AuthorRohit Chauhan

Analysis – Maruti Suzuki Ltd

By Rohit Chauhan
In Investment ideas, Uncategorized
May 16, 2008
4 Min read
6 comments
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About
Maruti Suzuki is india’s largest car company with brands such as Maruti 800, Alto, Swift etc. The company sold around 760000 cars in FY08 and currently holds a 50%+ market share

Financials
The company has achieved a 10%+ growth for the last few years. In addition the ROE has been 20%+ for the last few years and net of cash the ratio is upwards of 50%. The net profit margins have gone up from 5.8% to 9.8% in the current year. The company is a zero debt company and has almost 3000 Crs + cash and investments as of 2007.

In addition the efficiency ratios have improved from 2003 onwards. The company is now working on 0 Wcap. The recievables ratio is up from 14 to around 19 (2007). The total asset ratio has improved to around 5.

The company has thus improved its profitability and asset turns in the last few years. The improvement in net margins is really commendable as this has happened in times of rising raw material prices and higher competition.

Positives
Maruti is one the most well know brands. I really doubt if there is an indian who is not aware of maruti suzuki (rather their cars).

The company has a strong balance sheet, great brands and has been able to add new successful models consistently in the past few years. In addition the company now has full support from the parent for new models.

In addition to the above the company has the largest dealer and service network.

Risks
I see competition as the biggest risk. There will be swings in the demand. However as India prospers, the unit volumes are bound to go up. However with China and India being the high growth markets globally, there is bound to be intense competition in this sector. This could have an impact on the margins going forward.

The risk to margins is not from the pricing alone. Higher competition means, shorter product cycles and hence the amorization of the development expenses is now over shorter period. Case in point – The Company has rightly hiked its depreciation rates.

In addition during the year 2000-2002, the company had quite a stumble. The company was suddenly faced with slowing demand and increased competition. As a result the company made its first loss in years. However the company has learnt from it and has become far more efficient.

Competitive analysis
The firm has competitive advantage from a high market share and well know brands. The high volumes drives economies of scale for the company in manufacturing, purchasing, distribution and such scale driven activities.

In addition the company has increased the lead by expanding its distribution networks (more dealers), opening new service centres and by expanding into allied services such as insurance and used car sales. All this results in higher customer lockin and more repeat business.

Valuation
It is quite apparent that the company has considerable competitive advantage. However what is not easy to figure is how competition will increase and impact margins in the future.

With an assumption that the margins will remain between 7-9% (which is slightly higher than the global averages) and a 8-10% growth, and CAP of 9 years , the intrinsic value comes to around 1200-1300. I think the growth and CAP assumptions are reasonable. However the net margins are a wild card.

Added note: A 6-7% margin assumption would give an intrinsic value of around 1100.

Conclusion
The company sells at around 40% discount to the above intrinsic value. However I still have my doubts on the net margins. As a result although the company appears undervalued at current prices, I do not have any investment in the company. I would be prefer to have a higher discount to intrinsic value to make a commitment in order to reduce the downside risk from net margins.

Disclaimer – I may change my mind based on new information and may invest in the company. I may however not post when I do so. So as usual please make your own decision and read the disclaimer.

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The three risks for IT industry

By Rohit Chauhan
In Industry analysis, Uncategorized
May 5, 2008
2 Min read
Add comment
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I had recently posted on NIIT tech and uploaded the valuation (see here). The way I see it, there seem to be three key risks for the IT industry which I have tried to include in my valuations.

Risk 1 : US slowdown – This is a medium term risk and should not impact the long term economics of the IT industry. On the contrary I think the slow down will not really impact the industry much in terms of overall growth. There could be a bit of a slow down and some pricing pressure. But not much beyond that.

