Stock Valuvation

8/4/2019 Stock Valuvation

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Vantage Point # 1: Business Analyst

Our first witness is a business analyst. He is not trying to value the company.

Rather, his job is to evaluate whether this is a great business or not. How would

he do this?

First, he would look at the companys balance sheet, an extract of which is

reproduced below. Notice, you dont know the name of the company yet, and you


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wont for a while
http://fundooprofessor.files.wordpress.com/2011/04/balance_sheet.jpg


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. Lets keep the suspense on.

What do you see? Let me tell you what I see and while I see this stuff, some

questions will arise, to which I would like to know the answers in due course.

Thats part of the puzzle we are trying to solve, right?

I see a company which, as of end of March 2011, employed Rs 247 cr of assets.

Out of these, Rs 139 cr was deployed in net fixed assets.

The first question that comes to my mind is whether the company is fixed capital

intensive? Well, I dont know the answer to that question until I get to compare

the amount of fixed assets employed with annual revenues of the company.

Thats what capital intensity (or fixed asset turnover) means number of rupees

of fixed assets required to produce a rupee of revenue. So, I dont know yet if this

business is fixed capital intensive or not. But I soon will. Lets move forward.

What else do I see? I see the company is sitting on investments worth Rs 190 cr.

I have a whole lot of questions about that. What are these investments? Are they

marketable securities? (Yes) Are they money parked in debt mutual funds?

(Yes). Are they surplus to the needs of the business? (Yes).

What else that is important do I see on the face of the balance sheet? I see a

negative working capital of 95 cr. Many questions arise. Why is working capital

negative? Is this is a company which is running out of cash and is therefore,

distressed?

Hmmm. I know the answer to that one and the answer is no.

How did I arrive at that conclusion? Think about this for a moment.

Let me tell you how I arrived at that conclusion. One piece of evidence is the

presence of Rs 190 cr. of investments. As I look deeper in the investment

schedule of the balance sheet, I find that almost all of this money is parked in


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money market mutual funds and therefore, is as good as cash. If this company

was financially distressed, it wont be sitting on so much of cash, would it?

The second piece of evidence that supports my hunch that this is not a financially

troubled company, is to do with something that is missing on the balance sheet.

Can you guess?

Take a look at the balance sheet again. What do you dontsee?

Debt! There is no debt!

If this company was financially troubled, you should have seen a lot of debt on

the balance sheet. But there is nodebt! The absenceof debt proves that this

company is notin distress.

You see, sometimes what you dontsee is terribly important. Thats a useful

principle to keep in mind. Most people overweigh what they see and underweigh

what they dont see. But youre not going be like most people, now, are you?

If the company has negative working capital, and is not in any distress because

its debt-free and has substantial cash, then what could cause the working capital

to become negative? Think about this for a moment

Working capital can only be negative if current liabilities exceed current assets.

So what part of current liabilities contributes towards negative working capital.

Lets take a look at the current liabilities schedule.


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Notice that the company has sundry creditors of Rs 161 crores which, when

compared with the total of inventories, receivables and cash on the current

assets (see the balance sheet) would still result in a positive working capital.

However, there is one item pertaining to Advances from Customersof Rs 92 cr in

the above schedule which explains why working capital is negative.

What does this figure tell us about the quality of the business model of this

company? Notice, we havent even looked at the income statement, or the cash

flow statement yet. Those will come later. But without even looking at those

statements, we can conclude that this company has a solid business model,

enabling it to demand its customers to pay for its products in advance thats

what advance from customers means isnt it? In an ordinary business, customers

buy first, and pay later. In extraordinary businesses, customers pay first, and

receive what they bought later. (In this case, the companys customers are not

end consumers but the distributors of its products who are willing to give it

advances first and lift inventory later.)

So it appears that this company has an extraordinary business which is

supported by our earlier two discoveries: the presenceof substantial surplus

cash held as investments, and the absenceof debt.
http://fundooprofessor.files.wordpress.com/2011/04/liabilities.jpg


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Great businesses are much more likely to have the winning combination of: (1)

being debt-free; (2) being cash rich; and (3) with a negative working capital. For

example take a look at the balance sheet of two great businesses Colgate and

Hindustan Unilever- and you will find the same pieces of evidence.

So what have we discovered so far when we put ourselves in the shoes of a

business analyst? We have discovered that this company is well financed and

probably has a solid business model. Lets move forward with our analysis.

