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Session 2
Assessing business quality (1 of 2)
1
Disclaimer – this is not the usual
stuff in fine print, so please do read!
• Please assume that I am interested / have a position in all the
stocks discussed through the course
• Please do not assume that a discussion on a stock is a
recommendation to buy or sell it
• Please do your own research before buying / selling any stock
• All examples are only meant to illustrate concepts and help you
learn
• The course really contains no ‘secrets’ – I have mostly synthesized
and built on the thoughts and ideas of hundreds of people who
have taught me in class, in conversations and through their books
• All copyrights and trademarks are acknowledged, and images
drawn from searches on the Internet are the property of their
respective owners
2
Agenda
• The importance of assessing business quality
• How to assess the quality of a business
• Assessing industry attractiveness
3
As we saw in session 1, the ‘intrinsic value’ of a
business may lie mostly in its future cash flows
Indicative illustration of the share of AIP and PVGO in ‘intrinsic value’
100%
90%
80% 30%
70%
60% 70%
50% 100% 100%
40%
30% 70%
20%
10% 30%
0%
Benjamin Slow growing Acyclical Lossmaking but
Graham style cyclical steadily growing fast growing
'net net' business business tech startup
PVGO Assets in place
5
Understanding the link between
growth and value creation (2 of 5)
• Consider project A for company X. Should company X invest in this
project?
• 100 invested upfront at year 0, no further investments
• Cash inflow of 40 every year from year 1 to 10
• Cost of capital is 15%
• The NPV of the stream of cash flows (-100, 40, 40, 40, 40, 40, 40, 40,
40, 40, 40) at 15% cost of capital is 88 – this is a positive NPV project,
and so it is definitely worth investing in
• Rapid growth can be viewed as simultaneous investment into many
identical (or similar) projects at the same time, rather than investing
in them sequentially
• Now imagine that company X wants to grow faster - project A can be
done in 10 markets at the same time with identical cash flows as
above, and funding is not a constraint for company X
• Logically, X should invest in all 10 of these projects – the upfront
investment is 1000, and 880 of value will be created for the
shareholders of X
6
Understanding the link between
growth and value creation (3 of 5)
• Now consider project B for company Y. Should company Y invest in
this project?
• 100 invested upfront at year 0, no further investments
• Cash inflow of 20 every year from year 1 to 10
• Cost of capital is 15%
• The NPV of the stream of cash flows (-100, 20, 20, 20, 20, 20, 20, 20,
20, 20, 20) at 15% cost of capital is 0.3 (which is essentially zero) –
this is a project that creates no value
• An investment in project B is not value destructive, but does not create
value for shareholders of company Y
• Further, imagine that project B can be done in 10 markets at the same
time with identical cash flows as above, and funding is not a constraint
for company Y
• If Y invests in all 10 of these projects, the upfront investment is 1000,
and 3 of value (essentially zero) will be created. By doing so, company
Y can grow very rapidly but no value will be created for shareholders
of Y
7
Understanding the link between
growth and value creation (4 of 5)
• Consider project C for company Z. Should company Z invest in this
project?
