Company Analysis 3: Valuation Part 3

Earnings and Repo Rate Based Valuation Method

In our last article 'Comapany Analysis 3: Valuation Part 2' we discussed the DCF model for valuation along with its limitations. I also promised you to discuss the valuation model I personally use to value companies. Today, I am here to discuss it but before doing so I want to clarify something. The model I am discussing today works well not because it is a rocket science rather because it is comparatively easier to understand and implement. One should use this model only if he finds it logical. Being clear about not promoting this model rather just trying to help you simplify the investment process let me get straight into the valuation.

Steps:

• Get the required data,

1. Current Repo Rate.
2. EPS for the Last 5 Years.

• Prepare Return Ranges as

1. Bad Return < 2.5 * Repo Rate(R1)
2. 2.5 * Repo Rate(R1) < Fair Return < 3 * Repo Rate(R2) 
3. 3 * Repo Rate(R2) < Great Returns

• Find Money Doubling time Y1 for (2*Repo Rate) and Y2 for (3*Repo Rate) by 72 rule.
• Find the ESP growth rate (G) for last 5 years.
• Find cumulative future earnings till Y1 as E1 and Y2 as E2.
• Fair value is between E2 and E1.  

Calculations for CESC Ltd.

• Required Data

1. Current Repo Rate = 4%
2. EPS for FY 2016 = 34.99, FY2017 = 40.39, FY2018 = 53.36, FY2019 = 77.83, FY2020 = 97.73.
   

• Return Ranges:

1. Bad Return < 10% ......(R1=2.5* Repo Rate=2*4=8)
2. Fair Returns = 10% to 12%........(2.5*Repo Rate to 3*Repo Rate(R2))
3. Great Returns > 12%..........(3*Repo Rate(R2))

• Money Doubling time

1. For R1 = 10%, Y1 = 72/R1 = 72/10 = 7 Years.
2. For R2 = 12%, Y2 = 72/R2 = 72/12 = 6 Years.

• EPS Growth Rate by CAGR Formulae (G) = [(Final Value/Initial Value)^(1/time Period)] - 1 = [(97.73/34.99)^(1/5)] -1 = 0.2281 or 22.81%
• Cumulative Future Earning = Current EPS*[(1+G)+(1+G)^2+....+(1+G)^(Y)]

1. Till Y1(7 years) = E1 = 97.73*[(1+0.2281) + (1+0.2281)^2 + (1+0.2281)^3 + (1+0.2281)^4 + (1+0.2281)^5 + (1+0.2281)^6 + (1+0.2281)^7] = 1690.85 Rs.
2. Till Y2 (6 Years) = E2 = 97.73*[(1+0.2281) + (1+0.2281)^2 + (1+0.2281)^3 + (1+0.2281)^4 + (1+0.2281)^5 + (1+0.2281)^6] = 1279.07 Rs.

• So, the Fair valuation range for CESC Ltd. is 1279.07 Rs. to 1690.85 Rs. 

Logic Behind This Calculation

• Here, we are first taking the repo rate as a base rate. We all know that most banks offer FDs rates between 1.5 to 2 times Repo Rate. FDs are comparatively secure investments so we expect no less than 2.5 times repo rate return when investing in businesses. The upper band is set arbitrarily as a 3 times repo rate. You are allowed to change both the bands but only in a higher direction. i.e. if you expect returns to be in the range of 3-5 times the Repo Rate you may take corresponding numbers as R1 and R2 but don't take lower numbers.
• After finding the expected return we are finding the number of years taken for the money to double with expected returns.
• Now let us say we want to invest 100rs in a company to double in 5 years. What the company has to do for that? Clearly, the company has to earn 100rs against your stake of 100rs in the next five years. So the value of your stake will increase by 100rs and your money will be doubled. 
• That is what we are calculating. The amount of money the company will earn per share in next money doubling period. If we buy shares at a price that is equal to money doubling period earnings then theoretically our investment value will double in the same period.
• Yes, this is a theoretical calculation but let me tell you something, I have backtested this valuation method and the real-life results are even more encouraging as the prices are actually increasing to more than triple the price and at times to bagging as much as 10X in money doubling period.
• You don't need to blindly trust me I will be discussing such multi-bagger companies with their complete analysis at entries and exits.

Disclaimer:

• The calculation for a valuation done above is for learning purposes only and it should not be taken as investment advice. 
• I may have invested interest in the company discussed above.