Q&A: Fair Value, Industry P/E, Torrent Pharma, Current Ratio

Modified on July 2, 2018

The current article in this series provides responses related to:

  • Assessment of fair/intrinsic value of a stock
  • Current ratio of companies
  • Clarifications on P/E ratio of Industries
  • Queries: Torrent Pharmaceuticals Limited
  • Investing in loss making companies
  • Identification of low cost producers in an industry

 

Query

I want to solve my problem of calculating the fair value of a stock.

We invest in stocks today in the view of future increase of its stock price. In other words, we are expecting its future earnings to grow. (Assuming we have already made a decision on company A)

  1. Let’s say Company A at Rs 100 stock price is growing 10% every year till yesterday. At their annual results update, they are giving a guidance of 15% for next year. So keeping this in mind, the ideal price for this stock by end of the next year should be 115. So, for some reason if the stock price goes up to 115 the very same day or in a month. Can we safely say the stock price is currently priced in the earnings for next year? And therefore a good time to exit? (Assuming Company A’s fair value is 100)
  2. For some reason, the price tanks by 20% to 80. Then given the guidance of 15% from the company and looking at past growth of 10% at the minimum, Can I assume it’s available at a discount?

I may be going by the guidance of the company but that’s just taking into some past and relatively moderate future expectations of the company.

If my above assumptions are correct then I am interested in finding the fair value. Can u pls help me arrive at a simple valuation formula which is more or less closer to the intrinsic value of the stock?

Author’s Response:

Hi,

Thanks for writing to me!

I do not try to assign any definite intrinsic/target value to a company. The company might have used some projections estimates or some other technique to give guidance. 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. Management guidance prove wrong almost all the time and almost every time managements have plausible reasons to convince investors why they are not able to meet guidance. Whereas the actual reason is that the management had expected certain economic environment which did not pan out as they had expected, which no one can predict.

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.

Therefore, I advise reader to look at the past performance of the company and at current stock price to assess if the company has margin of safety and then decide to invest or avoid. An investor should rely on future guidance.

One may read about calculating margin of safety of a stock in the following article:

3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of StockInvesting

Regards,

Vijay

 

Query

Hi Vijay,

Thanks a ton for this series, quiet amazing and explains fundamentals quiet simply. One query around current ratio, just checked few companies form Auto sector like hero, Bajaj auto Eicher and found that CR for them is 0.8 currently, how does that impact, kindly share more insights around this.

Thanks

Author’s Response:

Hi,

Thanks for writing to me!

In recent years, due to new companies act, the classification of balance sheet items have undergone a lot of change. Therefore, many items, which earlier did not use to be part of current liabilities, are now being included in current liabilities (esp. other current liabilities section).

Therefore, the current ratio needs to be seen in conjunction with the kind of item included in current assets and current liabilities.

I prefer to calculate current ratio as (Inventory + Receivables + Cash & equivalents + Current investments)/ (trade payables)

Therefore, I advise investors to calculate current ratio on their own from the balance sheet section of the annual report and not rely on the ratio computed by financial websites like moneycontrol etc.

You should recheck the current ratios for the above companies by taking the above information from the annual reports.

Hope it would clarify your query.

Regards,

Vijay

 

Query 

Is Industry P/E Ratio Relevant for Investors

Thanks, Dr Vijay for detail analysis. Here are my two cents:

Industry PE does give an idea about the relative position of the company within the industry, but it can be deceptive at times, particular when there is an excess optimism surrounds that industry, better known as fads.

Consider year 2000. Wipro and Infosys were quoting at 100 +PE multiples. Due to high multiples, it became very easy for fly by night operators (companies) to join the bandwagon as it was easy to get a PE of 30 to 40. And even after 40 PE, it was still at a steep discount to the leading player, which attract even more investors to these stocks (they found the bargain!!). There were companies, which had hardly anything to do with IT, changed their names and added Infosys at the end and their share price got the sudden boost.

Consider a case of a company which is getting PE of 30. Traditionally, to get a PE of 30, you need the very strong competitive advantage, for example, ITC today (PE of 25). But just because the company happens to be in IT, it was fetching higher multiples – considering Industry PE.

I think the company on its own need to stand investing merits. Industry PE can be a guiding factor in evaluation, but relying too much on it can be hazardous to investment returns.

