February 25, 2008

Reverse engineering the L&T stock price

I got the following comment from abhishek

Hi Rohit,

Using the same concept, dont u think L&T is a very expensive stock trading at PE of above 70.
To sustain this PE, how much growth it must show in the future?
Does this PE look sustainable?
If no, could u please help us understand this calculation by using L&T as an example?

Following is a very brief unpacking or analysis of the expectations embedded in the stock price. Is the stock undervalued?…that is your call

Caution: I have done a quick analysis and hence there are a lot of assumptions (such as net profit = Free cash flow) and shortcuts. i have not done a detailed analysis as the company does not pass my initial selection criteria

The stock sells at a PE of around 30 (assuming consolidated profits of around 3000 crs for the year. LY was 2250 Crs).

The ROE is around 30%+ and Debt equity is around 1:1 based on 2007 Balance sheet.

You can plug the following numbers in the spreadsheet – quantitative calculation – ROC and PE to calculate the embedded expectations

1. ROE = 30% (approximate). Use the DCF calcluations on line 88
2. Growth ~ 20% ( 5 year average growth was 50% per annum). This is clearly an assumption and one can play around with it
3. CAP – Take as 10 years. Again an assumption. Increase or decrease based on your assesment of competition and industry
4. Free cash flow = Net profit

If you plug the above numbers, the model throws a PE of around 36 (close enough!)

So the expectations seem to be

- Company will maintain an ROE of 30% or more
- Growth for the 10 years would be 20%. If you are more optimistic, increase the number and you will find the company is undervalued (as expected).
- After 10 years , L&T would be a 40 bn dollar company! , with net profit of 4.5 bn dollars (19000 crore)
So the stock market is discounting the above performance. If you think the company is undervalued you are saying

The ROE of the company will be higher than 30%
Growth with higher than 20% and hence 10 years later the company would be a much larger company, making the same margins and profits.

Suggestion: I have not done this, but look around for such EPC companies worldwide and check the size, growth and PE for these companies. That could give a hint how large and profitable L&T can get.

3 comments:

Dweep said...

Hello Rohit,
This is my first comment on your blog and i must say that you are both a good analyst as well as a good writer.
I am just starting off systematic fundamental analysis(thought i read balance sheets casually for many years)
Firstly disclosure that i own L\$T.
I can bet on L&T without calculating its intrinsic value, sole reason being its order book.It has got so many disclosed orders (and how many in process-only management knows!) that its likely to grow enormously.
Though i shall calculate its intrinsic value (i'll be a bit liberal) so that i can get an idea on which level to buy, but a buy for sure.
Pls give your views on this.

Rohit Chauhan said...

Hi dweep

thanks for the complement.

i think its a good start for investing to calculate the instrinsic value. however you seem to have made up your mind. my only suggestion is that the order book and growth are already priced in to some extent. for you to do better, the company will have to perform better than what's priced in.

that may very well happen. you just need to do the analysis and be comfortable with it

what will you realise over time is that intrinsic value for all the formulae and math,is still a very subjective exercise

regards
rohit

Nitin Rao said...

The efficiency and on time performance of L&T on many of it's projects plus considering it's such a good play on infrastrucure makes it hard to put down

Nitin @ My 2dimes