Sunday, May 14, 2017

Using Enterprise Value To Compare Companies

Courtesy : Investopedia

The enterprise value - or EV for short - is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focusing on its current market capitalization. It measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a clearer picture of real value with EV than with market capitalization.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

The Calculation
Simply put, EV is the sum of a company's market cap and its net debt. To compute the EV, first calculate the company's market cap, add total debt (including long- and short-term debt reported in the balance sheet) and subtract cash and investments (also reported in the balance sheet).

Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 shares and each currently sells for $25, the market capitalization is $250. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company's value, market cap simply represents the company's price tag.

The Role of Debt and Cash
Why are debt and cash considered when valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions, price is typically set higher than the market price) and must also repay the firm's debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted from the firm's price as represented by market cap.

Think of two companies that have equal market caps. One has no debt on its balance sheet while the other one is debt heavy. The debt-laden company will be making interest payments on the debt over the years. (Preferred stock and convertibles that pay interest should also be considered debt for the purposes of calculating value.) So, even though the two companies have equal market caps, the company with debt is worth more.

By the same token, imagine two companies with equal market caps of $250 and no debt. One has negligible cash and cash equivalents on hand, and the other has $250 in cash. If you bought the first company for $250, you will have a company worth, presumably, $250. But if you bought the second company for $500, it would have cost you just $250, since you instantly get $250 in cash.

If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay a lot more than $250 if he or she were to buy the company's entire stock. The buyer has to assume $150 in debt, which brings the total acquisition price to $400. Long-term debt serves effectively to increase the value of a company, making any assessments that take only the stock into account preliminary at best.

Cash and short-term investments, by contrast, have the opposite effect. They decrease the effective price an acquirer has to pay. Let's say a company with a market cap of $25 has $5 cash in the bank. Although an acquirer would still need to fork out $25 to get the equity, it would immediately recoup $5 from the cash reserve, making the effective price only $20.

Ratio Matters
Frankly, knowing a company's EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company's cash flow or EBIT. Comparative ratios demonstrate nicely how EV works better than market cap for assessing companies with differing debt or cash levels or, in other words, differing capital structures.

It is important to use EBIT - earnings before interest and tax - in the comparative ratio because EV assumes that, upon the acquisition of a company, its acquirer immediately pays debt and consumes cash, not accounting for interest costs or interest income. Even better is free cash flow, which helps avoid other accounting distortions.

The Bottom Line

The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.

Tuesday, May 9, 2017


Websol Energy reported the above result for the March Quarter/Year Ended 2017. Even excluding other income ,company performed exceptionally well . More than the result, as per notes, company succeeded in its debt reduction efforts and at the same time doubled its production capacity.

Discl: Personally holding shares of Websol, hence my views may be biased.

Saturday, May 6, 2017

Managing The Risks In Value Investing

  Courtesy: Investopedia
Although value investing properly executed is a low-to-medium-risk strategy, it still comes with the possibility of losing money. This section describes the key risks to be aware of and offers guidance on how to mitigate them.

Key Risks

  • Basing Your Calculations on the Wrong Numbers
    Since value investing decisions are partly based on an analysis of financial statements, it is imperative that these calculations be performed correctly. Using the wrong numbers, performing the wrong calculation or making a mathematical typo can result in basing an investment decision on faulty information. Such a mistake could mean making a poor investment or missing out on a great one. If you aren't yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don't place any trades until you're truly ready.
  • Overlooking Extraordinary Gains or Losses
Some years, companies will experience unusually large losses or gains from events such as natural disasters, corporate restructuring or unusual lawsuits and will report these on the income statement under a label such as "extraordinary item – gain" or "extraordinary item – loss." When making your calculations, it is important to remove these financial anomalies from the equation to get a better idea of how the company might perform in an ordinary year. However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also beware a pattern of write-offs.

             Ignoring the Flaws in Ratio Analysis
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company's financial health. The problem with financial ratios is that they can be calculated in different ways. Here are a few factors that can affect the meaning of these ratios:
    • They can be calculated with before-tax or after-tax numbers.
    • Some ratios provide only rough estimates.
    • A company's reported earnings per share (EPS) can vary significantly depending on how "earnings" is defined.
    • Companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same ratios. (Learn more about when a company recognizes profits in Understanding The Income Statement.)

One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer you pay to the stock's fair market value – or even worse, if you overpay – the bigger your risk of losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all of your investments. This means purchasing stocks at a price of around two-thirds or less of their inherent value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.

           Not Diversifying

Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his "Little Book of Value Investing." Famous value investor Benjamin Graham suggested 10 to 30 companies is enough to adequately diversify. On the other hand, the authors of "Value Investing for Dummies, 2nd. ed.," say that the more stocks you own, the greater your chances of achieving average market returns. They recommend investing in only a few companies and watching them closely. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.

            Listening to Your Emotions

It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. You must remember that to be a value investor means to avoid the herd-mentality investment behaviors of buying when a stock's price is rising and selling when it is falling. Such behavior will destroy your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.
Value-investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).

