2/4/2017 Understandingandapplyingvalueinvestingprinciples:MisleadbythePEratio

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Understandingandapplyingvalueinvestingprinciples

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SEPTEMBER16,2016 INVESTMENTADVISORY

MisleadbythePEratio
AcommonlyusedthumbruleininvestingisthatacompanysellingbelowaPEof10is
likelytobecheapandoneabove30islikelytobeexpensive.Ihavebeenguiltyofusing
thisrule,oftensubconsciouslyandhavepaidaheavypriceforit.

Theadvantageofwritingablogfor10+yearsisthatIdonthavetogoanywheretofind
examplesofmistakes.IcanalwaysfindoneIhavecommittedandwrittenaboutit. SEARCHTHISBLOG

ToseetheexampleofaPEdriveninvestmentgonewrong,readtheanalysisofFacor Search
alloyshere.Inayearstime,IrealizedthatIhadmadeamistakeandexitedthisposition
witha12%lossyoucanreadmyanalysishere.IfIhadheldontotheposition,Iwould SUBSCRIBE
havelostcloseto85%ofmyinvestment,evenasthestockcontinuedtosellataverylow
valuation(currentPEbeing3)

Reasoningfromfirstprinciples
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The First Principles Meth... enteremailid

Tweetsby@rohitchauhan
RohitChauhan
@rohitchauhan
Investorshavesuchshort
memories.Within2monthsnone
ofthisisaproblem?
valueinvestorindia.blogspot.in/20
16/11/losing

35m
Intheabovevideo,elonmusktalksaboutreasoningfromfirstprinciples.Whyshould
onedothat? RohitChauhan
@rohitchauhan
Reasoningfromfirstprinciplesleadsonetounderstandthefundamentalsfactorsdriving
theissueinquestion.Sohowdoweapplythisconcepttoinvesting? Plantoreadthisassoonasitis
available.Lifestoryofoneofthe
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Iwrotethefollowingonit

FOLLOWTHISBLOG
Quitesimply,theoneabsoluteandimmutablefactofinvestingisthatthevalueofan Followers(521)Next
assetisthesumofthediscountedfreecashflow,itwillgenerateoveritslifetime.The
abovestatementdoesnotmeanthatanassetcannotsellaboveorbelowthisvaluefrom
timetotime,butanyoneholdinganassetoveritslifetime,cannotmakemorethanthe
cashflowsitsgeneratesoverthisperiod.

Letsbreaktheabovepointdownintoitskeycomponents
Freecashflow
Lifetime
Discounted

Follow
Youcanfindmultipledefinitionsofcashflow,buttheonewhichIliketouseisthecash
youcanreceivefromtheasset,withoutimpairingitslongtermearningcapacity.Lets
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2/4/2017 Understandingandapplyingvalueinvestingprinciples:MisleadbythePEratio

applythistoasimplerexamplethanacompanyAhouseoraflatwhereitiseasierto POPULARPOSTS
analyzethecashflows.
Thevalueofovervalued
FreecashflowCanbeestimatedasfollows:Grossrenttaxesmaintenance
stocks
expenseotheroverheads
Themadnessforgrowth
Maintenanceexpenseusuallyinvolvesrepairingthehouse,cleaningitafterthetenant
vacatesitandanyotherexpenseincurredtokeepitinarentableconditions.Other
Itisallaboutdurability
overheadscanbesociety&brokerchargestoletoutahouseetc.Soafterpayingoutall
thesecosts,thecashleftbehindwouldbetherecurringfreecashflowtoanowner. Cheapanddurable(price
LifetimeThisistheperiodanassetcanbeexpectedtogenerateacashflow.Incaseof matters!)
aflatorhouseonecantakeasitas30years,beforeonehastopermanentlyreplaceit
withanewconstruction.Inanextremeconditionyoucanstretchitto50years,however Activepatience
trylettingoutaveryoldhouseandyoumayrealizethattherentalsaremuchbelowthe
marketrates. Thecostsofinvesting

DiscountThedefinitionofdiscountingcanbefoundhere.Usuallythisdependsonthe Acatalogueofrisk
riskinessofanasset.
Howtorejectastock
Sohowwouldyouvaluethehouseorflatnow?
Thegrossrentalyieldsthesedaysareusuallyaround23%.Attheseyields,oneisin Howtomissa10bagger
effectpaying50timespretaxfreecashflow.Thisofcourseassumes100%occupancy
andnotaxes. MisleadbythePEratio

