Learnings from Shyam’s Column – Part 2 of 3

Learnings from Shyam’s Colum – Part 1 of 3 here

Shyam moves on to stock specific information and has some very valuable advice, including what he calls the God ratio.

1) The God Ratio in Finance – If there were one metric to measure a company’s performance that would be its return-on-capital. In simple terms the return-on-capital is the amount that the company generates in a year expressed as a % of the total capital that it uses. In practice, companies use a combination of equity capital and debt capital. Equity capital is the money contributed by promoters and other shareholders in return for shares in the company plus the portion of past profits that are retained in the company over the years. Since shareholders are the owners of a company, the company’s retained profits belong to shareholders and are considered part of equity capital. Debt capital is the money borrowed from the bank or from other investors by issuing them bonds that carries interest charges. The ‘Total capital’ in a company is the sum of ‘Equity capital’ and ‘Debt capital’. This value can be got from the Balance Sheet of a company under ‘Source of Funds’. The ‘Source of Funds’ is split between ‘Shareholders funds’ (i.e. Equity Capital) and ‘Loan funds’ (i.e. Debt Capital).

Return on capital (or Return on Total capital) for a company in a particular year (in %) = (Net Profit + Interest Charges) for the year *100/ (Equity capital + Debt capital) at end of previous year

As shareholders (who contribute to Equity capital) why should we be bothered about ‘Debt capital’ and ‘Interest charges’? Should we just not calculate Return on ‘Equity capital’ i.e. Net Profit/ Equity capital? The answer to this is that we want to know how effectively and efficiently the company is utilizing its ‘Total’ capital, so that we can decide if it is a good business or a poor business. In a way we are saying there is no color of money, when evaluating how well the company is using its money.

For identifying superior businesses (or companies) you need to look at Return on ‘Total capital’ and not just Return on ‘equity capital’, because the latter does not clearly reflect the actual performance of the business. Why? Because, by using a lot of borrowed money one can easily boost the Return on ‘equity capital’. Good businesses do well by generating high return on ‘total’ capital – meaning they don’t have to depend on capital structure for oomph! There is an interest in the numerator, so more the interest more the ROC.  But isnt this interest the company is paying for the loan it has got?  That’s the reason you stay away from companies that have more than 25% of total capital as debt. Also higher the debt/equity ratio, the lower the return on total capital.

Therefore, a minimum of 20% return on capital would be a benchmark for a good company.  And the ratio of Debt to Total capital not greater than 25%

2) At what price should one acquire a company? – First, Enterprise Value. What is Enterprise value?

Enterprise value (value of a listed company as per Mr. Market) = Market capitalization + Debt capital = Share price * total number of shares + Debt capital

In English, the above equation merely implies that if you want to buy a company, you need to buy all the shares of the company plus pay off (or takeover) the loans that the company has borrowed from banks etc. If the share price changes, the ‘Enterprise value’ of the company changes.

The next step is to find out whether the ‘Enterprise value’ is cheap enough so that you could acquire the shares from Mr. Market and reap a minimum 15% annual ‘return on your investment’ over the long term. Every year, the return on capital of the company will determine the additional amount that the company would earn on its total capital. These earnings can either be reinvested in the company (by adding to total capital) or taken out as dividend for you the shareholder. Either ways this would bring you closer to break-even, at the end of every year – by bridging the gap between what you paid in the form of ‘Enterprise value’ and what you get in the form of the company’s total capital + dividends. At the end of 5 years, the company’s total capital + dividends (accreted over the period) would have compounded and will be equal to the original total capital of company at time of acquisition * (1+ average return on capital %)^5. Based on the conservative business owner logic, you need to ensure that the price at which you buy the company (or its shares in our case) is less than the compounded amount above so that you will be able to recoup your cost of investment within 5 years.

So, essentially – ‘Enterprise value’ paid at time of acquiring shares should be less than Total capital of company * (1+ average return on capital % over previous 5-10 years)^5.

 

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  1. Learnings from Shyam’s Column – Part 3 of 3 « Kiran Learns to Value Invest

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