Will Your Company Be Around a Decade From Now? - The 5 Minute WrapUp by Equitymaster
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Will Your Company Be Around a Decade From Now?

Dec 2, 2015
In this issue:
» Banks to see better credit demand ahead
» RBI working to transmit interest cuts better
» ...and more!
00.00
Devanshu Sampat, Research analyst

The discounted cash flow (DCF) is a simple yet powerful tool to gauge company valuations. But as easy as it is to build, it's just as easy to get it wrong. According to Curtis Jensen from Third Avenue Management, 'Discounted cash flows to us are sort of like the Hubble telescope - you turn it a fraction of an inch and you're in a different galaxy. There are just so many variables in this kind of an analysis - that's not for us.'

Here's a quick introduction to DCF for the uninitiated. As you would already know, a value of a company is worth the present value of its future cash flows. To arrive at future cash flows, one needs to make two broad assumptions.

The first assumption concerns a projected period. The second concerns 'terminal value'. Terminal value is the value of the future cash flows (in perpetuity) that is calculated after the projected period. For example, if cash flows are projected for a ten-year period (the projected period), the terminal value is calculated on cash flows after the tenth year until perpetuity. These results are added together to arrive at the company's present value.

The key inputs for this model are growth rates (for both phases) and the discount rate. The latter is the required rate of return for an investor.

Proponents of value investing are quite divided on this valuation tool, but we're not here to debate today. The point is that the staying power of a company matters.

Let's dive right into it...

Suppose ABC is a high growth company. Its cash flow for the current year stands at Rs 100 million. The company has developed a new product, which is mind bogglingly amazing. It has completely disrupted the market. As their product introduces a completely new category to the market - one with massive potential - the company is expected to grow at a scorching pace of 25% per year for the next decade. All else being equal, the cash flows would grow at the same pace.

Post this ten-year period, the expectation is that the market will become saturated. Thus, growth would be in line with inflation levels. Let's assume it to be a comfortable figure of 3%. The discount rate assumed here is 15%.

Now, here's a question: How much of an influence will the ten-year, high-growth phase have on the overall value we arrive at?

I wouldn't blame if you thought it would have a major impact. However, you would be wrong. Its weightage would be about 45%. The balance 55% of the value is dependent on how the cash flow will behave a decade from now, i.e. the value it derives through its 'terminal value'.

Here's a chart to put things in perspective...

What Influences Business Value?

In the chart above, the X-axis represents growth during the projected phase. The Y-axis represents the weightage of the total value.

As you can see, as the growth rate increases, the weightage of the terminal value rises. The slower the growth rate, the more the influence of the projected period.

Mind you, the results have a lot to do with the discount rate. If I assume the discount rate to be 8% (unlikely for Indian equities), then the weightage shifts more towards the terminal value. And if I up the discount rate to 20%, then the weightages shift significantly in favour of the value derived from the 'projected phase'.

This becomes obvious as every Rupee loses more of its value as time goes by; as such, the inflows up front play a strong role in influencing a company's value.

Nevertheless, using such high and low figures would defeat the purpose. As a research house, we believe discount rates should be in the range of 12 to 15% - average figures calculated by doubling the post-tax (average 30% income bracket) G-Sec yield and the long-term returns of the equity indices.

This analysis shows that a major portion of a company's value is derived from surviving in the long run. Allow me to a quote from a previous edition of the 5-Minute Wrap Up:

  • Rather than focusing too much on the output of such models (referring to DCF here), investors should devote time in understanding the business. This time can be more fruitful. It can enable investors to arrive at a better investment decision without being subject to the vagaries of forecasting errors.

Investors would do well to focus their energies on determining whether companies have the staying power to be in business many years from now.

What attributes should you look at to gauge whether a company will be in business many years from now? Let us know your comments or share your views in the Equitymaster Club

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02:25 Chart of the day

The economy is witnessing some recovery as reflected in the GDP growth rate. After growing by 7% in the June 2015 quarter, the GDP rose a tad higher at 7.4% in the September 2015 quarter. And the pick-up in the economic output has been on the back of a smart 9.4% jump in the manufacturing output. This spells good news for the banking sector that has been reeling under slow credit off take and rising bad loans. Since the Industry comprising of Micro & Small, Medium and Large players is the largest borrower having more than 40% share of the outstanding bank loans, a pick-up in manufacturing should translate in to better loan growth.

However, numbers suggest that the banking industry is yet to reap the benefits from the recovery in manufacturing output. During the first seven months of this fiscal, the deployment of bank credit to industry contracted by 0.3% as compared to a growth of 0.7% in the year-ago period. In the industrial sector, barring a few such as infrastructure, metals, drugs & pharma and petrochemicals, credit offtake by all the other industry groups has contracted during the period April-October 2015.

On the positive side, growth in personal loans and borrowings by the services sector has accelerated as compared to the year-ago period. These two sectors account for 20% and 23% of the outstanding bank loans. Thus along with an uptick in the manufacturing sector, the banking industry is likely to witness better credit demand in future.

Manufacturing revival eludes credit offtake
03.45

The Reserve Bank of India has been at loggerheads with banks for not fully transmitting the rate cuts. The central bank has reduced interest rates by 1.25% so far in 2015. But as per the RBI governor, less than half of this reduction has been passed on by the banks in the form of base rate cuts. The highest rate cuts have been by SBI and HDFC bank that have slashed base rates by 0.7% and 0.65% respectively in 2015.

And one reason for the poor rate cut transmission by banks is the long tenure deposit. Since these deposits do not come up for repricing in the immediate future, the average cost of funds remain high making banks reluctant to cut rates. And to get around this problem, RBI has asked banks to use the marginal cost of funds while pricing incremental loans even as historical loans will be priced on the base rate. Since the marginal cost of funds is based on the latest interest rate payable on current, savings and term deposits, the rate cut is likely to be passed to the borrowers much faster.

04.45

At the time of writing, the Indian equity markets were trading weak with the Sensex down by about 95 points or 0.4%. Stocks from the mid and small cap segments were not in favour as well as their representative indices were down by 0.3% each. Stocks across sectors were trading weak with those from the banking and information technology spaces leading the pack of losers.

04.55 Today's Investing Mantra

"If you don't study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst) and Madhu Gupta (Research Analyst).

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