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Don't pay more than book value for these firms

Jul 10, 2012

How would you define a minimum expected rate of return? Well, there is no universally true answer for this. The number would mostly depend upon the inflation rate prevailing in a country. And also the asset class under consideration.

For e.g. a five percent return on an investment in India would be considered grossly inadequate by Indian investors. For it does not even cover the rise in inflation, that until recently was as high as 9%-10%.

However, the five percent return would be more than satisfactory for a person in the US where the official inflation figures are barely above 2%-3% or may be even less.Secondly, a return of 10% on a bond investment in India can be considered good enough. But if the same return were expected of a stock, it would again be inadequate we believe.

Stocks are riskier than bonds and hence, to cover the extra risk, the expected returns should also be higher. Something in the range of 12%-15% will be more appropriate for stocks we believe.

This isn't a very complicated rule to follow, isn't it? But we routinely encounter cases in stock markets where people price stocks in such a way that returns expected of them end up being much lower than bonds.

Take the example of the firms in the table below. Assume for the sake of this article that your expected rate of return from a stock is 15%. Thus, what book value multiple would you be willing to give to a stock where ROE (Return on Equity) has averaged not more than 15% over the past five years? A maximum price to book value of 1x, isn't it?

CompanyLast 5 year avg RONWP/BV*
Asahi India Glass Ltd.2.4 6.31
Sunteck Realty Ltd.4.4 6.06
Vakrangee Softwares Ltd.13.7 5.27
Shoppers Stop Ltd.4.9 4.70
Dr Reddys Laboratories Ltd.13.3 4.16
Tata Coffee Ltd.11.1 3.88
Hexaware Technologies Ltd.12.2 3.80
Apollo Hospitals Enterprise Ltd.11.1 3.72
Oberoi Realty Ltd.8.6 3.52
Reliance Industrial Infrastructure Ltd.14.7 3.51
Source: Ace Equity, BSE 500 universe, standalone numbers
* Price as on 6th July 2012(Banks, holding companies and firms with negative numbers have been excluded)

Anything more than that and your effective returns will come down to less than 15%. Of course, one would argue that the higher multiple is justified because unlike bonds, earnings of a firm keep growing.

But this is a flawed assumption to make. Please bear in mind one of the most important tenets of investing. Growth in earnings is meaningful if and only if the return on equity of a firm is higher than the investor's expected rate of return. In other words, for firms those have a maximum ROE of not more than 15%, growth in earnings is not meaningful as the expected rate of return is also 15%.

Thus, the maximum price to book value multiple that one would be willing to pay such firms is at the most 1x. This is the case irrespective of the growth in earnings. Investors, like the ones invested in the companies mentioned above are making a grave mistake by assigning higher multiples to stocks where average RONW over the past five years has not exceeded 15%.

Of course, they would be under the delusion that RONW could go up going forward thus justifying their investments. But the effort of investing in companies that consistently earn ROEs above the returns expected of them, i.e. 15% in this case, is paid off much handsomely in the future we believe.

Rahul Shah

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.

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