In the last and final part, Shyam lists out a step by step method of calculating a value stock, using the example of ‘Kansai Nerolac’ (The same can be applied to any company, except for Banks and Financial Services)
Step 1: Download company’s Annual reports for the last five years (usually available on the company website). Go to the ‘Consolidated’ Balance Sheet and Profit & Loss account (usually available in the section titled ‘Consolidated statements’ towards the end of the Annual report). A warning for those using third party sources such as Moneycontrol: the figures reported there are for ‘Standalone Company’ and hence not appropriate.
• Step 2: Calculate Return on capital for the company over last five years and take an average (Refer my article dated April 12, 2009 for the return-on-capital formula). Is the average greater than 20 per cent? If yes, proceed. For Kansai Nerolac, the average return on capital from financial year 2005 to 2009 is 23 per cent.
• Step 3: Calculate the company’s total capital at end of previous financial year (from consolidated balance sheet). Is debt capital divided by total capital less than 25%? If yes, proceed.
For Kansai Nerolac, the consolidated total capital of company, as on Mar ’08 (since balance sheet for financial year 2009 is not yet released) is 737.5 crores (Equity capital = 612.7 cr, Debt capital = 124.8 cr). Debt capital/Total capital = 17 per cent
• Step 4: Compute Total capital of company * (1+ average return on capital over previous 5-10 years)^5
For Kansai Nerolac, 737.5 *(1+ 23 per cent) ^5 = 737.5 * 2.8 = 2065 crores
• Step 5: Calculate the market capitalisation of the company (i.e share price multiplied by total number of shares). Don’t fail to add the value of unlisted preference shares if there are any (you can look this up from the Balance Sheet under Equity capital section)
For Kansai Nerolac, market capitalisation (based on Monday’s closing share price of Rs 468) is Rs 1261 crores and the company has no preference shares outstanding.
• Step 6: Compute Enterprise value = Market capitalisation + value of preference shares if any + Debt capital
For Kansai Nerolac, Enterprise value = 1261 cr + 124.8 cr = 1385.8 crores (significantly less than the five-year breakeven value of 2065 crores and hence fulfils our ‘cheapness indicator’)
The fact that the ‘Enterprise Value’ of Kansai Nerolac is at a 33 per cent discount to the benchmark on the right hand side of the ‘cheapness indicator’ formula gives us a comfortable ‘margin of safety’ to acquire the stock. Typically, companies with share prices that obey our formula are also cheap in terms of price to earnings ratio (P/E). For example, Kansai Nerolac has a P/E ratio of 12, extremely low and attractive.