December 31, 2017

Can We Trust the Auditors, Is Credit Rating Mandatory, What to do when Growth slows down after P/E Rerating, How to Learn about New Industries (Q&A)

www.drvijaymalik.com has a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:
  • Can we trust the work done by auditors of companies?
  • Is a credit rating mandatory for all the companies having debt?
  • How can an investor calculate the CAGR of a portfolio?
  • What do we do when the growth of a company slows down after P/E rerating?
  • How can an investor learn about industries, which are new to her?
  • How to combine standalone & consolidated financials of companies for analysis?
  • Role of depreciation in CFO and Capex calculations


Can we trust the auditors, Is a credit rating mandatory for debt, calculate the CAGR of a portfolio, growth of a company slows down, learn about new industries, combine standalone & consolidated financials


Can we trust the work done by auditors of companies? 

Is a credit rating mandatory for all the companies having debt? 

How can an investor calculate the CAGR of a portfolio?


Hi Dr Vijay,

I have a few questions. Hope you can shed some light on the points below:
  1. Credit Rating: Is there a minimum amount or duration of loan that requires a company to go for Credit Rating. I am analysing a small company, which has debt on its books. However, I am unable to find the credit rating report for this company.
  2. Role of Creditors & Auditors regarding check Cash/Bank/Investments: What is the degree of detail that Creditors and Auditor go through while reviewing books of accounts. Do they verify the existence of cash on books and investments?
  3. How to calculate CAGR of a Portfolio: I have been investing for the last 13 yrs and want to calculate the CAGR of my portfolio. I have multiple buys and sells in a year.


Author’s Response:

Hi,

Thanks for writing to us!

1) The credit rating requirement seems to have a minimum loan amount threshold. E.g. for commercial papers, if the amount is more than ₹6 lac, then the credit rating is needed as per RBI guidelines. If we are not wrong, then for bank loans, the minimum threshold may be about ₹10 cr. Loans below the minimum threshold may not need to be credit rated. You may need to search for it a bit. Alternatively, you may directly write to the company about its credit rating.


2) Ideally, the auditors should verify each bank account statement, FD receipts, MF statements etc. However, in case an auditor is hand in glove with over-smart promoters, then we're not sure what can be the level of due diligence.


3) For CAGR, investors may use the XIRR formula of the Excel. There would be many tutorials about XIRR on the internet, which you may refer to for guidance on usage of XIRR.

All the best for your investing journey!

Regards,

Dr Vijay Malik

What do we do when the growth of a company slows down after P/E rerating? 

How can an investor learn about industries, which are new to her?


Hi Dr. Vijay,

Hope you are doing well. I have a few questions that I hope you can shed some light on:
  1. P/E rerating: How should you evaluate whether to hold/sell a stock whose P/E let’s say has increased from 8 at the time of purchase to 70, with key facts being that sales growth have slowed down, but its sales and dividend yield is comparable to industry leaders now, and profitability remains the same.
  2. Resources: Could you provide some resources on how different industries can be evaluated like you explained "percentage of completion method is used for real estate sector" and how it is different to evaluate a bank like for its SCF especially its CFO. If you could provide some links and resources I could look up, I would be grateful.

A follow up to the above question: Could you also provide guidance on how to widen one's circle of competence?

Thank you

Regards

Author’s Response:

Hi,

Thanks for writing to us!

1) We do not sell portfolio stocks if they become overvalued. We have held stocks rising from P/E of 6 to about 40 and we have been ok with it. We have not seen valuations rise to 70 P/E until now in our portfolio so we can only speculate what our reaction would be in such a scenario. However, we believe that our approach would not change provided the fundamentals of the company are intact.

Further advised reading: When to Sell a Stock

2) You may refer to the following article to learn more about industries, which might be new to you and to increase the circle of competence:


All the best for your investing journey!

Regards,

Dr Vijay Malik

How to combine standalone & consolidated financials of companies for analysis?


How should we combine different financials for last 10 years in the Screener “Export to Excel” sheet when we need to use standalone financials for some of the years and consolidated financials for rest of the years?

Author’s Response:

Hi,

Thanks for writing to us!

Let us explain the steps that we follow in such cases of merging of standalone & consolidated financials of companies in the excel file. We have taken the example of Omkar Speciality Chemicals Limited for illustration:


Can we trust the auditors, Is a credit rating mandatory for debt, calculate the CAGR of a portfolio, growth of a company slows down, learn about new industries, combine standalone & consolidated financials

1) Download both the standalone & the consolidated financials separately.

2) Copy the standalone financial data from the "Data Sheet" of the excel file(quarters, P&L, Balance sheet, cash flow, price, adjusted number of shares) for the particular years e.g. for FY2007, 2008, 2009, 2010 in case of Omkar.

3) Paste the data copied in the above step in the consolidated financial excel file in the columns for the years FY2007, 2008, 2009, 2010.

Now the analysis sheet "Dr Vijay Malik Analysis" will contain all the calculations containing the standalone figures for FY2007-10 and consolidated figures for FY2011-16.

In this way, we get the complete financial picture for last 10 years for the company with the relevant financials.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Role of depreciation in CFO and Capex calculations


Hi Dr. Malik,

I am amazed by your clarity of thought. Thanks for sharing whatever you have learned with small investors.

I notice that the depreciation is double counted in free cash flow (FCF) calculation.

You mentioned that FCF = CFO - Capex.

Therefore,

FCF = PBT - Tax paid - Working capital changes + Dep - Interest Income + NFA1 + CWIP1 - NFA0 - CWIP0 + Dep

As we can see, Depreciation is added in both, CFO as well as Capex and leads to being counted twice.

Could you correct if I am wrong?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

It may seem that depreciation appears twice in the formula because we are using a reverse calculation to arrive at both CFO as well as Capex. However, the formula is correct.



The alternative method to calculate free cash flow would be to look at the bank account entries of the company to find the cash it has finally made from operations and again check the bank account entries to find how much money it paid for purchasing fixed assets. However, as this data (bank account statements) of the company is not available, then we have to use the indirect/reverse calculation method.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Addendum Answer from Abhinav Mehrotra from the comments below:

"You mentioned that FCF = CFO - Capex.

Therefore,

FCF = PBT - Tax paid - Working capital changes + Dep - Interest Income + NFA1 + CWIP1 - NFA0 - CWIP0 + Dep"

The formula written above has not been adjusted for the -ve sign in the CAPEX figure in the 1st formula.

Actual formula with -ve CAPEX would be:
FCF = PBT - Tax paid - Working capital changes + Dep - Interest Income - (NFA1 + CWIP1 - NFA0 - CWIP0 + Dep)

So D&A gets cancelled in FCF calculation as it is a non-cash expense.

We thank Abhinav for his valuable inputs.

Regards,

Dr Vijay Malik

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DISCLAIMER


Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above