Basing Your Investment Decisions on Fraudulent Accounting Statements

After the accounting scandals associated with Enron, WorldCom and other companies, it would be easy to let our fears of false accounting statements prevent us from investing in stocks. Selecting individual stocks requires trusting the numbers that companies report about themselves on their balance sheets and income statements. Sure, regulations have been tightened and statements are audited by independent accounting firms, but regulations have failed in the past and accountants have become their clients' bedfellows. How do you know if you can trust what you read?  
One strategy is to read the footnotes. These are the notes  that explain a company's financial statements in greater detail. They follow the statements and explain the company's accounting methods and elaborate on reported results. If the footnotes are unintelligible or the information they present seems unreasonable, you'll have a better idea on whether to pass on the company.
Not Comparing Apples to Apples

Comparing a company's stock to that of its competitors is one way value investors analyze their potential investments. However, companies differ in their accounting policies in ways that are perfectly legal. When you're comparing one company's P/E ratio to another's, you have to make sure that EPS has been calculated the same way for both companies. Also you might not be able to compare companies from different industries. If companies use different accounting principles, you will need to adjust the numbers to compare apples to apples; otherwise you can't accurately compare two companies on this metric

Selling at the Wrong Time

Even if you do everything right in terms of researching and purchasing your stocks, your entire strategy can fall apart if you sell at the wrong time. The wrong time to sell is when the market is suffering and stock prices are falling simply because investors are panicking, not because they are assessing the value of the quality of the underlying companies they have invested in. Another bad time to sell is when a stock's price falls because its earnings have fallen short of analysts' predictions.
The ideal time to sell your stock is when shares are overpriced relative to the company's intrinsic value. However, sometimes a significant change in the company or the industry that lowers the company's intrinsic value might also warrant a sale if you see losses on the horizon. It can be tricky not to confuse these times with general investor panic. Also, if part of your investment strategy involves passing on wealth to your heirs, the right time to sell may be never (at least for a portion of your portfolio).

Sunday, April 30, 2017

3 Simple Steps To Building Wealth

Courtesy :Investopedia

Building wealth – it's a topic that sparks heated debate, promotes quirky "get rich quick" schemes and drives people to pursue transactions they might otherwise never consider. "Three Simple Steps To Building Wealth" may seem like a misleading title, but it isn't. While these steps are simple to understand, they're not easy to follow.

The Steps

Basically, building wealth boils down to this: to accumulate wealth over time, you need to do three things:
1.     You need to make it. This means that before you can begin to save or invest, you need to have a long-term source of income that's sufficient to have some left over after you've covered your necessities.
2.     You need to save it. Once you have an income that's enough to cover your basics, you need to develop a proactive savings plan.
3.     You need to invest it. Once you've set aside a monthly savings goal, you need to invest it prudently.

Step 1: Making Enough Money

This step may seem elementary, but for those who are just starting out, or are in transition, this is the most fundamental step. Most of us have seen tables showing that a small amount regularly saved and compounded over time can eventually add up to substantial wealth. But those tables never cover the other sides of the story – that is, are you making enough to save in the first place? And are you good enough at what you do and do you enjoy it enough that you can do it for 40 or 50 years in order to save that money?
To begin, there are two types of income – earned and passive. Earned income comes from what you "do for a living," while passive income is derived from investments. This section deals with earned income.
Those beginning their careers or in the midst of a career change can think about the following four considerations to decide how to derive their "earned income":
1.     Consider what you enjoy. You will perform better and be more likely to succeed financially doing something you enjoy.
2.     Consider what you're good at. Look at what you do well and how you can use those talents to earn a living.
3.     Consider what will pay well. Look at careers using what you enjoy and do well that will meet your financial expectations.
4.     Consider how to get there (educational requirements, etc.). Determine the education requirements, if any, needed to pursue your options.
Taking these considerations into account will put you on the right path. The key is to be open-minded and proactive. You should also evaluate your income situation annually.

Step 2: Saving Enough of It

You make enough money, you live pretty well, but you're not saving enough. What's wrong? There's only one reason why this occurs: your wants exceed your budget. To develop a budget or to get your existing budget on track, try these steps:
1.     Track your spending for at least a month. You may want to use a financial software package to help you do this. If not, your checkbook is the best place to start. Either way, make sure you categorize your expenditures. Sometimes just being aware of how much you are spending will help you control your spending habits.
2.     Trim the fat. Break down your wants and needs. The need for food, shelter and clothing are obvious, but you also need to address less obvious needs. For instance, you may realize you're eating lunch at a restaurant every day. Bringing your own lunch to work two or more days a week will help you save money.
3.     Adjust according to your changing needs. As you go along, you probably will find that you've over- or under-budgeted a particular item and need to adjust your budget accordingly.
4.     Build your cushion – you never really know what's around the corner. You should aim to save around three to six months' worth of living expenses. This prepares you for financial setbacks, such as job loss or health problems. If saving this cushion seems daunting, start small.
5.     Get matched! Contribute to your employer's  and try to get the maximum your employer is matching. Some employers match 100% of the participant's contribution, and this can be a big incentive to add even a few dollars each paycheck.
The most important step is to distinguish between what you really need and what you merely want. Finding simple ways to save a few extra bucks here and there could include: programming your thermostat to turn itself down when you're not at home; using plain unleaded gasoline instead of premium; keeping your tires fully inflated; buying furniture from a quality thrift shop; and learning how to cook. This doesn't mean that you have to be thrifty all the time: if you're meeting savings goals, you should be willing to reward yourself and splurge (an appropriate amount) once in a while! You'll feel better and be motivated to make more money.

