Latest stories

Grindwell norton and Free cash flow

By Rohit Chauhan
In Investment ideas, Uncategorized
November 29, 2007
3 Min read
1 comment
G

I received the following email from sanjay shetty and decided to post it as he has asked a very important question on valuation. I have done some work on it on my own and have put the results in the worksheet – Quantitative calculations.xls

You can download is from here or use the download link in the side bar. Please see the tabs – Maintenance capex and FCF anal.

My responses are in italics. There is a follow up question from sanjay on maintenance capex. I will post on it in detail shortly with an example. If you have looked at my valuation templates, you may have noticed that I use FCF based on maintenance capex for valuation purposes

Hi Rohit,

I’ve been viewing your blog, after your comment on my blog (http://indiainvestor.wordpress.com).

I had a few questions for you.

What methodology are you using to value companies in India?

DCF, comparitive or relative valuation, sum of parts etc. I try to value a company based on multiple approaches and also depending on the nature of the company

Are you using a Discounted Cash Flow method to calculate Intrinsic value? If so, are you checking the Free Cash Flow, how are you calculating it?

yes, i use free cash flow. I however do not use capital expenditure directly. I use maintenance capex needed to support unit volumes or competitive position (maintenance capex). Difficult for me to explain in brief. i have a few excels uploaded in my google group explaining the calculation.

I’ve see most of the companies I’ve analyzed seem to be blowing enormous amounts of cash, with almost negative free cash flow which is worrying. –

I think the key point is whether the capex is maintenance or for growth / accquisition. Let’s take a short example. If a company earns 5% on capital , and has 10% margins (asset turn is 0.5). Then to grow by 5%, the company will use all its free cash flow. Also 5% growth is roughly inflation, so in this case the company is using all its free cash for maintenance capex
In case of a company growing by 20% and 10% margins (asset turns is 2), growth of 5% requires only 50% of the netprofit . The rest is cash flow which company can use to aqcuire other companies, give dividend or build assets. This is the case with grindwell norton. Grindwell has low FCF as it is investing the surplus cash in assets to increase volumes.

Hope the above clarifies .i have tried to provide a quick explaination and have left a few things out (like adding back depreciation)

Take for instance Grindwell Norton, which you’ve recently mentioned on your blog, Every thing seems rosy however Free Cash Flow is the concern.

I have taken out the detailed calculations by sanjay and put the final computations

 Free Cash Flow
Mar’ 02 29.178
Mar ’03 21.802
Mar ’04 17.149
Mar ’05 18.481
Mar ’06 3.121

The worrying fact about this company is the amount of cash it’s blowing, though currently it’s Sales, ROIC etc. are all healthy and growing.
Free Cash flow growth is actually going from bad to worse. I’m calculating Free Cash Flow as Net Cash from Operations minus Capital Expenditure which is Purchase of Fixed Assets.

Read on1 comment

Real estate valuation – Random thoughts

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 23, 2007
3 Min read
1 comment
R

I have been reading the book ‘Seeking wisdom – From darwin to munger’ which talks of various mental models and applying them to a problem to analyse it in detail.

The book is itself inspired by charlie munger and his lecture on the same topic. I have attempted to apply some models to valuing and analysing real estate.

The first post was valuing the real estate as a financial asset like stocks and bonds

The second post was trying to invert the problem.

The third post was looking at psychological baises in valuation of real estate. I will follow up with more posts on the same topic with other models.

I would like to add a personal approach for a first time buyer (buying for personal use)

If you are buying a house to stay (not investment), the maximum value of the investment would be driven by two numbers – EMI and personal debt to equity.

Let me explain
Suppose I earn 40000 as net income. My current networth ( all stocks, bonds, cash etc) is 10 lacs (10 lacs = 1 million). To be on the safe side, I would look at a house where my EMI is around 16000 / month (40% of net income)
So based on the above EMI, I can afford a loan of around 16 lacs at an interest of 10% for a 20 year tenure.

Assuming I have to put up 20% of the value of the house, I would look at a maximum investment of 20 lacs (2 million).
For a 16 lacs loan, my personal debt to equity is around 1.6 (16/10). This is higher than what I am comfortable. However it is not too high if you are in your 20s or 30s and have a long career ahead.

