Strictly for the intellectuals..cash flow analysis

Also would anyone like to add some contribution to free cash flow... which forms the crux of cash flow analysis.... which ratios of free cash flows would u like to analyse.... because these are the ratios that a broker or hotshot analyst wouldn't want the public to know as they will unearth skeletons

 

First of all, it is not any one element that goes into taking a decision to either buy a stock or to hold on to a stock.

The analysis framework to follow depends on each person. Personally, for me it is :

At the stock level
1. Revenues greater than INR 500 Crores
2. Revenue growth not less than 15% year on year for last three years
3. Operating margin not less than 18 - 20%
4. Net Profit not less than 15%
5. ROE greater than 18%
6. ROCE greater than cost of capital by at least 8%
7. Operating Cash flow positive and growing year on year
8. Net cash position growing unless there is clear evidence of constructive investment
9. Operating margin growth greater than rate of growth of interest cost
10. ROA greater than 18%
11. Growth funded through a mixture of debt and internal acruals and only rarely with equity dilution
12. Debt / Equity Ratio well under control

So while cash flow analysis is one part of the story, by no means is it the whole story. In the end, you look for industry attractiveness, company attractiveness ( business opportunity size + management ability ) and share price attractiveness. For each of the three there is a mixture of numerical and qualitative analysis needed.

No wonder making money in the stock market is not as easy as we imagine it to be.

 

Super analysis. Very good learning experience.

 

Also the three most important lines in stock market investing...MARGIN OF SAFETY...

 

Now let's assume a hypothetical situation... A company is meeting most of your above criteria but has following problems...
1) company is young and has around 500 to 600 crore revenue..
2) Growing exceedingly fast say a cagr in revenue of >25%..
3) has a ROE AND ROCE OF 25% since 3 years BUT most of the capital employed is via debt and controlled dilution of equity (since company is micro cap)
4) has plans to still expand so that it wants to expand its revenue to 1000 crores in say 3 years..
5) spending some money on advertisement..
6) management integrity is not clear.. (may be or may not be honest)..
7) available at forward p/e of 3 or 4 when company will churn out a revenue of 1500 crore... trailing p/e of say <10..
8) d/e ratio of 1.5 or more.. but mind u company is young .. and also company has an excellent debt /burden ratio...
Would u invest... or are there some more issues u would like to see... like, is the company burning itself up by super rapid growth...
How will u know the company may become a future superpower or a dud...(In the sense it will sink under its own debt)..

 

I don't like to see too much debt in a company. That is a always a red flag for me. The other key aspect to look at when analysing rapidly growing firms is the organisational structure. Can t he firm absorb all the growth and deliver ? Or will lack of delivery at the higher levels lead to non performance and hence sub optimality. Here is where the track record of the management is fundamental and the ability of ownership to put in place a structure for the future becomes key. Key signs to watch for are if management guidance on earnings are always met. If they achieve any milestone they set for themselves or not.But too much debt is always a red flag.

 

Excellent ..! Management guidance and meeting their guidance on key things must be the core matter to understand about the management ...

 

How comfortable are u people with debt....how much do you think u can allow the debt / equity ratio to stretch.. 1 or 1.5 or are u investing in companies with a d/e of <0.5.... can u give examples of reputed companies with stretched d/e but still doing well.... I can give one CEAT..It had a d/e of 1.08 before June quarters... but after a super quaterly result it bought the debt to 0.3 ...

 

When Reliance Communication was born it was an almost zero debt company. Anil Ambani kept Tom tomming this and that he could take on debt as his b/s was clean. Everyone loves leverage, especially owners. But this lulled the group into complacency and over time the debt burden has crushed them.

Like in all things, it is good in measured quantities. Debt aversion makes no sense since one loses leverage. But debt fuelled growth always ends badly. Personally, if there is two parts equity and one part debt, I like that.

 

Hi,

Your point 6 : ROCE doesnt consider cost of capital for what it reflects is how efficiently is total capital being deployed (common equity plus debt) and is a very important ratio to consider in conjunction with ROE ( which has only common equity) and which if looked in isolation may ignore that the company is highly leveraged.