• 100 invested upfront at year 0, no further investments
• Cash inflow of 10 every year from year 1 to 10
• Cost of capital is 15%
• The NPV of the stream of cash flows (-100, 10, 10, 10, 10, 10, 10, 10,
10, 10, 10) at 15% cost of capital is -43 – this is a project that
destroys a significant amount of value of shareholders of Z
• Now imagine that project C can be done in 10 markets at the same
time with identical cash flows as above, and funding is not a
constraint for company Z
• If Z invests in all 10 of these projects, the upfront investment is 1000,
and 430 of value will be destroyed. By doing so, company Z can
grow rapidly but it will destroy a lot of value for its shareholders of Z
• Company Z should in fact have returned the cash to its shareholders
instead of growing rapidly by investing in value destructive projects
8
Understanding the link between
growth and value creation (5 of 5)
Positive NPV
Growth creates value
projects
Zero NPV
Growth creates no value
projects
Negative NPV
Growth destroys value
projects
9
A modified view of the simplified corporate investment
and growth cycle which we saw in session 1
Return to
providers of
debt / equity
10
A detour into micro-economics: a
simplified view of how competition works
Company X
launches a
Company X and new product Y
all new entrants
no longer make
abnormal profits If product Y is a
hit, X can earn
large abnormal
profits
Margins in product Y
fall sharply due to
competition
Other companies
are attracted by
the profit
opportunity and
enter the market
11
Competition thus drives returns
down to the cost of capital
Company X
Company X and all
launches a
new entrants NO
new product Y
LONGER EARN
RETURNS ABOVE
If product Y is a
COST OF
hit, X can earn
CAPITAL
RETURNS WELL
ABOVE COST OF
CAPITAL
Margins in product Y
fall sharply due to
competition Other companies
are attracted by
the profit
opportunity and
enter the market
13
Historical returns on capital are a good
indicator of future returns on capital
1 Has the company earned returns above cost of capital in the past?
2 Why?
15
To summarize
Most of the intrinsic value of a company may lie in the
present value of investments made for growth
16
Agenda
• The importance of assessing business quality
• How to assess the quality of a business
• Assessing industry attractiveness
17
How NOT to assess the quality of a
business
“The company “My wife “The
is in the ET enjoys company
500 / Fortune working pays large
500” there” dividends”
“My banker
friend tells me “The stock is
“I love their they repay up 10x in 3
products” their loans on years”
time”
18
The right way to assess business
quality
Secondary
Margin stability
metric
business quality (1 of 2)
• Return on Tangible Capital Employed (‘ROTCE’) can best compare firms,
whether they grow organically or through M&A
• ROTCE = Operating EBIT / Average Tangible Capital Employed
• Operating EBIT = Sales – Cost of goods sold – Employee costs – Other
selling and administrative expenses – Depreciation and amortization
• Ignore non-operating ‘other income’ such as interest / dividend from
deposits / investments
• Ignore large, one-off amounts like foreign exchange translation gains
or losses (if one-off!)
• Ignore restructuring costs and asset impairments (if one-off!)
• Tangible Capital Employed = Net fixed tangible assets + operating current
assets excluding cash – operating current liabilities excluding debt
• Ignore non-operating assets / investments
• Ignore deferred tax (asset / liability)
• Ignore intangible assets like goodwill or patents
• In businesses with large lease commitments (such as airlines), the leases
should be capitalized as if they were on the Balance Sheet
ROTCE is the best metric of ROTCE
business quality (2 of 2)
• Compare ROTCE against pre-tax Weighted Average Cost of Capital (WACC) to
assess the quality of the business
• If ROTCE < pre-tax WACC over a business cycle, it is a bad business
• Business cycles usually last 4-6 years, so a 5 year median ROTCE is a good
measure of over-a-cycle ROTCE
• An alternative to the median ROTCE is a weighted average ROTCE over a
business cycle, where ROTCE of each year is weighted by capital employed for
that year
• Note that in some cases (such as in commodity cycles), the length of cycles
can be 10+ years, so an over-the-cycle perspective may need to include
many more years
• If ROTCE over a cycle >> pre-tax WACC, it is a good business
• A business consistently earning an over-the-cycle median ROTCE that is at least 5
