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

 

1. Do you understand the business ? Is this an industry you are comfortable talking about ?
2. What does the company do to make money ?
3. Is company taking undue advantage of any of its stakeholder ?
4. Will Company be in business for next 5 to 10 years ?
5. What is the competitive advantage of the business ? (Moat)
6. Does company has ability to raise prices ?
7. Is the product differentiated ? Corollary to the above question ?
8. Is management honest and competent ?
9. Is the business capital-intensive ?
10. Is the business doing mindless imitation of peers ?
11. Are debt proportions for company meaningful ?
12. 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

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– 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

Where,

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	1522	1903	2283

 

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
EPS	42.79	38.09	26.41	21.88	16.16	27.55%
DPS	6.50	5.50	2.00	0.50	0.20	138.77%
BVPS	184.61	147.96	114.72	91.95	72.96	26.12%
ROE	23.18%	25.74%	23.02%	23.79%	22.16%
Payout Ratio	15.19%	14.44%	7.57%	2.29%	1.24%

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

Average Data
ROE	23.58%
Payout	8.15%
P/E Ratio	9.08

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
EPS	42.79	54.58	69.62	88.80	113.26	144.47
DPS	6.50	4.45	5.67	7.23	9.23	11.77
Earnings after 5 years	144.47
Sum Of dividend paid	44.84
Projected Price	1311.44

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
BVPS	184.61	224.59	273.23	332.40	404.39	491.97
EPS	43.53	52.95	64.42	78.37	95.34	115.99
DPS	3.55	4.31	5.25	6.38	7.77	9.45
Earnings after 5 years	115.99
Sum Of dividend paid	36.70
Projected Price	1052.91

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