amazon, price and value

In February 2014, I asked how long is long term for Amazon. At that time we could buy its entire equity for $160 b if we had that kind of money, and analysts had estimated that in a year's time the market cap of Amazon's equity would be $200 b. And lo and behold, it is $235 b now.  

Analysts sometimes are better at estimating short term, rather than long term. If they were good at long term consistently, they would stop talking and become rich; and that's another matter for another day.

How can Amazon back up its story? During 2014, it clocked revenues of $88.9 b, an increase of over 19% compared to 2013 revenues. In fact, revenues have increased at much higher rate during the last five years. Check this out: Amazon had revenues of $19 b in 2008. If Jeff Bezos had a vision of scaling its revenues, well, we know where he stands. 

What about its operating margins? Although, I do not go by the external service provider's reporting, I know that it is very low and has been coming down over the years.

One adjustment we can make to its reported numbers is its non-cancellable lease commitments. Nevertheless, the operating margins of Amazon are minuscule. It does generate some free cash flows to firm; yet, they aren't adequate.

Amazon started as a book retailer, and moved on to become an online general retailer, and now is also involved in cloud computing and drones. So we know, it has the ingredients to scale up its revenues much higher. 

With all this, will it succeed in bringing its operating margins to a respectable number? Because without this it will not be possible for Amazon to increase its intrinsic value. Or are we missing the big picture? Can we also make a case for adjustment of its advertising costs and research and development costs and argue, if we believe in the argument, that they are more of an enduring nature?

Low operating margins have not stopped analysts from being bullish on its story. No one is recommending a sell.

Now, the mean estimate for Amazon's equity is $300 b in a year's time. I did a valuation of Amazon in February 2014, and my story about Amazon has not changed since then. 

I do wish Amazon and Bezos a happy long term story. Bezos is an amazing guy.

roi, the walmart way

Recently I was reading the 2015 annual report of Walmart. Sure, it is a great business, and has rewarded its long term shareholders in more than a meaningful way. Yet, that does not make it unprejudiced.

Walmart said its return on investment was 16.9% and 17% for 2015 and 2014 respectively. I wouldn't have debated much, if it was left at that; ambiguous, yet, unarguable at the first instance. However, Walmart was more transparent, which any corporate manager should be, about its definition.

And here it is, the way it is calculated by Walmart:

I am always wary of any adjusted numbers. It left me wondering why corporates treat depreciation like the way they do. If it is not part of operating costs, what the heck it is? By the way, I have seen many analysts also doing this. And what is that rent doing there to be added back? Furthermore, just imagine if those interest costs were significant enough to make an impact. There is no consideration of tax expense too; aren't they genuine? I don't even want to go to the denominator. This is a classic mess up of a key performance indicator that is widely used as an input for estimating the value of a business.

We would probably understand if Walmart had instead added back some portion of its advertising costs reasoning that their benefit usually spreads more than a year; but then it should be added back to the denominator as well to be meaningful. I am being simplistic because the asset thus created will have to be amortized and included in operating costs. All this if we consider that Walmart also has brand value which attracts customers, in addition to its low cost premise.

Return on investment (capital) measures the quality of the investment made by a business. The higher the return, the higher the efficiency, and when it exceeds the cost of capital, the business increases its intrinsic value.

Here's Walmart's measure of free cash flows:

I could not figure out whether it is free cash flows to equity, which are after debt considerations, or free cash flows to firm.

This is one reason I don't use service providers' calculation of any number; the outsiders are either sloppy or don't know enough of what they do; probably both most of the time; and they are biased too. It is always better to go to the original source, such as the annual reports, quarterly reports, and company webcasts. And here too it is better to take only the raw data rather than any calculated numbers such as Walmart's return on investment.

Most of the corporates only disclose the calculated numbers, but do not give their basis of calculation. At least Walmart has been more transparent. It is left to the investors to make out of it.

By the way, Walmart repurchased its stock at $75.82 per share in 2015, at $74.99 in 2014, and at $67.15 in 2013. The total cost for three years was $15.3 b. Is it fair given the stock has been languishing for quite sometime? May be a thought for another post.

where're the market fundas

Nifty ended at 7812 on 22 Sept 2015; It had a 52-week high of 9119.20 and a low of 7539.50. This is a broader market, and might appear to be a buying opportunity for those who feel that way. 

It is also trading at 21.65 times earnings and 3.15 times book value. The earnings multiple is higher than the long term average of 18.60; however, lower than the book value average of 3.56. Not a close call, though. 

I did mention in my previous post that the market at levels (7785.85) it was, did not interest me much. In fact, I found it to be expensive. How about now, after just a few days?

I will make it short. Value of an asset is a function of its cash flows, growth and risk in those cash flows. Stating the obvious, the higher the growth, the higher the value. It is not just the physical growth that drives value, but the excess returns from growth. Growth can achieved in two ways: through new investments and through efficiency in current investments. The former leads to higher reinvestment at current return on capital, and the latter leads to higher return on capital without additional capital. The current market fundamentals do not give a picture of better future: The growth rate of Nifty at the moment is less than 10%, which was never there in any of the last 15 years barring a few days in March-April 2003. The return on equity is less than 15%, which is also one of the lowest.

