MOSL WEALTH CREATION STUDY NOTES

- By Venkatesh Jayaraman

Wealth Creation Studies are conducted annually by Shri. Raamdeo Agrawal of MOSL

This note covers the Wealth Creation Studies of Year 2017 – 2018

Stock related discussions are not covered in these notes unless essential to explain a concept. Such
references to stocks are not recommendations.

This document is intended for education purposes only and not for recommendation.

The full Wealth creation Study documents of 2017/2018 can be downloaded from
https://www.motilaloswal.com/stock-market-research/Wealth-Creation-Study.aspx

Visit my landing page for more such notes, presentations, compilations and Mind Maps at
https://www.linkedin.com/pulse/my-notes-compilation-value-investing-venkatesh-jayaraman/

Contents
2017 – CAP & GAP .................................................................................................................................. 2
1. Preamble ................................................................................................................................................................... 3
2. Two Dimensions of Longevity ................................................................................................................................... 3
3. Measuring Longevity of Moat ................................................................................................................................... 6
3.1 What is CAP? ........................................................................................................................................................................ 6
3.2 Factors determining CAP ...................................................................................................................................................... 7
3.2.1 Industry Structure...............................................................................................................................................................................7
3.2.2 Corporate Strategy ...........................................................................................................................................................................10
3.3 CAP Matrix ......................................................................................................................................................................... 10
3.3 Why CAP may end? ............................................................................................................................................................ 10
3.3.1 Disruptive Competition .....................................................................................................................................................................10
3.3.2 Business Downturn ...........................................................................................................................................................................11
3.3.3 Regulatory Shocks ............................................................................................................................................................................11
3.3.4 Capital Misallocation........................................................................................................................................................................11
4. CAP – The Indian Context ........................................................................................................................................ 11
5. Measuring Longevity of Growth ............................................................................................................................. 11
5.1 What is GAP? ...................................................................................................................................................................... 11
5.2 Factors Determining GAP ................................................................................................................................................... 13
5.2.1 CAP ...................................................................................................................................................................................................13
5.2.2 Industry Growth ...............................................................................................................................................................................13
5.2.3 Company’s Growth Mindset .............................................................................................................................................................15
5.3 Two Dimensions of GAP – Length and Height .................................................................................................................... 15
5.4 The GAP Matrix .................................................................................................................................................................. 15
5.5 Why GAP may end ............................................................................................................................................................. 16
5.5.1 End of CAP ........................................................................................................................................................................................16
5.5.2 Industry Maturity .............................................................................................................................................................................16
5.5.3 High Base Effect ...............................................................................................................................................................................16
6. GAP – The Indian Context ....................................................................................................................................... 16
7. Putting it all together .............................................................................................................................................. 18
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 7.1 The key characteristics of CAP-cum-GAP companies ......................................................................................................... 18
Conclusions ................................................................................................................................................................. 19
2018 – Valuation Insights ...................................................................................................................... 19
1. Introduction ............................................................................................................................................................ 22
2. Evolution of Valuation ............................................................................................................................................. 23
3. What is Value .......................................................................................................................................................... 23
3.1 Intrinsic Value for Bonds .................................................................................................................................................... 23
3.2 Intrinsic Value of Equity ..................................................................................................................................................... 24
4. Two key drivers of Equity Value .............................................................................................................................. 24
4.1 Interplay between RoE and Growth determines Free Cash Flow ...................................................................................... 25
4.2 All Growth is not necessarily good ..................................................................................................................................... 25
4.3 Beyond a point growth adds more value than RoE ............................................................................................................ 26
4.4 Earnings Growth and Stock Valuation are exponentially related ...................................................................................... 27
5. RoE, Earnings Growth and Stock Returns – The Indian Experience ........................................................................ 27
6. Reasonable Price ..................................................................................................................................................... 29
6.1 PE ....................................................................................................................................................................................... 29
6.2 PE relative to Market ......................................................................................................................................................... 30
6.3 PEG ..................................................................................................................................................................................... 30
6.4 Payback Ratio ..................................................................................................................................................................... 30
7. Current State of Valuations ..................................................................................................................................... 31
7.1 Built in Expectations of the Current Sensex Valuations ..................................................................................................... 31
Annexure – RoE and Earnings Growth Drivers ............................................................................................................ 31
Drivers of RoE ........................................................................................................................................................................... 31
External - Attractiveness of Industry Structure..........................................................................................................................................31
Internal - Effectiveness of Company’s Strategy .........................................................................................................................................31
What Hurts RoE .........................................................................................................................................................................................32
Drivers of Earnings Growth ...................................................................................................................................................... 32
External - Industry Growth ........................................................................................................................................................................32
Internal - Company Growth Mindset .........................................................................................................................................................32
What hurts growth? ..................................................................................................................................................................................32
Interesting Insights...................................................................................................................................................... 32
Conclusions ................................................................................................................................................................. 33

2017 – CAP & GAP

Highlights

• Companies with long run of profit growth are few.

