the story that ril has

Reliance Industries had a story to tell: its foray into telecom, and its declining returns. Now with the passage of time, the story seems to have changed, at least for the analysts. 

Reliance is yet to come near its historical high market valuation.

It had a high market capitalization of Rs.4,794 b in 2008 and Rs.3,705 b in 2015 (so far). At the current market value of Rs.2,835 b, it is about 41% lower than its all time high. There was a lot of optimism built into the high market prices in 2008 and 2009. 

Subsequently, it has had its share of issues to deal with, some external and some internal, due to which its return on equity and return on capital have been declining. 

Its investment in telecom has been significant, and it has a delayed return cycle. This itself is the biggest drag on its return on capital. Reliance has spent over Rs.2,000 b in capex since 2011 twice its previous 5-year capex spend. As of 31 March 2015 there were more than Rs.400 b of commitments outstanding. 

However, if we believe in the changed storyline there is potential for efficiency in capital allocation for the company as a whole. Its capital expenditure cycle is going to be completed soon. 

For a careful investor there were opportunities in 2012 and 2013 to buy the stock at much lower prices. I am not sure how many did though.

Yet, the next few years are going to be interesting for this business. 

when's the money amazon?

I like the business; I like the way it disrupted retail; I like the way Kindle revolutionized reading. For the year 2014, Amazon had revenues of $89 b. So far so good, and I thought about it as a firm with long term vision. But later I had to ask how long is this long term. 

Long term shareholders of this business have made money all along: In May 2010, it had a market cap of $56 b, and today it is $200 b. Just last year in Feb, it was selling for $159 b. Funnily enough, since it came out with its initial public offering in May 1997, it has never made any real money. 

Revenues increased 19% in 2014, and that's about it. Sure, Amazon is still in a disruptive growth mode, where you care about market share and then about making money. 

For its part, it presents the statement of cash flows first before statement of income and balance sheet. The reason appears to be obvious:

In claiming those free cash flows, it has conveniently forgotten that stock-based compensations are real expenses for the business.

Arguing that these costs are non-cash will be at their own peril. Otherwise, it would be much easier to pay every supplier with stocks and bring cash expenses to zero. This is for discussion another day.

It has also excluded acquisitions from calculating free cash flows, an error whether acquisitions are made through cash or by issuing stock.

At the moment, all I see is that Amazon as a business is yet to make real money. Usually, stock prices follow business profits in the long run. So far, the long run seems like too far away for Amazon because the stock prices are not reflecting business fundamentals.

There is another storyline for this business: Current earnings do not matter. What matters is the future earning power of the business. As long as Amazon is going to make disproportionately larger profits in later years, it is going to be fine. Market knows this, that's why it is factoring in the stock prices.

Which side of the story are you in? 

rate hike and markets

If the rate hike is appropriate this year and later, what should happen to the stock prices, and the market as a whole? Well, if cash flows are not going to change the prices should fall. At least, the intrinsic value of all cash flow generating assets should fall. If they don't, it would mean that prices are expensive for a buyer. 

While bond prices adjust pretty quickly to the changes in interest rates, it is not going to be as easy as it sounds for equities. This is because at least for individual firms the cash flows pattern and their growth rate could be different. There aren't fixed coupons to be paid out and the time line is perpetuity.

There would also be flow of capital from let's say emerging markets where interest rates are much higher back to the US. Since the rate hikes are going to be gradual, to come back to what we can call the normalized interest rate (and inflation) environment it could still take several years. In the meantime, currency-based investments may still not be the best option. So for investments in the US, equities should remain favorites.

Nevertheless, interest rate is an important factor in making decisions about allocating capital. It measures our opportunity costs in investment options.

are you a pe - squeezing the market

Value of a business is the present value of its future cash flows. For an investor it becomes difficult to predict cash flows and estimate the right discount rate. He struggles in that attempt all the time. What to expect of an investment, say, in a stock, is a pertinent question. 

While many analysts stick to the standard DCF model (of course, they do complicate it in the process is another matter), some loathe it citing reasons that it is difficult to predict cash flows. The latter take solace in applying multiples. And a few others use the combo - a mix of DCF and multiples. Really, there is no dearth of imagination when it comes to an analyst's emotions and his excel worksheet.

I can argue that it is possible to use DCF model in estimating an approximate (rather than precise) value of a business. I would rather keep that for another post.

The topic of this post is how venture capital and private equity firms earn their returns. They use different models to supply finance and acquire stake in the (often a private) business. The simplest form is usually the most sought after: Invest in equity of the business. Estimate the price (it isn't value) of the business 3-5 years hence. The pricing model usually is earnings-multiple, revenue multiple, or any other multiple. Have a minimum hurdle rate for the investment. Work back to calculate the price to be paid for the equity today.

If that means squeezing the present owners, so be it. In capitalism, it is fair. What is fancy in this investment model is that it is not fancy.

I want to argue that it is not difficult to use this pricing (not valuation) model for a small individual investor. It is actually a superior model to use for returns in excess of the market returns provided he is aware that pricing game is what is played here. The key to success with this model is of course the behavior of the investor.

Here's how it works:

The buy price depends upon the expected return:

As we can see for an investor who wants 30% return, the buy price has to be 47.40 which has an implied PE ratio of 13.54. This is about 52.60% down from the current price.

Is it possible to play this game in a publicly listed company? Of course it is possible because the market can be squeezed on occasion. For a patient investor there would be occasions to buy at his price. After all, the markets are inefficient, and a more-sensible investor can make money at the cost of the less-sensible one.

Two things hold out: Estimating future growth rate and PE ratio can be anybody's guess, and in addition, the emotions of the analyst can flow through to spoil the pricing game.

Nevertheless, thinking like a private equity investor is often useful. At least, it lets you to play the game on your terms.