March 27, 2008

Mr Simpleton and Mr Hotshot Investor

Simpleton and hotshot investor are close friends. Simpleton is a small time businessman …doesn’t understand stock market much. But he knows cash is king. Hotshot is all into investing. Reads blogs like this, talks of DCF, PE, options, subprime and all that.

So one day Hotshot comes to meet simpleton and both get talking of business and stocks and all that.

Hotshot – how’s business?

Simpleton – ok …not too good though. You know that store I have. Used to do very well, but now with that new mall, business is not so good. Too much competition

Hotshot (all puffed) – So why don’t you sell it and put the money in stock market ? You know I made 5 times my money in the market in the last 3 years!!

Now this gets simpleton thinking ..here I am working hard and barely making 20% return every year and this cool dude is able to make so much money.

Simpleton – you study all this stock and business…you analyse all these big companies. How much should I sell my business for ?

Hotshot (opening his sleek laptop) – You know, I have analysed so many companies. I have this complicated spreadsheet. Just give me the numbers and I will tell you

Simpleton – let me see. Last year, I had sales of around 5,00,000 per month and I made around 50,000 per month after all expenses. I keep around 7,00,000 of inventory and I give some credit also. So I have a debt of around 3,00,000 per month. As of now I am having around 7,00,000 cash also in safe. Store is my own, so I don’t have to pay rent.

Hotshot – those are last year’s numbers. How much did you make year before that and last 5 years. I need all those numbers for my spreadsheet.

Simpleton – Around the same. I told you ..too much competition. But you know, I have some loyal customers, so last 5 years I have been making roughly the same. Maybe 3-4 % increase every year.

Hotshot (shaking his head) – not good, not good. No growth ..bad ..very bad. Why don’t you invest this cash some in high growth business

Simpleton – You know, I have not done any other business and I have been managing this store for last 15 years. So I don’t think I will be good at it. Actually, 5 years back I opened a chicken farm and lost all the money …you know bird flu !! . So whatever profit I make, I keep it as cash.

Hotshot (shaking his head even more now, lets out a sigh) – then you have to sell your business for 7,00,000. At best 10,00,000. See no growth, means no future

Simpleton (completely surprised) – what are you saying ? I have cash of 7,00,000. I have inventory, this store and all this good will !!

Hotshot (shutting down his laptop) – All that doesn’t matter. No growth …means no growth. If you cannot grow ..your business is worthless !! don’t believe me .. I will show big companies selling for peanuts because they cannot grow. I am not saying that …the stock market which has millions of intelligent people are saying that !

Simpleton cannot believe what hotshot is saying. How can it be true ? why should he sell his business for the cash he has in the safe ? If he sold his inventory and the store, he would make more money. But then he thinks ..the stock market must be smarter than him !!

11 comments:

Alok said...

Nice Story and how true in real life.
many unglamorous companies selling for much less than their worth.
At the same time, so called growth stocks getting valuations of 50 multiples over future earnings !!

However I presume in the long run, Hotshots(Bear sterns of the world?)loose out to Simpletons ie if simpletons stick to their core businesses.



Alok

Nilesh said...

Nice story man.

as story points out Mr simpleton could increase the value of his business (as perceived by Mr hotshot) by splitting to various subsidiaries like inventories, cash, real estate (store). a fantastic example of value unlocking through demerger as it is called in stock market jargon:)

Rohit Chauhan said...

thanks ..only difference is that for public companies selling at cash or very low valuation, a minority shareholder cannot unlock the value. he/she has to depend on the management to do that

Anonymous said...

Simpleton also doesn't depend on bigger fools to value his business:

http://indiaplay.blogspot.com/2008/03/bigger-fool-nation.html

Shankar said...

Hi,

I would suggest a reading of an excellent book by Wilbur Yegge - "A Basic Guide for Valuing a Company". The focus of the book is on valuation of small companies.

In the book, Yegge lays emphasis to a technique called the excess earnings method - a combination of assets held by the business and the intangible business value.

Two things are quite relevant -
a) The earnings multiplier used in a store like this will not be more than 5x (depending on the business)
b) The purchase price needs to factor in the financing options thrown by the buyer.

Warm Regards
Shankar
http://scrip-tures.blogspot.com

Rohit Chauhan said...

Hi shankar
thanks for the book recommendation.

some thoughts -

I think 5x is too low for a business. it equates to a 20% yield. i assuming that we are not considering the cash (which is surplus).
unless the asset is very specialised and does not have alternative uses, a 5x multiple would give the investment back in 5 years without growth.

I would value a non growing cash flow at 10 times aleast considering the risks involved. all this ofcourse for a private business where one has control on the free cash flow.

in the public companies if the management is blowing away the cash or destroying the company, even 5x may turn out to be excess

Shankar said...

Hi Rohit,

I can understand when you say that 5x is very low for the business. Here's my take.

I value this business in 2 parts (just like Yegge says in his book)

Part 1 : (Earnings)

When we say 5x, we are obviously referring to the price-earning ratio. Repeat : price-EARNING i.e. the price we are ready to pay for a business earning 1 rupee of profit. So, when it's 5x - it means, we are paying 5 rupees for the business's ability to reward that capital with 1 rupee of profits.

Part 2 : (Assets)

The other aspect is the value we'll put for assets in the company, which can be tangible or intangible. Lets me take 3 distinct examples to illustrate this -
a) Cash - a rupee of cash is worth a rupee of cash. There is no appreciation on cash. So i'll value it at phase value
b) Loans and advances - Every loan given to a customer or supplier has a risk of default attached to it. A buyer will evaluate this risk before attaching a value to it.
c) Patents and licenses - Intangibles but they are precious.

So, I was the buyer and evaluating the business - I will catagorize my valuation into 2 parts.

Just another point - I dont know what product this store retails, but this is another important distinction point. E.g. lets say the business we are valuing is a dentist clinic. Now, would we like to pay 10x for such a shop post which the dentist is free to leave. Ofcourse, NO! because the dentist carrries with him a certain skill and a loyal client base.

This has been the bane in valuing small companies. Without scalability and replicability, assigning a multiplier is almost impossible on the basis of existing cash flows.

Warm Regards
Shankar
http://scrip-tures.blogspot.com

Rohit Chauhan said...

Hi shankar
great points. I would add surplus capital to part 1(earnings) based valuation.

The multiple 5X or more is a much more difficult question. It can be low if the company is doing well and has some competitive advantages. however 5x can be high in some cases as you point where the company is not scalable.

In some cases i think it is just not possible to confidently value the company at all ..out of circle of competence ? ..i tend to not proceed further in such cases

regards
rohit

Amit said...

Rohit,
Hospitality sector seems to be out of favour these days. I have picked Hotel Leela from this sector. As i am new to value investing, i wanted your view regarding its attractiveness at the price of Rs 40. Also how do you calculate the intrinsic value of stock?

Amit

Rohit Chauhan said...

Hi amit
i havent checked hotel stocks for quite some time, so i cannot comment.
i will be publishing a post on calculating intrinsic value soon. however various ways are listed in valuation template spreadsheets i have uploaded in the google group

Shankar said...

Hi Amit,

I find Hotel Leela Ventures a great stock to have. I bought over 1500 shares at Rs. 61 .. see no harm in accumlating more.

My post on this is featured in :
http://scrip-tures.blogspot.com/2008/01/hotel-leela-ventures.html

The business offers a significant moat (as building hotels take time). More importantly, an additional moat in terms of brand-name exists with Leela. The demand-supply situation favours hotel companies, and amongst them Leela has one of the lowest valuations.

Warm Regards
Shankar
http://scrip-tures.blogspot.com