There are urban legends where startup deals were done on restaurant napkins. Can we do similar calculations for listed companies too ?
There are few back of the envelope calculations you can do on stocks too before you invest. We will explain some of these techniques of valuing companies with very limited data.
Fundamental analysts have the job to evangelize the future value of a company based on their history and future projections. It is common practice to estimate cashflows for next 5 years when using balance sheet data. Beyond 5 years, its modelled as if the business goes on till perpetuity. This part is called the terminal value of a stock. What is interesting is that there is empirical evidence that perpetual value is about 70% of the value of a company. Hence, usually the near term 5 year projections only account for 30% of the value.
Having looked at a forward looking measure, let us now look at PE, a very popular historical indicator of value. PE multiples, tell you how many times the last 12 month earning are you willing to pay to own one share of such a business. When a bank gives you a home loan, they typically give you 5x your annual income. For companies we pay 18x on an average. This should immediately make the case for entrepreneurship, but then that’s for another day.
We are now going to connect the dots above and illustrate this with a real case study as an example only. Lets take the case of NELCO which is a Tata subsidiary. They are one of the few licensed in India to provide internet on flights. They are about -35% from its lifetime high recorded in August 2018. Tata group also has other business like airlines and telecom that can give NELCO some industry advantage in terms of knowledge and management insights. They are now trading at 34.5x PE. In other we are prepared to buy an unit of earnings till perpetuity for Rs 34.5 as of today.
Leaving 70% of the value to terminal value as we explained above, we can approximately assign 30% weight to the near term valuation which is 30% of 34.5 or roughly 10, over next 5 years. To make it simple, we are now going to leave a lot of details like discounting by WACC, adjusting for tax efficiencies, industry dynamics etc and by sacrificing accuracy, create approximations for quick calculations. So with that caveat, we can say for next 5 years, every rupee in stock price should earn about 10 rupees of income combined. In other words, 1 rupee invested today should produce 10 rupee worth earnings in next 5 years. That needs an annual compounded growth of earnings of 60%. This is compared to average 6% to 8% we currently get on an average to expected 15% average growth expected going forward in 2021. Hence, NELCO must do 4-5x better than an average Indian company.
However, if the terminal value was 70% of the value of this company when interest rates were higher by 1.5%, we need to adjust for that given interest rates have fallen. So roughly 25% reduction in interest rate from 8% to 6% now, will shift about 1.25×70% to terminal value or about 85%. So instead of the next 5 years attributing 30% of the value, it would be reduced to 15%. Then instead of Rs 10, we need to make only Rs 4.5 over next 5 years to justify this price. Importantly with this adjustment, the compounded annual growth in earnings drops from 60% to 35%. With earnings expected to grow 15% on average by many analysts, NELCO only needs to do 2.5x better. With a captive airline customer (Air Asia, Vistara and possibly Air India) – its not impossible to think they might meet and exceed this target.
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