Overthelongtermtheserentalsusuallyfollowtheinflationrate.Sooverthelifeofaflat
orahouse,youwillearnbackaround60%ofthecostintheformofrental.Thevalueof LABELS
landunderlyingahouseoraflathasbeenknowntoappreciateatthenominalGDPrate
(GDPgrowth+inflationrate). Investmentideas(94)
Investmentprocess(62)
Ifyouputallthesecashflowstogetheranddiscountitataround10%,thefinalDCFvalue
comestoabout1.5Xpurchaseprice.Inotherwords,theassetisgeneratinganIRRof Generalthoughts(61)
12%. Companyanalysis(54)
Industryanalysis(39)
Isthischeaporexpensive?Itdependsonwhatyoubelievethepriceoflandwillbe30
yearsfromnowandif12%isgoodenoughfortheriskandeffortofmanagingarental Warrenbuffett(26)
property. Bookreview(22)
TheproblemwithPEratios InvestingPhilosophy(20)
Asyoucanseefromtheaboveexample,thePEratioisdependentonseveralvariables Marketanalysis(20)
whichwehadtoestimateupfront.Inthecaseofsomeassetssuchasarentalproperty,it
Arbitrage(18)
maybepossibletoestimateitwithacertainlevelofconfidence.
Portfoliomanagement
Thisishowevernotalwaysthecase (18)
Viewsonnews(14)
Letsay,forthesakeofexample,thatthehouseturnsouttobeonanoldburialground
wherethereareghostsandsoonewanttorentorbuythatland.Whathappensthen? Competitiveadvantage
Welltheentireinvestmentgoestozero. (10)
Notablevalueinvestors
Ontheotherhand,letsassumethatthegovernmentannouncesalargeITparkcloseto (9)
thepropertyandtherentalgoupby5X.Irrespectiveoftheactualincreaseintheproperty FinanceandBanking(8)
price,thecashflowbasedvaluationdefinitelygoesupastherentalshaveincreased
Nonequityassets(8)
drastically.Thisiswhathasoccurredinseveralcitiesacrossthecountryinthelast10
years. Valuation(8)
Charliemunger(6)
SotheinitialPEturnsouttobecheaporexpensivedependingonthesubsequentcash
flowsandterminalvalueoftheasset Mutualfunds(5)
Fromotherblogs(4)
PEratioinequitiesisevenmoremisleading
Rejectedinvestment
Inthecaseofcompanies,theproblemwefaceisthatthecashflowsarequitedifficultto ideas(4)
estimate,thereisnofixeddurationandtheterminalvalueinthereallongrunforany Quickthoughts(2)
businessisusually0.
behavioralfinance(2)
IntheexampleofFacoralloys,thePEappearedtobelowbasedontherecentcashflow
(asof2010)whichhadbeeninexcessof30Crs.Asaresult,ifoneassumedthatthese BLOGARCHIVE
cashflowswouldpersist,thecompanyappearedcheapat34timescashflow.
BlogArchive
Theaboveassumptionturnedouttobewrong.Thecashflowswereatapeakduetoa
cyclicalhighindemandfromthesteelindustry.Inadditiontoacrashinthedemand,the

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2/4/2017 Understandingandapplyingvalueinvestingprinciples:MisleadbythePEratio

managementdivertedthecashflowstoanothersisterfirmwhichdemonstratedpoor
corporategovernance.

Ineffect,theexpectedcashflowanddurationturnedouttobewrong.Insuchascenario,
thePEratiowassimplymisleading.

Asacounterexample,considerthecaseofCRISIL(apastholding)whichhasalways
appearedexpensivebasedontheusualmeasuresofvaluation.Howeverthecompany
hasdeliveredaboveaveragereturnsasithasgeneratedtheexpectedcashflowswithout
muchvariabilityinafairlypredictablefashion.Thecompetitivepositioncontinuesto
improveandthecompanyislikelytokeepgrowingwithahighreturnoninvestedcapital
fortheforeseeablefuture.

Understandthebusiness
Theonlywaytoevaluateifacompanyisoverorunderpricedistobeabletopredictits
cashflow.Thehigherthevaluation,thelongerthepredictionperiod.

Soifacompanyissellingfor2timesearningandyouarefairlyconfidentthatthecurrent
cashflowwillpersistfor5years,thenyouhaveabargain.Ontheotherhandifyouare
lookingatacommoditycompanywhosecashflowsdependonthepriceofavolatile
commodity,thenmakinganypredictionisusuallyawasteoftime.Youmaybeableto
lookatsomelongpricechartsoftheunderlyingcommodityandgetluckyfromtimeto
time,butgoodluckwithtryingtomakeitkeystoneofyourinvestingstrategy.

Ontheflipside,ifyouarelookingatacompanysellingfor100timesearnings,oneneeds
tohaveahighdegreeofconfidenceontheexpectedcashflowfor20+yearsand
beyond.Anyoneclaimingsuchclairvoyanceisworthofworship!!

