this is due to
the fact that the cost of mining and producing the minerals is
much less than what they earn in revenues from selling them.
( Please see table in Appendix 4 on page 89 )
Conclusion
86
Equitymasters Secrets
87
14.9%
163,323
22,449
Interest Earned
150,527
12.2
Shareholder's Funds
0.1
1,832,708
13.7%
Total Assets
Mar-09
DuPont Analysis
[INR-Millions]
Data Source: Ace Equity
215,225
2,224,586
29,487
161,727
13.7%
10.3
0.1
18.2%
Mar-10
253,793
2,773,526
39,264
199,282
15.5%
10.9
0.1
19.7%
Mar-11
Appendix 4
299,247
3,379,095
51,671
278,742
17.3%
11.3
0.1
18.5%
Mar-12
362,141
4,003,319
67,263
350,649
18.6%
11.1
0.1
19.2%
Mar-13
88
Equitymasters Secrets
78.8%
3.8
117.0%
202,393
25,007
81,937
21,375
Net Sales
Total Assets
Shareholder's Funds
3.5
2.5
[INR-Millions]
Data Source: Ace Equity
26,689
92,580
21,027
175,238
1.9
12.0%
12.4%
Mar-10
Mar-09
DuPont Analysis
27,350
101,405
23,060
197,355
84.3%
3.7
1.9
11.7%
Mar-11
36,811
111,973
26,914
221,164
73.1%
3.0
2.0
12.2%
Mar-12
28,648
118,833
37,967
258,102
132.5%
4.1
2.2
14.7%
Mar-13
89
75,640
43,724
168,254
116,369
Total Assets
Shareholder's Funds
1.4
Net Sales
0.4
37.6%
57.8%
Mar-09
DuPont Analysis
[INR-Millions]
Data Source: Ace Equity
142,724
213,976
34,473
62,391
24.2%
1.5
0.3
55.3%
Mar-10
192,145
283,429
64,996
113,693
33.8%
1.5
0.4
57.2%
Mar-11
244,064
351,588
72,656
112,619
29.8%
1.4
0.3
64.5%
Mar-12
275,110
407,978
63,405
107,043
23.0%
1.5
0.3
59.2%
Mar-13
Chapter 9
91
The insiders are the promoters and their families, the top
executives of the firm, and the directors on the board.
92
Equitymasters Secrets
93
94
When the scam came to light, on 7th January, the stock fell
by 82%.
Equitymasters Secrets
They stretch expenses too far into the future even if the
useful life of asset has long been over.
95
years.
96
Equitymasters Secrets
criteria.
97
98
Investors should look out for such instances and view them
with suspicion.
Equitymasters Secrets
5. Contingent liabilities
Standalone (nos)
FY09
FY10
FY11
FY12
FY13
30.9%
24.6%
22.2%
15.7%
0.72
0.51
0.57
0.37
1.01
99
But if you look at the trend of the same over the past 5 years,
you get a completely different picture.
100
Equitymasters Secrets
Concentrate on Cash
Ideally, increasing profits (as per the Profit & Loss Statement)
should broadly result in corresponding increase in cash flow
from operations over time.
Conclusion
One must also look out for any qualified or adverse opinions
by auditors in Auditors Report (included in Annual Report).
101
102
Equitymasters Secrets
5,415
Bills discounted
21,485
1,754
30
Revenue
Debtors
Debtor days
73
5,898
29,499
92.5%
57.5%
8,526
9,217
FY10
89.8%
6,032
Contingent Liabilities
YoY (%)
FY09
Standalone (Rs m)
78
11,250
52,432
90.6%
10.1%
9,391
10,362
FY11
Appendix 5
117
21,147
65,936
72.3%
22.9%
11,545
15,966
FY12
140
35,463
92,223
76.0%
29.6%
14,965
19,695
FY13
Separating
Good
Management
from Bad
Chapter 10
Separating Good
Management from Bad I
What is Management?
105
Analyzing Management
Role of Management
106
Equitymasters Secrets
107
Ideally, the more they possess these qualities, the better they
will fulfill their roles and deliver strong results.
Qualities include:
A strong understanding and knowledge of the business
under consideration.