to 10 percentage points above WACC is a good business
• In the Indian context, 20+% ROTCE is very good (and ~15% is a ‘middling’
business), while 15+% ROTCE is very good for developed markets which
have a lower cost of capital
• Note that we will further qualify this statement while considering additional risk
parameters in session 3, but this assessment is a good starting point
• Cash Return on Capital Invested (‘CROCI’) is an alternative to ROTCE, which uses
operating cash flow figures rather than EBIT
Walk-through of ROTCE – ROTCE
Hindustan Unilever
• Step 1: Calculate EBIT for year ended 3/18 (‘FY18’)
• Step 2: Calculate Tangible Capital Employed as at 3/17 and 3/18
• Step 3: Calculate Average Tangible Capital Employed
• Step 4: ROTCE = EBIT / Average Tangible Capital Employed
• The FY18 annual report for Hindustan Unilever (‘HUL’) is at
https://www.hul.co.in/Images/hul-annual-report-2017-18_tcm1255-
523195_en.pdf
• Bear in mind that HUL has a net cash financial position, no debt,
and that pre-tax WACC for HUL (depending on what assumptions
are made) would be 12-14%
• Note: 1 crore = 10 million
22
ROTCE
Employed Calculation (1 of 2)
₹ crores As at As at
3/18 3/17
Loans (security 4 0
deposits, loans
to employees)
Trade 1,310 1,085
receivables
Other current 656 552
assets
Sub-total A 8,647 8,221
Employed Calculation (2 of 2)
₹ crores As at As at
3/18 3/17
Employed calculation
₹ crores As at As at
₹ crores As at As at 3/18 3/17
3/18 3/17
Sub-total A 8,647 8,221
Tangible (1,023) 258 (see previous
capital slide)
employed Less: 800 514
Average (383) Provisions
Tangible Other non- 197 207
Capital current
Employed liabilities
Trade payables 7,170 6,186
26
ROTCE
27
Even including intangibles and other
assets, HUL is a great business ROTCE
As at As at
3/18 3/17
ROTCE of X, Y, Z
100% 72%
53%
X 50% 36% 29%
0%
Year 1 Year 2 Year 3 Year 4
20%
16% 16% 15%
15% 14% 13%
11%
9%
Y 10%
7%
5% 4%
0%
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
300% 254%
250% 204%
200% 159%
Z 140% 141% 133%
150% 123%
100%
50%
50%
0%
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
30
But this is actually one company –
Sesa Goa from 1991 to 2011! ROTCE
100%
72%
53% 50%
50% 36%
29%
14% 16% 9% 16% 15% 13%
4% 7% 11%
0%
1991
1992
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1993
2011
Would you say Sesa Goa is a good business?
31
32
In some situations, historical ROTCE may
not be the best indicator of future ROTCE
Upfront • With increasing scale, fixed costs can get
shared over a larger base of revenues, and
investments
profitability at company level can improve
and increasing significantly as the business grows
scale
• A portion of the company may have high
returns on capital, but the company’s return
on capital may be dragged down by other
Improved parts of the company that are laggards
capital • Divesting the laggard businesses that destroy
allocation value, or even stopping incremental
investment in them, over time, can improve
the return on capital profile of the company
• Improved industry dynamics and / or better
(usually new) management can lead a
business to perform substantially better than
Turnarounds it did in the past
• Some of these turnarounds may be primarily
due to factors outside the company’s control,
such as a sharp rise in a commodity price
34
In this example, understanding unit economics
can help assess if scale will matter Upfront
investments and
increasing scale
35
Example 2: Upfront R&D costs in an
R&D intensive business (1 of 2) Upfront
investments and
increasing scale
• When there are upfront R&D costs that are relatively fixed,
increasing scale can significantly improve profitability and returns on
capital
• Facebook Inc. had been profitable and earned high ROTCE for
many years, but this example can still illustrate the impact of
growing scale on an R&D intensive businesses
• In the case of Facebook below – total costs in 2015 were 65% of
sales, falling to 50% of sales in 2017, and operating margins
expanded sharply
37
Example 3: Selling a division that
was a bad business Improved capital
allocation
38
Example 4: Turnaround of a company with Turnarounds
-15,000
-17,045
-20,000
39
Example 4: Turnaround of a company with Turnarounds
40
41
Stability of margins is a secondary
measure of business quality (1 of 2)
• A business’ ability to maintain its Margin
stability
margins over a business cycle is
indicative of its pricing power (to
raise selling prices when costs go
up) and / or good cost management
• Pricing power is most common in
industries where:
