BHEL: Are the negatives fully priced in? - Views on News from Equitymaster

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BHEL: Are the negatives fully priced in?

Jul 16, 2013

A BSE-Sensex constituent. A rock solid balance sheet. Dividend yield of nearly 3% and a dominant market position. If you stack up these factors, it will be hard to present a case of not making an investment in the stock. However, investors do not seem to be doing the same with respect to Bharat Heavy Electricals (BHEL), the firm we are talking about.

32%. That's how much the stock has lost from its 52-week highs. In fact, go back to the 2009-10 days and the stock has crashed more than 50% from those levels. All this for a firm that was touted to be one of the foremost beneficiaries of the power story in India. However, with the power story ending up in tears, the fate of investors who'd bought into the stock in recent years has been no different.

Intrinsic value: Easier said than done

Thus, with the stock making new lows, the question that begs itself is whether all the negatives are now fully priced into the stock. Theoretically, the answer to this question is pretty simple. All that one needs to do is find out the intrinsic value of the stock and then figure out whether the stock is trading at an appropriate margin of safety to the same. And if the answer is yes, short movements be damned, one can clearly go ahead and buy the stock for the long term.

Sadly, the theory does not apply itself quite well in something that is as fuzzy as the valuation of a stock. Of course, valuation is nothing but the value of all the cash flows that the firm produces over its lifetime discounted by an appropriate discount rate. But ask 100 different people to use this formula and you are likely to get 100 different answers. Simply because one needs to make predictions to arrive at an intrinsic value and these predictions can be highly subjective. Even more so for a company that faces as uncertain a future as BHEL.

So, what is the investor to do in such cases? Fortunately, there does exist a way around this problem. Of course, it does not lead to pin point precision but certainly makes our task a lot easier.

The theory of inversion

Well, the solution answers to the name of inversion. Usually, we arrive at the intrinsic value of the stock by performing a DCF or some such sort of analysis. What we do with the technique of inversion is reverse the problem. In other words, we use the current stock price as the starting point and then try and figure what cash flows the market is expecting the firm to generate over its lifetime. And if we feel that the market is being too conservative and that the stock will easily earn more cash flows than what the stock price implies, we go ahead and buy the stock.

What does a similar analysis for BHEL lead to? Well, let's try and figure out. But first we will have to make certain assumptions. Let us assume a discount rate of 12% and also that after the first 10 years, the stock settles down to a growth rate of 4% for arriving at the terminal value figure.

Our calculations suggest that for the eight years leading to the year FY12 (FY13 annual report is still not out), the company had an average cash flow to net profit ratio of 50%. This cash flow is after accounting for working capital needs and also the capex.

Thus, if this ratio were to hold true in the future as well, all that the cash flow of the company has to do is grow by 4% over the next 10 years and then again keep on growing at the same rate on a perpetual basis to justify the current stock price of Rs 186 per share.

However, if we assume the margins of the company to fall and cash flow to PAT ratio to go down to 30%, then the cash flow growth that is required for the next 10 years to justify the current stock price goes up to as much as 11%. In other words, the cash flow will have to grow at 11% CAGR over the next 10 years and at 4% on a perpetual basis 11th year onwards to justify the current stock price.

A great tool to have

Whether the cash flows will grow by that much and what cash flow to net profit ratio to consider can only be arrived at after doing a detailed analysis on the company and its fundamentals. However, what this method of inversion does is it takes a lot of subjectivity out of the equation and helps one take a balanced view of things.

After all even Peter Lynch was referring to this method when he said that PE ratio is nothing but the no of years it takes for the company to earn back one's initial investment i.e. the price. Thus, if PE is 10, it will take the earnings to take 10 years to earn back the price if the earnings remain constant.

Thus, the idea is to use the technique of inversion on a lot of companies like BHEL and try and find out whether the market is too pessimistic or optimistic on them and thus, get an edge over other investors.

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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6 Responses to "BHEL: Are the negatives fully priced in?"

K Swaminathan

Sep 22, 2013

Mark my words bhel stock would touch Rs.80 in two months

Like (2)

Dr Rajeev Kapur

Aug 6, 2013

Mr Rajendran T. You can only pray and hope that BHEL does not sink below 100. See how the mighty have fallen! The carnage at Dalal street today has toppled many Blue Chips. All engineering and metal giants are biting dust. All the analysis based on PE, RONW, ROE, DCF, DUPONT Analysis, Sell-Buy limits, Enterprise value etc fails in front of market sentiment. With impending general elections and the inability of the govt to stem the downfall of INR vs USD one is tempted to get out and salvage whatever is left. If you can hold the loss and have patience to ride out the rough you can hoe to recover some loss after two years or so.

Like (1)

sivakumar

Aug 3, 2013

It is not a wise decision to invest in BHEL now or in the next 3 to 4 months to come. Hope you have gone through the quarterly results announced on 3rd August. BHEL is set to crash down and will remain neglected for a long time from now. Government has to infuse vim and vigour into BHEL through broader policies but this may not happen in the near future.

Like (1)

Equitymaster

Jul 26, 2013

With reference to your query, please note that since this is not a forum for stock recommendation, we have refrained from giving our view on the stock. However, since you are a lifetime member, you can always check out our latest view on the stock by looking into our most recent communication on the stock. We stand by that view and any change in our stance will be notified to all our subscribers.

Like (1)

Senthil kumar

Jul 17, 2013

In the aforesaid analysis it appears that if cash flow to net profit ratio of 50% remains the same in the foreseeable future it is a definite buy. But if the ratio is taken as 30% then it totally depends on the revival of the economy and BHEL's continued dominance albeit to the lesser extent so we can buy at this price.
But is it India Growth story will be there without power sector revival?

Like (1)

Rajendran. T

Jul 17, 2013

I am holding 460 shares of BHEL bought in 2011 and my average purchase price is 305.51. What should I do now
The above report on BHEL is not clear to me.

I am a lifetime member of equitymaster

Like (3)
  
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