Is this Famous Tata Stock a Hidden Trap for Investors?

At its core, investing is all about finding the intrinsic value of a stock and comparing it with the stock price.

If the intrinsic or the fair value of the stock comes to be as Rs 100 and if the stock is currently trading at Rs 50 in the stock market, we buy the stock.

Conversely, if the fair value is Rs 100 and if the stock price is Rs 200, we term the stock as expensive and reject it. This is all there is to it.

However, here's an interesting question. Should you look at the stock price first and then calculate the intrinsic value or should you first calculate the intrinsic value and then look at the stock price?

I believe that you should analyse the stock first, arrive at its intrinsic value and then look at the stock price.

Looking at the stock price first could prove to be unhealthy. A lot of biases can creep into your analysis if you look at the stock price first. Your mind can start playing games with you.

On the other hand, you can do a more independent analysis of the stock if you first calculate the intrinsic value and then look at the stock price.

Your estimate of the stock's intrinsic value or fair value will be more neutral if you have no idea of its stock price.

Let us try this approach on a big company of the Tata group.

For this stock, we will not look at the stock price. We will calculate its intrinsic value first and then look at the stock price.

In fact, I will even hide the name of the stock from you. I will disclose both the name as well as the stock price last.

So, here's the P&L statement of the company over the last 10 years. Focus on the 10-year performance between FY13 and FY23.

 

The net profit of the company has remained almost static between FY17 and FY22. The profits have crashed in FY23 but they were more a result of one-time adjustments than anything else.

Hence, it should be safe to assume that the earnings power of the company has stood at Rs 550 crores on average based on its performance over the last few years. This translates into an EPS of Rs 16 per share.

In other words, the company is capable of earning Rs 16 per share in a normal year.

Now, all we need is a suitable PE multiple that we can assign to this stock.

This PE multiple multiplied by the earnings power of the company will give us the intrinsic value or the fair value of the stock.

But before we assign the PE multiple, let us look at the balance sheet of the company and some other financial parameters.

Here's a snapshot of the balance sheet of the company.

 

As you can see the balance sheet seems to be quite strong.

The company is asset light as fixed assets contribute just 5% of the total assets.

Also, there is very little debt on the balance sheet as the overall borrowings are just 10% of the equity. Put differently, the stock has a very low debt to equity ratio.

Therefore, the company does score good marks on the balance sheet front.

Let us look at some of the other financial parameters.

 

As you can see, the company's sales growth, profit growth and return on equity are below average to be honest. The company has not only struggled to grow in recent years but has also given below par returns on shareholder equity.

Hence, the verdict is clear. Although the company has an earnings power or earnings capacity of close to Rs 16 per share, it has struggled to grow both its topline as well as bottomline.

Also, while it may boast of a strong balance sheet, it has not done a great job on the return on equity front.

What do you make of the Tata group company we just saw?

Is it an average company, a good company, or a great company?

I think calling it a great company is out of the question. A great company has strong growth as well as strong return ratios. And this company fails on both these parameters.

I think it is an average company at best. But for argument's sake, let us think of it as a good company and hence, give it a PE multiple of 27-30x.

The intrinsic value of the stock come to Rs 480 per share. An earnings power of Rs 16 per share multiplied by a PE of 30x gives us a fair value or an intrinsic value of Rs 480 per share.

So, as per this calculation an entry price of Rs 320 or lower can qualify the stock as an attractive investment candidate.

In other words, there is a 50% upside from the entry price of Rs 320 and exit price of Rs 480 per share.

Well, now is the time for the big reveal.

This Tata Group company, which we felt had an intrinsic value of Rs 480 per share, is currently trading at close to Rs 1,400 per share in the stock market.

Yes, that's correct. The stock is almost 3x as expensive as compared to our estimate of its intrinsic value.

Here's another shocker. This company is none other than Voltas limited, India's largest AC manufacturer.

Is there anything wrong in our calculation?

How come we valued a stock like Voltas at Rs 480 per share whereas it is trading in the stock market at Rs 1,400 per share.

Well, there's nothing wrong in our calculation.

The difference is that while we have been realistic in our assessment of the stock's intrinsic value, the market seems extremely optimistic.

It believes that the future of Voltas is so bright that it deserves to be valued at Rs 1,400 per share.

However, I am not buying this argument.

Based on Voltas' historical performance, the risk-reward equation of investing in the stock at a price of Rs 1,400 per share is just not in the favour of investors.

It is a very risky bet in my view.

Let us assume for the time being that an investor invests in Voltas at the current price of Rs 1,400 per share. His target is to double his money in the next 4-5 years.

Assuming a PE multiple of 30x, Voltas will have to earn an EPS of more than Rs 90 per share for the investor to double his money.

This means that Voltas will have to grow its EPS by almost 6x from the current levels of Rs 16 per share.

Even if we assume a PE multiple of 40x that we give to a great company, Voltas will still have to grow its EPS by 4x over the next 4-5 years.

A growth of this magnitude is not impossible, but it is certainly very difficult given the competitive nature of the white goods industry.

Hence, the future of Voltas may no doubt be bright.

But are you willing to pay a PE multiple of almost 90x to be part of this bright future?

Well, I am not so optimistic as I don't find the risk-reward equation in favour of the investors at all.

I believe there are other stocks out there with better risk-reward equation than Voltas.

Let me know what you think. Do you agree with my assessment, or you think I am being too conservative?

This article is for information purposes only and not a recommendation.

Happy investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)