• Understanding Competitive Advantage Period (CAP) and Growth Advantage Period (GAP) helps to
identify them
• Moat without growth leads to underperformance. Growth without Moat ends soon.
• Longevity and high growth rates are inversely co-related.
• Three characteristics of CAP-cum-GAP companies are (1) Clear strategy, (2) High Growth mindset
and (3) High Growth industry situations.
"The strategy is to find a good business – and one that I can understand why it's good – with a durable
competitive advantage, run by able and honest people, and available at a price that makes sense. Because
we are not going to sell the business, we don't need something with earnings that go up the next month or
the next quarter; we need something that will earn more money 10 and 20 and 30 years from now."
– Warren Buffett, in Forbes Magazine's 100th Anniversary Issue

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Theme 2017 – CAP & GAP
Power of longevity in Wealth Creation

If you don’t have competitive edge, do not compete. — Jack Welch

If you don’t have growth advantage, do not invest. — Raamdeo Agrawal
1. Preamble
• Longevity in general is “Duration of anything”.
• Longevity in the context of study is the duration a company can maintain its competitive advantage
and earnings growth.
• Why is study of longevity important? Equities as an asset class has the ability to give high returns
for a very long duration of time.
• Such long term, high return opportunities are very few.
• In order to earn high, long term returns in equities, two questions must be answered.
o How long can the company survive?
o How long will profitability grow?
Company lifecycle

• Every company has a life cycle (Ref. exhibit 3.)

• It is important to identify the high profit growth phase
along with longevity.
• Profit growth is what increases the value of the company.
• Stock prices are a reflection of the underlying value of the
company .
• In order to get multifold increase in stock prices, we need
to invest in companies during the multifold profit period.
• This is easy said than done.
• There is no science or technique that can help to figure
out the profit growth which is complex and multivariate.
• As a result we are unable to value long term profitable growth.
• Given this mystique any insights into estimating (1) Length of growth (2) height of growth and (3) limits
of growth would be useful.
• Growth is useful only, if the return on capital is higher than cost of capital.
• This can happen only when the company enjoys a distinct competitive advantage over its rivals.
• So, it is not only important to study about the growth alone, but also the durability of competitive
advantage.
This study attempts to:

• Measure the longevity in both growth and competitive advantage.

• Combine the learnings to identify companies with a high, long profit growth

2. Two Dimensions of Longevity

Moat and Growth

• The two dimensions of a company longevity are

1. Longevity of competitive advantage – Popularly called as ‘Moat’ or ‘Economic Moat’ by
Warren Buffett
2. Longevity of profit growth

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 • Moat protect the company’s profit and profitability from being attacked by its competitors for a
extended periods of time.
• Companies with high moats enjoy high quality business – High RoE and cash flows.
• The Moat and Growth can be plotted in a 2x2 matrix
o Quality Trap: Company with Moat and no Growth – Likely underperform benchmark indices
o Growth Trap: Company with no Moat but a high Growth – Transitionary multi baggers. If not
sold at the right level, may come down to where it started or even below that.

It is established that long term Moat and Growth advantage is important, how to measure it?
1. Longevity of Moat – Competitive Advantage Period
2. Longevity of Growth – Growth Advantage Period

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3. Measuring Longevity of Moat
Competitive Advantage Period (CAP)
3.1 What is CAP?
• Competitive Advantage Period is the duration or the number of years that a company earns returns
above the cost of Capital.
• When a company earns above average returns than cost, more players (Competitors) enter the
business who operate at lower returns.
• Thus moving the overall industry returns to the cost of capital or even lesser than that.
• CAP is the measure of longevity of a Moat.

Two real examples are given below. It is to be noted that the returns during the CAP is meaningfully higher
than the non-CAP.

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3.2 Factors determining CAP
There are two factors:
1. Attractiveness of Industry Structure
2. Company’s own strategy
3.2.1 Industry Structure
Five Force Analysis of Michael Porter is a good frame work to assess the attractiveness of the industry
structure.

Porters Five forces – Implications and Examples

Force 1: Interfirm Rivalry
Implications • This lies in the core of the industry structure analysis.
• The more the rivalry between the incumbents, lesser the attraction of the industry.
Examples • Indian Telecom industry is a huge opportunity with 3 major players, but there is
intense competition and tariff wars, making it unattractive. Profits are declining.
• Gold Mortgage sector is also a huge opportunity with large number of players. But
the benign rivalry between the firms keeps the sector profit growth healthy.
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Force 2: Threat of new Entrants
Implications • Threat of new entrants forces the incumbents to operate at lower profitability as a
strategy towards them off.
Examples • Realty sector is always in threat of new entrants hurting profit of incumbents.
• Paint industry need an extensive distribution system sees a lesser threat of new
entrants and profit of the incumbents is intact.