Thesweetspotisusuallywhenthevaluationsappearreasonable(in1525range)and
onecanmakeareasonableestimateofthecashflowbasedonanindepth
understandingofthecompany,itsindustryandthecompetitivesituation.

Insummary,thebestwaytoapproachaninvestmentcandidateistofilterouttheextreme
casesandthendigintothebusinessasmuchaspossible.Thisshouldhelponemakea
reasonableestimateofthecashflowsanditsduration.Onceyouhaveareasonablefix
onthesekeyinputs,doingavaluationandcomparingitwiththemarketpriceistheeasy
part.

Homework:IscoalindiaLtdavaluestock?
Itissellingfor10timesearningsnetofcashforsure.PersonallyIthinkthePEratiohere
ismeaningless.OneismakingabetthatCoalwillcontinuetobeadominantfuelforus
forthenext1020yearsinfaceofdroppingcostofsolarandotherenergysourcessuch
asNaturalgas.Inadditionthereisalsotheheadwindofclimatechangeregulationsand
dropinpricesglobally.InshortIdontknowenoughtopredictthecashflowandhence
theideaisapassforme.Ifyouplantobuyorholdit,youneedtoanswertheabove
questionswithahighdegreeofconfidence.

Stocksdiscussedinthispostareforeducationalpurposeonlyandnotrecommendations
tobuyorsell.Pleasecontactacertifiedinvestmentadviserforyourinvestmentdecisions.
Pleasereaddisclaimertowardstheendofblog.

PostedbyRohitChauhan

9comments:
Anonymoussaid...
IamamusedaboutwhatyoumentionedondiscountrateUsuallythis
dependsontheriskinessofanasset.

Ihaveheardvalueinvestorsharpingabouthowdiscountratehasnothing
todowithriskandyoucannotreduceriskbyincreasingdiscountrate.At
thesametime,theyarefinewithincreasingmarginofsafety.

Botharetoolstodealwithuncertaincashflows.Youcanuseeither,butnot

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2/4/2017 Understandingandapplyingvalueinvestingprinciples:MisleadbythePEratio

togethertocausedoublecounting.Bothdiscountrateandmarginofsafety
canbearbitraryandcandothesamejobquitesatisfactorily.

Whatdoyouhavetosayaboutthis?Thisisnotacriticism,justliketohear
yourthoughts.Youcanchoosetoignorethismessageifyoufeelthatway.
September16,2016

RohitChauhansaid...
Hianon
discountratehasbeendiscussedindefinitelybyacademicsandIwasjust
sharingthetheory.

personallyIjustuseastandardhurdlerateof1011%andthenaccountfor
riskinessviacashflowestimation.intheexampleshowIusedadiscount
rateofaround10%..

MOSanddiscountratesareofcoursearbitrarytothatextentanditcomes
tothemainpointofthepostacademicstrytorunDCFmodelwithout
tryingtodigdeepintoabiz.theywantsomemathwhichworksinallcases.
Ithinkthat'sasinine..youcannotvaluebizwithoutunderstandingitwelland
noMOSordiscountratecanhelp

asanexample,applyinganydiscountrateorMOStoMTNLwouldnothave
helpedinearly2000withoutunderstandingwhatwashappeninginthe
telecomspace.
September16,2016

Anonymoussaid...
Thankyouforyourresponseondiscountrate,Rohit
September16,2016

kurichhsaid...
So,Inanalysingacompanyfirstcomesthebusinessandmanagement
thennumberscancomeafterwards
September17,2016

LaximarayanBhatsaid...
ThanksforaverysimplifiedwayofexplainingoverdependenceonPE.I
amarelativelybeginnerbutfrommyexperiencesbelievethatthereal
screenertestisQualityofbusinessandQualityofManagement.Ifthe
managementisadeptandagiletunedtocurrentglobalconditionsitcan
managebusinesstroughsandsteertheshipaccordingly.Attheriskof
soundingnaive,wouldliketomakeacontrarianstatement.Current
businessclimatesareevolvingrapidlyascomparedtobusinessesa
decadesago.Inthisconditionsforecastingcashflowislikecrystalgazing.
HenceifwejustusetheQualityofManagementandQualityofbusiness
filteralmostsurelyyoucangowrong.Valuationprincipleswillhelpsqueeze
outalittleextrapoints.Inmyquesttolearnappreciateyourcomments.
September17,2016

Anonymoussaid...
"Ifyouputallthesecashflowstogetheranddiscountitataround10%,the
finalDCFvaluecomestoabout1.5Xpurchaseprice.Inotherwords,the

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