need for a broader index

We know that the Dow Jones Industrial Average is the most widely covered and watched index in the world for obvious reasons. The obvious is: not because it tracks the American economy, but, because everyone is so much used to using it; its long history backs it up.

There are at least two problems with DJIA: It includes only 30 stocks compared to over 6000 listed stocks in the country. Consequently, the total market value of DJIA index stocks is too tiny compared to that of all the listed companies. Worse still is DJIA is a price-weighted, as opposed to free-float capitalization weighted, average. These issues make DJIA not only meaningless, but also useless. Yet, the world talks about it all the time. 

The S&P-500 supplies far better information about how the US economy is doing on a relative basis compared to DJIA.

Let's come to the Indian markets. What we see is that people are no different wherever you go: the collective human behavior remains the same. 

The BSE Sensex is the most gauged index for the Indian market. It also has only 30 stocks in the index, and is a poor indicator of the Indian market compared to even S&P CNX Nifty which has only 50 stocks in the index. Both Sensex and Nifty are not great indicators of the economy. However, the fact that India does not have too many good companies makes both of these indices relatively less stupid compared to DJIA.

You can see how far these indices go in terms of tracking their respective economies:

As we can see these indices are not that good at what they are supposed to be doing. The index setters are not able to realize the fact that times have changed, we are no more in a manual-labor economy, as the number of companies and sectors have increased manifold. Automation-led economy is here to stay, and it is time that we adapt ourselves to these facts soon enough.

While the S&P-500 appears adequate, for other indices, the obvious fix is to do a revamp, and include more number of companies. The index should be tracking at least 75% of the total market value of the listed firms in the country. If that is not possible, it is fine, but let's not talk about them in the same breath, though.

It seems that DJIA has become sort of a brand not to be ignored. It's amazing how stupid habits remain stupid for very long.

The conclusion is that unless one is investing in the index itself, which actually is not a bad idea at all, it is not all that important to track these indices. The S&P-500 is fine; for other index buyers where there isn't much choice, whatever index is available should be taken. They will eventually do well because the index comprises at least a diversified mix of good businesses; something to thank for.

Better yet, if it suits, is to do some selective stock picking for long-term profit-making.

bulldozed in dealmaking

All deals are similar, whether corporate or otherwise

The homemaker goes to the fruit vendor for some fruits to buy; The buyer asks for the price, the vendor says, $50 for a dozen; The buyer indicates weakness for the fruit in zest, still tries to negotiate for lower price; The vendor recognizes the buyer's weakness for the fruit, desperation and lack of knowledge of price of the fruit sold in the neighborhood; The vendor does not budge, keeps the price intact, but this time, gives only a minute to the buyer to decide. What does the buyer do? It is anybody's guess, the buyer buys fruit at the price quoted by the vendor and also within the time set by the vendor. 

Dealmaking sounds powerful

Dealmaking is fun, attracts attention, boosts ego, and helps create an empire. This sounds good, doesn't it? Who wants routine stuff when one can fly high with dealmaking? 

Well, I come back again, growth is never free. For growth to have value, it has to create value; to create value, the acquired business has to earn in excess of the price paid. For this to happen, the dealmaker has to understand cash flows, growth and risk in that business. 

Unfortunately, we find many a deal in merger and acquisition arena that goes without understanding value by at least one party to the deal. More often the party has been the acquirer, rather than the seller. The result is that the acquirer suffers losses sooner or later. Time and again these things happen; nothing is learnt from history, history of human behavior and finance, in particular. 

One is ignorant and desperate; the other is a bully

Well, if in an even transaction the acquirers have the history of losses to show, destroying the shareholder value, what would happen in an uneven transaction? That is when one party, more often the acquirer, is bullied by the other. Such transactions are not new, though; history has a lot to offer on these types too.

As per this report, one such transaction took place, and the acquirer is now in deep crisis, a more modest way to describe. The CEO and probably the board too did not understand business, finance, value and price; Apparently, there was no financial due diligence done; Financial advice was taken from conflicted (and probably unethical) investment bankers; The acquirer had no financial muscle to pull off in case of a downturn; and the final bullets were: The acquirer was a bank; And the seller just bullied the buyer; Add to this a weaker corporate governance within the acquirer's business.

What results does one expect of this deal? The risk was too much, mainly due to lack of knowledge, and consequently, recipe for disaster was written all over, unless of course, things got luckier. Alas, they didn't.