Force 3: Threat of substitute product and services

Implications • Threat of substitutes forces the incumbents to operate at lower profitability.
• This is very rare
Examples • Print and TV media is substituted by Internet.
• Two wheeler sector, Scooters are substituting bikes

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Force 4: Bargaining power of Customers
Implications • Higher the bargaining power of the customer, lower is the attractiveness of the
industry and vice versa.
• Big and concentrated customer have a higher bargaining power than fragmented
customers.
• High brand pull and switching costs reduces the bargaining power of customers.
Examples Auto Industry:
• Ancillary company that supply parts to car manufacturer have lower margins. (Big
and Concentrated customers).
• The car manufacturers supply to huge volumes of retail customers and enjoy higher
margins (Fragmented).

Force 5: Bargaining power of Supplier

Implications • Higher the bargaining power of the supplier, lower is the attractiveness of the
industry and vice versa.
• Big and concentrated suppliers have a higher bargaining power than fragmented
suppliers.
Examples • Packaging sector – Buys their raw material from large suppliers (polymer and
Aluminum manufacturers). Their profit margins are less. [Suppliers are big and few]
• Cigarette industry – Buys their raw material tobacco from large number of farmers
across the country. They have lesser bargaining power and the industry enjoys higher
profit margins.
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3.2.2 Corporate Strategy
• The second aspect of CAP is corporate strategy. (Individual companies within the same industry)
• Strategy is all about creating, maintaining and increasing the competitive advantage against their
rivals.
• A company with sound strategy enjoys longer CAP and vice versa.
• There are three strategies according to Michael Porter (1) Differentiation, (2) Low Cost and (3)
focus.
For details of these three strategies refer the Appendix of WCS 2018.
3.3 CAP Matrix
• The industry structure and company
strategy can be favorable (F) or
unfavorable (U).
• This gives a 2x2 Matrix with 4
quadrants and associated CAP.
• F-F is the most favorable having the
longest CAP.

3.3 Why CAP may end?

CAP may be adversely affected by various factors:
3.3.1 Disruptive Competition
• Amazon was disruptive to America’s largest book chain Barnes and Noble.
• Now recently they are disruptive to retail like Walmart.
• Similarly Reliance Jio offering free voice calls is disruptive to the industry as a whole.

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3.3.2 Business Downturn
• Business down cycles tend to drag down CAP
3.3.3 Regulatory Shocks
• Regulatory shocks affect CAP.
• In 2008-2013 Oil Marketing companies were affected due to price control regime.
3.3.4 Capital Misallocation
• All above were external to the company, but this aspect is the ONLY internal aspect that can affect
CAP.
• Tata Steel, before and after acquisition of Corus.

4. CAP – The Indian Context

Key Takeaways

• Companies in the favourable industry with a strategy enjoyed long CAP (Ability to maintain RoE
above Cost of Equity for a long period of time.)
• A portfolio of such longevated CAP companies meaningfully outperformed the bench mark indices.

5. Measuring Longevity of Growth

5.1 What is GAP?
• Growth Advantage Period (GAP) is the time during which the company grows its profit at a rate
higher than the bench mark indices. (15% in case of Sensex)
• The pace of wealth creation by the stock is highest during this period
• Since stock prices are correlated with the profit growth, it is logical that the company outperforms
the indices during this period.

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Real life examples, where the returns were significantly higher in GAP than the Non-GAP.

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5.2 Factors Determining GAP
Three factors that determine GAP are (1) CAP, (2) Industry Growth and (3) Company’s Growth Mindset
5.2.1 CAP
• CAP is the foundation for sustained GAP.
• Beyond this if other two factors fall in place then the company have a long GAP
5.2.2 Industry Growth
This is the primarily driver for GAP which depends on a few growth situations:
Global and/or Domestic Economic Growth

• This forms the base rate for growth in most of the industries
• Domestically rising per-capita income leads to exponential spends in discretionary consumption.
• Increased saving and investment leads to higher derived demand for capital goods, construction
and engineering.
Linear increase in Per-capita income leads to exponential growth in discretionary

• India has added its 1st Trillion dollars of GDP in 2008, after 60 years.
• It is expected to add every NTD at a faster pace.
• This would give rise to demand in consumption of goods and services.

