Starting from this, I want to make a series of posts on different valuation techniques we use to value the companies like,
1) Young companies
2) Growth companies
3) Mature companies
4) Cyclical companies
5) Commodity based companies
6) Declying companies etc
In my previous post I have already discussed, how differently we value Financial firms.
In this post, I am going to discuss on how to value cyclical company by taking Maruthi Suzuki as example.
Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust upon them by external factors. As a consequence, even mature companies have volatile earnings and cash flows.
It is always a challenge to value companies that have volatile earnings.
What makes the cyclical companies different?
These are the companies whose fortunes rest in large part on how the economy is doing. This companies historically reported lower earnings/revenues during economic downturns and higher earnings/revenues during economic boom.
Cyclical firms can be in diverse businesses, but they do share some common factors than affect how we have to value them. While it is true that good management and right strategic business choices can make some cyclicals less exposed to movements in the economy, but on a whole we face it difficult to value those businesses.
What are the valuation issues?
Volatile earnings and cash flows: The volatility in revenues at cyclical will be magnified at the Operating Income level because these companies tend to have high Operating Leverage (high fixed costs). These companies has to Operate the plants without closing them, even though they produce half there capacity on some years.
Even the healthiest firms can be at risk:
If the macro move is very negative, the risk can be magnified as we move down the Income statement, resulting in high voatility in Net Income, and can happen with blue chip companies as well.
Normalized Valuations : The easiest way to value cyclical companies is to look past the year to year swings in earnings and cash flows and to look for a smoothed out numbers underneath. Now, we will begin by defining what comprises a normal value first and then consider different techniques that can be used to estimate this number. A normal year would be one that represents the mid-point of the economic cycle, where the numbers are neither moved up nor deflated by economic conditions. These normalized earnings can taken using different methods.
a) Absoulte average of the company over time (Taking average of the earnings of the company that you are valuing)
b) Relative average (Taking relative average of the company vis-a-vis to the leader in the market)
c) Sector average (Taking the average of the sector as a whole)
Here in this post, I am using Absoulte average Earnings techique to value one of the most trusted automobile brands “Maruthi Suzuki”.
Maruthi Suzuki is one of the most reputed player in Indian automobile industry and also being a decent wealth creator in the long term.
How ever in 2012-13 the company has faced the WORST phase (Manesar plant Riots, slow down in sales) since inception. To put it in company’s own words, here is the screen shot from company’s annual report of 2012-13.
OK, let’s get back to number crunching (which I love the most :) )
To normalize Maruthi Suzuki’s operating income, we look at its operating performance for a period of 10 years, i.e from 2004 to 2013
As on 2013, Maruthi Suzuki has very minimal debt of 1389.2 crores, and Debt/Equity is a healthy value of 0.07.
Calculating Normalized Operating Income from the above values:
To proceed further in the calculations, we need these values:
Bringing together the normalized operating income (5246.24 Cr), the marginal tax rate for India (33.99%), the reinvestment rate (31.70%), we can estimate the value of the operating assets at Maruthi Suzuki:
Operating Assets = Operating Income *(1+g)*(1- tax rate)*(1- Reinvestment Rate) / (Cost of capital – g)
Using this formula and substituting the value in the above table, we get value of Operating assets as 2666.36 Cr.
Adding in cash (775 Cr) and non-operating assets (894 Cr), subtracting out debt (1,389.20 Cr) and minority interests in consolidated subsidiaries (106 Cr), and dividing by the number of shares (Approx 30.2 Cr shares).
Value per share = (Operating Assets + Cash + Non – operating Assets – Debt – Minority Interest) / Number of shares
By substituting all the values we get,
Yields a value per share of 2213.00 rupees per share and with a margin of saftey of 15%, we get the intrinsic value as 1881 rupees.
Hence as on July 2014, any price between 1850 to 2250 can be a good price to enter the stock as per the derived Intrinsic value.
Disclaimer: This post is not to suggest any Buy/Sell call on Maruthi Suzuki, instead it is an example taken to explain Normalized earnings technique used to value cyclical companies. Please don’t act based on the numbers in this post.
Reference: Little book on Valuation by Damodaran