By looking at the equity schedule we find that company has 1.54 cr shares of Rs

10 face value. Since there is no debt, we can take the total assets of Rs 247 cr

and divide by 1.54 cr shares to arrive at the per-share book value of Rs 160.

Next, as business analysts, we want to determine the average capital employed

in the companys operations over the last few years. For that we need to look at

figures given in the tables below for fixed assets as well as working capital.

Using the figures in the above table, we calculate average fixed assets employed

in the business over the last six years. This comes to Rs 109 cr. Similarly, we

calculate the average working capital employed over this period. This comes to a

negative Rs 83 cr. Deducting Rs 83 cr from Rs 109 cr, we find that on average

the company employed only Rs 26 of assets over the last six years.
http://fundooprofessor.files.wordpress.com/2011/04/capital_employed.jpg


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Next, lets take a look at the income statement which is given below:

The first thing that catches my attention is the total revenues of Rs 1,125 cr.

My god! I am thinking. This company employs, on average, only Rs 26 cr in

assets but has revenues of more than Rs 1,000 cr! Wow! So, now we have the

answer to the question I had asked in the beginning: Is this company capital

intensive? The answer, of course, is no.
http://fundooprofessor.files.wordpress.com/2011/04/income_statement.jpg


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But wait a second. I also notice that of the revenues of 1,125 cr, Rs 653 cr or

58% of revenues- goes to the government as excise duty! Wow! Thats big isnt

it? It makes me think: Hey this company is in the business of making money for

the government. And the government must dependon it.

Can you guess what this business could be?

Let me fix my earlier error. I should compare netrevenues after excise duty with

capital employed to determine capital intensity. Net revenues of Rs 472 cr were

produced by employing, on average, only Rs 26 cr of assets. So even after fixing

my error, our conclusion that this business is notcapital intensive is still valid.

The capital turnover ratio of 18 times (472 cr/26 cr) implies very low capital

intensity.

What other conclusion can we draw from this analysis? When capital turnover

ratio is high, the company can afford to have a low margin, and still deliver an

exceptional return on capital. Thats basic du-pont analysis you have read

about elsewhere. That analysis, you will recall, involves splitting Return on

Invested Capital (Profit/Capital) into two components: (1) Margin

(Profit/Revenues); and (2) Turnover (Revenues/Capital).

In case of our company, we already know that Capital Turnover is 18. So, even if

the company operates at a 5% margin, it can earn a 90% return on capital! Not

bad at all.

The big lesson here is that not all low margin businesses are necessarily bad. So

next time, you meet someone who tells you that his business has very low

margins, ask him or her about its capital turnover ratio, before making any

judgments about the quality of the business.

The next step for us is to see whats the margin earned by our company. Take a

look at the income statement again. From the Rs 98 cr of total profit before

taxation and exceptional item, lets deduct other income of Rs 33 cr. which


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pertains to treasury assets. We are left with an operating profit of Rs 65 cr, which

on net revenues of Rs 472 cr, translates into a profit margin of about 14%.

Wow! When we combine a 14% margin with a capital turnover of 18 times, we

get a pretax return on capital employed of a staggering 250%! We can double

check by directly comparing the pretax operating profit of Rs 65 cr with Rs 26 cr

of average capital employed to get the same answer.

This is one hell-of-a-business isnt it?

Two more questions come to mind: (1) Are the reported earnings real; and (2) if

they are real, then whats causing this company to be insanely profitable?

To answer the first question we need to look at the companys cash flow

statement, which is given below:


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Recall that from the income statement, we found that the company earned an

operating profit of Rs 65 cr in FY 2010. This figure was arrived at after

accounting for depreciation. The cash flow statement above shows that cash

generated from operations was Rs 81 cr and if we adjust this for the depreciation

of Rs 18 cr, we arrive at Rs 63 cr. So, the cash flow statement is consistent with

the earnings statement for FY 10. We can do the same analysis for the earlier

years and we arrive at the same conclusion.

An extract from the cash flow statement for the last six years is given below:
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Total cash flow from operations for these six years comes to Rs 567 cr and

annual average cash flow comes to Rs 94 cr. However, since the FY 10s

number was less than the average, lets assume that number of Rs 81 cr to be

our estimate of sustainable cash flow going forward. This Rs 81 cr of sustainable

cash flow is an important number I want you to keep in mind.

