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

Modified on July 23, 2018

The current article in this series provides responses related to the following queries:

  • Can we trust the work done by auditors of companies?
  • 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?
  • Role of depreciation in CFO and Capex calculations

Can we trust the work done by auditors of companies? 

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. 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?
  2. 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) 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.

Further advised reading: 7 Steps to find out whether a Company is cooking its Books

2) 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:

How to Analyse Companies in the Industries New to You

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.

Further advised reading: Understanding Cash Flow from Operations (CFO)

Further advised reading for FCF: 3 Simple Ways to Find out Margin of Safety in a Stock

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:

“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

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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