Thanks again,

Author’s Response:

Hi,

Thanks for your feedback and valuable inputs!

You have highlighted very pertinent points with respect to the pitfalls of investment in high P/E ratios at the time of euphoric conditions. Other renowned investors have also cautioned the investors that most of the investment mistakes have happened when investors buy cheap quality at expensive prices during the height of bull market.

I have written an article dedicated to the risks of investing in high P/E stocks. I hope that you would find it interesting. You may read it here:

https://www.drvijaymalik.com/2016/02/hidden-risk-of-investing-in-high-pe-stocks.html

All the best for your investing journey!

Regards,

Vijay

 

Query 

Hi Vijay,

Analysis: Torrent Pharmaceuticals Limited

Nice analysis on Torrent Pharmaceuticals. There are few points which I would like to bring to your notice. Although the receivables are high but they are more or less balanced by high payables. The cash conversion cycle for the last five years are as follows FY15 (10.54); FY14 (3.25); FY13 (7.50); FY12 (-7.86); FY11 (17.68). Therefore, the efficiency of working capital is very good in my opinion. This is the reason they have been able to maintain high ROE (26-40%) in last 5 years.

Moreover, if you look at their cost of debt then it falls between 5-7% in last five years which again is very low. FY15 (175/2740 = 6.39%); FY14 (59/1132 = 5.21%) and so on. They might have raised cheap debt from abroad. This might be one of the reason why they are keeping high cash balance without retiring debt. Please post your opinion on the same.

Thanks and Regards,

Author’s Response:

Hi,

Thanks for writing to me and sharing your inputs. I appreciate the time and effort spent by you in analysis of Torrent Pharma & sharing it with author and readers of drvijaymalik.com

Here are my views about the two points raised by you:

1) A company can maintain its working capital cycle/cash conversion cycle despite increasing receivables days by delaying payments to vendors. However, conceptually both rising receivables and payables are sign of financial strains. Payments should be done and collected within timelines. Long overdue receivables lead to bad debtors and long overdue payables lead to withdrawal of good credit terms by vendors. However, cash conversion cycle being a composite parameter is not able to highlight these issues.

This is one of the reason that I do not prefer using composite parameters like CCC and even ROE/ROCE.

2) The cost of debt calculated by you is based on the interest expense shown in the P&L. Companies capitalize interest cost of capex as part of fixed assets/CWIP, which is not shown in P&L. I prefer using entire interest outgo (both P&L and capitalized amount) for estimating the interest burden of a company.

Hope it clarifies.

Regards,

Vijay

 

Query 

Sir, how do you value a company, if it’s making stringent losses for consecutive years? Because of its losses its share price gets beaten down. Would u like to buy that company in such situation hoping a turn around and do u like to buy net nets which are trading at 1/3 of its working capital? What about buying beaten down sectors like power, infra, metals, oil & gas?

Author’s Response:

Hi,

Thanks for writing to me!

I do not believe in investing in loss making companies or turnaround stories. Similarly I do not look for asset plays or net net investing.

I look for companies which are growing at a good pace with sustained profitability and are conservatively financed with proven management competence.

You may find my criteria for stock selection in the following article:

https://www.drvijaymalik.com/2015/01/selecting-top-stocks-to-buy-step-by.html

All the best for your investing journey!

Regards,

Vijay

 

Query 

Sir, how can anyone find whether a company is a low cost producer compared to its peers in the same industry by looking in to the annual report?

Author’s Response:

Thanks for writing to me!

You may compare the operating margins or EBITDA margins of different peers. The company with highest operating margin or EBITDA margin is usually the lowest cost producer.

Regards,

Vijay

 

Query 

Sir, do u use the same checklist while investing in cyclical and commodity businesses, since they have varying sales and profits all the time? And how do u analyse such companies?

Thank u for answering my earlier query.

Author’s Response:

Hi,

I do not follow any separate criteria designed specifically for cyclical stocks. I believe that fundamentally sound stocks, which are conservatively financed if bought and held for duration long enough that cover many business cycles would help an investor in seasonal stock price variations.

You may find my criteria for stock selection in the following article:

https://www.drvijaymalik.com/2015/01/selecting-top-stocks-to-buy-step-by.html

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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