Risk 2 : Rupee appreciation – I think this with cost pressures is the most critical risks as this would impact the margins of the IT companies. In the scenario I have built I am assuming that margins will drop by half in the next 2 years due to the appreciation and cost pressure

Risk 3 : Taxation issues – The tax holiday enjoyed by the industry would be taken out by the government. In response to the slowdown and rupee appreciation the government has extended the tax holiday and there has been a sudden rally due to that. However I think the tax breaks are bound to go, only question is when. However this risk is definable and can easily be worked into the valuation

In my valuation I have assumed the worst case scenario for all the three risks. However as we saw recently if the rupee appreciates, the tax breaks could get extended a bit and that could mitigate the impact. So it is quite likely that the worst may not come to pass. The stock price assumed the worst in march. Since then there has some correction as the market realised that things are not as bad. However it would not take much to change the mood again.

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Berkshire hathaway annual meeting and quarterly results

By Rohit Chauhan
In Uncategorized, Warren buffett
May 4, 2008
4 Min read
1 comment
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Berkshire hathaway (warren buffett’s company) is having their annual meeting over this weekend. This meeting is called the woodstock of capitalists. I have been reading and following buffett for the last 10 years and tend to read his every interview, speech and the Q&A session of the annual meetings.

You can find a great compilation of everything buffett here

His letter to shareholder are a must read and I would recommend reading them multiple times.

Berkshire declared their quarterly results and reported a 65% drop in profits. Although as an indian investor, we cannot invest in this company, I would recommend reading the letter to shareholders and analysing the company to learn how a great company works and what it means to be shareholder oriented (the company is a gold standard).

I cannot explain the company in detail here. However if you have been following the company and have an idea about it, below is my analysis of the cause of the drop in profits.

Buffett has called derivatives as financial weapons of mass destruction and has cautioned against them. I am pretty sure that media, seeing a drop in profits due to derivatives, would crow about how the world’s greatest investor has himself got burnt by the same. However one has to understand that though buffett has warned against using derivatives if the company cannot understand the risks behind it, he himself understands them better than most and clearly knows what he is doing.

The quarter’s loss have been due to mark to market loss on the put options and CDS written by buffett. The put option buffett has written is similar to supercat insurance written by the company. The company gets a premium and insures a low probability event. if the event occurs then the company has to pay the insured amount. now over the years buffett has indicated the they could lose money on specific policies, but over a long term , they work with the odds on their side and would make a profit.

In case of the put, although we do not have the specific details, i would assume a similar approach. In addition buffett has indicated that he looks at the exposure also (total max loss) and no matter what the odds would never risk a huge amount. The puts are deep puts and the odds of the markets being lower 20 years later is low (we dont know what is the strike price of the puts, but they are based on the index and not on a company).

Berkshire accounts for MTM losses or profits which are accounting or book keeping losses/ profits if the options are closed today (unlikely to happen). So the company gets to keep the premium, invest it and get a good return from it for the next 20 years. This is on a low probability event that the market would be way lower 20 years later, in which case the company may well exercise the put and buy the index at the ultra-low valuations.

You would think that if the above is such a good deal, then why are other companies not doing it?

It is explained in the current year’s letter to shareholder and I can think of the following reasons

– The accounting as we can see in this quarter is very volatile. There are almost no companies which would risk a billion dollar hit to their results via such derivatives. The CEO would lose his job for such results
– There is counter party risk too. The buyer of the put option should believe that the company writing the put will be around 20 years later to pay up. Very few companies can do that

ofcourse media is going to make a show about this drop as they dont understand the company or how the options in this case are different from the one’s written by banks and other financial institutions.

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Business scalability and valuation

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
May 1, 2008
2 Min read
3 comments
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My pervious post was about business scalability, a term used by Rakesh jhunjhunwala frequently. I attempted to lay out my understanding of the term in that post.

Business scalability is a critical factor in valuation. As I detailed on my post on intrinsic value, the DCF formulae can be used to calculate this number. There are two key variables in the formuale – Free cash flow and the duration of the same before the terminal value is applied. This duration also referred to as CAP (competitive advantage period) is the time period during which the company is able to earn above its cost of capital. Beyond this period the company earns its cost of capital and hence is valued at its terminal value.

A company with a scalable business will be able to grow its free cash flow faster (higher growth) and also have a higher CAP at the same time. Now higher the growth and CAP, higher is the intrinsic value. If you can identify such a company much before the market does, as Rakesh jhunjhunwala and other top investors are able to, then the returns are very very high.

