DCF as a method is theoretically perfect as is not influenced by market movements. But, it needs a lot of assumptions leading to a higher degree of sensitivity – Garbage In Garbage Out.

(1) Future Cash Flows

• FCFF: Expresses the present value of the business attributable to all claimants (like equity shareholders, debt holders, preference shareholders etc.) as a function of its future cash-earning capacity. Cash flows are discounted using WACC

• FCFE: Expresses the present value of the business attributable to equity shareholders as a function of its future cash-earning capacity. Cash flows are discounted using Ke.

  

• Which method is preferred for DCF Valuations? FCFE model requires one to estimate the net borrowings of a firm. In the absence of a plan by the firm under consideration, estimating net borrowings is extremely subjective. In such a case, it is more prudent to use the based model to estimate the Enterprise Value first, and then arrive at Equity Value; Also, under FCFF we don’t need to worry about changing debt structure as FCFF does not consider debt cash flow. Thus, Usually, FCFF is preferred over FCFE. But FCFE is preferred for companies where D/E is stable, or Company has Nil debt;

• Calculating FCFF and FCFE

(2) Weighted Avg Cost of Capital (WACC)

• WACC or Kc means the opportunity cost of all capital invested in an entity. It is the rate a company needs to pay to its stakeholders (Debt and equity holders) and is computed by taking the market value weights of post-tax Kd and Ke.

• The Capital Asset Pricing Model (CAPM) assumes that if an investor wants to earn a return without taking any risk he earns a return called as Rf. For higher risk, the return requirement increases

• Sometimes practically, we don’t have enough time/data to calculate discount rates accurately, thus its better to take some approximate value and then perform a sensitivity analysis – the higher the risk higher the discount rates expected

• Kc for a PE Fund is its Internal required rate of return – which is pre-defined; But for public companies, it’s the returns required by the stock market investors (IRR vs WACC)

• The entire, WACC formula can get complicated as shown in the below diagram. Thus, we generally consider a broad 15-20% range as WACC depending on the risk profile of the company:

We have broken down and explained each element of WACC in a separate blog.

(3) Terminal Value

• As per going concern, the value of a firm is the PV of infinite cash flows. But as cash flows cannot be accurately predicted after a specified forecast period (generally 5 to 10 years), the value of the firm after the forecast period is computed as Terminal Value

• As a thumb rule, Terminal Value should not represent more than 50-60% of the firm’s value – because then the DCF is probably too dependent on future assumptions.

• When is the Terminal Growth Method preferred over the Multiple Approach? If we have no good Comparable Companies or if have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Terminal Growth Rate (g)

• The terminal growth rate is the constant rate at which a company is expected to grow forever. This growth rate starts at the end of the last forecasted cash flow period in a discounted cash flow model and goes into perpetuity.

• A company cannot grow at 15-20% forever, there’ll be stable returns - This stability is being derived from the rate at which the Indian economy is expected to grow.

• Companies can’t grow at a rate higher than the rate at which the economy grows i.e. ~8% nominal growth rate for the next 3-4 decades. Thus, the maximum possible terminal growth rate will be the GDP of the economy i.e. 8%.

How do we calculate WACC and Ke in Real Life?

• The existing academic formula for WACC & Ke is very complex. Investors in real life like to keep things simple.

• Equity Investors generally take Ke = Risk Free Interest Rate + Extra for equity risk (4-8%)

• But, also Ke reflects the investor’s expected IRR. So, if I want a long-term IRR of 25%, Ke for me will be 25%; WACC will then be derived from a weighted average of my Ke and Kd:

(4) Enterprise Value

• Enterprise Value is the value of the company’s Core Business Operations (i.e. only the assets related to its core business), but to all the possible stakeholders (i.e. Equity, Debt & Preferred)

• Equity Value is the value of everything the company owns (ALL its assets) but only to the Equity Investor

• EV is very useful in comparing companies with different capital structures because a change in capital structure will not affect the amount of enterprise value. Hence, it is more commonly used in valuation techniques.

• While computing EV, Cash/Investments/unused lands are excluded as these are non-operating assets and not relevant to the company's core operations.

• Ideally, we should use market value for everything for calculating EV but in practice, we usually use market value only for the Equity Value portion, because it’s almost impossible to establish market values for the rest of the items in the formula

(Source: Ashwat Damodaran’s Blog)

Delhivery’s DCF Example

Financial Models are similar to blueprints of buildings - not all the details, but enough to make a decision. They help to quantify your views of a company thus it’s highly subjective in nature. The broad steps of evaluating a company are:

(1) How to choose a particular method?