Step 3: Investing It Appropriately

You're making enough money and you're saving enough, but you're putting it all in conservative investments. That's fine, right? Wrong! If you want to build a sizable portfolio, you have to take on risk, which means you'll have to invest in equities. So how do you determine what's the right exposure for you?
Begin with an assessment of your situation. The CFA Institute advises investors to build an Investment Policy Statement. To begin, determine your return and risk objectives. Quantify all of the elements affecting your financial life including: household income; your time horizon; tax considerations; cash flow/liquidity needs; and any other factors that are unique to you.
Next, determine the appropriate asset allocation for you. Most likely you will need to meet with a financial advisor unless you know enough to do this on your own. This allocation will be based on the Investment Policy Statement you have devised. Your allocation will most likely include a mixture of cash, fixed income, equities and alternative investments.
Risk-averse investors should keep in mind that portfolios need at least some equity exposure to protect against inflation. Also, younger investors can afford to allocate more of their portfolios to equities than older investors, as they have time on their side.
Finally, diversify. Invest your equity and fixed income exposures over a range of classes and styles. Do not try to time the market. When one style (e.g., large cap growth) is underperforming the S&P 500, it is quite possible that another is outperforming. Diversification takes the timing element out of the game. A qualified investment advisor can help you develop a prudent diversification strategy.

Saturday, April 22, 2017

Are you a lay investor? Trading in derivatives could make your money vanish...

Courtesy: Economic Times
Those who study narcotics addiction have invented the term ‘gateway drug’. It seems that many drug-users start with mild narcotics like marijuana and gradually move up to harder stuff like heroin and crack. It so happens that there’s an almost exact equivalent to this in equity investing as well, except that the first stage is actually beneficial.

The default Indian saver saves all of his or her money in deposits with banks or post offices or the government. Some of these people—perhaps about two crores of them—start investing in equity funds. The gateway investment to equity funds is often a tax-saving fund—one of the so-called ELSS funds.

As ELSS investments come with a lock-in, they are forced to stay put for three years, which is a reasonably long period to see good gains. For most of these investors, the idea that equity funds can get you good returns becomes an obvious. So far, so good.
A certain proportion goes beyond this gateway stage—generally with the help of equity investment’s equivalent of a drug dealer. This person often goes by the name of a wealth manager or a relationship manager or something like that and is generally employed by a bank or a stockbroker.
The logic given is simple: why are you wasting your time? Since you know that equity returns are better than a bank deposit, let me introduce you to the form of equity that can get you the highest possible returns from equity, which is effendo.
Even though ‘effendo’ sounds like a magical spell from Harry Potter (like Confundo or Diffindo), it is not. It is actually the popular way to pronounce F&O, otherwise known as futures and options, or derivatives. Effendo is closely related to a Harry Potter spell called Evanesco which makes things vanish.

Effendo can make money vanish as if by magic, as it regularly does for investors lured into short-term trading using these types of investment avenues. Actually, effendo does not make money vanish, as much as it transfers it magically into the bank accounts of your broker.
Now I know the whole shpiel about how derivatives provide depth and breadth to the stock markets, but for a vast majority of small investors, they are none of that. Instead, as Warren Buffet pointed out, they are nothing but financial weapons of mass destruction. But aren’t derivatives meant to be a good thing?

The answer to that question lies in one of the distortions that have crept it into the Indian stock markets ever since derivatives trading began. Derivatives like futures and options can be used to protect traders against risk, acting like an insurance policy.

However, they can also be used to enhance risk and returns, effectively as an instrument that offers a chance of higher gains, but also a high risk of huge losses, including completely wiping out the investor’s capital.

The real problem is not that using futures and options in this manner is possible, but that almost every part of the equities trading industry is dedicated to getting customers into this kind of trading. Practically every broker—and that definitely includes banks’ ‘wealth management’ units—does this and certainly, all the stock exchanges have spared no effort in getting as many people to trade as speculatively as possible.

This kind of institutional behaviour is certainly disappointing, but not surprising. So much of the behaviour of India’s big financial players is sub-ethical that one suffers from a bit of outrage fatigue.

However, the important point is that savers should save themselves from being herded into such kind of trading. It’s certainly not a natural extension of safe and sensible investing of the kind that one does in a tax-saving or other equity fund. There will be people who will try and tell you stories and earn fat commissions out of your money but it’s your job to show them the door.

Those who study narcotics addiction have invented the term ‘gateway drug’. It seems that many drug-users start with mild narcotics like marijuana and gradually move up to harder stuff like heroin and crack. It so happens that there’s an almost exact equivalent to this in equity investing as well, except that the first stage is actually beneficial.


Tweet TopOfBlogs