Thursday, October 7, 2010

Investing in Equities - part 3

Having answered a YES in the 11 questions listed in my last blog – the company in question (CRISIL) is in our shortlist for investment – it means that the company has
  • a long term sustainable competitive advantage;
  • has good future good cash generation potential; and
  • is in the hands of a good management that has managed it well for the past 10 years.
Now, we come to the final 3 questions – these questions will help us decide at what price we must invest in the stocks of this company. Remember that a good company with all the advantages listed above is not a good investment until the share price is right. The next three questions help us decide what the right share price is. There is a bit of maths here – but I have tried to make it as simple as possible.
Q12 - What is the initial rate of return (IRR) and relative value to a Govt bond?
Government bonds are considered to be zero risk investments - in India, the 10 year Govt bond has an interest rate of 8% as of Oct 2010.  This question focuses on the comparison between the returns on the chosen share with these 8% Govt. Bonds.
The basic understanding is that as a share holder, your annual return per share is the Earnings per share (EPS data is available in the P&L statement).  We need to compare the returns based on the the EPS data and the current market price of share, with the returns from Govt bond (8%). Further, as the EPS changes every year, we need to look at the 10 year CAGR of the EPS and also account for this in our analysis.
For example in CRISIL, the current EPS is Rs. 208.08 - which means that CRISIL has earned Rs. 208.08  for each share in the period Jan 2009 to Dec 2009.  With the current share price of CRISIL at Rs.6130, and EPS of Rs. 208.08 , CRISIL share is giving a 3.4% return as compared to a Govt bond’s 8% return. If we had to earn the same amount (Rs 208.48) via investment in 8% Govt Bonds – we would need to invest only 208.08 / 0.08 = Rs 2606. Based on this logic, it does seem that CRISIL share price is pretty high.
However, this analysis is not complete as it must also take into account the fact the EPS of CRISIL is growing year on year and hence the returns on CRISIL will increase year on year. The CAGR of EPS of CRISIL is 27.8% (please refer to the calculations in http://www.slideshare.net/sgrajasekharan/crisil-data). Even though CRISIL share is currently giving us a return of 3.4% as compared to a Govt bond return of 8% - this return of 3.4% is growing at a CAGR of 27.8% yoy.  In four years time, the current returns of 3.4% would surpass 8% and hence after 4 years, the CRISIL investment made today would have a better IRR than a Govt Bond.
Hence the answer to this question is that CRISIL’s share price is on the higher side as of now   - however, if we buy it at the current price and keep it for 4 years, the returns will match that of 8% Govt bonds.

Q13 - What is the projected share value and return on investment using historical earnings growth rate
Q14 -What is the projected share value and return on investment using sustainable growth rate
Q13 and Q14 give us ways of forecasting the share price of the company 10 years from now. They follow two different approaches and there would be two different share prices forecasted. Being conservative investors that we are, we would consider the lower of the two prices. The common theme in these two approaches are:
  • both approaches try to forecast the EPS into the future;  
  • we assume that the average Price to Earnings ratio (PE Ratio) of the share for the last 10 years would be same as the PE ratio for the next 10 years;
  • the future price of the share in 2020 = future EPS in 2020 * average PE ratio
  • we also assume that the average dividend payout ratio ( calculated as the ratio of dividend paid out per share to the earnings per share) for the past 10 years can be taken as a average dividend payout ratio for the next 10 years.
We calculate the following as we forecast the future share price value:
  • The CAGR of EPS for the past ten years - the calculations for CRISIL is shown in the excel sheet and it is 27.8%
  • The average Returns on Equity (ROE) for the past ten years – the calculations for CRISIL is shown in the excel sheet and it is 23%
  • The average Dividend Payout ratio for the past 10 years - the calculations for CRISIL is shown in the excel sheet and it is 33.95%
  • The average PE ratio for the past 10 years – here we need to get the High and Low share price for the past 10 years and use this data along with the EPS for the past 10 years to calculate the average High PE and average Low PE ratios. The overall average of the High and Low PE ratios is the average PE ratio - the calculations for CRISIL is shown in the excel sheet and it is 20.545.
Answer to Q13 – The Historical earnings Growth rate:
Please see the excel sheet as we do this forecasting of future share price.
We take the EPS for the current year (Rs. 208.08) and the average CAGR of EPS (27.8%) and calculate the EPS for the next 10 years using the formula:
EPS for 2011 = EPS for 2010 * average CAGR of EPS.
We also calculate the Dividends that will be paid out each year in the future based on the formula:
Dividend for 2011 = EPS for 2011 * average Dividend payout ratio
By this method we can calculate the EPS for the year 2020 (Rs 2418.46) and with an average PE ratio of 20.545, the future price of CRISIL share in 2020 is Rs 2418.46 * 20.545 = Rs 48687.26.
To this we must add the sum of dividends paid for the period 2010 to 2020 (Rs 3520.43) to calculate the total gains = Rs.53207.69.  Assuming the current price of 6132 – the CAGR of this investment over the next 10 years comes to 24.37% - which is remarkably good.
Answer to Q14 – The Sustainable Growth rate:
Please see the excel sheet as we do this forecasting of future share price using this model.
Here we take the Book value of the share in 2009 and calculate the EPS of the share for 2010 using the formula:
EPS for 2010 = Book value of the share in 2009 * average ROE (which has been calculated as 23%)
We further calculate the Dividend payout for each year from the EPS and the dividend payout ratio (as done for the last question) and based on this we calculate the retained earnings (Retained earnings = EPS –Dividend paid out).
We then calculate the Book value for the next year using the formula:
Book value for 2011 = Book Value for 2010 + Retained earnings for 2010.
This model is used to predict the EPS for 2020 (Rs 539.8) and the total dividends paid out for the period 2010 -2020 (Rs 1096.34). With an average PE ratio of 20.545, the future price of CRISIL share in 2020 is Rs 539.8 * 20.545 = Rs 11090.21.
To this we must add the sum of dividends paid for the period 2010 to 2020 to calculate the total gains = Rs.12186.55.  Assuming the current price of 6132 – the CAGR of this investment over the next 10 years comes to 7.1% - which is not all that good especially when we know that Govt bonds give 8% returns per annum.
As conservative investors, we will take the lower of the two figures that we get from the two models – hence the return from the second model (Sustainable growth rate model) is what we will take. For us to get a CAGR of at least 12%, the current price must be Rs.3923.8.
Hence we would be happy to invest in CRISIL share at a price of around Rs 4000 but not at the current price of Rs 6132.
CRISIL was priced around Rs. 250 in 2003 and today it is Rs. 6132 – it has grown by 24 times in 7 years. In 2003, when we had done the same calculation, we had predicted that the share price would go to Rs 1350 by 2010 – time has shown that our estimate was very conservative. Hence the call is whether we should look at investing in this stock at the current levels or wait for a level of Rs 4000 which may never happen. My approach would be to wait and if it does not come to this level – we should still be patient.