• Practically, we use three valuation methodologies: DCF, Comparable Comps, and Precedent Transactions. But overall the valuation methods are of the following types:

  

• Depends on the sector and data available. Practically we use one out of the 3 valuation methods namely, DCF, Comparable Comps, & Precedent Transactions. Generally, whenever you value a company, you value it using multiple methods come out with a range, and show it through a footfall field diagram

• In the case of Conglomerates ‘Sum of the Parts’ is used - Valuing each division of a company separately & adding them together

• DCF Preferred: It’s the most preferred method of evaluating a company where long-term cash flows can be predicted with a fair degree of accuracy. However, it involved a lot of assumptions and thus was not preferred in the case of early-stage companies.

• DCF Not Preferred: Banking Companies (because Interest is like Raw Material to them); Startups (as they are loss-making and it difficult to forecast future earnings

(2) Collecting Historical Financial Data

It’s just a mechanical exercise, but you need proficiency in the abovementioned Databases. We generally refer to Annual Reports, Investor Presentation and paid company databases like CapitalIQ and Ace Equity. Broadly here are the sources of collecting historical:

• Annual Report [Company Website, www.bseindia.com]

• Investor Presentation and Con-calls [Screener, Capital IQ]

• Historical Financials and Ratios in Excel [Screener, Ace Equity, Capitaline, CapIQ]

• Equity Research Reports [Initiating coverage and Quarterly coverage]

  • Our common drive contains a huge repository of Initiating coverage reports (https://rebrand.ly/Fin_Ajit)

  • Trendline (free): https://trendlyne.com/research-reports/all/

  • Google Search: <company name> <initiating coverage/research reports> filetype:pdf

  • Paid databases like Bloomberg and Thompson Reuters

• Discussion forums like https://forum.valuepickr.com/

• IPO Prospectus of similar company (SEBI Website); Credit research reports

• Paid Databases [Bloomberg, CapitalIQ, AceEquity, Capitaline, Thomson Reuters, VccEdge, Private Circle]

Bonus: We have prepared a template file for downloading past financials of any company using CapitalIQ. If you have access, to CapitalIQ the sheet gets auto-populated:

• Link for Normal companies (Non-Banks)

• Link for Banking companies (Banks & NBFCs)

(3) Financial Projections

We have discussed financial projections here.

(4) Valuations Assumption

• There are n number of assumptions we need to make while doing valuation, which include computing, Cost of capital, Beta, Risk-free rate, etc.

• Before going forward, please note this basic Numerator-Denominator rule – which means that your values in the numerator should be of a similar nature as the denominator value:

• We have explained this assumption, which discusses DCF valuation in detail, in a separate post.

Bonus: Dividend Discount Model

• When is DDM Used? DDM can be used for Mature companies (like Coal India, and IOCL) as they don’t reinvest their profits and give out most of the profits as dividends. Otherwise DDM will understate the value of a company

• Issues with DDM?

  • Not a lot of mature companies in India; Company usually don’t pay dividends or low dividends

  • No consistent dividend policies – Policy depends on Govt for PSU entities & on MNC promoters

  • Difficult to project dividend growth rates

• Thus, in developing economics where most of the profits are retained, we can use a modified form of DDM i.e. DCF valuation which calculates the capacity of a company to pay dividends irrespective of whether they pay it or not.

Let’s start understanding DCF and Relative valuation.

There is a lot of material on the internet on how to project the three financials of a company (P&L, CFS and B/S), so let’s hear what Aswath Damodaran has to say on Projections:

Bonus: We have prepared a template file for projecting the financials of any standard company. If you have access, to CapitalIQ the sheet gets auto-populated. Or you will have to manually punch in the numbers

• Link for Normal companies (Non-Banks)

• Link for Banking companies (Banks & NBFCs)

Guidelines for Projections

While projecting the financials is more of an art, than a science, we have tried to highlight the broad parameters for projecting each line item:

All these estimates are generally built on your understanding of the business and industry’s fundamentals, which you can get from:

• Management Commentary (Concalls, interviews, annual report)

• Industry Trend & Recent Changes

• Analyst Estimates

• Last 3-4 years average trend

Projecting Sales

As highlighted, Sales projections are inarguably the most important part of any financial projections. Here, the funda is to explicitly project the growth rates for the near term (2-3 years), and then take a declining sustainable growth rate till the end of the forecast period.