The above is a very simplistic approach and may sound conservative. But I prefer to plan for adversity and for a situation where things can go wrong. Buying a house as a first time buyer is less of an investment for me and more of having a roof on my head (in worst possible situation).

Some bad reasons for buying real estate
– Because the price has risen a lot lately or because the broker is predicting a rise.
– Because one can never lose in real estate
– Because your friend is buying it
– Because you can get a loan to buy it
– FII / Institutional investors are investing money – This is really a strange reason. FII/ foreign investors may have a good reason or maybe they are just following the herd. Just because an investor is an FII does not mean they have extra brains. Sometimes they are worse than an ordinary investor

A few links to value real estate
http://en.wikipedia.org/wiki/Real_estate_appraisal
Real estate valuation and analysis – read on the Cap rate which is similar to the P/R ratio
Deepak shenoy’s real estate cash flow calculator – Excellent worksheet to value real estate. Please read his terms.

Read on1 comment

Real estate valuation – Psychological biases

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 20, 2007
2 Min read
4 comments
R

I think there are several psychological baises working in case of real estate. The first is incentive caused bais. Typically real estate is sold via brokers or by sales agents of the builder. They have an incentive to sell the property and typically earn a commision based on sale price. It is quite obvious that the broker or sales agent would be motivated to sell at as high price as possible. In addition it is likely that he will give you a bullish outlook for the property prices.

The second strong bias is social- proof and deprival super reaction tendency. You see you friend buy a property and make easy money. At the same if you have not invested money and feel deprival super reaction tendency as everyone one else is making easy money.

So these two tendencies work together and motivate us to look for a property. Combine this with the incentive caused bias where the broker is constantly trying to create a scarcity (he will tell you that he has a lot of buyers and even you don’t buy now then the price will go up), lack of information and overoptimism on our part and this creates a combined effect. All these factors add up and can cause the buyer to become irrational.

I personally think the risk of bubbles are higher in real estate for the following reasons
– the common notion that real estate cannot lose value and represent something limited which is land
– High amount of leverage. Typically loans on a property is around 20%
– Lack of transparency and information in this market.
– All the above psychological factors

Read on4 comments

Real estate valuation – Inverting the problem

By Rohit Chauhan
In Non-equity assets, Uncategorized
November 18, 2007
3 Min read
Add comment
R

As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

In the last post, I developed the basic logic that real estate valuation depends on the rentals. Lets say you are looking at a property valued at say 50 lacs (5 million) . Now the reason to invest in this property is that you expect to make more than fixed income. Lets say you expect 15% p.a.

So the property should be worth 1 Cr (10 million) in the next five years. Such a property to sell at 10 Million, should atleast yield a rent of 40000 Rs/ month (assuming a P/R of 20). For some one to pay a rent of 40000/month, that individual should be earning atleast 170000 rs / month pre-tax.

How did I come up with number? assume a 30% tax rate and that a person would not prefer to spend more than 30% of his net income on rent in the long run. So we are talking of a person making 20-22 lacs per annum.

I agree salaries in india are rising and will continue to do so, but think of it this way – How many people can earn 20-22 lacs per annum (or 50000 usd ). To give a comparison, 50000 usd income is around the median income in the US too. On the flip side, with dollar depreciation and margins of IT/BPO companies getting squezed do you think it is feasible for indian companies to keep increasing salaries at 15% for the next 5-6 years and still be competitive?
Going one step further, if the investor thinks he can sell the property for 10 million , the person buying it will have to do a similar math. If the next investor expects 15% p.a , then he may agree to buy the property for 10 Million at a P/R of 20. However the property should then be 20 million, 10 years from now and needs a tenant making 40 lacs p.a (100000 dollars) to support the rents.
At any point during the next 10 years, if the above assumptions break, due to drop in salaries or recesion, the P/R (like P/E of a stock) could fall and returns could drop. I would agree that in the above scenario there are a lot of assumptions and ifs and buts. However one should think hard before going ahead with a big investment decision.

Please note that I am not talking of local knowledge of real estate. If someone has special knowledge of an area and knows that the area would develop in the next few years, then that person has an information edge and can make high returns. My example is of a general case of an apartment in a city which is what most of the investors put their money in.
Read onAdd comment

Subscription

Enter your email address if you would like to be notified when a new post is posted:

I agree to be emailed to confirm my subscription to this list

Recent Posts

Select category to filter posts

Archives