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Value Migration

• “Value migrates from outmoded business designs to new ones that are better able to satisfy
customers’ most important priorities.” - Adrian J Slywotzky.
• Value migration is a gradual but a major shift of how the current and future profit pools is shared in
the industry.
• Value migration is one of the potent driver of growth which creates sizeable and sustained business
opportunities for its beneficiaries.
• There are two important varieties
1. Global Value Migration
▪ IT and Healthcare sectors migrating to India
▪ Manufacturing migrating to China
2. Domestic Value Migration
▪ Wired to wireless telephones
▪ PSU to Private banks

Low Product Penetration

• Products with low penetration enjoy high level of growth for prolonged period of time.
• Cars and air conditioners in Indian market compared to China.
• Such companies have a long favourable CAP.
New Industry / Product

• Completely new industries have a long run way till they reach maturity.
• Such companies enjoy a high level of GAP
• Example: Ipod in US and Air Coolers in India
Change in Five Force Structure

• Any change in industry structure would have a favorable or unfavorable impact on GAP.
• Nestle withdrawing Milo, benefited GSK Horlicks – Favorable impact
• Patanjali entry affects incumbents like Colgate, Unilever and Dabur – Unfavorable impact
Regulatory Changes

• This has favorable and unfavorable impact on GAP.

• Price deregulation favorable for OMC.
• Price control is unfavorable for pharma

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5.2.3 Company’s Growth Mindset
Psychologically there are two kind of mindsets
1. Fixed Mindset
a. This assumes our (a) character, (b) intelligence and (c) creative ability is static and cannot be
changed
b. Attributes success to intelligence
c. Hence the focus is more to avoid failures
2. Growth Mindset
a. This mindset thrives on challenges
b. Failure is not seen due to unintelligence, but a chance to learn and stretch existing capabilities
A company with growth mindset may take one of the several forms:

• Aggressive capacity expansion – to gain market share.

o Sometimes even ahead of the future growth in demand.
o Shree cements grew its capacity aggressively and increased its profits, even as the industry
profits remained same.
• Launches new products or business initiatives regularly
• Active inorganic growth
• Improves operating and Financial structure
o Outcome of pursuing aggressive growth strategy.
5.3 Two Dimensions of GAP – Length and Height
The two dimensions of GAP are:
1. Length – Period of High Growth
2. Height – Magnitude of Growth
o Studies indicate that supernormal growth can sustain only for a short term.
o Such high growth can be found in cyclic companies and secular companies (in their initial
growth stage)
o In such investments the sell point is equally important as the buy decision
o Should the exit decision be wrong, the investor could end up coming down to where they
started or even lower than that.
5.4 The GAP Matrix

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5.5 Why GAP may end
GAP get hurts due to three reasons (1) End of CAP, (2) Industry Maturity and (3) High-base effect
5.5.1 End of CAP
• End of CAP is a definite reason for end of GAP.
• End of CAP implies that RoE is slipping down below the cost of Equity and profit growth is slow or
negative.
• All factors leading to end of CAP lead to end of GAP.
5.5.2 Industry Maturity
• A industry moving from growth to maturity phases affects the profit growth of companies in the
industry ending the GAP.
• E.g. Salt, Tooth Paste, Tea etc
5.5.3 High Base Effect
• Even if a company is in growth phase (not reached maturity), a large company will have a slower
growth on account of high base effect.
• Indian IT is a best example. Even as the global demand is huge and large, many leading companies
are showing growth slow down.

6. GAP – The Indian Context

6.1 Short listing methodology
GAP Definition: The long-term profit growth rate of benchmark indices was around 15%. GAP is defined as
the number of successive years, where the profit growth was 15% with PAT of every year higher than the
preceding year.
6.2 GAP Matrix – Key findings
GAP is dependent on two factors. The ratings for them was as:
1. Industry growth – Companies with growth greater than 15% were rated as H and less than 15% as L
2. Company’s growth mindset – Company with growth mindset was rated as H or L
This lead to a 2x2 Matrix with 4 possibilities

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The following are the inferences from the matrix:

• Sustaining profit growth of 15% for a period more than 9 years was challenging
• Only 30 companies had 15% profit growth for a 9 year period. Out of this:
o 20 companies (67%) were in H-H quadrant
o 4 companies (12%) were in L-H quadrant
• Thus 80% of the companies with a GAP of 9 years and profit growth of 15% comes from company
growth mind set (Second factor)
• Two outlier companies in the L-L quadrant had a GAP of 11 years. They are GSK and Colgate.

This same analysis was carried out for secular and cyclic companies. Which had the following outcomes

• Irrespective of secular or cyclic, it is difficult for companies to have GAP more than 9 years.
• Of the 30 companies that had GAP of 9 years, 80% of them were from secular industries.
• In terms of GAP height, cyclicals tend to have higher growth than seculars at the beginning of the
cycle. However, on a longer duration, seculars have a higher growth.

