X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
The Mid Caps that pass the 'One Rupee' test - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Sep 12, 2011

    The Mid Caps that pass the 'One Rupee' test

    Warren Buffett is not just one of the greatest investors ever. He is also someone who can qualify as a prolific writer. Anyone who has gone through the great man's writings over the years can testify this. Of course, there is a wealth of investment wisdom in his works. But there is perhaps hardly anyone who has more clarity of expression and simplicity in his writing than the Oracle of Omaha.

    A good illustration of the simplicity of thought could be found in his idea of a good investment candidate. A stock is a good investment candidate according to Buffett if every dollar invested in the business generates at least one dollar throughout the business' lifetime. In other words, Buffett says that our job is to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.

    Clearly, there cannot be a simpler and more precise definition of a good investment than the one mentioned above. Simply put, it means that a stock is a good stock if the underlying business generates higher return on equity (ROE) than the cost of capital for a sustained period of time. Thus, if the business reinvests most of its earnings, those earnings should also generate return on equity than the higher cost of capital. If that is not the case, the total return on equity will eventually come down and the stock will stop being a good investment.

    Say for e.g. a business has a net worth of Rs 100 and an ROE of 20%. Also assume the opportunity cost of capital to be 15%. Thus, if this business keeps on generating ROE of 20% forever and does not invest a single rupee back into the business but rather pays out as dividends to shareholders then the intrinsic value of this business is said to be Rs 133.3 (20 divided by 15% which is the cost of capital). Therefore, as can be seen, every rupee in the business is worth Rs 1.33. Naturally, this is a good investment as per Buffett because one rupee has created a market value of Rs 1.33.

    Now, assume that the same business does not choose to pay back all its profits but wants to invest some money back into the business. It should be noted that as long as the profits which are invested back into the business generate an ROE of at least 15%, they should be allowed to be reinvested. But if the ROE on this incremental capital is less than 15% then a sustained reinvestment of such sort can eventually take down the total ROE to less than 15%. Thus, in this case, in the long run, one rupee of money invested as equity back into the business may not eventually translate into at least one rupee of market value.

    The above explanation can have profound implications for the way we invest. Investors most often are lured into believing that companies that witness the highest earnings growth are considered to be good investments. But if the profit growth takes the overall return on equity of the business down to less than the cost of capital, then that business has destroyed market value and not created it.

    Also, doubling of share price is no proof that the investment is good business. What needs to be found out is the fact that how much money has been added to company's net worth to bring about the doubling of share price. If net worth has increased by Rs 150 and market value by Rs 100 then it is no use.

    Thus, the most important factor while analysing the company is the 'one rupee' test as highlighted above and not the growth in earnings per share. Only if the business has generated more than one rupee of market value for every rupee invested over a long period of time, it should be considered as a potential investment candidate.

    Now, let us try and perform this so called 'one rupee test' on the BSE Mid cap universe. In other words, we will have a look at those Midcaps that have provided the maximum bang for the buck in the last five years. This is to say that for every one rupee increase in the net worth of these stocks, what is the market value that the investors have assigned to them. It is important to add here that we have considered only those stocks where the average Debt to equity ratio (D/E) in the last five years has been less than 0.5 times. This is because increasing debt could be the best way to increase ROE but increase beyond a certain debt to equity ratio makes the stock a speculation rather than an investment and we are only concerned with the latter.

    Out of the more than 250 stocks that we have considered from the BSE Midcap index for our study, only about 75 managed to pass the 'one rupee test' i.e. not only did these stocks generate more than one rupee of market value for every rupee increase in net worth but they managed to do it by keeping the average D/E ratio less than 0.5 times. The list below presents the top 20 such stocks.

    Name Increase in net
    worth in Rs m (A)
    Increase in market
    value in Rs m (B)
    Value created for
    every Re. 1 invested (B/A)
    Eicher Motors 439 26,239 59.7
    Astrazeneca Pharma 380 16,283 42.9
    Zydus Wellness 1,213 22,900 18.9
    GSK Consumer 4,173 73,816 17.7
    Clariant Chemicals 586 10,318 17.6
    Abbott India 596 9,736 16.3
    P&G Hygiene and Healthcare 2,620 38,597 14.7
    Gillette India 2,228 32,509 14.6
    CRISIL 1,997 27,406 13.7
    National Fertilizers 3,014 37,775 12.5
    Emami 4,538 48,535 10.7
    Jagran Prakashan 1,895 17,593 9.3
    Gujarat Gas Company 4,066 35,444 8.7
    Kansai Nerolac Paints 4,059 30,843 7.6
    Bayer CropScience 3,415 25,763 7.5
    Info Edge (India) 2,469 17,912 7.3
    Wyeth 1,281 9,266 7.2
    Pidilite Industries 6,518 46,995 7.2
    3M India 3,156 20,705 6.6
    Rallis India 3,817 22,545 5.9

    Source: Ace Equity
    Note: Standalone figures


    Please be informed that the top few numbers look improbable in the future as they seem to be the result of some one time equity restructuring or other such one off effects. In fact, we believe that the numbers towards the end and in single digits are more likely to be maintained in the near future. Even if they do come down, the value created in these cases is expected to remain more than one for every rupee invested in the long run. Investors should keep an eye on such companies.

     

     

    Equitymaster requests your view! Post a comment on "The Mid Caps that pass the 'One Rupee' test". Click here!

    3 Responses to "The Mid Caps that pass the 'One Rupee' test"

    DG

    Sep 15, 2011

    Can I know what is the period selected for the above study?

    Like 

    Brijesh Trivedi

    Sep 13, 2011

    Great article. Proud to be an Eq Master subscriber. Really
    appreciate last few articles and the effort put in by your
    team to bring into notice the good companies to the
    investor community.

    Like 

    S.Sridharan

    Sep 12, 2011

    Pl note that I am seeing and appreciating your labour of
    selecting the Mid Caps that pass the `one rupee' test

    I am very much thankful to your Team for this Great
    Service.

    Regards.

    S. Sridharan

    Like 
      
    Equitymaster requests your view! Post a comment on "The Mid Caps that pass the 'One Rupee' test". Click here!
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    Which Gods Will Bring Down the US Empire? (Vivek Kaul's Diary)

    Aug 17, 2017

    Mr Trump is in the White House and the gods are in their heavens; what's not to like?

    Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

    Aug 16, 2017

    All across the country, the old gods become devils. New, gluten-free gods take their places...

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

    Aug 4, 2017

    The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 17, 2017 (Close)

    MARKET STATS