Honesty and transparency in dealing with stakeholders.
Passion for the business.
108
Equitymasters Secrets
109
110
Equitymasters Secrets
They can bring new ideas to the company that insiders may
not have had.
111
Conclusion
112
Equitymasters Secrets
Chapter 11
Separating Good
Management from Bad II
Management Compensation
113
They were founded in 1952 and they are the third largest
steel producer in India.
114
Equitymasters Secrets
FY11
FY12
FY13
Salary
106
120
121
0.04
0.04
566
615
429
Total Compensation
672
734
550
37,539
39,649
29,101
1.8%
1.9%
1.9%
Perquisites
115
FY11
FY12
FY13
Salary
11
13
Perquisites
Commission
28
48
38
Total Compensation
42
64
57
68,657
66,964
50,630
0.1%
0.1%
0.1%
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picture, i.e. have a long term strategic vision and plan for
the company.
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This was a large expense, and the sole purpose was to fund
the extravagant lifestyle of the management.
But when this is done using company funds and that too
without a genuine need, it is clearly not correct.
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falling, and the companys stock price fell 44% over the
course of a month.
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If so, then they are doing the right thing. If not, then they are
doing the wrong thing.
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The Tata Nano car & the Tata Swach water purifier are
examples of frugal innovation.
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Conclusion
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Chapter 12
Separating Good
Management from Bad III
Treatment of Minority Shareholders MNCs and Subsidiaries
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It was among the first few early entrants into the lucrative
US market.
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For Ranbaxy, the US market has been a focus area and also
forms a major revenue contributor.
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18-Nov2013
Change
Ranbaxy Lab
157,753
181,295
14.9%
Sun Pharma
41,444
1,263,410
423.3%
Lupin Ltd
51,283
386,953
654.5%
Dr Reddy's Lab
121,316
419,117
245.5%
Rs million
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138,711
772
0.6%
9.0
7.5
0.6%
1,184
205,011
FY09*
6.5
0.9%
1,579
177,643
FY10
6.5
1.4%
2,689
196,910
FY11
CY07
Rs million (Consolidated)
Appendix 6
7.5
1.3%
3,072
34,363
FY12
18.5
1.5%
3,923
70,040
FY13
16%
38%
14%
5-Yr CAGR
137
2.7%
5.0
3.5
3.3%
6,777
205,579
FY09
6.0
3.5%
10,168
293,028
FY10
7.5
5.2%
18,925
366,112
FY11
4,931
180,208
Net Sales
Royalty Payments
FY08
Rs million (Consolidated)
FY12
7.5
5.1%
18,031
351,972
8.0
5.7%
24,540
432,159
FY13
10%
38%
19%
5-Yr CAGR
Valuation
Methods
Chapter 13
Introduction to Valuation
Renowned Greek story teller Aesop (600 BC) had once said,
A bird in hand is worth two in the bush.
Warren Buffett has often referred to this line as the basis for
valuing all assets.
How much more? Well, that depends on the rent that the
money earns. This rent is nothing but what we popularly
know as the interest rate.
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10*(1+0.08)^3 = 12.6
Alternatively, you could use the same interest rate to find out
the present value (PV) of Rs 10 m that is offered 3 years from
today. This is called discounting.
10/(1+0.08)^3 = 7.9
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Under the DCF method, you first forecast cash flows for the
current and future periods out to a reasonable date.
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Here are some limitations that make the DCF method less
reliable.
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Reliability of Information
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reproduction value.
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Liabilities and equity are the sources that fund the assets.
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Now find out the market cap plus the value of debt of the
firm under consideration. Call this the market enterprise
value.
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Conclusion
In this chapter, we discussed the time value of money concept and
its importance in determining intrinsic value.
While the DCF Method is a sound theoretical framework, its
practical application has too many limitations.
For companies that do not enjoy any economic moat, future growth
has no value and hence are well-suited for asset based valuation.
In the next chapter, we will discuss valuation methods for
companies that have an economic moat.
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Chapter 14
ABV can be used where firms either earn less than their
cost of capital or are just about able to match their cost of
capital.
For e.g. if the cost of capital is 12% and if the ROE or ROIC of
the firm is around 10%-12% on a sustainable basis, it makes
more sense to use asset based valuation than any of the
others.