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Takeaways:

• Long GAP companies are secular business which have high profit growth over long periods of time
• High GAP companies are typically cyclical business that give super normal profit in a short burst.

7. Putting it all together

The CAP-GAP Confluence
Combining the learning of CAP and GAP arrive at:
1. The characteristics of CAP-cum-GAP companies
2. Apply this to Nifty to arrive at likely earning growth outperformers
7.1 The key characteristics of CAP-cum-GAP companies
• There were 112 GAP companies. Out of which 103 companies had CAP.
• These 103 companies were fitted in a 4x4 CAP-GAP matrix

How to read this table – Illustrative example

Of the 52 companies with High Industry Growth and High Company Growth Mindset (GAP
Quadrant H-H):
• 21 have Favorable Industry Structure and Favorable Company Strategy (CAP Quadrant
F-F).
• 23 have Unfavorable Industry Structure but Favorable Company Strategy (CAP
Quadrant U-F).
• 4 have Favorable Industry Structure but Unfavorable Strategy (CAP Quadrant F-U) and
• 4 have Unfavorable Industry Structure and Unfavorable Strategy (CAP Quadrant U-U).

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The maximum number of occurrences can be seen in two quadrants shaded in grey. They determine the
characteristics to determine CAP-cum-GAP companies.

• Look for industry with high growth situation (First H)

• Within this look for companies with high growth mind set (Second H)
• Look for companies with a favorable strategy (F).
In short, the three key characteristics of CAP-cum-GAP companies are
1. Clear strategy
2. High growth mindset
3. High growth industry situations
Two of the three strategies (Growth mindset and strategy) related to the company management. Hence a
high level understanding and assessment of company management is important for investment success. As
Phil Fisher says in his book, Path To Wealth Through Common Stocks, “in evaluating a common stock, the
management is 90%, industry is 9% and all other factors are 1%.”

Conclusions
CAP and GAP help to harness the power of longevity of wealth creation

• Longevated profit growth companies are very few. CAP and GAP frameworks increase the probability
of identifying those companies.
• CAP is the time during which the company RoE is above cost of equity. Favorable industry structure
and company strategy ensure the longevity of CAP.
• GAP is the time during which the company grows it profits above the benchmark indices. Industry
growth coupled with company’s growth mind set ensure the longevity of GAP.
• There are two aspects of GAP height (Growth rate) and length (Length of time). Longevity and speed
of growth are inversely proportional.
• There are three characteristics of CAP-cum-GAP companies (1) Clear Strategy (2) Growth Mindset
and (3) High growth industry situation.
• Two of the three characteristics above pertain to management. Hence in analyzing the industry,
through assessment of management. In words of Philip Fisher, Management is 90%, Industry is 9%
and all other factors are 1%.

2018 – Valuation Insights

Highlights

• The two drivers of Intrinsic Value (1) High RoE and (2) Earnings growth are important.
• Intrinsic Value can grow only when the RoE is higher than Cost of Equity.
• Low RoE companies must focus to increase the RoE.
• High RoE companies must focus on Earnings growth.
• Difficult to sustain high RoE and high Earnings growth for long periods of time.
• PE-G < 1 is near infallible method to create outperformance.
• Current valuation are very high indicating earnings growth expectations. Hence market to remain
soft.

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Objective, Concept and Methodology
Objective

• The foundation of wealth creation study is to identify and buy stocks substantially below “Intrinsic
Value” or “Expected Value”.
• Higher the Intrinsic Value to the current market valuations, greater is the margin of safety.
• YoY WCS aims to cull out the characteristics of business that create value to shareholders.
• Phil Fisher - “It seems logical that even before thinking of buying any common stock, the first step is
to see how money has been most successfully made in the past.”
• WCS uses the past as a guide to gain insights into various dynamics of stock market investing.
Concept and Methodology

• Wealth creation is the process of enhancing the market value of shareholder’s capital.
• This is the basic measure of success for any business venture.
• Wealth creation can be defined as the difference in market capitalization in the last five years after
adjusting corporate events like buy-backs, mergers, demergers etc.
PEG is a solid formula

• For the purpose of PEG calculation, the trailing 12 month PE and 5 year future earning CAGR is
considered.
• If a stock in 2013, had a PE of 20 and the 5 year (2013 -2018) CAGR was around 25, then the PEG
ratio is 20-25 = 0.8

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Theme 2018 – Valuation Insights
What works, what does not.
1. Introduction
The success in equity investing is buying and staying investing in a stock with a significant Value-Price gap.
Buffett says, “Price is what you pay, Value is what you get”. So, equity investing process can be put into
three simple steps.
1. Assessing the value of a stock.
2. Comparing this value with the prevailing price.
3. Buy and hold only, if there is a sufficient Margin of Safety. (The price should be significantly less
than value to account for any risk in investing)
MOSL follows QGLP philosophy, where the QGL constitutes the value component. This is compared with P
(Reasonable price). Many past studies focused on QGL. This study focus on P (Reasonable Pricing).