When does the forecast period end? It depends. While most analysts would vouch for a 5-7 years forecast period, we prefer taking a 10-15 years forecast period, as being an eternal optimist we should always want our companies to survive for decades, and keep outperforming the industry for at least 10-15 years (sustainable growth rate). Post which we can assume the company to grow at the nominal GDP growth rate of the country.

How exactly do we find out the sustainable growth rate? There is no quantitative formula for, indicatively it can be gauged from the following Industry level and company level parameters:

Projecting Asian Paint’s Financials

Asian Paints has a pretty simple business model, as they are a consumer-facing company, with most of their sales coming from decorative paints. The entire excel model can be accessed from here:

Projecting Delhivery’s Financials

Let’s understand the financial projection using Delhivery’s example. They operate in multiple sub-segments within logistics. You don’t need to know about the sub-segment, but look at how we have broken down the total revenue, into revenue from each sub-segment, and then further to volume growth, and price growth and have done a sanity check the market-share with respect to the industry. The complete excel model can be accessed from here:

Let’s project the other items for Delhivery. As the margin profiles for each sub-segment are different, we have started with projecting EBITDA margins and than other corporate over-heads:

Now that, we have understood the basics of projecting financials, let’s head to the next section on valuations.

Let’s start with a simple example:

• Fact: Asian Paints has grown at 15% CAGR over the last 10 years

• What? Asian Paints has grown at 15% (vs 12% of Berger Paints)

• How? Asian Paints has grown at 15% due to 11% volume growth & 4% price mix change

• Why? Asian Paints has grown at 15% due to 11% volume growth (led by higher replacement demand & distributor addition) & 4% price mix change (due to superior pricing power

• Then What? Asian Paints might continue to deliver superior earning growths due to ..….

• But isn’t that obvious? So, this information won’t lead to higher alpha in Investing

Howard Marks’s Second-level thinking can help us with this (source):

Porter’s Five Forces

Porter’s Five Forces is a good starting point for evaluating the attractiveness of the Industry - the collective strength of the five forces determines an industry’s potential for value creation (source)

Unit Economics

Unit economics is a method applied to analyze a company's cost-to-revenue ratio in relation to its basic unit, hence the term. The “unit” in unit economics is a company's core element measured to understand the source of its revenue. For SaaS businesses, as a rule, such a unit is a customer.

Zomato’s Unit Economics: This showcases that Zomato now makes more money on each order compared to the money they spend fulfilling that order:

Please refer to how the founder of Zomato, Deepinder Goyal, breaks down the elements of unit economics here. (It is a bit dated, a recent break-down of Zomato’s economics is here)

Understanding it using a model of an Apparel Retail

Aditya Vision is a leading electronic retailer in Bihar. Their business model is similar to Reliance Digital, but they focus more on Tier 2/3 cities like Patna & Gaya. To understand their business model, let’s look at the high-level sales and operating costs of one store:

Here, as you might have noticed, we are trying to find the Return on Investment (RoI) of an individual store. This RoI broadly depends on three factors, (A) Amount of Capex (B) Sales generated from this capex, and (C) Operating Margins generated from the sales.

To explain these components using Aditya Vision’s stores, each store needs ~2.5 cr of initial investments, this in turn results in ~12cr of annual sales (i.e a Sales turnover of 4.8x). But of this 12 cr of sales, the company is left with an operating income of ~0.9cr (i.e an Operating margin of 8.5%).

Understanding Moats

How to identify & measure Moats? The best indicator of a moat or competitive advantage is a business’s ability to increase prices without losing customers. For most companies having long-term sustainable moats, one or more of the following characteristics exist:

• Strong brand power (e.g. Titan, HDFC Bank, Bharti Airtel)

• High switching costs (e.g. Apple, B2B IT Companies, )

• Network effect, or (e.g. Naukri.com, Delhivery)

• Low cost of operations, (e.g. Dixon, Relaxo)

There are a lot of resources on the Internet to understand Moats using Indian examples. Some of our favourites are:

• Blog by Safal Niveshak: https://www.safalniveshak.com/measuring-the-moat-part1/

• Prof. Sanjay Bakshi’s explanation on Moat using Relaxo’s (Part 1, Part 2)

• Saurabh Mukherjea’s book ‘Unusual Billionaires’ explains what makes a company truly outstanding, using examples of companies like HDFC Bank, Axis Bank, Marico, Berger Paints, Page Industries and Astral Poly (Book Summary)

Understanding Market Cycles

• Cyclical stocks are those whose fortunes swing as per the business cycle of an economy. A cyclical stock typically moves up or down depending on the upward or downward movement in the economy.