The deal

Seller's cost of initial acquisition, an assessed value, was Euro 6.6 b;

Not much later, seller's sale price, i.e. buyer's cost of acquisition was Euro 9 b;

Date of transaction was at the start of the financial crisis, i.e. by end of 2007;

The result was instant profits for the seller; and a little delayed but huge losses for the buyer.

Now, the bank is on the lookout for fresh capital to recoup losses and pay off bailout proceeds. If not, once again, it will be bailed out, in all probability, but this time will likely become part of the government. 

The lessons from the story

The intention is not to point the folly of the acquirers (or even of the sellers) in this story, but to understand what it means to make a deal. 

In any acquisition transaction the key to profits and happiness is to first have a grip over the deal by understanding its intricacies and be able to value the business. For business valuation the vital ingredients are understanding of the business itself, its cash flows generating capacity, its growth prospects, and risk involved. Finally, it is imperative to be able to distinguish between the price (to be paid as cost of acquisition) and value (to be gained as a result of acquisition).

Only then the usual justifications of an acquisition, i.e. control, synergy, and enhancing shareholder value, would crystalize.

If these lessons are not learnt, we recall someone's observation: what we learn from history is that we don't learn from history. 

Back to the report we say, bulldozed!

shades of whiter teeth

Not that exciting.....

Colgate-Palmolive India, a subsidiary of Colgate-Palmolive US, has been operating in India for a long time. All it does is operate an Oral health care business. Not very exciting as it seems for someone who is looking for action and complex matters to solve. Never mind, we can choose to be simple and easy-going just for a while and see what it has to offer for an investor in this business. 

I am looking at its 2012-13 annual report which we can say is dated since two quarters have lapsed already. However, we don't have a regulation that requires a full set of financials from a listed company for its quarterly reporting. That is something that I loathe all the time; we can deal with that another time.

The past 

For any business to see as a potential investment it is quite nice to have a look at what the business looked like many years ago and what it looks like now. That provides some insight on what kind of investments it made in the past, how these were funded and how these performed. 

Over the last ten-year period, Colgate made reinvestment of about Rs.1.10 b in both capex and working capital. Capex was mainly for new plants and expansion of existing plants; plants that make tooth paste, tooth powder, toothbrush and mouthwash. It never used debt; it never raised cash from new issue of shares for a long time. In fact, in 2007 it did something different; it returned a lot of cash back to the shareholders. Implied in this decision was that the company had a lot of excess cash which had no meaningful use; the managers had no new investments in mind; accordingly, Rs.1.2 b cash was returned. The company not only continued to make earnings, but increased it as well: 2007 earnings Rs.1.6 b; 2013 earnings Rs.5 b. Only in 2012 and 2013 (annual report) it made higher capex, and announced new plants in Gujarat and Andra Pradesh. 

The last ten years tell you something: Revenue increased from Rs.9 b in 2004 to Rs.32 b in 2013; operating income increased from Rs.1 b to Rs.6 b. It also had cash of Rs.3.4 b in March 2013. With high operating and net margins, Colgate has been making absurd returns on capital and equity; remember, capital is very little compared to income it is generating. It could be a not-so-exciting business, but it is one heck of a business. It has passed the test of revenue growth and earnings growth on a consistent basis. 

The dividend policy has been straightforward. That boring business does not need much of cash to operate, hence, the payout ratio has been very high. Total dividend payments over last ten years were Rs.21 b.

Additional reward to the shareholders (excluding dividends):

The story so far is good: 

The future

For an analyst, although historical performance is much useful information, it is the expected future performance that matters most. The clues are supplied by the historical information, yet, value of the business is driven by future cash flows and growth. We cannot tell how much the earnings will grow, but, we do know that they will grow at some rate. Then it is easy to drop these expectations into a spreadsheet and come up with a value for such an easy business as Colgate. Nevertheless, I don't want to do this lest I hold any bias created by past performance. 

It is much easier to see how market is valuing this business, though. All I am going to do is: given its current operating income, tax rate, and reinvestment needs, I want to see how much growth market is factoring to give its current market value for equity at about Rs.173 b. This is often a useful exercise to check whether the market's implied indicators are good enough for an investor to make investment decisions. 

Just now....

