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Friday, September 25, 2009

Overview of Indian Banking Sector

Liberalization of Indian Banking sector post 1991 led to a shift in banking culture from Class banking to Mass banking. This sector was and will continue to be the backbone of Indian economy. According to RBI, Indian banking industry is now well-regulated and adequately capitalized compared to banks across other developed countries. This has helped them in remaining resilient in the wake of global meltdown and sub-prime crisis.


Increasing presence of foreign banks, heightened competition and rapid technological advancement forced banks to become cost efficient and financially strong. Taking risks is part of a banks core business. They borrow money in the form of deposits and leverage it to lend it to borrowers at a higher rate. Banks therefore need to be highly regulated as even a small liquidity problem can create panic amongst depositors’, further deteriorating liquidity.


Since accepting deposits and providing loans and credit is primary business of a bank, some loans are bound to go bad. Making provisions for such losses on bad debts is therefore important to maintain liquidity. They also carry huge liabilities in the form of customer deposits. The best parameter used to judge a bank is the level of Non-Performing Assets it is carrying on its balance sheet. These are loans that do not pay off their principle amount or interest for at least 90 days. Due to its peculiar nature of business, cash flow statements of banks do not provide much insight into their performance.


Five important factors that investors should judge before investing in a bank are capital adequacy, credit quality, liquidity position, earnings and capital efficiency. Recent sub-prime crisis has highlighted the importance of banks’ credit quality.


Banks usually pay-out dividends and are high yielding stocks. Performance of banking stocks on stock markets is directly impacted by overall economy’s health and changes in interest rates announced by RBI. This is reflected on Bankex, the index for banking stocks.


Indian banks are still recovering from the last year’s sub-prime effect and experts believe that several banks are still trading at a much lower price-to-earning ratio compared to the overall market. While public sector banks are shedding their excess flab by pruning manpower and NPAs, private banks are seen consolidating though mergers and acquisitions.


Government’s effort to encourage public sector banks to keep lending during the slowdown is expected to show positive results as soon as the economy shows positive signs. Private Banks played smart by shifting their focus from corporate lending to retail lending to cap their losses. Besides, indications from RBI that it does not plan to increase interest rates any time soon also helped improve investor sentiments about banking stocks. Experts believe that credit off-take will increase around 18% to 22% during the remaining part of this year driven by soaring demand from corporate sector.

Wednesday, September 23, 2009

Valuation of Early Ventures

In previous blogs, we have discussed several valuation models, including the famous Dividend Discounting Model, Earnings Capitalization and P/E ratio. While these traditional methods can be used to value companies with track record of revenues and profits, they are irrelevant for determining value of a start-up company. Too many assumptions of moving variables make valuing early ventures using these methods useless.


Determining expected growth rate of revenue and profits is meaningless when the success of a start-up cannot be confirmed. A market may reject the new product or the regulators might not approve the product in the first place. Moreover, several ventures may be based on new ideas which are not yet tested and do not have an established market. Valuing start-ups is still important, especially for investors as it helps them in deciding the percentage of ownership they will receive. Investors in early ventures expect to gain a good multiple on their investment. In other words, the business should be expected to reach a higher Market-to-Book ratio.


It is normal for start-ups to lose money during initial years. Several new technology companies which are internet based tend to be loss making even at the time they are being sold. While Price to Sales can be applied, it completely ignores the operating efficiency, growth rate and relative market size.


It is generally observed that new technology companies are valued higher than companies from other sectors like consumer products, chemical and other manufacturing sectors. One prime factor distinguishing technology sector and traditional sectors is that while traditional companies face geographical constraints due to product weight, jurisdiction wise regulation etc; technological companies can avoid these constraints by using third-party distributors or internet. They can expand and grow globally very fast compared to other sectors, that too with a very low capital base. Moreover, their gross margins can easily range between 70% and 100%, as against commodity companies that run on low margins.


Successful ventures can either be sold to larger companies or they can opt for an IPO. Early venture investors tend to determine two values; the potential value at the time of next round of fund raising and the potential value of the company at the time of exit or sale. They then determine the value of the venture today to get an idea of the multiple they would gain. This method is referred to as ‘Venture Capital Method’.