Its the concept of EVA which truely considers cost of capital ( including an attributed charge for common equity). Companies with positive and growing EVA's are the true gems for its they which create shareholders value and which the market rewards through MVA ie shareprice appreciation.

My intent is not to belittle the importance of ROE and ROCE. These are amongst the most important readily available performance parameters (EVA's is pretty complex and i believe is not publicly available)

 

Like banks which is purely based on leverage play... hence we are supposed to assess return on assets... and can u expand EVA plz...

 

Oh for banks the debt equity ratio is never used. but they have some prescriptions around reserve requirements, minimum capitalisation, capital adequacy ratio, structural liquidity monitoring and various other do's and dont's. So its not pure leverage

So banks remain tightly regulated with high entry barriers.

EVA is EConomic Value Addition aka Economic Capital and in simple terms Is net operating profit less weighted average cost of capital

So for example if a company total capital is say 100 (40 equity and 60 debt and their respective cost is 12% and 8%) the weighted cost of capital is 9.6%. so if the company profits are more than 9.6 then its has positive EVA ie creates shareholder value. But say if its profit is 8 then whilst it has a ROE of 20% it still doesnt generate economic profits

 

Aka economic profits and not economic capital

 

And yes common equity has an inherent and intangible cost unlike debt which has a real pnl charge ( interest expense on debentures)

And guess what - common equity is more often than not the most expensive source of capital

 

Can u break up the explanation of EVA a little more could not get ur example... suppose a company has employed 100 rs capital (to simplify things ) out of 100 rs 30 has come from retained earnings.. 40 rs via equity dilution and 30 via bank loan.. how to calculate EVA?.. and also in ur above example is 40 rs retained earnings( if so how can it be charged with 12%interest... ) I got lost there..

 

Also in my above example of 100 .. where 30 rs is via bank borrowings.. let's assume company has to pay up interest of 10% per annum... and roce of the company is 30%.. but profit generated by the company has to be used to pay the interest as well... so how to calculate EVA here...regards

 

If ROCE is 30% then EBIT is 30. Interest expense will be 3.PBT is 27 and if tax rate is 30% then PAT is 18. (assuming tax of 9)

Reserves in your example will be treated as common equity. Say the cost of common equity (shareholders funds) is 12% ( i will explain why shareholders fund seperately) the the weighted average cost of capital is

70x12% plus 30x7% ( post tax cost of debt) = 10.5% (hurdle rate)

NOPAT = 21 (EBIT less tax)

EVA = NOPAT less total capital x hurdle rate

EVA = 21 - 10.5 = 10.5

 

So do you think that equity and reserves is free money? If you think it is then you are wrong. Usually it is more expensive than debt ( from a perspective of assessing true performance)

Say for instance a friend appraoches you to invest ( as equity) in his business proposal. I am keeping this absolute simple ok. So will you give him the money for free or without any expectation? I suppose not right. Say at the time of you giving him the money you tell him that you expect a return of 15% on this money investment.

Can your friend be carefree and start thinking that he has got interest free money ( because it is shown as share capital on the business's balancesheet?

What if he earns on a return of say 10%, 11% and 12% in the first three years.... Will you be very happy and dance with you? I suppose not because he has not matched your ( shareholders) expecatation.

If he earns only 15% in each of the three years then he just meets the expecatation

But if he earns 16%, 17% and 20% return then and only then does he not only meets your ( shareholders expectations) but also creates shareholder value of 1%, 2% and 3% in the three years respectively. This 1, 2, and 3% is the EVA. and how did we arrive at this 1,2 and 3% - its tge return earned ( accounting profit usually) less an 'imputed/notional charge of 15%' ( 15% being your (shareholders) expected return and why notional - because its not a real charge in the business pnl because its on equity)

Hope this gives you clarity

And companies with positive EVA's see continous share price appreciation. So all things same between two companies, the share price of company with positive EVA will show more appreciation than the one without positive EVA

 

VERY EXCELLENT EXPLANATION.

 

Hi so 70 *12%+30*7%= hurdle rate...
So here 70 is common equity (retained earnings+share ) 12%is cost of common equity..
30 (is EBITA) 7% ???
In this regard I have 2 questions how did u arrive at 12% being the cost of equity... and what is this 7%..
Also add a note on post tax cost of debt... regards