Considering the above, it is hard to conclude that the market is a bargain. This of course is the current view. If the corporates make an effort to increase earnings and return on capital in the coming years, the tag line of good years ahead can be apt; otherwise, we are going to have a period of wait.

too big to fail banks

The RBI has designated SBI and ICICI bank as (domestic) systemically important banks. This would mean if these banks fail, there would be financial crisis and chaos in the country, impacting India's economy and its growth prospects. Why only these two and not other big banks can only be answered by RBI which has done the selection based on the systemic importance score, which takes into account the size, complexity and alternatives in the event of a crisis. 

The consequence of designation is that these banks will have to maintain equity capital in excess of the regulated norms for other banks. This is 0.60% for SBI and 0.20% for ICICI bank to be achieved in a phased manner by April 2019. They will also be subjected to much closer supervision, whatever that is.

The minimum Tier 1 capital ratio to be maintained as per Basel III norms is 7% as of March 2015, and 9.50% as of March 2019. While this is the minimum requirement, a prudent bank would have higher (internally) regulated equity capital ratio. While some may argue that it comes at the cost of growth, we can counter that with: growth for its own sake is no good; this is especially so for a bank. 

ICICI bank is in a comfortable position even when we set the Tier 1 capital ratio not at 7.20% as required for being a systemically important bank, but at 9.70% that is required by 2019. As of March 2015, its Tier 1 capital ratio was 12.79%. With the assumption of this ratio reducing gradually to 12% in the next five years, risk-weighted assets moving from Rs.5.5 trillion to Rs.9.7 trillion by 2020, and return on equity coming down considerably from 16.02% to 11.01%, ICICI bank should be able to generate free cash flows and payout dividends without raising further equity. Of course, Ms.Chanda Kochhar has indicated that the bank is not expected to raise fresh equity for the next couple of years; this indicates that the growth rate she is targeting is higher than what I have assumed in my estimates. Higher growth rates require higher reinvestment, and therefore may prompt external equity. 

The same cannot be said of SBI, which is a much bigger and more important bank. Although, it has a comfortable Tier 1 capital ratio of 9.49% (March 2015), due to its higher assets base it would require immediate fresh equity if it aims for growth. With the assumption of Tier 1 capital ratio increasing gradually to 12% in the next five years, risk-weighted assets moving from Rs.16 trillion to Rs.26 trillion by 2020, and return on equity coming down marginally from 11.53% to 10.98%, SBI would not be able to generate free cash flows in any of the next five years. It has to aggressively seek fresh equity of Rs.180 b, or grow assets at lower rates. Obviously, SBI won't be able to payout dividends unless fresh equity is raised; and even that would mean you take from shareholders and give it back to them; not much fun. However, if one shareholder supplies capital, it would be welcome. For minority shareholders, equity dilution is better than their entire capital at risk. And the good news is that the government is planning to give Rs.50 b to SBI soon, and has plans of Rs.700 b of equity infusion by 2019 in public sector banks.

In fact, all banks are big enough to fail and cause damage. The key, however, is to operate such that assets wouldn't have to be categorized as non-performing or bad, or to be written off. We don't want banks to continue to be in that vicious cycle.

Current times aren't too good for banks. Bank Nifty has been hit badly.

And SBI and ICICI bank stock prices have hit 52-week lows. May be the shareholders can take solace in Horace and say, many shall be restored that are now fallen...

is it time to buy now

Markets have been crashing all over. 

We can probably talk more freely about one market than other. Nevertheless, I know for a fact that in the short term, markets make a lot of mistakes; call it irrationality, rather than efficiency; yet, in the long term, they reason, and prices move towards value. 

Therefore, before we ask ourselves what to do with the current markets, we should take a deep breath, if that's what makes us more comfortable, and then ask whether there is any value here. Value is driven by cash flows, growth and risk in those cash flows. So we should ask whether any of the events taking place at the moment would have a long term impact on cash flows, growth and risk. Generally speaking, when we talk about the broader markets, short term events do not have the tendency to impact long term events; that is to say, generally in the long term, markets move upwards because corporates and countries grow.

Considering this, investors can continue their periodic market (the broader index) buying operation; for not-stock-pickers, this should not be stopped in any event; they should continue this activity irrespective of market levels. However, when it comes to individual stocks, it is a different matter. The investors need to work on the long term economics of the business and its capacity to generate excess returns over long term. When they find significant gap between price and value, they should act with meaningful amounts. 

Let's come back to the broader markets again. Apart from the periodic index buying program, can investors buy into indices given that they are falling? The so-called experts have been doing the talking, since they like talking, asking either to sell for the fear of coming bears, or to buy for the pleasure of getting bargains. I wish they had sat quietly at their home and executed those orders for themselves, and made themselves richer; I guess, they are too scared to do that. Prediction is a game nobody is good at; yet not many are able to accept this fact; they want attention and activity in their life.

For the moment, let's check out the Indian markets. How good or bad are they for an investor? Both Sensex and Nifty have had a free fall since the last week of August 2015. On 3 Aug 2015, Nifty was at 8543.05; and on 1 Sept 2015, it is at 7785.85; this is a fall of 757.20 points.

In the usual talking terms, Nifty is trading at a PE of 21.57, PB of 3.13, and dividend yield of 1.52%. Current PE multiple is definitely higher than the long term average, although it has not reached the previous highs.

There is another variable that we can use to check where markets stand, and that is the equity risk premium. Based on this, although it is better priced than July 2015, I find that current market level is one of the expensive ones on historical terms. Of course, that it is not like Jan 2000 and Jan 2011 is a consolation.

In short, I would not want to make significant investment at current levels. I would like to see the fall of 757.20 points in the right perspective, i.e. an 8.86% fall; and it is not good enough to invest other than on a periodic index buying program.