For valuing a start-up, a venture capitalist also depends on his intuitions and knowledge and perception about the industry. Following are some of the important factors which the investor should examine while judging the value of an early venture:


  • Valuations of comparable publicly listed companies
  • Addressable size of the market
  • Valuations of merger and acquisition transactions
  • Gross margins of similar companies
  • Expected long run growth rate
  • How different is the new product or service


Several start-ups launch new products and services. In such cases, it is difficult to judge competitiveness of these ventures and valuing them based on comparative valuations will be inappropriate. Using Cash Flow Discounting Model would be ideal in such cases if it is possible to forecast future cash flows. Several venture capitalists prefer valuing intangibles to overcome the shortcomings of traditional methods.


Tuesday, September 22, 2009

Valuing Real Estate Companies

Last few years saw real estate property prices go through the roof. Three factors that impact property price are property cost, interest rate and income levels. Given the fact that in India, shortage of residential units is approximately 19 million, demand side will never be an issue. Reduction in interest rates and tax incentives for home loan repayment drastically increased the affordability and demand of residential properties after 2005. And as supply lags behind the demand for residential properties, prices logically rose drastically. Similarly, growth in IT and ITES sector and organized retail sector resulted in increase in commercial property prices.


Driven by soaring commercial and residential property prices, valuation of real estate companies also increased dramatically. Some investors consider size of ‘land banks’ as a key parameter for investing in real estate companies, and give little importance to margins and execution time taken to complete these projects. The major pitfall of this approach is that even loss making realty companies will be valued highly, despite having poor fundamentals.


While size of land banks held do provide indication about expected growth of a real estate company’s revenue, investors should also consider certain ratios specific to this industry. Operating margin and Return on Capital Employed should not be ignored as they provide valuable insight into a realty company’s operating efficiency. Also, since realty projects have long gestation period, it is important to understand how the company is financed. Hence, debt to equity and working capital to sales are very important ratios to be applied while analyzing real estate companies.


Investors who value real estate companies based on the total land held use ‘best price per square foot’ method to value the land size, experts opine that since it tends to ignore the risks involved, using ‘normalized price per square foot’ or ‘profit per square foot’ are more appropriate methods. According to some experts, Price to Earnings ratio and Price to Sales are appropriate methods for valuing real estate companies.


One major shortcoming of valuing land banks for determining the value of real estate companies is that there is no standard price which can be used. Moreover, land prices defer widely from location to location. Using higher values per square feet will tend to overvalue companies.

Thursday, September 17, 2009

Growth Drivers for Real Estate Sector

Losses of industry players were capped by timely intervention of RBI which increased interest rate since 2006, the sector continues to remains unsteady. However, driven by the global economic recovery and macro-economic and sector-specific factors, experts believe that capital will start flowing in this sector. Besides global economic recovery, following are the indicators of this sector’s growth in the near future:


Industry experts estimate that by 2010, Indian IT and ITES sector will need approximately 150 million sq ft of official space.


Growth in organized retail sector will provide significant boost to commercial real estate sector, which is expected to demand 220 million sq ft of additional commercial space across tier-I and tier-II cities.


According to the Tenth Five Year Plan of the government, there is a shortage of approximately 22 million residential units and over the medium and long term around 90 million dwelling units will have to be constructed especially for middle and lower income families. Housing Development & Infrastructure Ltd (HDIL) and the Mumbai Metropolitan Development Authority (MMRDA), together plan to build a residential-cum-commercial complex in Virar, a suburb of Mumbai at a cost of around $1.49 billion.


Introduction of REMFs (Real Estate Mutual Funds) and REITs (Real Estate Investment Trusts) will definitely have a major impact on realty sector by helping players for price determination. As per CRISIL, REITs has the potential to reach the size of $1400 billion in next 3 years.

Following section are some of the new projects expected to be undertaken by private realty developers:


  • Tata Housing Development Company is expected to build around 1300 low-cost residential units at Boisar, 100km from Mumbai
  • Atlas Group plans to diversify into Indian real estate sector and invest $201.51 million in Kerala over the next years
  • Tata Realty and Infrastructure (TRIL) will invest approximately $4.2 billion for building SEZs, roads and other core sector projects
  • All major realty players including DLF, Unitech and HDIL have big housing projects lined up for marked-down properties
  • Avinash Bhosale Group (ABIL) will invest $126.25 million across Pune, Nagpur and Mumbai for developing 5-star hotels
  • Marriott International plans to open 24 new properties in India over the next three years
  • Cinepolis, a Mexican global multiplex operator plans to invest around $357.7 million in India and open 500 movie screens in the next 7 years for its film exhibition business.

