Value Investing

Sources of Value
Growth of EPS
Growth of volume
Growth of margin
Quality of EPS Growth RoE
Higher margin
Operating leverage
Financial leverage

Volume
Growth

Price
Leverage

Operating
Leverage

Financial
Leverage

Framework to Analyze Sources of Value - Quality

Quality of Business
Profit pool
Value Migration
Dominant market share
Niche Opportunities
Low competitive intensities
Competitive advantages Producer or Consumer
Favorable demand supply dynamics
Quality of Management
Unquestionable integrity
Demonstrable competency
Growth mindset

Framework to Analyze Sources of Value - Growth

Earning Growth
Volume growth
Realization growth
Higher capacity utilization
Higher capital utilization
Valuation Growth
Growth in earnings
Growth in multiples

Framework to Analyze Sources of Value Quality

vis--vis Growth

Framework to Analyze Sources of Value Longevity

Extending Competitive Advantage Period

Delaying Mean Reversion of Growth Rate

New stream of organic growth
Judicious inorganic growth

Framework to Analyze Sources of Value S & P

Size
Size of sales
Size of market capitalization
Price
Lower multiples

Emergence of Value
RoE > 15%

Endurance of Value
RoE > 15%

Value Investing

Bottom-up Approach of Investment: Four Aspects

Financial Aspects
What is the return on equity?
What is the companys owner earnings?
What are the profit margin?
Has the company created at least one dollar of market
value for every dollar retained?
Business Aspects
Is the business simple and predictable?
Does the business have a consistent operating history?
Dose the business have favorable long-term prospect?
Management Aspects
Is the management rational?
Is management candid with its shareholders?
Does management resist the institutional imperatives?
Value Aspects
What is value of the company
Can it be purchased at a significant discount to its value?

Financial Aspects
Focus on ROE rather than EPS
EPS can grow because of reinvested earnings
Calculation of ROE should have certain adjustments
to reflect the return from the business operations
Marketable securities should be valued at cost
not at market value
Excludes capital gains & losses
Exclude extra ordinary items
ROE should be attractive without debt: Leverage
would increase the risk of failure
Worry of companies which is requiring too much
of capital

Changing the Capital Structure: Facts

Assets
Debt
Equity
D/E Ratio
Share Price
Shares Issued
Interest Rate

Current
8,000,000
0
8,000,000
0
20
400000
10%

Proposed
8,000,000
4,000,000
4,000,000
1
20
200000
10%

Changing the Capital Structure: Facts

Current Structure

Recession

Normal

Expansion

EBIT

500000

1,000,000

1,500,000

Interest

NI

500000

1,000,000

1,500,000

ROE

6.25%

12.50%

18.75%

EPS

1.25

2.50

3.75

Proposed Structure Recession

Normal

Expansion

EBIT

500000

1,000,000

1,500,000

Interest

400,000

400,000

400,000

NI

100000

600000

1,100,000

ROE

2.5%

15%

27.50%

EPS

0.50

3.00

5.50

Financial Aspects
Owner earnings
EPS is starting point for determining the economic value
of the business not the end
Not all earnings are created equal: Asset heavy business
could report erratic earnings
Net cash flow (income after taxes plus depreciation,
depletion, amortization, and other non-cash charges) is
not always better measure
It could be good to measure net cash flow for
companies which has large investment in the
beginning and smaller outlays latter on
Companies that requires ongoing capital expenditure;
net cash flow could be miss-leading
Capital expenditure is an expense like labor and capital
Owner earning is defined as
Net income + depreciation + depletion + amortization
amount of capital expenditure and additional
working capital required

Financial Aspects
Profit Margins
Revenue growth is not enough, sales has to
convert into profit
Declining gross margin is a warning signal
Non-operating expenses needs to be controlled
The one dollar premise
Goal is to invest in companies that generate at
least one dollar in market value from the one
dollar retained earnings

