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Where will you invest? - Views on News from Equitymaster
 
 
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  • Apr 17, 2007

    Where will you invest?

    Investor decisions are many a times guided by the media hype that surrounds the stocks and not solely on the back of fundamentals, as they actually should be. Do not believe us? Take a look at the fate of stocks that had the realty story attached to them. Still finding it a little difficult to believe? We suggest you take a few moments to see the financials given below of company A and B. And before you go further, make a choice of the company you would invest in based solely on the parameters given below.

    Financial Snapshot
    Particulars A B
    Sales (TTM) (Rs m) 121,034 165,221
    Total Assets 64,809 195,231
    OPM (TTM) 13.6% 38.1%
    NPM (TTM) 15.3% 20.6%
    Cash Profit growth over 5 years 2.5% 111.2%
    ROCE (TTM)* 64.0% 20.9%
    ROE (TTM) 61.0% 42.0%
    Cash Flow after capex and working capital changes 20,770 7,976
    P/E (based on TTM EPS) 25 42
    *RoCE=EBIT/TA-CL CY05/FY06 data

    Revenues

    The sales figures for TTM (trailing twelve months) are comparable for both the companies. However, what distinguishes them is the asset base that is used by the two to attain the same i.e. how productively is a company able to utilize its assets. The asset utilisation ratio of company 'A' stands at 187% whilst that of company 'B stands at 85%. Also the return on assets for company 'A' is higher than that of company 'B' indicating that it is able to utilize its assets more profitably.

    Profitability

    The operating profit margin of company B is more superior than that of company A, reflecting on its ability to keep in check its operating costs. It could also mean that many of the operating costs items are fixed in nature and hence as sales increase, they will lead to an increase in operating profits. Although the net profit margin of company B is better than that of A, one should also note that it is way below its own operating profit margin, indicating the presence of a high amount of depreciation expense and/or debt financing/interest cost.

    Return on capital employed is indicative of the return the company generates for its investors. Company A has got a much higher ROCE as compared to B indicating its ability to generate superior returns for the providers of capital. Also there is not much difference between the ROCE and ROE of company A indicating that it has low debt levels while the opposite can be said for B i.e. it has sufficient amount of debt on its books, which may also be causing its RoE to be higher than it actually should be.

    However, company B has been able to grow its cash profits 111% annually over the past five years. Despite this, given its high capex/working capital requirement, its cash flow generation remains very low. While it may be argued that company B is preparing for the future, the fact remains that predicting what will happen 3-4 years down the line always has some risk associated with it.

    Valuation

    As is evident from the P/E multiple, the valuations of company A appear to be far more attractive as compared to those of B. The company A attracts almost half the valuation of that of company B despite being a better performer in terms of asset utilisation and cash flow generation post capex and working capital requirements.

    Belling the cat

    Before you read the next few lines we would like you to decide as to which company would you prefer to make an investment in based on the parameters given in the table.

    Letting the cat out of the bag

    The two companies that we have just compared are very well known companies across the length and breadth of the country. While company A has been around for years, company B has emerged over the last decade or so. And before we disclose the names we would like to tell you that there may be other arguments that you may have to raise in case you have chosen B over A, but remember that despite all of them valuations would have a completely different story to tell. And while you may want to adjust them slightly to better reflect the other macros like growth potential, lifecycle stage of the industry in which the companies operate etc, the broader picture will still not change drastically. Well, the company A is an FMCG behemoth that goes around by the name HLL. Company B on the other hand, is just as well known and is also the country's largest mobile company Bharti Airtel.

    Coming full circle

    Investor decisions are many a times guided by the media hype that surrounds the stocks and not solely on the back of fundamentals, as they actually should be. Still don't believe us well then ask a friend of yours which company would he rather invest in Bharti Airtel or HLL. Chances are you will hear the former, of course there is a phenomenal growth story attached to it - no denying that, but what about the industry economics and valuations? We are not saying the company is bad, or does not have its fundamentals right - all we are saying that it looks expensive on a comparative basis and if you will merely block the noise out and focus a little bit more on companies that are equally good but not as 'glamorous' you will be making better investment decisions.

     

     

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