• Some examples of cyclical industries are Hotels, Construction Companies, Airlines, Automakers, etc.

• The below chart showcases the occupancy rates of Hotels in India, clearly showing where are are in the cycle:

• Do read Mastering the Market Cycle by Howard Marks (Book Summary, Video Summary)

Market Sizing

Before we analyze any company, its important to understand and get a sense of how big the target industry is. There are multiple factors one can look its, which we have tried explaining using the Indian grocery retail market, and how the pie of organized retail players (read, D-Mart, Reliance Fresher) is going to evolve:

Disruptions

A disruptive technology/ innovation is one that helps create a new market and value network. Eventually, it goes on to disrupt an existing market and value network (over a few years or decades), displacing conventional wisdom or technology.

EXAMPLE: Multiplex is a great example of how the pace of disruption has accelerated, particularly when it involves technology. Technology makes acceleration possible because it has increased the speed and reduced the cost of innovation in many industries through the ever-reducing cost of processing power that has facilitated and enabled more digital disruption. Ultimately this has important ramifications for long-term investing, including the nature and durability of competitive advantage, identification of sustainable long-term growth trends, and corporate capital allocation.

All this vulnerability came into light post-covid as:

• Penetration of Smart TVs & online food delivery improved (improving viewing experience)

• Construction of Malls slowed down (slowing down opening of new screens)

• Adoption of OTTs (impacting bargaining power of Multiplexes over regional distributors)

Eventually, leading to bankruptcy (Carnival, Cineworld) or mergers (INOX-PVR) in the sector

If you were to predict the impact of OTT in Multiplex, which industry data will you look at?

• Past instances of such occurrences

  • Globally in the US and Europe

  • Other disruptions to cinema in India (DVDs, TVs)

• ROI of Multiplex Release vs. OTT Release

• Previous instances of Disruptions (2008 Recession, Beginning of IPL)

The income statement illustrates the profitability of a company under accrual accounting rules. The balance sheet shows a company’s assets, liabilities, & shareholders’ equity at a particular point in time. The cash flow statement shows cash movements from operating, investing, and financing activities.

If you don’t have a hold on each of the financial statements, we would suggest the following articles as a refresher on the basics:

• Profit & Loss Basics (Zerodha’s Varsity)

• Balance Sheet Basics (Zerodha’s Varsity)

• Cash Flow Statement Basics (Zerodha’s Varsity)

• Reading Annual Report (Zerodha’s Varsity)

Let’s start with a summary of the three financial statements and what they look like, and then we will discuss the important highlights:

Profit & Loss Statement

• COGS includes all the direct costs attributable to the production of a finished good, which includes the following costs: a) Raw Materials b) Labour Costs c) Freight Charges, and d) Other overhead charges

• Consolidated vs Standalone Statements: Usually Consol statement is used for Analysis. But if the Subsidiary is large or is in a different business segment, then both Standalone Entity and subsidiary are to be analyzed separately.

Balance Sheet

• Can Equity be negative or very low: Yes, but as per books of account. Consistently loss-making startups generally have a negative equity balance; Companies with >100% dividend payout might have very low equity

Cash Flow Statement

• We can also summarize the CFS into sources and usage of funds, as follows:

Cash vs Accrual

• Cash flows are given priority over Income Statement items >>>

  • EBITDA is used as a proxy for Cash Income, but it doesn’t reflect WC Changes, Capex & Debt related outflows

  • Real proxy for cash flows can be FCFF/FCFE, thus they are used while computing the valuation of a company

• Why do some companies sit on huge cash in their books?

  • Cue to cash advances from customers (e.g. IndiaMart)

  • Conservatism due to cyclical business and need cash to tide over tough times (e.g. Indigo)

  • or because they might be generating huge amounts of cash flow and are still left with excess cash after paying out huge dividends (e.g. IT Companies)

Optimum Capital Structure

• Capital Structure refers to the mix of Equity and debt funding in a company’s balance sheet:

  • Why Equity? No fixed payment obligations as in Debt borrowings; Listing also generates goodwill and investor oversight

  • Why Debt? No dilution of ownership; Interest payment is tax deductible, thus effectively this is cheaper than equities

    

• The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital.

