‘The Safal Niveshak Mastermind Module 5 | Lesson 39 uo The Safal Niveshak Mastermind Residual Earnings Valuation Module 5 | Lesson 39. One of the big drawbacks of DCF valuation is that it employs cash accounting, and cash can often be a negative number. In fact, for most companies, the FCF used as a base in DCF is a negative number. For such companies, by applying the DCF model, you would come up with a negative present value from their negative cash flows, and prices cannot be negative. You recognize, of course, that you have to add a “terminal growth value” to solve the problem. But here your problem is compounded; the continuing value (based on the long-term cash flows) is greater than 100% of the value (as we must have a positive price) and yet we have no idea about how to calculate it because a growth rate applied to a negative amount will not do. More than 100% of the value rides on forecasts for the long term and it is the long term that is most uncertain. A speculative valuation, indeed! Stephen Penman writes in Accounting for Value... Graham did not like valuations that depend on long-term growth rates. Growth in a continuing value is speculative. Indeed, Graham and his fellow fundamentalists were apprehensive about paying for growth at all. It is a guess; growth can be competed away unless there is a clear protected franchise A valuation that rides on estimated growth is a risky valuation. It is better to anchor a valuation on something we can observe now or can predict fairly confidently in the short term. We want value justified by the facts. For that we need an alternative, less speculative accounting. An Alternative to DCF Accounting Penman writes in his book... The problem with DCF valuation is an accounting problem. Cash flow from operations is the net cash from selling to customers and of course adds to value, but the FCF calculation then subtracts cash investment (capital expenditure). This is odd because investments are made to add value, not reduce it (the notorious corporate jet aside). www.safalniveshal.com Page 1 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 Firms consume cash to generate value (that’s fundamental!). Firms reduce FCF when they increase investments (reducing value in the DCF calculation) and increase FCF when they reduce investments (increasing DCF value). ng FCF in valuation is not only odd, it’s perverse. While I won't junk the DCF valuation model here given that it is a useful way to estimate values of companies that have stable businesses and consistently,generate positive FCFs, there's no denying that it (DCF) has its share of flaws as well. What Penman mentions above — that increasing capex and thus reducing FCF can add value to a business — makes a lot of sense. Good companies become great only when they growth their business over a number of years. And growth is often a result of expansion, which leads to capex and may thus lead to pressure of FCF for some years. Rejecting a business just because of its low FCF that causes.a/ low DCF value as compared to the stock price can thus lead to a great opportunity loss. A better way, Penman suggests, is to focus on thejbook value and see where it is going in the future. He lays down two of his most important principles of valuation as — 1. To get a handle on value, think ofWhatithe book value is likely to be in the future. ‘To get a handle on value, think first 6f what the book value is likely be in the future and, second, what the rate- of>return on that book value is likely to be. Penman suggests that future bookkvalue of a business is determined by current book value plus future earnings, and thus'you can equivalently state the first valuation principle above as follow — Think of current book value and the earnings likely to be added to boék value in the future, Historical data indeed ¢onifirms the principle that stock returns over five-and ten- year periods are largely explained by earnings that companies add to book value. Investing —A Game Against Other Investors Penman writes in his book... Equity inyesting iS not a game against nature but against other investors. So it serves little purpose to discover the “true” intrinsic value, or the value for speculative rowth, as if it existed somewhere out there. Rather, valuation models should be/fised to understand how an investor thinks differently from other investors in the market. Titds the right question to ask of a model is not what the “right” value is but rather whether the model can help the investor understand the perceptions of other investors embedded in the market price — so those perceptions can be challenged. www.safalniveshal.com Page 2 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 ‘The investor is “negotiating with Mr. Market” and, in those negotiations, the onus not on the investor to come up with a forecast or a valuation, but rather to understand the forecast that explains Mr. Market's valuation, in order to accept it or reject his asking price. In simpler words, what Penman suggests is that instead of estimating an intringic value for a business, we must focus on assessing whether the stock's existing market valuation (which is based on what others are willing to pay for it now) is, right or wrong. We must focus on identifying the amount of speculation in a stock’sycurrent price, which causes the stock to be priced more than what the book value and future carnings would justify. Here is how Penman draws such a model... (ROGE, ~r) x By ler B+ Value of equity, = B, + Value of speculative growth This formula can be explained as. Value of Equity = Book Value + Value from Short-Term Accounting + Value from Long-Term