However identifying such companies is not easy. The most common error I have seen with analysts is that they identify the market opportunity, pick a company most likely to do well and stop at that. The analysis should also involve analysing the business model in detail, identifying the key drivers of performance and doing an assessment of these drivers. If this sounds complicated, then it is. The value is not easily apparent and requires quite a bit of analysis and digging around. All this has to be done before the market recognizes the company and bids up the price.

I think this approach to investing is a very advanced form of investing. It is not easy for a novice investor to practise this form of investing easily. One should have a keen understanding of business models, valuations, economics and other aspects of investing. Graham or deep value investing requires much lesser expertise and also has more diversification of risk. However this form of investing, where an investor can correctly identify a scalable business, is the key to long term riches.

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Business scalability

By Rohit Chauhan
In Investment process, Uncategorized, Valuation
April 27, 2008
4 Min read
2 comments
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I received the following question from rathin and thought that this a good question which cannot be answered in a short comment.

Hi Rohit,Can you elaborate more on “Business scability”…Rakesh JhunJhunwala emphasises on that…Can you also give one practical example of a company??

Rakesh Jhunjhunwala empahsizes the term ‘business scalability’ a lot in his interviews and presentations. Let me try to give my understanding of of the term

I think business scalability should be analysed based on two key factors

1. Market opportunity – How big is the addressable market, the company is trying to target
2. Business model – How scalable is the business model in its ability to tap the above opportunity profitably

Let me expand further on the above two points via some examples

Lets take the example of Bharti or any other similar telecom company.

Market opportunity – The market opportunity is case of telecom is huge. Telecom services are still far below international level and even after years of hyper growth, there is still a large untapped market. Market opportunity is easier to identify and one can compare the indian market with other markets to get a sense of it. However the fallacy by most analysts is to take a direct linear estimation. For ex: for argument sake US consumes 20 Kg of choclate per capita per annum. India’s per capita consumption is say 100 gm. so the market opportunity is 200 times that of US.

This is a very simplistic approach and should be taken with a pinch of salt. There are far more variables involved in evaluating market opportunity and a range of values for most products and services should be considered.

Business model – This is far more complex to analyse. This is where the genius of investors such as Rakesh jhunjhunwala is apparent. They are able to evaluate the business model far in advance and are able to judge if the business model of the company can scale profitably.

For ex: In case of telecom, there is a huge upfront investment in the infrastructure, license, setting up the marketing infrastructure etc. However once these investments are done, incremental cost of gaining a Rupee of revenue is low. Such business models are far more scalable

To get technical – The marginal cost remains steady or reduces in scalable models. Such companies get more profitable as they grow.

In contrast lets look at IT companies. It is apparent that the market opportunity is large. However the business model is not as scalable as Telecom. Here the relationship of revenue and cost is at best linear. In some case there may be a disadvantage to the scale. As the company grows larger, you need to manage more employees, have more layers and there are other costs involved in managing such large organizations. The top tier IT companies now have 100000 employees . A 10% CAGR growth for next 10 years , which is not a high assumption , would take the employee strength to 1 million plus. So you are talking of model which is not as scalable as Telecom

Lets take an extreme example of a roadside eatry. The addressable market is big. However the business model is not scalable as the eatry can only serve limited geography and may be limited by the competency of its owner and the employees running it. However if the owner can develop a franchise and start licensing it, then the model is scalable. Alternatively if the owner can brand its product then it is scalable to a certain extent

Among the two factors discussed above, I think the more crucial aspect is the scalability of the business model and how competent would the management be in tapping the external opportunity.

Next post: How does scalability impact valuations ?

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What is intrinsic value ?

By Rohit Chauhan
In Investment process, Uncategorized
April 24, 2008
3 Min read
9 comments
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In all my posts on investment ideas, I typically refer to the instrinsic value of the company. Although the definition and the concept is deceptively simple, application takes a lifetime.

What is intrinsic value – It is the total free cash flow the company will produce from now to closure of the firm. Discounting these cash flows gives the intrinsic value.