The financial triad of QGLP

1. RoE – Reflects the Q (Quality of Business and Management)
2. PAT Growth – Reflects G
3. P/E – Helps to determine reasonable price

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 • These three variables were studied independently.
• A simplified version of Discounted Free Cash Flow to Equity (DFCEE) offers an intelligent integration
of RoE-PAT Growth-P/E triad.
• Other insights on a few pricing heuristics covered in this study
o PE Ratio (Absolute and Relative to Market)
o PEG
o Payback Ratio

2. Evolution of Valuation
• Different valuation was used in different times – The concept is evolving.
• The journey is from Book value-based bargains from the times of Benjamin Graham to RoE based
approach by Warren Buffett.
• There is never going to be a final say for valuation.
• New tools and techniques will evolve.
• Practitioners use what is best suitable for them.

3. What is Value
Investopedia defines Intrinsic value as “The perceived or calculated value of a company, including tangible
and intangible factors using fundamental analysis. The intrinsic value may or may not be same as current
market value”

• The word ‘perceived’ in the above definition is very important.

• People know the price of everything, but the Value of nothing – A famous quote.
• This is because Price is universal to all, but Value is in the minds of investor.
• This is the very reason that stocks trade.
o A person who sees the price as less than their perceived value buys it.
o whereas the person seeing the price as more than their perceived value sells it.
• Irrefutable definition of any asset – The present value of all future cash flows.
• This method is useful to value fixed income instruments
3.1 Intrinsic Value for Bonds
Initial investment: 1000, Coupon 8% and Annual interest 80.

• Investor 1 considers Discount Rate 10%. Intrinsic value is INR 877.

• Investor 2 considers Discount Rate 12%. Intrinsic value is INR 774.

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3.2 Intrinsic Value of Equity
It is not easy to do a similar calculation for equity, unlike the above example for bonds. This approach is
increasing being adopted.
No Fixed Coupon

• There is no fixed coupon in equities unlike the bonds.

• Dividend is the equivalent of coupons.
• This dividend is not consistent and depends on:
o The earning for the year and
o The Dividend payout policy of the company.
• Sometimes even with good earnings, company don’t pay out dividends to accommodate future
growth requirement.
No Fixed tenure and terminal value

• Unlike bond there is no fixed tenure and terminal value.

• Lack of this dimension adds a level of uncertainty in arriving at Intrinsic value.
• It is very difficult to arrive at how long the company would produce the earnings.
Challenge in discount rate

• Intrinsic value calculation is very sensitive to required return (discount rate is the term as used in
the bond/fixed income securities).
• In stock market, every investor has their own expectations on return.
• Accordingly, they arrive at their own Intrinsic Value.
• Choosing the appropriate return value is very crucial for calculation of Intrinsic Value.

4. Two key drivers of Equity Value

The book on Valuation (Check reference to other reads) shows an interesting perspective that DCF is
essentially driven by two factors (a) RoIC and (b) Sales growth
This study is simplified by considering (a) RoE as proxy to RoIC an (b) Profit growth as proxy to Sales growth

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4.1 Interplay between RoE and Growth determines Free Cash Flow
• Growth is a choice – It is for the company management to choose embark on growth.
• If they want to grow, what is the growth rate?
• The decision on growth rate determines the amount of incremental reinvestment needed.
• This reinvestment depends on the RoE.
• Let us assume that a company currently enjoys a PAT of INR 100.
• The company chooses to grow at the rate of 20%
• There are different scenarios based on varying RoE.

RoE (%) Reinvestment Free Cash Flow

(INR) (INR)
25 80 20
20 100 0
15 133 -33

• The last case of RoE – 15% would need fresh capital infusion.
• Takeaway: RoE must be above the growth rate to avoid any additional capital requirements.
Balance Sheet and Core RoE

• Many Indian companies over a period of time have accumulated a huge amount of cash, more than
what they needed for their immediate requirement.
• This huge cash may earn 4-5% post tax.
• This low return on cash component mutes the overall RoE
• Thus, comes two kinds of RoE –
o Balance Sheet RoE
o Core RoE
• The issue now is which of the RoE must be considered in the calculation that we discussed in the
previous section.
• Market is efficient to compute the core RoE and value the companies accordingly.
• But in some cases, market fears of capital misallocation and hence have low valuations.
• Companies must reduce the gap between Balance sheet and core RoE by a combination of:
o Higher dividend payout and
o Share Buybacks
4.2 All Growth is not necessarily good
Market reward earnings growth. In the short and medium term, companies with high earnings growth are
rewarded by investors by the way of higher stock prices and market value. But not all growth is good.