Indian Real Estate

Real Estate is now the second most important industry in India only after Agriculture in terms of its contribution to the country’s GDP (which is expected to further increase from 5% to 6%). Residential property development comprises 80% of the total Indian Real Estate market, remaining consists of commercial space including shopping malls, hotels and hospitals.

Experts opine that, driven by faster economic growth, property markets of BRIC nations will recover faster than US and UK markets. No doubt that Indian property market is expected to attract around $12 billion over the next 5 years. Moreover, construction project in India generates higher profits compared to US. As per a recent McKinsey report, average profit from construction in India is 18 per cent, almost twice the profitability from a construction project undertaken in US.

The Indian government has been introducing several stimulus packages to unlock the huge potential of real estate industry. Last decade has seen several progressive reforms undertaken by the government to attract foreign capital and to introduce professionalism to this industry. One of the most important reforms was allowing 100% FDI in realty projects through automatic route. This coupled with the decrease in minimum area allowed to be developed under integrated township resulted in massive inflow of FDI in both residential and commercial space. Single-brand retail outlets and cash-and-carry outlets are now allowed to bring in upto 51% and 100% FDI respectively. RBI now allows banks to give special treatment to real estate sector, further boosting the credit flow.

Sensing the revenue potential of SEZs, Union Ministry of Commerce & Industry initiated progressive steps by simplifying the process and reducing the time taken to develop SEZs.

Despite growth incentives infused by government, global slowdown due to sub-prime crisis hit Indian Real Estate industry which was on a high since 2006. From January 2006 to January 2008 the BSE Realty index rose almost 6 times, only to fall 89% thereafter until March 2009. All major realty players including DLF and Unitech experienced a drastic fall in sales and profits. Ironically, these companies had massive expansion plans an intended to expand their operations abroad. Unfortunately, all expansion plans were stopped and liquidity crunch suddenly creped as buyers preferred postponing their purchase decision. Emaar MGF withdrew its maiden public offer of Rs.7,000 crore in February 2008 due to bad market conditions.

While losses of industry players were capped by timely intervention of RBI which increased interest rate since 2006, scenario still remains unsteady. However, driven by the global economic recovery and macro-economic and sector-specific factors, experts believe that capital will start flowing in this sector.

Wednesday, September 9, 2009

Overview of Indian Tyre Industry

The Rs.20, 000 crore Indian Tyre Industry, is highly raw material intensive and predominantly a Cross Ply (or Bias) tyre manufacturing industry. It produces all categories of tyres, except Snow Tyres and Aero Tyre for which there is no demand domestically. Indian tyre industry is highly concentrated wherein 10 large manufacturers account for over 95% of the total tonnage production of 11.35 lakh M.T. On an average, 55% of the production is for replacement market, followed by 29.8% sold to OEMs directly and the remaining is exported.

Over the years, tyre manufacturers have developed a vast marketing network using dealers and depots and as such all types of tyres are now easily available even in the remotest corner of the country. No doubt, international auto majors in India now roll out their vehicles using Indian manufactured tyres.






Slowdown in automotive industry and global economic in general negatively impacted the Indian tyre industry in 2009. The industry tonnage growth was only 2.19% during first nine months of FY09, compared to 7.38% growth experienced during the same period last year. Demand side was also severely affected as almost all auto manufacturers were forced to adjust their production last year. A major relief for tyre manufacturers was provided by the government by reducing the excise duty on tyres from 14% to 10% in December 2008, and further to 8% in February 2009.

Increasing Cost of Raw Materials: Ram materials primarily comprise of natural rubber, crude and steel based materials which have historically experienced volatility in prices, especially during the last few months when price of domestic natural rubber increased almost 40%. Given the fact that raw materials constitute around 70% of the cost of production, combined with the manufacturers’ inability to pass on the increased cost to their customers due to intense competition, rise in prices of these materials have a huge impact on profitability.

Increasing Radialization: Unlike in the developed countries, radialization has not yet reached its dominance in India. Particularly the truck, bus and LCV segments continue to be largely a cross ply based. Despite offering higher mileage, lower fuel consumption and improved safety, radial tyres have not yet caught on primarily because of poor road conditions and high initial cost which is approximately 25% higher than bias tyres. Moreover, the two important raw materials required for producing radial tyres (Steel Tyre Cord and Polyester Tyre Cord) are not manufactured domestically. Moving towards radialization will be vital if tyre producers want to protect their share in international markets. As of 2008, radialization as a percent of total production in passenger car tyres, LCV and heavy vehicles was 95%, 12% and 3% respectively.