The following graph shows value of Colgate at different growth rates for the next ten years; the terminal value is set based on stable growth (mature business) assumptions, i.e. sustainable return on capital (I assume that Colgate is capable of generating reasonable level of excess returns until perpetuity), sustainable margins, appropriate level of reinvestment, and cost of capital.

There is caution here as if we mess up mature business assumptions it can upset value, big time. It is useful to remind ourselves that no business, however good it can be, can sustain great performance forever; the limits have to be set at more realistic levels.

As we can see, the market is expecting Colgate's cash flows (after-tax operating profits less reinvestment) to grow at 21.50% for the next 10 years and giving the value of Rs.173 b. Is it possible? Of course, it is. But if it did not, and grew at 15% instead, the value will be Rs.112 b.

The market here represents mainly institutional investors who own about 26% of stock and are the price setters. 

It is for the analyst to pick a growth rate and be comfortable about Colgate achieving it before a decision can be made. 

The concluding thoughts for an analyst are given by Colgate:

markets beat google

Google stock price surged on Friday to a record high at above $1000. You can see it to believe it:

And the 5-day stock performance: bravo!

The market value shot up too; Google is worth $337 b now. The day before it was worth $296 b. That is about $40 b increase in value in a day. What must have caused this difference? Either the markets were not recognizing its true worth until Friday, or it is not worth that much which markets have failed to recognize. Since both the arguments cannot be right, we have to deliberate. 

The news that caused this reaction was the latest quarter's earnings report from Google. While the financial reports show strong revenue and earnings growth, the key question is whether the company is worth $337 b today.

I don't have an answer to that; but, it appears that given its current operating income, tax rate and return on capital, it takes a very low rate to discount its cash flows to get its current market value, not a comfortable situation. It seems that markets have beaten Google rather than the other way around.

It has cash pile of $56 b now and debt is very negligible at $5 b; call it the war chest, Google looks ready to embark upon its next phase of growth. And as always, growth is not free. It remains to be seen whether it will succeed over long term.

Nevertheless, Google's historical performance has been superior.

One heck of a performer despite odds here and there.

There would be some sparks if it trades between, say, $175 b and $200 b; some kidding there.

when owners want their cash back

Cash becomes excess in a business after all reinvestment needs are met; cash then becomes a potential dividend. However, if any of the capital expenditure payments is postponed, say, for the next period, cash is better served if retained for that purpose. That is, cash then does not become eligible for dividends. 

Usually, managers decide on both the amount of and per share dividend to be paid out. This in practical terms is based directly on the historical per share dividend. Since firms seldom prefer to reduce per share dividend or payout ratio it becomes increasingly difficult to do so in any period. Lower dividends have immediate effect on the market price of the stock. 

Occasionally, however, the owners get to decide on most aspects of corporate finance in a listed firm. This includes investing, financing and dividends decisions. 

This story tells us about one such occasion where the owner decides on the dividend policy for the firm. When the government is the major shareholder in a firm and is in dire need of cash, it is not surprising to see it demand its cash. 

Well, the shareholder is demanding dividends higher and sooner than that of the prior year. We can only hope that cash is not called at the cost of capital expenditure requirements. If it is, the consequences will be felt not now but in later years. Reinvestment is imperative on two counts: for maintaining competitive advantages and expanding market share. 

Ideally, the government is better off in letting public listed firms run independently just like private listed firms so that there is no added pressure on the managers; only caution is that these firms should behave and operate like private firms, without abusing their public status.

Its primary job at this time is to create an environment conducive to investments. Private firms, both domestic and foreign, are ever ready to invest in India given its demographic potential. The government should concentrate on just that lest the opportunity is lost. To achieve that it better be right with its policies.  

Let's hope for that.

value creation, growth and returns

The value of a business
It is common knowledge in finance (I hope it is) that value of a business is the present value of cash flows over its life discounted at an appropriate rate. But, what is not that common is that despite this knowledge, many analysts do not use it to value firms. 

The folly

Because the discounted cash flow model requires more difficult estimates to make, easier route is taken by the analysts and investors to come up with a so-called value for the firm. Take for example, the multiples. Price to earnings, price to book or price to sales multiples are used in isolation or in conjunction with cash flows of next few years to value the firm. This method is not only flawed, but also brings with it a lot of subjective bias in valuation. You cannot assume that the market is overall correct (which is what you do when using multiples). Ideally, you need to ignore the market while valuing a business.