Understanding the Numbers in Financial Statements

Financial statements are full of assumptions and estimates
Soft Facts vis--vis Hard Facts
What are the assumption in the number?
Are there any estimates in the numbers?
What is the bias and implications due to assumptions and
estimates
Profit is an estimate!!!
Gross profit: How much is enough?
What is the benchmark?
How to benchmark?
What is the trend?
Operative profit (EBIT) is the key to health and it measures
The demand for the product and services
The companys efficiency in delivering product and services
Bankers, venders & investors look at these numbers
Net profit and how to fix it
Reduce the COGS and G&A expenses
Improve the revenue
Pricing
New markets

Types of Ratios
Profitability ratio
Gross margin = Gross profit / Revenue
Operating margin = Operating profit / Revenue
Net profit margin = Net profit / Revenue
Return on assets = Net profit / Total assets
Implications of ROA being too high in comparison to
industry standards?
Is it renewing the asset for the future or not?
Is there anything morecase of Enron!!!
Return on equity = Net profit / Shareholders equity
Leverage ratios
Debt-to-equity ratio = Total liabilities / Shareholders equity
Interest coverage ratio = Operating profit / Annual interest
charges
Liquidity ratio
Current ratio = Current assets / Current liabilities
Quick ratio = [Current assets Inventories] / Current liabilities

Types of Ratios
Efficiency ratio
Days in inventory = Average inventory / COGS per day
Inventory turns = 360 / Days in inventory
Days sales outstanding = Ending A/R / Revenue per day
Days payable outstanding = Ending A/P / Revenue per day
Property, Plant, and Equipment (PPE) Turnover =
Revenue / PPE
Total Asset Turnover = Revenue / Total assets
Which ratios are important for which business?
The power of percentage of sales
Ratio relation ship
Example
ROA = Net income / Assets
ROA = {Net income / Revenue} * {Revenue/Assets}
ROA = Net profit margin * Asset turnover ratio

Business Aspects
A simple and understandable business
Invest in business which one understands
Operate with in ones circle of competency
It is extremely difficult to predict the future of a business if
one does not understand it
Investment success is not a matter of how much you
know, but how realistically you define what you do not
know
Consistency
If a company has delivered over a long period of time it
would deliver in future
Turnaround and restructuring hardly works
Favorable long term prospects
Products or services are needed or desired
Products or services has no substitutes
Products or services is not regulated
Business that has survived economic downturn

Management Aspects
Rationality in decision making
A company generating average or below average
return with excess cash can;
Continue to invest in sub-optimal projects
It can buy growth through acquisition
It can return the money to shareholders
Raising dividends: Assumes that the investors
can generate better returns somewhere else.
Buy-back of shares Double whammy for
under valued companies
Capital allocation decision
How are the management allocating the
earnings?
Is reinvested earnings giving return higher than
cost of capital?

Management Aspects
Candid communication with the shareholders
Report financial results genuinely
Admit mistakes and discuss the failure openly
Is it possible for a professionally managed company?
The institutional imperatives
Blind imitation of the competitor
Hide behind the failures of the competitor
Excessive focus on short-term
Management ethics
Honest and straight forward
Financial reporting
Corporate governance
Executive compensation
Accounting of stock options
Can one really put a value on management?
Compare the annual reports and observe the change
Footnotes communicate Unintelligible footnotes
Blowing the trumpet of success and hiding the failure

Value Aspects
Calculate what the business is worth
Use the DDM by using the appropriate information
Buy at a attractive price
Putting it together
The business aspects is focused on predictability of business
Management aspects focused on companies that are well run
Together the business and good management would give you
a good sense of future earning potential
Financial aspects would help you calculate the value
Value would guide you make the investment

 http://www.motilaloswal.com/Financial-Services/Research/Detailed-Report/India-StrategyReport/13335/-/
http://www.motilaloswal.com/Financial-Services/Research/Detailed-Report/ValuationsHandbook/13283
http://www.motilaloswal.com/Financial-Services/Research/Detailed-Report/Wealth-CreationStudy/11538
http://www.motilaloswal.com/Financial-Services/Research/Detailed-Report/Wealth-CreationStudy/7971
http://www.motilaloswal.com/Financial-Services/Research/Detailed-Report/CompanyUpdates/12600/532659