January 23, 2008

Valuation - reverse engineering the stock price

I discussed my approach on evaluating PE ratios (see here). In addition based on the table shown in the previous post, we can work out the assumptions built into the stock price in terms of the ROC, CAP and growth rates. These variables can be compared with the actual and expected results of the company to decide if the stock is undervalued or not. Sounds easy in concept, and it is if you understand the company and the industry well. This approach is also called as expectations investing and I learnt about it in the book -.expectationsinvesting. I would recommend reading this book to understand DCF and the previous post better.

The above approach is a very useful tool in analysing a company. Let me give two examples.

Example A – CRISIL . This company sells for a PE of almost 60+. The embedded expectations are
ROC – 25% (current value)
Profit growth ( Net profit = Free cash flow) – 18% p.a for last 6 years
CAP – 20 years

Basically the company needs to grow at 18% per annum for the next 20 years and maintain the ROC. The company would be earning a net profit of almost 1000 odd crores by then. To make money on the stock in long run, one has to believe that the company will do better than what is implied by the stock price. Will the company do as good or better than implied above? I don’t know and certainly not comfortable or confident of a company to do this well for such a long period of time.

Example B – Novartis. The company sells for an adjusted PE (take cash out from mcap) of around 7.
ROC – 50% +
Profit growth – around 10% per annum for last 6 years
CAP (implied) – 0 years (if you assume terminal value at 10-12 times cash flow).

Basically the company sells for 7 times earnings. Current earnings are around 90 crores on a very low capital base. In addition the company has strong competitive advantage. So with a mcap of around 600 odd crores, the company will earn the current investment back in 5 years. The market is current pricing novartis with an assumption that the company will be out of business in 4-5 years.

I have given the two examples for illustrative purposes only. It does not mean that the stock will do well for novartis in the next few months or do badly for Crisil. But the above analysis is useful in making investment decisions.


Anonymous said...

Hi Rohit,

do u have the link for the book expectations investing....or we have to buy it.


Rohit Chauhan said...

i dont think the book is available online. you have to buy it


Anonymous said...

I think your estimate of crisil has come from query rather than actual looking into the numbers. The consolidated PE for Crisil is around 24 times one year forward..which is not really expensive considering the potential that the company has.. Novartis is simply not launching new products..exisiting products losing market share..not woth touching with a bargepole..Given a choice between the two CRISIL is any day better than Novartis...Different people different views.:-)

Rohit Chauhan said...

Hi anonymous

yes ..you are right ..the numbers for crisil are from icicidirect and not the consolidated numbers.

i have provided the two companies as an example only and not to indicate that CRISIL has lower potential. It definitely has higher potential than a novartis.

however one key point is how much the stock price discounts the potential, which is the main point of the post. higher the PE higher the future discounted by the market. So if you have do well in the stock, then you have to belive that the company will do better than implied by the stock price.

so you are perfectly right that crisil could grow faster than novartis. i am not sure that would automatically make the stock a better option at current prices though.