I have also seen analysts discounting earnings rather than cash flows. Baffling, it implicitly assumes that depreciation is all that is needed for reinvestment. The flaw becomes more prominent, when these analysts attach a growth rate to these earnings. Aiming for some free lunches, I guess; more on this later.

Imprecise but quite useful enough
The dcf valuation is not free from bias either; however, if used properly, can yield better estimates of value than any other methods. Only caution I would add is that the aim should not be to come up with a more precise value, rather a fair estimate of a range of values, just enough to help conclude whether a business is selling at far higher or far lower than its value. If we ever try to make that model precise, we would only be its victim. That is a risky proposition.

The good news is that if we are able to make reasonable estimates of revenue, margins, reinvestment, return on capital and cost of capital, it should be possible for us to make a reasonable estimate of value. What is nice about this process is that if it is not possible to make those estimates reasonably, you can skip that business from analysis. What is the point in guessing its value for the sake of guessing, after all? Time is well spent if you can pick a business where you are more comfortable in making those estimates.

The growth rate and value
This brings us to the growth rates. While it is easy to plug in a growth rate that we would like to see for our business, the growth does not come that easy. For growth to come, the firm has to reinvest enough.

Now, let's talk about value. Of course, it is eventually the present value of all cash flows. However, many managers believe that it is possible to create value just by physical growth. Either they don't know finance well, or they don't know what they don't know. The fact remains, however: All growth creates value is just a myth.

Each business has its own set of fundamentals; it cannot grow at any rate without looking at how well it is going to reinvest; and that is measured by the return on capital. A firm that has high return on capital needs lower reinvestment compared to the firm having lower return on capital for the same growth.

The excess returns 
For growth to create value, it has to generate positive cash flows. That is possible only when the firm's return on capital exceeds its cost of capital. These excess returns drive value. The higher and longer these excess returns, the higher the value.

We can argue that the quest for value creation lies in a firm's return on capital and its cost of capital. These depend on the type of business and operating leverage (its competitive advantages), and the financial leverage. Ceteris paribus, higher leverage brings down return on capital and increases cost of capital since the firm is exposed to volatility in margins and default risk. 

The return 
That is why it is prudent to estimate a firm's return on capital based on its fundamentals during its growth period, and based on both fundamentals and industry average when it becomes a mature business. 

The cost
The cost of capital is more complicated, yet possible to estimate. For this we have some choices; one is to use the corporate finance models to get a precise-but-almost-incorrect estimate; the other is to use a more intuitive model which estimates cost of capital based on what investors seek to earn on their investments, yet, is not-so-precise-but-a-useful estimate. This cost has to be in excess of the long-term inflation rate plus some additional points. The business has to provide this return at a minimum. 

The implications for an investor

There are several implications of this analysis:

A business will lose its value if it continues earnings negative returns (cost of capital higher than return on capital) for long. Investors should shun these declining firms. Many big firms make this list too. So one should not be carried away with the size of the firm. Sooner or later the value destruction will be apparent even for those firms with access to large capital. Watch out for return on capital declining at a steady rate over the period; it is a sign of caution.

It is not possible to sustain high return on capital (and consequent excess returns) for long. As the firm grows over the period, the excess returns have to come down (and may eventually have to move towards zero); perpetual high excess returns remain valid only on the spreadsheet. What it means is that while valuing a firm with high return on capital, one has to be alert enough to bring it to more prudent levels. Investors should look out for firms that have demonstrated high return on capital over long-term; it is a sign that managers of these firms are good at capital allocation, a key measure of survival.

When excess returns are nil, i.e. return on capital equals cost of capital, the value of the firm becomes a function of its book value of capital and growth rate. However, while setting the growth rate it is advisable to consider the reinvestment that is required in conjunction with the return on capital. Otherwise, the analyst can easily set a very high growth rate and say, lo behold, value is created even without having any excess returns! That works in fantasy island. As a corollary, when the growth rate is zero and there are no excess returns, the value of the business is its current book value of capital. Although, this thought appears academic, while valuing a firm on a stable-growth basis, these assumptions are useful.

Long-term returns for investors 
Go look for those bright stars who have demonstrated ability to generate excess returns for a long period, and not shown any signs of its deterioration. This is hard to come by for two reasons, though: One, these firms are rare to find. The consolation, however, is that if one doesn't try, someone else will and reap rewards; investors are well advised to work hard at that if they are any serious about making money. Two, these firms sell at premium prices. The consolation again, however, is the market inefficiency. If investors don't believe in market inefficiency, they are well advised to at least buy the index.