• In theory, debt financing offers the lowest cost of capital due to its tax deductibility, but debt levels higher than the optimum capital structure increase the risk of insolvency

• When should a company prefer issuing Equity instead of Debt? When the valuations are over-stretched; a New project/capex has some risk involved

Corporate Actions

• Dividends vs. Buybacks: Companies reward their shareholders in two main ways—by paying dividends or by buying back shares. The dividends will flow out of retained earnings, but the shares outstanding will remain the same. A buyback will reduce the share capital account and reduce the number of shares outstanding

• Basic vs. Diluted EPS: Diluted EPS is a calculation used to gauge the quality of a company's earnings per share (EPS) if all convertible securities (outstanding stock options, warrants, convertible preferred shares, convertible debentures etc.) were exercised

• Stock price cum-dividend vs. ex-dividend: When the company declares a dividend, the price is called cum-dividend. On the record date (freezing of the list of shareholders who would be receiving a dividend) the price changes from cum- to ex-dividend

• Bonus Shares: Bonus share are given out to increase the liquidity of stock; It is a cashless transaction (out of Reserves and surplus) and doesn’t impacts the total fair value of the company

• Stock Split: It has a similar impact as Bonus Shares; A bonus issue is an additional share given to existing shareholders while a stock split is the same share divided into two or more as per the split ratio. Bonus shares are benefiting to existing shareholders while both existing shareholders and potential investors can benefit from the stock split.

Time Value of Money

Why is NPV preferred over IRR?

A company’s objective is maximizing shareholder wealth, and the best way to do that is by choosing a project that comes with the highest net present value. Such a project exerts a positive effect on the price of shares and the wealth of shareholders. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.

• IRR assumes the reinvestment happening at the same rate

• In NPV you are using the opportunity cost as a discount rate so here you can assume that intermittent cashflows can be reinvested at that rate

• In terms of profits, we always want to evaluate the absolute profit of a project, which is calculated using NPV

Thus, IRR is preferred when deciding whether a single project is worth investing in. For deciding between multiple projects NPV is a more preferred measure.

These ratios access the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges as they come due.

• Debt to Equity Ratio: This ratio measures the amount of debt capital relative to equity capital. A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50%. The net D/E Ratio is also computed to remove the impact of excess cash & investment on the balance sheet.

• Financial Leverage Ratio: This ratio (often called simply as leverage ratio) measures the amount of total assets supported for each money unit of equity. For example, a value of 3 for this ratio means that each Rs 1 of equity supports Rs 3 of total assets

• Interest Coverage Ratio: This ratio measures the number of times a company’s EBIT (earnings before interest and tax) could cover its interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt from operating earnings.

Understanding Leverage at a Fundamental-level

• Leverage doesn’t only mean debt (a.k.a financial leverage), it can also be operating leverage.

• Leverage is a magnifying effect that results from the use of fixed costs – costs that stay the same within some range of activity – and can take two forms: operating leverage and financial leverage.

• Both financial & operating leverage are interlinked – the greater a company’s use of operating leverage, the greater the risk of the operating income stream available to cover debt payments; operating leverage can thus limit a company’s capacity to use financial leverage.

• This same content can also be explained through Degree of Financial leverage and Degree of Operating leverage (can skip if you find this confusing)

Operating Leverage - Cycles

• Operating Leverage leads to cycles in a sector. Take, the example of Hospitals, which is a capital-intensive business.

• While setting up a new hospital each bed takes ~1cr of capex, and it takes 3-4yrs to build footfalls, ensure stable doctor arrangements and optimize the client mix. Accordingly, every new hospital takes 3-4yrs to reach its optimum occupancy of 65-70% and thus reach peak EBITDA margins of 15-20%

• This leads to a capex cycle of 2-3yrs, and then no capex during the occupancy ramp-up stage for 3-4yrs, thus forming a cycle of 5-7yrs.

• Looking at the Capex/Sales% over the last 15 years, it clearly shows that the current cycle has topped out, and Hospitals have started to add new capacity.

• Investors generally mistake the peak-cycle RoEs to sustain, but understanding the earlier current cycle which peaked in 2021-23, with the highest RoEs and lowest Capex spends, was just an output of operating leverage at play. With new additions planned over 2023-25E, the RoE is bound to go down.

What is the ideal leverage ratio for a company?