Growth or Speculative Value ‘Thus, if you can find out the first two partsof the equation, what remains is value of speculative growth. If this last valu@is high, you can avoid the stock. If it’s low, you can consider it. si portant to understand thie following calculation in the above formula — (ROCE of current year — r) x Book value of previous year This is what Penman defines as residual earnings, which compares the rate-of-return on book value, ROCE, with your required return (1). ‘Residual carninig8tis sometimes referred to as excess earnings or abnormal earnings and is alternatively (but equivalently) calculated as... Earnings 6fcufrent year — (Expected rate of return x Book value of previous year) This 148t formula simply explains earnings less a charge against book value to cover theiinvestor’s required return (or the “cost-of-capital”, ic., r). Leb us understand the above formula with the example of a real-life example, and try ‘to estimate the “speculative value” in the stock of say, Hero Motocorp. Using this formula. www.safalniveshal.com Page 3 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 (ROCE, -r)xB, | (ROCE, ~ r) xB, + + Vah fF equity a a i: 1+? (I+r)xr + Value of speculative growth Here is the calculation for Hero Motocorp.. Value of Equity = 280.4 + {[(41.3% - 12%) x 280.4] / (1 + 12%)]} + {[(39.0% 1296) x 326.7] / [1 + 12%) x 12%]} = 280.4 + (73.4 + 656.2) + Value of Speculative Growth FY14A FY15E FYI6E! Eamings Per Share (EPS) 105.3 |_ 115.8 | 127.4 Expected EPS Growth 10.0% | 10.0% Dividend Per Share (DPS) 65.0| 695] 764 Book Value Per Share (BVPS) 2804 | 3267 | 377.7 ROCE/ROE 413%| 39.0% Residual Earnings 822] 882 Growth in Residual Earnings 7.3% Long-Term Growth in EPS 10.0% Thus, here is how the current s 1ck price of Hero Motocorp can be explained — Value of Equity = Book Value + Value from Short-Term Accounting + Value from Long-Term Growth or Speculative Value 2,345 (Current stock price of Hero Motocorp) = 280.4 + (73.4 + 656.2) + Value from Long-Term Growth or Speculative Value Thus, Value from Long-Term Growth or Speculative Value = 2,345 — 280.4 — 729.6. Solving this, we arrive atthe “speculative” value the stock market is placing on Hero’s growth to be around Rs 4,335) | caren stock Price ie 2:48) 7 z (Re 1,235) : 2 4 E : (R730) (Rs 220) Book ak vue Vatu tom or tr ‘anos Secuing ‘sown www.safalniveshal.com Page 4 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 ‘Through the above formula, we have used simple accounting to parse our uncertainty into what we know for sure ~ book value; what we know with some confidence — value from the short term; and what we are quite uncertain about — value from long- term growth prospects. To use Benjamin Graham’s words with some license, the diagram separates “minimum true value” from the additional “speculative component of value.” It is the latter where our uncertainty lies. It is the latter where we risk overpaying for growth. It is the third block in the above diagram that we wish to challenge 4 RS 1,339 is the price that Mr. Market is asking us to pay for growth. What is the growth forecast implicit in this Rs 1,335 ask? The answer comes quickly by bringing growth into our valuatiofiy using this formula Value of Equity = 280.4 + {[(41.3% - 12%) x 280.4] / (1 + 12%)]} + {[(39.0% - 12%) x 326.7] / [G+ 12%) x (12% - g]} Solving this for Hero Motocorp using this excel t@hrplate, I arrive at a ‘g’ of 8% — the implied long-term annual growth rate in residualearnings after FY16 — to justify a price of around Rs 2,345 for the stock. So, rather than applying a model to transform one’s own forecast to a value, we have applied the model in reverse engineering mode to extract the stock market's forecast for a company’s long-term earnings growth) Penman writes in his book... This is the way to handle yalWation models. By resisting the temptation to plug a speculative growth rate ito’ model, we have heeded Graham's warning about “formulas out of highef mathematics,” particularly the growth rate in those formulas. Rather, we have duthted?the model around as a tool to challenge the market speculation about growth of which he was so skeptical. Importantly, this approach to investing contrasts sharply with the advice to “buy stocks for the Jong run.” Rather than trusting the market to deliver returns in the long run, ¥ou ean use the above formulas to verify that the market's expectation for the long runiis a reasonable one. The)question is turned back on the market: Can the market deliver returns in the long run? @ Now, the growth rate is the residual earnings growth rate, a little difficult to get our minds around. But we can convert this growth rate to an EPS growth rate by reverse engineering the residual earnings calculation. www.safalniveshal.com Page 5 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 ‘As Residual earnings in the next year = Earnings growth in next year ~ (r x Book value), then Earnings in the next year = (Book value x r) + Residual earnings Hero Motocorp’s residual earnings two years ahead (2016) is Rs 88.2 per share, so the residual earnings forecasted for the third-year ahead (2017) at a growth rate of 8% is Rs 95.2. Thus, with a per-share book value of Rs 377.7 forecasted for the end@of 2016, the implicit forecast of EPS for 2017 is Rs 140.6 and the forecasted growth rate over 2011 is 10.3%. Extrapolating in the same way to subsequent years, you can develop th@earnings growth path that the market is forecasting, displayed in the following image for Hero's case... EPS Growth Path Implied by the Market Price 6f, Rs 2,345 for Hero Motocorp 10.9% 10.3% 10.1% 9.9% 97% FyieFYI7 FYI8.—FYI9.sF¥20.