• If RoE < Cost of Equity, then higher growth reduces firms value, as more capital has to be raised from
equity holders to fund growth. (Refer case of RoE 10% in the table).
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 • If RoE = Cost of Equity, there is no use of any level of growth. The PE in this case is 1/(Cost of Equity)
= 1/13 = 7.7 (Refer case of RoE 13% in the table)
• Growth adds positive value only when RoE > Cost of Equity
• If Growth = 0, any level of RoE does not add value to the company. The PE in this case is 1/(Cost of
Equity) = 1/13 = 7.7

4.3 Beyond a point growth adds more value than RoE

• Different iteration in DFCFE shows that increase in RoE beyond a certain level does not add value
correspondingly.
• Beyond RoE > 40-50% leads to lesser rise in PE ratio. (Refer Exhibit 10)
• Once RoE is comfortably above Cost of Equity, investors (and company management) must focus on
earnings growth to drive value, instead of expanding RoE.
• In the other end of spectrum, companies with low RoE must focus on increasing growth.
Exhibit 10 is for companies with high RoE, higher growth gives benefits. / Exhibit 11 is for companies with low RoE, higher RoE
gives benefits.

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4.4 Earnings Growth and Stock Valuation are exponentially related
• Once the RoE is above Cost of Equity, the Earnings Growth and Stock value are exponentially related.
• A stock with 40% growth commands a forward PE of 67x where as a company with 50% growth
command a forward PE of 108x.

5. RoE, Earnings Growth and Stock Returns – The Indian Experience

The 20 year RoE data of 1500 top listed companies were studied and following were the inferences:
High RoE is rare
On an average:

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 • 52% companies have RoE less than Cost of Equity (13%).
• 19% companies have RoE greater than 25%.
Sustaining RoE above Cost of Equity is a Challenge

• In 1998, there were 136 companies with RoE above 13%.

• This dropped steeply in next 7-8 years, followed by a gradual decrease.
• There are only 22 companies in 2018.

Like High RoE, High Earnings Growth is also difficult

On an average:

• Nearly 60% of companies have a 5 year PAT CAGR of less than 15%.
• Remaining 40% companies are almost equally divided to 15-25% PAT CAGR and 25%+ PAT CAGR.
• Hyper Earnings Growth is rarely retained above 5-6 years.
Implications to Stock Investing

• Market tends to extrapolate recent earnings into the future.

• If a company is in phase of hyper growth, then markets extrapolate too far into future and there by
bidding up valuations.
• We have seen that Hyper Growth does not last beyond 5-6 years.
• This prevents smart investors to invest in such companies based on unrealistic growth expectations.
• Investors holding companies in the Hyper growth must seriously consider exiting the stocks, if the
valuations are very high. (Refer Section 6 which suggest that PEG > 3 or Stock PE twice the Market
PE).
What works - High Roe, High Growth stocks

• Classified stock on the basis of 10 Year:

o Average RoE below and above 15%
o Earnings CAGR below and above 15%
• This gives to a 2x2 matrix with 4 possible combinations.
• Returns generated by this 4 categories is shown in exhibit 17.
• The High RoE / Growth stocks has outperformed:
o The bench marks for all periods of study.
o All the other strategies – except in 1998-2008 slow, which is a aberration.
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 • Emphasize this approach with reasonable valuations.

6. Reasonable Price
What works and what does not

• What is the difference between valuation and pricing of any asset, in our case stocks?
• Valuation is fundamental assessment of intrinsic value of a stock based on the expected future cash
flows.
• Pricing is more empirical and heuristic.
• The basis of such pricing is using appropriate multiples PE, Price-Book, Price-Sales and EV/EBITDA etc.
• Pricing is likely to relative more than absolute i.e. depending on what the comparable stock or
benchmark is priced at.
• Four pricing techniques were studied PE, PE relative to market, PEG and Payback Ratio.
6.1 PE
• This is the most used pricing ratio.
• The common mantra is ‘Buy Low-PE Stocks’

What Works What does not Work

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 • Buying low PE gives some chance of an • Buying PE > 50 does not work.
insignificant alpha. • High PE suggest that most of the optimism in
• This is not consistent. Many times, has given stock has been already priced.
negative alpha.

6.2 PE relative to Market

• When market is buoyant, individual stocks appear to be expensive.
• Pegging their valuation to market levels would appear justified.
• Stocks with superior performance would be expected command a premium over the market PE.