While we prefer companies with zero leverage on their balance sheet, there is no ideal D/E Ratio. The ideal D/E ratio also depends on the Industry, we are evaluating. Banks and NBFCs have 2x-10x leverage on their books, given the nature of their business which is largely fuelled by debt. Capex Intensive sectors like Auto, Cement, and Retail would have leverage of 1x-2x, as they constantly need funds to set up new stores/plants. High cash flow generating companies in FMCG, IT, and Services usually have zero debt. Below is an illustration of the leverage ratio across sectors:

The leverage ratio also reflects upon the business model and conservatism of the management. Take the example of the Aviation sector, which has seen multiple cycles due to increases/decreases in crude oil prices and intense competition. So Indigo Airlines, despite being in a capital-intensive sector and controlling 60%+ market share, has stayed away from taking leverage. In fact, they have 10,000cr+ of cash on their books.

Sounds challenging? Let’s deep dive into the basics of financial ratios to make this task interesting.

What are Financial Ratios Analysis?

It compares the line-item data from a company's financials to reveal insights regarding profitability, liquidity and operational efficiency. This analysis can be done between two similar competitors or to see how the company has performed over a period of time. For a better understanding let's take a hypothetical unit economics of setting up a retail store.

Aditya Vision is a leading electronic retailer in Bihar. Their business model is similar to Reliance Digital, but they focus more on Tier 2/3 cities like Patna & Gaya. To understand their business model, let’s look at the high-level sales and operating costs of one store:

Here, as you might have noticed, we are trying to find the Return on Investment (RoI) of an individual store. This RoI broadly depends on three factors, (A) Amount of Capex (B) Sales generated from this capex, and (C) Operating Margins generated from the sales.

To explain these components using Aditya Vision’s stores, each store needs ~2.5 cr of initial investments, this in turn results in ~12cr of annual sales (i.e a Sales turnover of 4.8x). But of this 12 cr of sales, the company is left with an operating income of ~0.9cr (i.e an Operating margin of 8.5%).

Let’s understand each of these ratios separately:

(Note: There is no exact formula of these ratios, it differ from Industry to Industry, we have taken the generally accepted and most popular ratios)

Profitability Ratios

• Gross Margins: Gross profit margin indicates the percentage of revenue available to cover operating and other expenditures. Higher gross profit margin (as compared to competitors) could be due to:

  • Higher product pricing: If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive technology), the company is better able to charge more for it, which might lead to higher gross margins.

  • Lower Production Cost: Higher gross profit margin can be due to a competitive advantage in production.

• Operating Margins: Operating margin is also a good measure of management’s efficiency. The reason for higher margins (as compared to competitors could be:

  • Scale benefits

  • Low-cost operating model

  • Technological advantage

• Net Profit Margins: A company’s net profit margin tells you how much after-tax profit the business makes for every Rs 1 it generates in revenue or sales. A high-profit margin typically indicates that a company either has a highly proprietary good or service, possibly one that’s “branded” and therefore able to carry a price premium.

Let us understand the profitability ratios using common-size statements of grocery retailers and connect their business model with the ratio:

But are higher margins always good? While as a thumb rule, it is better to have higher margins, it is more important to have a higher RoE, which represents the profit generated on investments made by the owners. That’s why analyzing only the Profitability Ratio is not enough, we also need to look at the Turnover Ratio & Leverage Ratio.

Turnover Ratios

Turnover ratios measure how efficiently the company utilizes assets, and its ability to convert different assets into cash or sales.

Working Capital Turnover Ratio:

• The working capital turnover ratio measures how well a company is utilizing its working capital to support a given level of sales.

• In Aditya Vision’s case, as they generate ~12cr of annual sales using ~2cr of Working Capital, the WC Turnover ratio is 6x. This basically means, the company can generate sales of 6 times the working capital it is holding.

• We have discussed the various components of WC in detail in this article.

Fixed Assets Turnover Ratio:

• It measures how efficiently the company generates revenues from its investments in fixed assets. Generally, a higher fixed asset turnover ratio indicates a more efficient use of fixed assets in generating revenue.

• A low Ratio indicates, inefficiency, a capital-intensive business environment, or a new business not operating at full capacity

• These ratios are higher for service-oriented businesses with lower fixed assets requirements

Note: We prefer taking Gross Fixed Assets (i.e before deducting depreciation) to compute this ratio, as Net Fixed Assets are distorted due to bookish deduction of depreciation and don't show a true picture of the assets.

Total Assets Turnover Ratio:

• This ratio measures the company’s overall ability to generate revenues with a given level of assets. A ratio of 3.0 indicates that the company is generating Rs 300 of revenues for every Rs 100 of average assets.

