There are urban legends where startup deals were done on restaurant napkins. Can we do similar calculations for listed companies too?
There are few back-of-the-envelope calculations you can do on stocks too before you invest. We will explain some of these techniques of valuing companies with very limited data.
Fundamental analysts have the job to evangelize the future value of a company based on its history and future projections. It is common practice to estimate cash flows for the next 5 years when using balance sheet data.
Beyond 5 years, it is modelled as if the business goes on till perpetuity. This part is called the terminal value of a stock. What is interesting is that there is empirical evidence that perpetual value is about 70 percent of the value of a company. Hence, usually, the near term 5-year projections only account for 30 percent of the value.
Having looked at a forward-looking measure, let us now look at PE, a very popular historical indicator of value. PE multiples, tell you how many times the last 12 month earning are you willing to pay to own one share of such a business.
When a bank gives you a home loan, they typically give you 5x your annual income. For companies, we pay 18x on average. This should immediately make the case for entrepreneurship, but then that’s for another day.
We are now going to connect the dots above and illustrate this with a real case study as an example only. Let’s take the case of NELCO which is a Tata subsidiary. They are one of the few licensed in India to provide internet on flights.
They are about -35 percent from their lifetime high recorded in August 2018. Tata group also has other businesses like airlines and telecom that can give NELCO some industry advantage in terms of knowledge and management insights.
They are now trading at 34.5x PE. In other, we are prepared to buy a unit of earnings till perpetuity for Rs 34.5 as of today.
Leaving 70 percent of the value to terminal value as we explained above, we can approximately assign 30% weight to the near term valuation which is 30% of 34.5 or roughly 10, over the next 5 years.
To make it simple, we are now going to leave a lot of details like discounting by WACC, adjusting for tax efficiencies, industry dynamics, etc. and by sacrificing accuracy, create approximations for quick calculations.
So with that caveat, we can say for the next 5 years, every rupee in stock price should earn about 10 rupees of income combined. In other words, 1 rupee invested today should produce 10 rupee worth earnings in the next 5 years.
That needs an annual compounded growth of earnings of 60 percent. This is compared to the average 6% to 8% we currently get on an average to expected 15 percent average growth expected going forward in 2021. Hence, NELCO must do 4-5x better than an average Indian company.
However, if the terminal value was 70 percent of the value of this company when interest rates were higher by 1.5 percent, we need to adjust for that given interest rates have fallen.
So roughly a 25 percent reduction in the interest rate from 8 percent to 6 percent now, will shift about 1.25×70% to terminal value or about 85 percent. So instead of the next 5 years attributing 30 percent of the value, it would be reduced to 15 percent.
Then instead of Rs 10, we need to make only Rs 4.5 over the next 5 years to justify this price. Importantly with this adjustment, the compounded annual growth in earnings drops from 60 percent to 35 percent.
With earnings expected to grow 15 percent on average by many analysts, NELCO only needs to do 2.5x better. With a captive airline customer (Air Asia, Vistara, and possibly Air India) – it’s not impossible to think they might meet and exceed this target.
Hence, with simple tools and back of the envelope calculations, we can quickly see that we can make more rational decisions compared to buying stocks purely on sentiment.
We at Lotusdew run AI models that capture dominant bets in the market and we use them to create global portfolios in India, the US, and Europe.
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