What Works What does not Work

• Buying stocks below market PE gives some • Buying 2x above the market PE is a recipe for
chance of an insignificant alpha. underperformance.
• This is not consistent. Many times, has given
negative alpha.
6.3 PEG
• PEG is a short form of PE to Growth Ratio
• For calculation purposes
o PE considers the training twelve-month (TTM) value
o Growth considers the forward 3-year earnings growth
• This forward earnings growth could be for any number of years.
• However, for the purpose of study MOSL has considered it as 3 year period.
• Thus, if March 2015 P/E is 30x and 2015-18 PAT CAGR works out to 25%, then March 2015 PEG is
1.2x (30÷25).

What Works What does not Work

• Buying PEG less than 1 is handsomely • Avoid PEG > 1.5
profitable. • PEG > 3 is a warning sign.
• PEG < 0.5 is much better.
• PEG < 1 is profitable even for different growth
periods ranging form 1-5 years.
• This depends on the number of years of insight
that the investor has
6.4 Payback Ratio
• This is the proprietary ratio of MOSL
• Lower the ratio, higher the stock returns.

What Works What does not Work

• Buying with a Payback Ratio of < 1 is highly • Payback Ratio > 3 is a clear sign of
rewarding. overvaluation.
• Even a ratio of 2 times, gives some chance of
outperformance.

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7. Current State of Valuations
7.1 Built in Expectations of the Current Sensex Valuations
Different iterations in DFCFE was carried out to calculate the built-in expectations in the current Sensex
Valuations. The results:

• RoE of 17% - against the 13% currently.

• 5 Years Earnings CAGR is 16% - against 3% in the last 5 years.
Robust corporate profit growth is elusive, else market to remain soft.

Annexure – RoE and Earnings Growth Drivers

Drivers of RoE
Two major factors drive company RoE:
1. External – Industry Structure
2. Internal – Company Strategy
External - Attractiveness of Industry Structure
• RoE varies across industry based on the competitive dynamics governing them.
• The Five Forces Framework of Michael Porter helps to understand the attractiveness of an Industry
structure. (Refer WCS 2017 for details of this framework)
• Higher each force, lower is the attractiveness of the industry.
• Companies in the industry with score above 3.5 tend to have higher RoE than those with the ones
in the industry with lower score.
Refer WCS report for Porters Five Forces score for different Industries.
Internal - Effectiveness of Company’s Strategy
• Within the same industry, different companies could have different RoE.
• This is because the company’s strategy plays an important role in determining the RoE.
• Strategy is all about creating, maintaining and improving the competitive advantage over its rivals.
• A company with sound strategy is likely to enjoy and sustain high RoE.
• Michael Porter identifies three kinds of strategies (1) Product Differentiation (2) Low Cost and (3)
Focus
Product Differentiation

• This is about offering a unique value proposition to the clients which is not easily replicated by the
competitors.
• This ensures consumer royalty, higher sales, profit and RoE.
• E.g. All the consumer facing companies offer something unique to its customers
Low Cost

• Where product differentiation is not possible, low cost in comparison with peers is the only option
to sustain competitive advantage.
• E.g. Products like paper, steel, cement etc. are undifferentiated in the eyes of the customer.
Focus

• Special case of companies with focus in one segment or a niche area.

• E.g. Symphony for air coolers and JK bank only for the state of JK.
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Stuck-in-the-middle

• Companies not having any of the above strategies.

• E.g. Many of the PSU.
What Hurts RoE
• External Factors
o Disruptive competition
o Prolonged business downcycle
o Regulatory shocks
• Internal Factors
o Capital Misallocation – Mega acquisition or unrelated diversification
Drivers of Earnings Growth
Two Major Factors

• External – Industry Growth

• Internal – Company Growth Mindset
External - Industry Growth
Global and Economic Growth
Refer WCS 2017
Value Migration
Refer WCS 2017
Internal - Company Growth Mindset
Refer WCS 2017
What hurts growth?
• Industry maturity
• Weakening competitive advantage
• High base effect

Interesting Insights
Wealth Creation, Valuation parameter analysis

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Conclusions
• Two drivers of value (1) RoE and (2) Earnings Growth.
• Value is created only when RoE is greater than Cost of Equity. If RoE is equal to Cost of Equity, any
amount of growth is of no value.
• Low RoE, companies must aim for higher RoE.
• High RoE companies must aim for increasing earnings growth.
• Both High RoE and High earnings growth are not sustainable, particularly high earnings growth.
• PEG < 1 is an infallible formula for healthy outperformance.
• Any growth insight, even if it means one year.
• PE > 50 have less chances of market outperformance.
• Use QGLP where longevity of growth is around 5-6 years and PEG < 1.
• Investor must consider selling even, if any of them is higher:
o PEG > 3
o Stock PE is 2 times the Market PE

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