I will not be able to give a complete rundown on the DCF (discounted cash flow) computation. That could be another post, when I am really in mood to bore everyone to tears :). However the formuale for the computations is present in my valuation template – see the tab ‘DCF’

You can find the formulae here. The key parameters are free cash flow, discount rate, terminal values and growth rate. There are volumes written on each parameter and I will not get into the pros and cons of it. Let me give you how I calculate each. You can find the mechanics for each in my worksheets for companies.

Free cash flow = Net profit (after adjusting for all one time gains / losses) + depreciation – maintenance capex

Discount rate = around 12-13 %. That’s the hurdle rate for me. I don’t use any risk premium above that. Discount rate is a research topic in itself. I prefer to use a rough approach though and not tie myself up in academic acrobatics.

Growth – self-explainatory

Terminal value – It is the value of the company from the nth year ( n-1 year are the no. of CAP years) onwards. I would suggest looking at some textbook for more details as it is difficult to explain it in a short post.

I take it as 12 times Free cash flow of the previous year. Simple formulae for terminal value is NOPAT (net operating profit after tax)/ WACC (weighted average cost of capital). However let me warn you that the DCF calculations are very sensitive to the terminal value and it is important to be conservative on this parameter.

Once you have worked these numbers, you can plug them into a spreadsheet and get the intrinsic value. As you can see all these numbers are estimate and hence intrinsic value is an estimate too. The trick is in the assumptions you make. You have to be careful in making conservative assumptions, otherwise the DCF calculation could give you inflated numbers. That’s why a good valuation requires an indepth understanding of the company and its economics.

Discounted cash flow (DCF) analysis is the most fundamental way of calculating the instrinsic value. The other approaches such as PE, relative valuation which depends on comparing the valuation with other companies in the same industry etc are indirect valuation approaches. They can be used an input into the valuation process, but should not be the sole approach

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Change of Wind

By Rohit Chauhan
In Uncategorized, Views on news
April 18, 2008
3 Min read
6 comments
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US is in recession, Rupee is going to appreciate, wage cost is increasing, IT industry is doomed over,gone ..ok I am exaggerating. This was roughly the view just 1 month back.

I was running a few filters around that time and a lot of IT midcaps came up in the list. Some of these companies were 500 Crs+ companies selling at 2-3 times PE and 3-4 year lows. I listed a few ideas here. Since then there has been a complete change in the outlook.

The initial runup in the stocks seemed to be a correction of over-reaction in the prices. However as soon as Infosys and other results started coming out, there seems to be panic buying happening. Stocks like NIIT tech have gone up from 90 to 135, patni from 200 to around 280. So most of the IT midcaps have seen a 30-40% runup.

So whats the point, you may ask. Well I have always had a dilemma. Once I figure out that a sector or stock is undervalued, how fast should I react in building up a position ?

Based on this episode with IT midcaps, a big position,quickly would make sense. However that is a retrospective approach based on after the fact. Most of my picks go into a coma for quite some time and I typically analyse the stock further in detail for months together and build my position over the course of a few months. This approach helps as I am able to average down my cost, get a better understanding and build a decent position.

However this approach fails me in sudden runups. However in view of my overall time constraints and my need to do a detailed analysis, I prefer to take my time and build my positions. I would rather lose a few quick gains than compromise on my approach and repent later for the sloppy analysis.

In case you are wondering, I did build a position in NIIT tech and Patni computers around the major lows. This was however pure luck. It is quite possible that the opinion may change again and the prices may drop back again and i may get an opportunity to add to these positions or build new ones. Unfortunately I have no abilities to predict the future and do not follow an approach based on one. The downside to the run-up is that these stocks are no longer compelling no-brainers at current prices.

As an aside, I am seeing articles popping up saying capital goods and real estate sectors are overpriced and IT seems to be undervalued. Now you tell me !!

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NIIT Tech – Few additional points

By Rohit Chauhan
In Investment ideas, Uncategorized
April 14, 2008
4 Min read
8 comments
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There has been quite a lot of discussion on this investment idea. You can check the comments for that.