Off the Road Tyres: Last year saw the top manufacturers, including CEAT and JK Tyres increasing their capacity of OTR (Off the Road) tyre production. OTR tyres are customized tyres and provide relatively higher margin. Increasing the proportion of OTR in the product mix is seen as a measure to improve profitability.

Increased Dumping: Besides material price fluctuations and lack of radialization, the industry is also suffering intense competition from low priced tyres from China and other South East Asian countries. Despite being of a better quality, Indian manufactured tyres loose ground when it comes to pricing. Moreover, slowing automotive demand from developed countries has made India a lucrative market for cheap tyres, thus resulting in increased dumping of cheap tyres from China.

Retreading: Another area of concern for the tyre manufacturers is the increasing retreading, where the worn out tread of the old tyre is replaced with a new tread. Retreading costs approximately 20% of a new tyre and is therefore gaining popularity, especially in Southern part of the country. Elgi Tyres and Tread Ltd are the two major retreaders in India. Significance of such retreaders can be gauged by the fact that around 85% of the tyre demand is for replacement.

Unresolved Tax Issue: The issue of inverted tax structure, wherein the import duty on natural rubber is 20% but import duty on finished tyres is as low as 10% still remains unaddressed. Operational inefficiency and taxation issues have being denting the competitiveness of Indian tyres.

Global Expansion: Several manufacturers are now moving global and are setting up manufacturing bases overseas. After acquiring Dunlop three years ago, Apollo Tyres recently acquired Vredetein Banden in Europe. JK Tyres acquired Tornel, a Mexican company last year to penetrate into American tyre market.

Despite these challenges, according to CARE Research, while the industry may register a tonnage growth of only 4.27% in FY09, the long term prospective seems to be bright. They expect the industry to experience a CAGR of approximately 8.21% between FY08 to FY13. Automotive companies have started experiencing increasing sales and raw material prices are stabilizing which will boost tyre sales over the coming months. However, experts suggest there will be some time lag before profitability picks up as tyre manufacturers are still carrying high cost inventories.



Friday, September 4, 2009

Discounting Cash Flow Method

Companies paying dividends can be valued using the Dividend Discounting Model and companies that do not pay dividends because they want to invest their earnings to expand further can be valued using Earnings Capitalization Method.


But what about companies that have been generating negative earnings and have never paid dividends?? In this case we discount the expected cash flows, using Discounting Cash Flow Method (DCF). According to experts, cash flows are a better projection of a company’s fundamentals. While earnings can be dressed up easily by manipulating income and expenses, manipulating cash flows is extremely difficult. Cash Flow Statement of a company is a true reflection of its income generation capacity, asset efficiency and how efficiently it employs its capital structure. Moreover, unlike cash flows, profitability does not necessarily indicate solvency.


The cash flows used in this valuation technique are Free Cash Flows (FCF), which are calculated as below:


FCF = Operating Profit + Depreciation + Amortized Goodwill – Capital Expenditure – Cash Taxes Paid – Change in Working Capital


Alternatively, it can also be calculated as:


FCF = Cash Flows generated from Operations – Capital Expenditure


From the above calculations, it is evident that negative FCF is not necessarily bad as it may also suggest that the company is making significant capital investment towards expansion, thus increasing its potential to earn higher returns in future.

Discount rate used to discount FCF should ideally be Weighted Average Cost of Capital (WACC). Besides valuing a business, DCF can also be used to estimate the value of a new project in isolation. If DCF of a project is higher than the initial investment required, it is worth taking up. In this case, cash outflows for the project would include:


  • Initial Investment
  • Expenses incurred during the life of the project
  • Interest paid on borrowed capital
  • Expenses incurred during termination of the project


Similarly, cash flows from a project would be:

  • Annual income
  • Proceeds received on termination of the project

While DCF is considered to be the most effective valuation method compared to Earnings Capitalization and Dividend Discounting Model, all these models have the one major shortcoming; they are as good as the assumptions used therein. Cash flows for DCF are generally projected over a relatively longer time horizon, and hence, any minor change in the assumptions and business environment can have a huge impact on valuation. Investors must therefore bear in mind that DCF is a running value and needs to be continuously updated for even a minor change in the applied variables.



