• JULY 16, 2013

BHEL: Are the negatives fully priced in?

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.

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