A few key points in the valuation of the company are as follows. I have uploaded the valuation (valuationtemplatev3NIITtemp.xls) based on the factors below in google groups. Please note that this is a rough back of the envelope calculation (see net impacts section of the spreadsheet) and may be off by 10-20%.

Impact of ESOP – This can be computed and I have detailed my logic in the comments. It is not completely accurate. However considering that ESOP’s account for 6-8% of the company’s current Mcap, a 20% errror would not amount to more 2-3% error in the computation of the intrinsic value. That is an acceptable error for me (although you would flunk a derivatives class for that error) as It would not change my overall conclusions.

Tax impact – I do not have the exact numbers on what the changes are. However for NIIT the current tax rate is around 15%. The average tax rate for Corporate india is around 25%. I have assumed that NIIT would be paying the average rates from 2010 onwards. You can see the impact of the tax changes in valuation excel I have uploaded in google groups.

US slow down and dollar depreciation – cannot really compute the impact. The downside is limited due to the fact that NIIT tech has 30% revenue from US. However that does not mean than Europe and Rest of world are immune from a US recession. I have taken the impact of a slowdown and dollar depreciation by considering that the net margins will drop from 14.5% to around 7.5% in the next two years. It could drop below that too …although the probability is low (my guess is good as anyone else). As a result of this the net profit could drop from around 130 Crs in 2007 to 90 Crs in 2010.

Forex hedge – The company does not have large hedges. So I do not see any open risks from hedges (such as the one which hit hexaware). However one cannot rule out such a risk in the future

ESOP computations – See section ‘options’ in the uploaded excel

Basic logic is as follows (which differs from the text book approach). This approach may have flaws and I think it is overly conservative.

i do not consider just the granted options alone. I consider all options already granted and to be granted. As the options approved by the board will be granted in the future and that would then dilute the shareholder’s equity in the business
a) Adjusted mcap = current price * (all options+issued stock).

Options which lapse can be re-issued to new employees, so lapsed options should not be netted out.b) value lost due to free options to employees – The option price is given in balance sheet (ESOP are not free to shareholders)
so reduction from intrinsic value = total options to be issued or exercised* option pricenet intrisic value = DCF based intrinsic value – cost of optionsso based on above i now compare adj mcap with net instrinsic value. If the adj mcap is 50% or below Net intrinsic value, then it is a buy for me.

Finally a correction – As pointed by others in the comments, I have calculated the net cash incorrectly. Post accquisitions and net of debt the net cash could be around 200-250 Crs (what are a few crores here or there 🙂 ?). Luckily that does not change the final conclusions much for me.

Please feel free to leave a comment for me if you find errors in my valuation.

Please read disclaimer at the bottom of the page. In addition I have a position in the stock.

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Analysis – NIIT Tech

By Rohit Chauhan
In Investment ideas, Uncategorized
April 9, 2008
4 Min read
31 comments
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Note: The analysis below is dated end of march – beginning of april. The stock has had a major jump since I started analysing the company. In interest of disclosure, I have a position in the stock. So please take this as a biased analysis. In addition I do not know if the jump in price is temporary and the price will fall again or it will continue rising. So as usual, please do your own analysis, read my disclaimer below and don’t blame me if your decision is based on my analysis alone. In summary – I am not recommending anyone to buy or sell the stock.

About
NIIT technologies is a 900 Crs company. It is a spinoff from NIIT ltd and is in the business of ITES and BPO. The company has 50% of revenue from Europe, around 30% from US and the rest from Asia, and other parts of the world

The company has a focus on a few key verticals such as BFSI (more in insurance), Transportation and retail services. The company has done a few targeted accquisition (such as ROOM solutions) in the above verticals in the last few years. In addition the company has signed a few JV’s too in the past. The company thus seems to be following an organic and in-organic path to growth

Financials
The company has done well in the past few years with ROE increasing from 17% to 30%+ in 2006. This has been driven by improvement in margins from 6% to around 12-14% in the recent years.
The revenue has also grown from around 500 Crs in 2004 to around 1000 odd crores in 2008 (expected). This translates into a revenue growth of around 18% p.a. The Net profit has grown from 33 Crs to around 110 Crs in 2007.