• Buyers are retail consumers who
are relatively less sophisticated
and not large individually – this is
true of most consumer products
and services
• The industry is oligopolistic, with
2-4 players accounting for most
of the industry – this limits the
options for buyers, and sellers
are able to raise prices
42
Stability of margins is a secondary
measure of business quality (2 of 2)
Margin
stability
• We study EBITDA or EBIT margins so that we can compare
different companies in the same industry with differing operating
models and capital structures
• One quantitative metric that can compare the stability of margins
across companies is the co-efficient of variation (standard
deviation of margin / average margin) of the margin – lower the
coefficient of variation, greater is the stability of the margin
• However, watch out for situations like a sharp turnaround in a
company with a patchy historical track record of profitability –
this company will also show up as having highly volatile
margins though the business may currently be in good shape
• In case a company is a ‘converter’ – such as a plastics processor
or packaging company – stability of EBITDA or EBIT per ton of
volume is a more appropriate measure than stability of % margin
43
Which of these companies is the
best business? Margin
stability
EBITDA margins of 5 companies in the same industry
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
-5.0%
44
These are 5 companies in the Indian
two-wheeler industry Margin
stability
EBITDA margin
35.0%
Hero Bajaj Company Standard Mean Co-efficient
30.0%
Eicher TVS
deviation (B) of variation
25.0%
(A) (A / B)
Honda
Hero 1.6% 14.6% 10.7%
20.0%
Bajaj 4.2% 17.7% 23.5%
15.0%
Eicher 10.8% 15.6% 68.9%
10.0%
TVS 1.6% 5.5% 29.9%
5.0%
Honda 2.0% 9.5% 20.7%
0.0%
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
-5.0%
45
We will look at other dimensions of
business quality in session 3
Defensibility Growth
Cash
Cyclicality
generation
Other
Rate of
business
change
risks
46
Agenda
• The importance of assessing business quality
• How to assess the quality of a business
• Assessing industry attractiveness
47
Ideally, invest in a good industry
48
Another way to look at this
Management track record
Best place
Can a company continue
Good for a long-term
to defy the industry?
shareholder
Low High
Attractiveness of industry
49
Empirically, returns on capital vary
widely across industries (1 of 2)
Median annual ROIC, excluding goodwill, for 7,000 US public companies
Better
industries
Source: https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-long-term-look-at-roic 50
Empirically, returns on capital vary
widely across industries (2 of 2)
Median annual ROIC, excluding goodwill, for 7,000 US public companies
Worse
industries
Source: https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-long-term-look-at-roic 51
How do we figure out what is a good
industry?
Structural
Porters’ Five Forces framework
attractiveness
Empirical
Look at the numbers!
attractiveness
52
Michael Porter’s ‘Five Forces’ framework assesses
the structural attractiveness of an industry
Bargaining
power of
customers
www.hbs.edu
Bargaining
Threat of new
power of
entrants
suppliers
Threat of Intra-industry
substitutes rivalry
53
Food for thought: 1 of 3
Food for
thought
54
Next, we empirically assess the
industry’s attractiveness
The Indian two-wheeler industry is the world’s largest and has many players
55
We will focus on 5 players who account
for 90+% of the market (1 of 2)
• Erstwhile joint venture partner of Honda,
separated in 2011
• Market leader, particularly strong in entry
level motorbikes
• For background information, see
https://www.heromotocorp.com/en-in/uploads/other_not
ifications/20180806043109-other-notifications-261.pdf
57
Some housekeeping about the
numbers to use, before we go further
• Standalone financials, to focus on the India business
59
Food for thought: 2 of 3
Food for
thought
• Think about what kind of work will help you understand if the Indian
two-wheeler industry is empirically attractive
• Pause here before moving to the rest of the slides
• We will discuss this in class
60
Food for thought: 3 of 3
Food for
thought
• Over the next few slides, review some information snippets about
the Indian two-wheeler industry. Think about the following
questions:
• What source data was used, and how was the analysis done?
• What does the analysis tell you?
• What important analysis is missing?
61
Snippet A
Total revenue of Indian two-wheeler industry (= sum of above 5 players)
₹ crores