—FY21. ss FY22 With the growth rates for Hero’s earnings plotted in the above chart, the investor has a concrete understanding of the market's speculation about the long term. Taking heed of the warting, beware of paying too much for growth, he or she then asks whether to pay for that growth: Is growth likely to be above the projected path — the buy zone,or below the line — the sell zone? Or, to thélinguliry of the defensive investor: Does the growth forecast look about right? Let'sstake)up another example here, that of Asian Paints, and run through the calculations again. Using this formula. www.safalniveshal.com Page 6 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 (ROCE, ~r)x B, , (ROCE, ~ 17) xB, ltr (l+r)xr Value of equity, = B, + + Value of speculative growth Here is the calculation for Asian Paints... Value of Equity = 42.1 + {{(34.7% = 12%) x 42.1] / (1 + 12%)]} + {{(33.0% “a29%) x 50.9] / [(1 + 12%) x 12%]} = 42.1 + (8.5 + 79.6) + Value of Speculative Growth [aa Waar Eamings Per Share (EPS) 127 146| 168 Expected EPS Growth 15.0% | 15.0% Dividend Per Share (OPS) ae 58] 67 Book Value Per Share (BVPS) 42.1 50.9] 60.9 ROCE/ROE 34.7%| 33.0% Residual Earnings 96| 107 Growth in Residual Earnings 11.9% Long-Term Growth in EPS 15.0% Thus, here is how the current stock price of Asian Paints can be explained — Value of Equity = Book Value + Value from,Short-Term Accounting + Value from Long-Term Growth or Speculative Value 510 (Current stock price of Asian Paints) = 42.1 + (8.5 + 79.6) + Value from Long- Term Growth or Speculative Value Thus, Value from Long-Term Growth or Speculative Value = 510 ~ 42.1 - 88.2. Solving this, we arrive at the'*speculative” value the stock market is placing on Hero’s growth to be around Rs 380 (out of a stock price of Rs 510). Now, what is the gtowthiforecast implicit in this Rs 380 ask? The answer comes quickly by bringing growth into our valuation, using this formula Value of Equity = 42.1 + {[(34.7% - 12%) x 42.1] / (1 + 129)]} + {[(93.0% - 12%) x 50.9] fi[(1 +. 12%) x (12% - g}} Solvingithis for Asian Paints using this excel template, I arrive at a ‘g’ of around 40.0% — the implied long-term annual growth rate in residual earnings after FY16 — to justify a price of around Rs 510 for the stock. Using the same process as above, we now plot an EPS growth path implied by the market price of Rs 510 for Asian Paints. www.safalniveshal.com Page 7 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 EPS Growth Path Implied by the Market Price of Rs 510 for Asian Paints 16.0% 15.0% Buy Zone 145% 4 en 130% ieee 127% Sell Zone 11.5% 10.0% . 4 FYi6FYITFYI8.FYIO.-FY20.—FY21.—FY22 How the Fundamentalist Would Think Now, the fundamentalist who refuses to pay for growth takes a firm stance: Pay only the no-growth price. Pay only for the value justified by the accounting. For Hero Motocorp, this is Rs 1,010. This builds in the margin of safety advocated by fundamentalists: “If the shares are tradingvat less than the no-growth price, I am probably getting a bargain, for in all likelihood there is some growth.” But this may just be too conservative Although this strategy may have delivered some bargains in Benjamin Graham's time, growth delivered considerable value over the last 20-30 years; growth characterizes the modern firm. Anyways, coming to Hero’s long term growth expectation of 8%, it compares well to India’s long term GDP growth expectation of 6-7%, and thus the stock price at the current level (Rs 2,345) does not look speculative. This can also be Said Of Asian Paints. With the long term growth expectation of 10.0%, the stock price at the current level of Rs 510 does not still look speculative. But it isn’t éheap Bither, as 10.0% long term growth is a positively optimistic rate of growth fof any kind of busines: So yoti{need to track if actual EPS growth falls below the EPS growth path (the Sell Zone).as shown in the above chart. That would be a cause of concern, especially if the fall in growth rate is not corresponded by the fall in the stock’s price. ‘What Next? Here is one key thing we have learned in thi model too literally; instead, see a valuat the stock price. lesson — Don’t take a valuation n model as a tool to challenge www.safalniveshal.com Page 8 of 9The Safal Niveshak Mastermind Module 5 | Lesson 39 Rather than plugging a growth rate into a model, apply the model to understand the future growth that the market expects. After all, valuation is not a game against nature, but a game against other investofs, and one proceeds by first understanding how other investors think. ‘As an investor, you are not required to establish a valuation, but only to acceptor reject the valuation of others. Exercise Use this Residual Earnings Valuation excel template and péfform a valuation analysis for two companies — Relaxo Footwear; and * One company of your choice. After you arrive at the growth rate embedded in the eurrent stock price for both these companies, head over to the Mastermind Forum via this link and share your thoughts on whether the growth rate implicit in the eurrent stock prices justified or not. Further Reading * Accounting for Value ~ Stephen Penman Disclaimer: This document is confidential and is supplied to you for informetion purposes only. It should not (directly oF {ndireely) be reproduced, further distrbuted to any person or published, in whole or in part, for any purpose whatsocver, ‘without the consent of Skylab Media & Research. This document does not constitute a personal recommendation or take into ‘account the particular investment objectives, nancial situstions, or needs of individual investors. www.safalniveshal.com Page 9 of 9