Q&A: Intrinsic Value, ROE, Promoters’ Salary & Others

Modified on July 14, 2018

The current article in this series provides responses related to:

  • Assessment of intrinsic value of a stock
  • Return on equity (ROE)
  • Reasonable levels of promoter’s salary
  • Treatment of inventory

Query

Hi Vijay,

I was recently reading an article titled “The Super investors of Graha-Doddsville”. In that he says when talking about Walter Schloss that he doesn’t really try to estimate next qtr. or year earnings.

Rick Gurien also asks the question how much is the business selling for and how much is the business worth (value). They always look for gaps in price and value.

In the same article Buffett says that when Washington Post was selling at $80m where as it was worth $400m. He says that it is the intrinsic value (IV). I generally read he rarely reveals the IV. I also know that he doesn’t use DCF.

Now I collected the 1971, 1972, 1973 annual reports. I don’t know he has arrived at an IV of $400m. All I can see is $160m in assets on the balance sheet (in 1972). Unless he has realized that there is some land/property which was quoted at historic prices and he had rough idea of what they were worth actually in 1972 (which I doubt), I feel he should have still used some projections. Or maybe I am missing something in those balance sheets/Annual reports.

I know this topic may not be any interest to you, but I wanted to see if I there is a way to estimate and see if I can get close to the same IV and hence the lessons learnt from the exercise can be applied to my own investing.

Can you please point me what to look for in those annual reports?

I have already looked at the things that are obvious. I just googled and got all the reports and the 1984 article. Let me know if I have to send them on your email.

Thanks

Author’s Response:

Hi,

Thanks for writing to me.

I am happy to see the efforts you are putting in assessing the value of a stock. It is commendable that you dug deeper into Buffett’s assessment of business value and read the past annual reports of Washington Post.

Unfortunately, I would not be able to help you in arriving at the intrinsic value of Washington Post ($400m). There are many reasons for it:

1) I do not try to assign any definite intrinsic/target value to a company. Buffett might have used some projections or any of his own valuation technique. However, I believe that it is very difficult for me to tell anyone including myself that the company is worth “X” amount of money. Economic environment keeps on changing constantly and any of the assumption/projection devised today is bound to be proved wrong tomorrow. We may find many such examples in Indian markets as well, where companies thought to be darlings of investors did not perform.

While investing, I try to find out a management which has reflected in its actions until now that it is a competent & shareholder friendly. And if I find that this management is running a business, which is not cash guzzling, then I buy the stock. I buy it with a faith on the management that they will keep steering the company through future changing scenarios and I as a minority shareholder would benefit by being a partner with them.

Buffett might have his own assumptions to arrive at $400m value to Washington Post from the annual report, if he did so, but I believe that Washington Post would not have generated good returns for him if the management was not competent. If without assessing management, his assumptions came true, then I would say that Buffett was plain lucky.

You may read about the parameters for assessing management in the following article:

How to do Management Analysis of a Company

2) Currently, due to paucity of time, I would not be able to devote time to reading these balance sheets.

Once again, I appreciate your efforts to improve your stock investing skills by analysing the stock picking approach of great investors. You are taking good initiatives to learn the skill.

All the best for your investing journey!

Regards,

Vijay

 

Query

Hello Dr. Vijay,

Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

I am an American investor and I do use return on equity (ROE) in my inputs, although I use it in the same way you do. i.e. if I find a company that earns roughly 10% ROE but is trading at 0.5BV, then as an investor I am earning a 20% return.

However, I would add that I believe ROE is very important in the long-run. If a company retains all its earnings and earns 20% ROE, that company will be worth much more than one that earns 10% ROE.

For example: We have one company that earns 10% ROE and trades at book value of 1 both when you purchase it and when you sell it, after 10 years, this hypothetically company would be worth 2.59. Your return is over 150%.

Now, we have another company that earns 20% ROE and trades at 4x book value of 1 but then declines to a more “fair value” of 2.5x book value over ten years. So book value grows to become 6.19, but since you paid 4x book value, your cost is 4. So your return is only 50%.

Now if you take these two same companies but only change the time period to twenty years you get a different result. The first company’s book value grows to 6.7 from your purchase price of 1, a 570% return! The second company grows book value to 38.3 from a purchase price of 4 (4x book value), for a return of 9.6x your money or 860%.

Your criticism may well be that 20 years is a long time for most people to wait, but this is what Buffett is talking about when he says time is the friend of the wonderful business.

Author’s Response:

Hi,

Thanks for providing your inputs!

I appreciate the time & effort put in by you to express your opinion, which is useful for both the author and the readers of the website.

Your calculation and depiction of different scenarios is insightful. 20 years should be the time horizon for investors and therefore, is not a very long term horizon.

As mentioned in the article, I advise readers to focus more on individual assessment parameters of any company instead of composite parameters like ROE (citing the example of DuPont’s analysis). I have noticed that whenever, I have found a fundamentally strong company with good business growth rate and handsome profitability margins, which is conservatively funded, always has a good ROE. Therefore, I advise readers to focus on each parameter separately. Looking only at one composite parameter like ROE many times hides some important aspects of assessment like leverage.

Read: Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

You have correctly identified that a company with good business performance is bound to reward shareholders. However, the more an investor pays for a company in terms of initial purchase price, the longer she has to wait to realize return.

Thanks once again for your inputs.

All the best for your investing journey!

Regards,

Vijay

 

Query

Analysis: Indo Borax and Chemicals Limited

just going through the annual report I have seen that that the owners has taken salary at 1cr each which is almost 10% of the PAT, does it raise a red flag ?

Author’s Response:

Hi,

Thanks for writing to me!

I am happy that you are doing your stock analysis and reading annual report, which is one of key requirement of stock research.

As far as level of promoters’ salary is concerned, it is not a straight forward yes or no decision. An investor needs to see many factors like the absolute amount of salary, trend of salary increase/decrease during times of business uptrend/slowdown etc. and whether promoters bring any specialized skill which is not available in the market in general.

Even at the end of this complete analysis, the interpretation of these parameters would differ from one investor to another.

Therefore, I would suggest that you analyse the performance of promoters on different parameter suggested in the following article and then take your decision about them:

How to do Management Analysis of a Company

All the best for your investing journey!

Regards,

Vijay

 

Query

Hello,

Thank you for your reply.

Could you please explain what is mean by Purchase of Stock-in-Trade? As for as I know from internet, company produced more product then it sold. The company deducts the cost incurred in manufacturing the extra goods from the current year costs. The company will add this cost when they manage to sell these extra products sometime in future. This cost, which the company adds back later, will be included in the “Purchases of Stock in Trade” line item. Is it correct? In that case company will include the total product cost or only expenses?

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you are spending time to understand accounting, which is the language of business. It is very essential to have a good understanding about the business of the companies, which an investor plans to analyse.

Your understanding is right. The cost related to the goods is recognized in P&L when these goods are sold. Otherwise, the cost is deducted from the cost of materials purchased in the year and is shown in the balance sheet under current assets/inventory.

Read: Understanding the Annual Report of a Company

All the best for your investing journey!

Regards,

Vijay

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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