My Back of the Envelope Valuation for BPCL & HPCL

Feb 19, 2024

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My Back of the Envelope Valuation for BPCL & HPCL

I believe all of us would agree that our parents and grand parents excelled at making pretty accurate back-of-the-envelope calculations.

Take my mom for instance. She managed the household budget for years by resorting to just a few general calculations.

There were no hundreds of rows for each line item and everything on the expense side was rounded off to the nearest multiple of 10 or 100. All she needed was a few minutes every month and voila, the budget of the house was done and dusted. It worked remarkably well to be honest.

I often used to ask her to get more scientific in her approach and bring in more precision. However, the appeal fell on deaf ears all the time.

She was of the view that scientific rigor and precision may be required in the engineering and design of complex structures. However, for something as mundane as household budgets, a back of the envelope calculation works just fine.

Does back of the envelope calculation work in a field like investing as well? Or is it a field where one is required to apply scientific rigor and precision?

Well, if you look at all the great investors like Ben Graham, Warren Buffett, and Peter Lynch, I don't think any of them applied complex mathematical formulae to evaluate their investments.

If the stock appeared expensive based on simple ratios like PE or price to book, they simple walked away. They never tried to get more precise with their calculations.

In fact, here's what Ben Graham once quoted about using higher order mathematics in the field of stock picking.

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  • In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.

    Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

In other words, keep it simple. If someone is trying very hard and using complex mathematics, he is simply trying to speculate in the garb of an investment.

I think Benjamin Graham has hit the nail on the head.

Allow me to show how you can use a simple back-of-the-envelope calculation to decide whether a stock can be considered for investment or whether it should be rejected. Please note that this is not a recommendation. It is only a tutorial to help you understand the concept better.

The stock that I have shortlisted for this exercise is none other than the oil refining and marketing giant BPCL. This stock has been shortlisted based on its recent popularity and the stellar bull run and nothing else.

You see, BPCL is an oil refining and marketing company whereby it takes crude oil as the raw material and makes it go through a series of steps and processes to produce different fuels like petrol, diesel, aviation fuel etc.

It then sells these fuels through its own marketing network and through tie ups with different entities.

Of course, since BPCL is an oil PSU and since oil is a political hot potato, it is subject to Government interference in the way it prices its products and allocates its profits. Not just that, the business is also quite sensitive to geopolitics outside of India's borders, almost all of which are beyond its control.

Hence, the uncertainty with respect to the profits it generates is high to that extent.

This is also reflected in the company's historical performance where profits had crashed to Rs 21.3 bn in FY23 after coming in at a huge Rs 117 bn the previous year. In fact, for the trailing twelve-month period, the profit has jumped to a staggering Rs 289 bn.

Having said that, if you look at the company's bottomline over the last few years, Rs 100 bn seems to be its earnings potential on a conservative, realistic basis.

As I just highlighted, profits had dipped to a mere Rs 21 bn in FY23 and have also gone as high as Rs 289 bn. However, these seem to be outliers with the normal earnings power being in the region of Rs 100 bn based on its historical performance over a 7-8 year period.

Thus, with Rs 2.13 bn shares outstanding, this translates into an EPS of around Rs 50 per share.

In other words, BPCL can be relied upon to earn an EPS of around Rs 50 per share in a normal year.

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Now, what kind of a PE ratio would you give to a stock like BPCL?

Well, the AAA corporate bond yield is currently at around 7.5%-7.6%. Inverse of yield is the PE ratio. This means that corporate bonds are available at a PE of around 13x-14x. Therefore, our margin of safety will be based on this number.

If we take a margin of safety of at least 33% on a PE of 14x then BPCL should be bought at a PE of around 10x or lower. But if we take a margin of safety of at least 50% considering BPCL's PSU status and its volatile business model, then the fair PE for BPCL drops to 7x or lower.

Let's be conservative and go for the second number i.e. 7x. Thus, considering the stock's earnings power of Rs 50 per share and a PE of 7x, we get a price of Rs 350 per share. In other words, as per our study, the stock become attractive at a price of Rs 350 or lower and becomes expensive after a gain of 50%-100% from these levels.

In fact, you should another Rs 40-Rs 45 per share to the maximum buy price of Rs 350 to account for its investments in listed entities like Indraprastha Gas and Petronet LNG. As I said before, this is not a recommendation but just a tutorial to help with better understanding of the topic.

So, there you are. This is how a back of the envelope calculation works for valuing a stock.

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Of course, while we took the current earnings power of BPCL to arrive at its fair value, one can also consider its future earnings power and work backwards from there. However, this will require a more detailed study of its prospects, its new initiatives and the kind of value they would add to the overall valuation for BPCL. If you are up for this effort then please go ahead and try it out. Otherwise, the approach that we discussed also works fine across a lot of companies.

In fact, why don't you try the same approach on HPCL and let us know what you get.

Over time, as you see the results, your trust and faith in this approach will definitely go up in my view.

Happy Investing.

Warm regards,

Rahul Shah
Editor and Research Analyst, Profit Hunter

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