• Because this ratio includes both fixed and current assets, inefficient working capital management can distort overall interpretations. It is, therefore, helpful to analyze working capital and fixed asset turnover ratios separately (as Total Assets are roughly equal to Fixed Assets + Working Capital)

Many analysts make the mistake of comparing Turnover ratios across multiple sectors. Let’s understand the problem this analysis entails. The below table shows the Turnover ratios and Margins of multiple retailers. It clearly shows that Jewellery and electronics are high turnover sectors compared to Grocery and Apparel retailing, largely due to higher ticket sizes. But this lower turnover for grocery/apparel sectors is compensated by higher EBITDA margins in respective sectors.

Note, one interesting trend in this table is that Titan clearly stands out because of its higher turnover ratio and relatively higher margins than other retailers. This translated to a higher RoE of 30%+ vs. the sector RoE of 15-20%.

Liquidity Ratios

• The liquidity ratio measures how quickly assets are converted into cash. It also showcases the company’s ability to pay off its short-term liabilities using current assets.

• The current and quick ratios reflect two measures of a company’s ability to pay current liabilities. Each uses a progressively stricter definition of liquid assets.

• Quick Ratio considers the quick assets i.e. assets that can be most quickly converted to cash (cash, marketable securities and receivables). The quick ratio reflects the fact that current assets like inventory might not be easily and quickly converted into cash, and furthermore, that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly.

• A ratio lower than the industry average may indicate a higher risk of distress or default. Alternatively, a higher ratio may indicate that the management is not using its assets efficiently

  

  Note: We generally calculate Liquidity Ratios for small companies or companies in distress. Larger listed companies generally have good credit ratings, and have relatively easier access to short-term debt financing, if needed.

Leverage Ratio

While Liquidity Ratios help measure a company’s ability to meet short-term obligations (how quickly assets are converted into cash), Leverage ratios help assess a company’s ability to fulfil its long-term capital obligations.

These ratios access the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges as they come due.

We have discussed about Leverage ratio in a separate article.

Shareholder Ratios

• Return on Assets: Return on Assets or ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. We include interest while computing RoA because it is the return generated from all assets invested in the company whether financed with debt or equity.

• Return on Capital Employed: Return on total capital measures the profits a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity). It can be either computed on a pre-tax or post-tax basis

• Return on Equity: A business that earns a high ROE is more likely to be one that is capable of generating cash internally and thus has less or no need for external capital (debt) to grow its operations. RoE is often compared to the average cost of capital as an aid in investment decision-making.

• Return on Invested Capital: It shows how efficiently the company is using the funds provided by the investors to generate income for the business. RoIC is calculated on the basis of total Invested capital, which is the amount of capital that is circulating in the business while capital employed is the total capital it has. Invested capital is, therefore, a subset of capital employed.

Breaking RoE using DuPoint Formula

• Having a higher RoE may not be always a good thing: It is important to know where the higher RoE is coming from, thus we need to de-construct the RoEs using the DuPoint formula into three parts

• The three-step DuPont model captures the efficacy of the company management to generate profits (net profit margin), utilize its assets (asset turnover) and deploy optimal leverage (equity multiplier).

• While it is noteworthy that an increase in leverage has the potential to magnify the returns shareholders receive from their shares, ultimately financial leverage increases the risk for a company’s shareholders.

• Higher RoEs of Zee and Crompton Greaves don’t give us comfort because their higher RoEs (compared to TV Today & Havells) are due to higher leverage taken on the balance sheet.

Combining all the Ratios…

Our thought process while solving this case will be:

• Receivables: It can be Nil only if we receive upfront payment from customers. So, it’s a direct-to-customer kind of company (like the service sector, e-comm, retail, multiplex, airlines, hotels, Hospitals, QSR, etc.)

• Fixed Asset T/o: It's 12x thus the sector is not capital intensive (or Assets/stores are on rent) - probably a service sector-related stock, but that can’t be the case as the Capital Employed T/o ratio is too low.

• Capital Employed T/o: Comparing this with the Fixed Asset T/o ratio, we conclude that Net Working Capital could be on the higher side. Which means either Investors or Receivables are higher. As receivables are Nil, the sector has a higher inventory. It clearly can't be a service sector company (can be e-comm, retail, QSR). Most likely it's a retail company.

• Gross margins: D-Mart & similar retail companies as they deal in low-margin products, GM can’t be 25%-30%. So probably it will be a fashion or luxury retail retailer, like Titan, V-mart, Trent, Shopper Stop etc.

