Q&A: EBITDA vs Sales Growth, NPM, CAGR vs YoY, CFO vs FCF

Modified on July 22, 2018

The current article in this series provides responses related to:

  • Using EBITDA growth instead of sales growth while analysing stocks
  • Usage of 10 years of financial data in stock analysis
  • Analysis of net profit margin of companies
  • CAGR or year on year growth rates
  • CFO vs FCF in stocks analysis 

 

Query

Dear Sir, I have no words to describe the job you have done in analysing Emmbi. I too am an investor in Emmbi and it has opened my eyes too.

Read: Analysis: Emmbi Industries Limited

However, I have two very basic fundamental queries, may not be connected to Emmbi per se.

First query is, why we attach so much importance to Sales Growth. To me sales growth in terms of rupees is misleading. Prices of raw material can go down. So sales in terms of money can show a dip. If we take Emmbi as an example, crude oil prices came down from 120 dollars to 40 dollars and now is in the 50s, hence Emmbi’s sales growth does not appear great. As per me we should see the EBIDTA growth, not sales growth. This captures the company’s ability to do business even during a downturn. EBIDTA is agnostic of raw material and finished product prices.

My second query is why we should take 10 years as the basis for cash flow analysis. Why not 5 years. For example, Emmbi was making very low margin high competition HDPE bags. Only from 2012-13 did the company started making higher margin products. So if we go back in history when the company was not doing well and use those numbers in our calculations, we may draw an incorrect conclusion.

I will be highly obliged if you can give your views to my two queries.

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you found the article useful.

You’re right that an investor may use EBITDA as it would remove the impact of movement of sales price, if linked to raw material prices. Sales value being more intuitive and being readily available at multiple publically available databases as well as being subject to filters in multiple screeners is being used. However, if an investor wishes to use EBITDA, then she might use it.

10 year parameter is a starting point for the analysis. However, as an investor reads more about the company, then she would continue to learn more about the specifics of the company and its different strategy decisions. The investor may then tweak her parameters accordingly.

Read: How to do Financial Analysis of Companies

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Vijay, we have seen that as the utilisation of a plant increases, operating leverage ensures higher profitability meaning net profit margin (% of sales) increases with plant utilisation. Whereas at lower capacity utilisation the net profit tends to be lesser.

My doubt: Since Net Profit margin is an indicator of the industry viz, monopoly, duopoly, highly commoditised, etc. at what level of capacity utilisation should one consider Profit Margin level

Author’s Response:

Hi,

Thanks for writing to me!

I do not consider net profit margin linked to industry. This is because within any industry, the NPM Of players differs by a huge margin.

I believe that if an investor is worried about year on year variations in the NPM, then an average of 3 years of NPM should work fine. Rest an investor may use any other criteria and check whether it works.

Read: How to do Financial Analysis of Companies

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

Follow up query 

Vijay, I think my query has not been understood. What I mean is suppose a plant is running at 20% utilisation, then it may have 8% margins. As plant utilisation increases, to say 60% and then 85%, NPM will also increase to say 13-15%.

NPM normally indicate the nature of the industry. Highly competitive and commoditised businesses have very low NPM say 5-7% and as monopolistic businesses / Moat businesses may show up to 25% NPM.

My query: At what % of plant capacity utilisation can one take the NPM for that business?

Author’s Response:

Hi,

Thanks for writing to me!

As rightly mentioned by you, the spreading of fixed costs over larger volume of goods as the capacity utilization increases, would lead to improving NPM over time.

I do not have any clear cut answer as to at what capacity utilization one should take ideal/sustainable NPM.

As mentioned earlier, I prefer to take an average of last 3 years of NPM, which takes care of changing capacity utilization. Alternatively, an investor may take NPM at the capacity utilization levels, which the company has been able to achieve in the past.

Moreover, an investor may focus more on OPM, which is not impacted by expense of plant costs like depreciation and the funding costs like interest expense.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Hello doc sir one question comes in my mind after reading ur article about analysis of stocks, while looking sales growth or NPM, you are saying that one should look at CAGR of last 7 to 10 years, so I want ask whether I have to look year by year like if I look sales growth year by year then it’s not above 15 % in all the years, which is your criteria but the CAGR of sales growth is 25%.

So what should we see, Sir? Each year or only CAGR?

Similarly, if we see NPM, then the CAGR might be there above 8%, however, year on year, it might be sometimes 3 % and sometimes 4%. Please clarify. Thanks a lot.

I am a small investor and a new learner. Now days, I am reading your blog sir and some queries have come to my mind so please don’t mind to help me to learning process. thanks.

Author’s Response:

Hi,

Thanks for writing to me!

Year on year performance is expected to vary significantly as the business environment keeps on changing year on year. Therefore, an investor should primarily focus on CAGR, however, she should also take care that the entire CAGR should not be because of abnormal growth in any one or two years.

Read: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Sir, I see at in two articles one is saying free cash flow (FCF) should positive other says that cash flow from operations (CFO) should be positive. So which point should be taken cfo or fcf? Please clear thanks because some companies have positive CFO but negative fcf

Author’s Response:

Hi,

Thanks for writing to me!

Both CFO and FCF should be positive.

FCF is calculated as CFO – Capital Expenditure

Therefore, FCF would in most cases be positive only if CFO is positive except in cases where capital expenditure is negative meaning that instead of building new assets, the company has sold its existing assets.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

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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