Wednesday, September 2, 2009

Business Valuation using Earnings Capitalization

In our previous blog, we discussed the valuation of a company’s stock based on the expected dividends. Growing companies generally prefer to plough-back their income into their business for future expansion, instead of shelling out dividends to their investors. Using Dividend Discounting Method for valuing such companies will therefore be difficult.


Value of growing companies that do not pay dividends can be determined using ‘Capitalization of Earnings’ method. That is, simply dividing the earnings that are expected one year ahead by a capitalization rate. Capitalization rate is the discount rate adjusted for growth rate (.i.e. Capitalization rate = Discount rate less Expected Growth rate). It can also be WACC (Weighted Average Cost of Capital). Capitalization rate represents the risk associated with the business to be valued.


Earnings used in the calculation are EBIT (Earnings before Interest and Tax) which are adjusted for non-recurring income and expenses. Adjusting one time items is important to arrive at a realistic valuation and avoid making wrong investment decisions. Please note that discounting EBIT will give you the value of the whole business. To determine the value for equity holders, you will have to subtract the value of debt from this value.


Also remember that value arrived by capitalizing earnings will depend on the strength of assumptions made about expected earnings and long term growth rate. Several estimates and projections go in determining the future growth rate of a business. The shortcoming of this method is that one cannot value companies that generate negative earnings.


Tuesday, September 1, 2009

Dividend Discounting Model

Valuing a stock is very important when it comes to fundamental investing, that is, for investors who plan to invest for a medium to longer time period. According to ‘Value Investors’, investing in a business is worth while only if its ‘Intrinsic value’ (also referred to as ‘Present Value’ or ‘Fundamental Value’) is more than its current market value. In simple words, it is worth investing in a stock only if present value of all the expected gains from this stock (in the form of dividends and capital appreciation) is higher than the current market value. When Present Value (PV) is higher than the current market price, the stock said to be being ‘Undervalued’, and when it is lower than the market value, the stock is referred to as being ‘Overvalued’.

For example, consider stock of a Company A with current market price of $20. A value investor will consider investing in this stock only if he feels that the intrinsic value is greater than $20. That is, he assumes that Company A is ‘undervalued’. On the contrary, if the PV is less than $20, an investor may consider selling it short. It’s important to remember is that a cheap stock is not necessarily ‘under valued’. A low price may reflect poor market sentiments or a general economic slowdown and may not necessarily mean that it is under valued.

PV is calculated by discounting all the future gains expected from a stock using the rate of return expected by the investor. These gains may be in the form of dividends and capital appreciation.

Dividend Discounting Method (DDM)

This is the most familiar method applied for valuing companies that have consistently paid out dividends to their investors over the last few years, and are assumed to pay dividends over the next few years as well. Mature companies generally pay-out dividends regularly and are valued using this method. DDM can be modified for companies that are expected to grow consistently at the same rate, or at a higher rate for the first few years and later grow at a lower rate. Following are some of the commonly used DDM formulas.

Companies that are expected to pay consistent dividend per share perpetually can be valued as:

Present Value = Dividend Per Share / Discount Rate

This is the most basic DDM formula. However, its biggest shortcoming is that it assumes zero growth, which is taken care in the following formula:

Present Value = Dividend Per Share / (Discount Rate – Dividend Growth rate)

Companies that are expected to grow at a constant rate perpetually can be valued using this formula, which is also referred to as Gordon Model or Constant Growth DDM. However, it cannot be applied if dividend growth rate exceeds the investor’s rate of return, as the denominator will be negative and a stock value can never be negative.

DDM can be further modified as a Multi Stage DDM for valuing companies that are expected to grow at varying rates initially and then at a constant rate perpetually. For example, a company say, A, can be expected to grow at 10% annually for the initial 3 years, at 7% for the following 3 years and then at 4% perpetually.

While applying DDM for valuing stocks, investors should bear in mind that the value calculated will be as good as their assumptions applied in DDM. A lot of assumptions need to be applied while valuing a stock using DDM. An investor should have a strong fundamental understanding of the company to determine its earnings growth rate and its dividend pay-out ratio, besides knowing his/her own risk adjusted rate of return. Understanding your risk profile will enable you to set a realistic expected rate of return. Hence, PV of a stock will be different for every investor. Higher the expected return, lower will be the PV. Similarly, longer the time period for holding the stock, lower the PV.

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