Final Answer: Titan

How to calculate Working Capital (WC)?

Broadly working capital is defined as Current Assets - Current Liabilities, but more specifically, we use the following formula for operating Working Capital

A more intuitive way to compute WC is by converting the components into days, i.e. if my Debtors are 200cr for a 1200cr annual sales, on average 60 days of my sales are blocked with Debtors. This is a more practical way to look at the WC cycle, because in real life when a business extends credit sales to its vendors, it’s calculated on the basis of days (for example, Safari extend ~30 days of credit to its vendors):

Inventory days are computed by dividing Average Inventory by Annual Sales. Note, that the base can be taken as COGS, as Annual Sales are marked up with a profit amount, that is still not earned on the inventory. But we still prefer taking Sales as the base, to compare the Inventory days across different Industry:

What are the Ideal Working Capital Days?

WC helps in assessing the short-term liquidity of a business and determining how well the company can cover the payment of its forthcoming liabilities. It provides an indication of how much cash a business has tied up in current assets and whether it can cover its short-term obligations. Theoretically ideal CA:CL ratio is 2:1, but in real life, it depends on the industry the company is operating in.

Also, the company is in a constant tussle between maintaining a fine balance between Profitability and Liquidity. For example, Dmart, one of India’s largest grocery retailers, pays off its suppliers on time and can get a hefty cash discount. So in return for a higher cash discount, it has reduced its creditor days:

Now, let’s understand each item of the Cash Conversion cycle in detail:

Inventory days

• It measures how many days it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales.

• Low inventory days (and high inventory turnover ratio) relative to industry norms might indicate highly effective inventory management.

• A high number of inventory days relative to the rest of the industry could be an indicator of slow-moving inventory, perhaps due to technological obsolescence or a change in fashion. Again, comparing the company’s sales growth with the industry can offer insight.

Receivables days

• It indicates the days within which a company is collecting cash from its customers/debtors.

• A high receivables days (low receivable turnover ratio) would typically raise questions about the efficiency of the company’s credit and collections procedures.

• Low receivable days could indicate that the company’s credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms.

Payables days

• It measures in how many days the company theoretically pays off all its creditors (like suppliers of raw materials).

• A low payable day (high payables turnover ratio) could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts.

• A high payable days could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms.

Who funds the Working Capital?

Working Capital can either be funded via the company’s internal accrual or by the Channel Partners (Supplies and customers). Looking at the funding source can give you great insights into the brand pull & moat the company has.

Monopoly businesses like IndiaMart (80% mkt share in B2B e-com) & Symphony (60%+ share in Air cooler), have funded their working capital via channel partners. In some cases, they have even shown a Negative working capital cycle, clearly showing the bargaining power they command over their customers/suppliers.

For instance, IndiaMart has ~3,200cr of cash on its balance sheet, which has been due to its upfront collections from paying suppliers on the platform:

Generally, customer-facing companies & subscription-based services (Retail Chains, Multiplexes, Telecom, Music Streaming etc.) has –ve WC because customers pay upfront – so they can use the cash generated to pay off their Creditors. This can be a sign of business efficiency.

Sometimes, -ve Working Capital could point to financial trouble/bankruptcy (for example, in case the company is not paying off its creditors on time). Thus, banks while giving out loans prefer companies with +ve WC

Understanding Business Models from WC Data

Now, that we have understood the basics of WC and how to analyse it, let’s deep-dive into inferring the business model by looking just at the WC days:

Few thumb rules for analyzing working capital days:

• Consumer-facing businesses (e.g. Multiplex, Retail Chains) have minimal receivable days

• Services businesses (like IT and Entertainment) have minimal inventory days

• WC might also vary due to business strategy. Like D-mart tries to extract maximum discounts from its suppliers by paying them up-front, they have relatively lower Payable days and better margins

• B2B and Government contracts entail higher Receivable days

WC trends over time can also be analyzed to get a sense of where the company is heading.

• Increase in WC: Piling Inventory, Extension of credit terms to distributors

• Decrease in WC: Inability to pay thus getting relaxed payment terms; Near-term distress

• Volatile WC: Change in Business Cycle; Or near-term Distress

• WC remains stable: Stable businesses (FMCG, IT)

Great! Now that you have mastered the art of reading working capital, head to screener.in to look at ratios of different listed companies and try to decipher the business models using just the Cash Conversion Cycle & comparing that with its competitors