It does not aim to value the earnings or the cash flows of the
company.
For e.g. if the cost of capital is 12% and if the ROE or ROIC of
the firm is around 15%-20% then the earnings power value
method can be used.
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And for the EPV to remain higher, the barriers to entry must
be sustainable at the current level for the indefinite future.
Importance of a Franchise
The difference between the EPV and the asset value is the
value of the franchise enjoyed by the company.
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Summary of EPV
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Lets assume that XYZ Ltd has a strong brand and is a highly
profitable company. Hence, competitors are lured to enter
into the industry.
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Please note that the firms franchise value would have been
zero if its EPV were equal to reproduction cost of assets.
But since it is much higher, the firm has some sort of strong
competitive advantage or a franchise.
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Conclusion
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Chapter 15
This way the more you invest, the more you will lose.
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But what we did not take into account was the growth in
earnings.
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For this, let us go back to the formula we used for the EPV
method and build on it.
Please note that the EBIT (1-tax rate) is the adjusted earnings
we used in the EPV formula.
Now, we are sure our readers are familiar with two of the
most basic formulas in finance.
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In the first, the numerator stays constant or does not grow for
an infinite period of time.
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This is the cash that will remain after investing for growth.
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PV = ((C*ROIC) (C*G))/(R-G)
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Did you see what just happened here? PV, which takes into
account growth came in lower than EPV where there is no
growth.
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ROIC / R
1.0
1.5
2.0
2.5
3.0
25%
1.0
1.1
1.2
1.2
1.2
50%
1.0
1.3
1.5
1.6
1.7
75%
1.0
2.0
2.5
2.8
3.0
In fact very few companies on the face of this earth are able
to command even that high a valuation. For competition
constantly chips away, trying to bring both growth rates and
ROIC down in the process.
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Value of Growth:
Only if the growth is within
advantage
Earnings Power Value:
Franchise value from current
Asset Value:
Free entry
cost of assets
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What should be the ideal P/E multiple for a stock? Let us try
and answer this question using our three valuation methods.
You would also recall the formula i.e. EPV = Adj. Earnings*
1/R
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Please note that this formula will not work for G>ROIC. But
this is not much of a problem because for most firms, long
term growth on a sustainable basis is lower than its ROIC.
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Conclusion
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Stock
Screeners
Chapter 16
Stock Screeners
There are two broad approaches to fundamental investing top-down approach and bottom-up approach.
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This, however, does not mean that one should ignore the
larger sectoral and macro trends. The idea is to be wary of
risks from top-down perspective but invest bottom up.
This can be useful to eliminate all the companies that dont fit
the prerequisite financial criteria.
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The next question is: How do you choose the right stock
screener? Ideally, the choice of the screener must reflect
your investment philosophy.
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Going back to the screener, the first condition said that the
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stock screener.
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When you use the P/E ratio, you compare a companys net
profits to its market capitalization.
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You run these two metrics on all the companies in your set.
Once you have all the companies with two respective ranks,
then next step is to do a combined ranking.
While stock screeners are great stock picking tools, there are
some things that investors must bear in mind.
1) Stock screeners are statistical tools. They may not always
be reliable indicators a companys quality and intrinsic value.
2) Stock screeners indicate a companys past performance.
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Conclusion
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Behavioral
Finance
Chapter 17
Behavioral Finance
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information.
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We will now shift our focus from market behavior to the mind
of an individual.
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This is a useful mental framework that can help increase selfawareness, and, thereby minimize thinking errors.
First Quadrant
We know what we know
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Second Quadrant
We know what we do not know
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Third Quadrant
We do not know what we know
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Fourth Quadrant
We do not know what we do not know
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This quadrant is not only the largest but also the least
understood.
Conclusion
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Portfolio
Analysis
Chapter 18
Portfolio Analysis
How much should you invest in such a stock? Should you put
all your money into it?
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Hence, the greater the portfolio volatility, the greater the risk.
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Portfolio Management
Graham Approach
As per him, simple, easy to follow rules are all that one
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The second thing is to buy stocks only when the price tag
looks attractive.
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Conclusion
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