Positives
The company has a cash balance of almost 250 Crs (2007) which could rise to 350 odd crs (approximate). This would account for more than 60% of the market cap of the company.The company has almost 50% revenue from europe and thus is less exposed to the dollar risk and recession in the US.
In addition the company seems to be growing well, improving margins and increasing scale. At the same time the revenue from top 10 clients as a % of total revenue seems to be coming down, which is a good thing.
The company has a repeat business of almost 89% which shows good stability of revenue.

Risks
The obvious ones – US dollar, global slowdown etc etc.
The non obvious – The company is mid-tier ITES company. It still does not have the scale of the tier I vendor. However if the company focusses on the specific verticals and scales up in those verticals, then this disadvantage could be eliminated
In addition the company is pursuing accquisitions also. This is always a riskier way to grow.

Competitive analysis
The ITES business depends on the following key factors
a) scale : NIIT seems to be building scale in specific verticals. This would be the key to the company’s future
b) Customer lock in: This seems to be working for the company as the repeat business is fairly high

The other factors such cost advantage, overall scale etc is no longer a key differentiator as all ITES companies have this advantage and it is now considered as a minimum requirement in this business.

Valuation
The company sells at 1-2 times Net profit (Net profit is equal to free cash flow here) if you take out cash. The market is pricing NIIT tech with a view that the company will be out of business by 2010.

Conclusion
Short the company shutting down by 2010, it cannot think of any other justification for such valuations.
Dollar depreciation, US slowdown and increase in taxation rate can hurt margins. However ITES companies have some flexibility and control on the net margins through variable pay, utilization etc. So even if the margins drop by 50% to around 6-7%, the company will still sell at 4-5 times PE which is still quite low.

In summary, the market is pricing NIIT tech to be out of business in the next 1-2 years. That is a very low probability event in my view

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Prof Greenwald’s valueinvesting talk

By Rohit Chauhan
In Uncategorized
April 5, 2008
3 Min read
Add comment
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Prof Bakshi co-hosted a valueinvesting talk by Prof greenwald and has uploaded the presentation on his website here

I have read prof greenwald’s book on competitive analysis twice and have found his book very useful. You can see the usage of the concepts in my valuation templates too.

My notes on the presentation

– A lot of analysts consider only equity value in the valuation. Debt is also important
– On valuation basis a number of companies especially midcaps are priced at or below asset value. The market assumes these companies are worth more dead than as a going concern
– Most valuation approaches for PE are based on growth. As prof greenwald rightly points out, PE depends on multiple factors such as cost of capital, cyclical position, management etc too. Important to adopt multiple valuation approaches rather than a single simplistic approach based on PE alone.
– Looking back, my most successful investments were in companies selling below asset value, but having a moderate growth and a certain amount of competitive advantage. The returns were realised when the market revalued the company to reflect the true value (for ex : asian paints, blue star, concor, Guj gas, pidilite, ICICI bank etc)
– Great section on barriers to entry (see here for academic understanding of demand supply curves). I had an idea of the demand supply curves and other concepts of competitive advantage. This is the first time I have been able to get an understanding of how these two concepts interact – great learning.
– Slide 27-33 has great explaination of how competitive advantage concepts can be combined with basic micro-economic theory.
– Slide 36 should be an eyeopener if you expect as a lot of market participants do, that the market should give an average of 25% returns per annum or higher. Even with the drop and shrinkage in PE, the prospective returns look like 10-11%.
– Slide 40 – A number of indian companies such real estate, capital goods are showing high ROE, high growth and hence high valuations. Is the growth and ROE sustainable? The high valuation will be justified only if they are sustainable. With competitive pressures, difficult to see how all companies in a sector can maintain high returns and high growth rates.
– Not able to understand the slide 42 completely. But it is interesting to apply the calculations to companies which are selling at PE’s of 40 or higher. Clearly lot of expectations from such companies.

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