Let's get on with work.

the shutdown: a kid's play

The most powerful country in the world is currently facing the shutdown of its operations; can we believe it? The spending is not approved; so, the government cannot pay its bills. At the same time the government is facing the debt ceiling crisis. What it means is that the government has reached its upper limit of borrowing and any further debt makes it illegal; so again, no more spending.

Both these issues are not new to the government, though. There was a shutdown before and there were debt ceiling crises before. And not surprisingly, these issues were resolved too. There wasn't any choice either.

The current issues will be resolved too; we have history to support when we say that. Then why this big drama? Some might ask. Valid question, but, without a good answer. 

I still see the US government and its policies as far superior to any other country's. Again, we have history to back, despite all the problems in the interim.

Nevertheless, I find these current issues as nothing but kids' fight between the Senate and the House; the Democrats and the Republicans; that kid and this kid. 

The kid-fight is alright; but the repercussions are not too nice. Not surprisingly, this has made headlines all over for the past many days. Sample this: the stake in 2016; open to short deal; the meeting; the markets; the temporary solution; what they want; the fiscal stalemate; signs of a thaw; pride, the biggest villain. And so much.

The US is never going to default; it is out of question. Its ability to print the mint ensures that. It might come to the point of breach, but, it won't breach. In some time to come both budget and debt problems will be resolved. That is given. 

What will remain in memory is this kiddish behavior from grown-ups.

All we can say now is grow up guys! It's time go come out of the kindergarten.

is tcs worth $65 billion

TCS market value crossed $65 billion (about Rs.4,000 billion). This is probably the highest market cap for an Indian company so far with some exceptions. 

I am just wondering whether this company, after so much of run-up on the stock market, is really worth that much. We know markets react in extreme ways and thus, display irrational exuberance on occasions. Let's try to see if this is really the case for TCS.

The company has superior fundamentals is given: As of 30 June 2013, it had operating capital of about Rs.315 b, negligible debt and cash of about Rs.100 b. Its last four quarters net income was about Rs.145 b. It is yet to report its September quarter results; so we have to live with what we have for now.

Now, if TCS had to be worth what it is, it must have the fundamentals in terms of cash flows and growth. Since, growth does not come free, the company has to reinvest part of its earnings. Reinvestment is required for its human capital, working capital and research needs. We can consider a simplistic case of perpetuity, and try to see the implied indicators to arrive at the value of Rs.4,000 b. 

We assume that its current net income will not only be sustained, but will grow until perpetuity. If perpetuity model is used, the value of TCS becomes a function of its estimated cost of equity, return on equity and growth rate. It is important to note that superior return on equity and growth rates cannot be sustained forever. 

The following shows current market value of TCS at various levels of return on equity:

It is clear that for TCS to get market value of Rs.4,000 b today, the gap between the company's cost of equity and growth rate has to narrow and come very close. As you reduce return on equity, the gap has to get closer. Even at 45% return on equity, the gap is only 3.15%. 

You can try any cost of equity; but, to deliver the required market value you need a growth rate that is closer to cost of equity. The implication is that we need a very low rate to discount the free cash flows to equity which grows until perpetuity. 

Is this realistic? Of course, not. TCS appears to be way overvalued at this stage. I find it quite funny.

costly reporting; a corporate governance matter

This story tells us how fortune can be lost in a short time. While it is easy to criticize, for fortune to be lost, first fortune has to be made. And, it is no mean feat.

Having said that, to keep that fortune and let it grow, is the toughest thing to do. Not everyone is successful at that. 

The markets had created expectations beyond reality; and who was responsible for this? When operational and financial disclosures are made by managers, it is vital that they are important, accurate, relevant and timely. They should know that whatever they say (and not say) has direct impact on market and its expectations. 

The firm is now defaulting on its debt payments. The consequence is near bankruptcy. That is the cost of debt: default risk, which is direct and measurable; and bankruptcy risk, which is indirect and probable, but is very costly. This is basic corporate finance. 

Coming back to transparent disclosures and oil and gas in particular, if managers are not honest and realistic about their reserves, reality will catch up sooner than later. This is what happened with the firm.