When we compare sustainable cash flow of Rs 81 cr a year with average capital

employed of Rs 26 cr, we find that the company earns a cash flow return on

capital of 319%, which brings us to the second question I asked earlier: What

makes this business insanely profitable?

It is now time to reveal the name of the company to you. Ladies and Gentlemen,

the company we are examining is called VST Industries, the Hyderabad-based

cigarette manufacturer which owns the Charms brand.

I think now you will begin to understand why is this company so profitable, isnt

it? Its because its in the business of selling nicotine to addicts who are brand

loyal and price insensitive.

Just how insensitive have these addicts been? We can learn more about that by

extracting some useful information from the annual reports of the company. Take

a look at the following table:
http://fundooprofessor.files.wordpress.com/2011/04/cash_flow_extract.jpg


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Notice also that the number of cigarettes sold by the company in FY10

were lessthan the number sold in FY06. And yet, earnings have growninstead

of shrinkingas can be seen from the table below:
http://fundooprofessor.files.wordpress.com/2011/04/pat.jpghttp://fundooprofessor.files.wordpress.com/2011/04/quantitative.jpg


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The reason for rise in revenues and profits despite lower business volume is

pricing power. Price per cigarette stick has increased at an annual average rate

of 13.9% a year. Every time the government increased excise duties on tobacco

products, the company simply passes it on to its addicted customers.

Thatspricing power, which is one the most important attributes of a great

business.

The next question that comes to mind is how sustainable are future cash flows of

Rs 81 cr a year going to be?. To answer that question, we have to think about

the likelihood of people giving up smoking. I think, we all agree, thats not going

to happen.

We als have to think about the possibility of a ban on tobacco consumption,

imposed by the government. Now, take a look at just how dependentthe

government is on VST by looking at excise duties paid by the company over the

years from the table below:
http://fundooprofessor.files.wordpress.com/2011/04/pl.jpg


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The table shows that over the last six years, VST has paid about Rs 3,000 cr as

excise duty to government. Now, you tell me how likely is it that the government

will kill this golden goose?

Combine this with the direct taxes paid by the company and we can easily

conclude that the vice of tobacco has a very good friend in the form of Indias

government and so its very unlikely to ban the product. This is a major

assumption we are making, however one that we will look at later on but for the

moment lets assume that there is unlikely to be any significant threat to this

companys ability to continue to sell tobacco products to a large population of

nicotine addicts.

Vantage Point # 2: Prudent Banker

Now lets shift focus from a business analysts vantage point to that of a prudent

banker.

Imagine that you are an old-fashioned, prudent banker who believes in the

banking dictum that one must lend money to only those borrowers who dont

need it.

How much money would you lend to VST against the security of its business (not

counting the surplus cash on the balance sheet?)

What are the key factors that prudent bankers think about before deciding how

much to lend to a borrower?

Three factors are critical: size, cyclicality, and interest cover. Other things

remaining unchanged, its prudent to lend to large companies whose businessesare not cyclical. If a business is cyclical, then a prudent banker would not depend

on peak earnings. Rather, he would compute averagepast earnings and then

ask for a higherinterest cover on those earnings than would have been the case

if those earnings were not cyclical.


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In the case of VST, we already know that the company is both large and not

cyclical. Tobacco is one of the least cyclical businesses in the world, after all.

So how much you, the prudent banker, would lend to VST?

Lets assume that youd rely on the work done earlier by the business analyst.

Lets also assume that the prudent banker is happy to assume that VST is quite

capable of delivering a sustainable cash flow of Rs 81 cr. a year. Lets further

assume that you, the prudent banker, would still insist upon a minimum interest

cover of 3 times on the total debt of VST.

Divide 81 cr by 3 and we get Rs 27 cr. This is the maximum amount of interest

that VSTs business can easily afford, says you the prudent banker. Given that

current interest rates for high-quality borrower are 9% p.a. at present, this means

that the maximum amount of debt that you the prudent banker will be pleased to

give to VST comes to Rs 300 cr. (Rs 27 cr/9%). In other words, if you give a loan

of Rs 300 cr to VST, then the interest on that loan at 9% a year would come to

Rs 27 cr a year which would be one-third of its sustainable annual cash flow of

Rs 81 cr. So there would be a huge margin of safety on your loan because

before your loan is in jeopardy, the earnings of VST must collapse by 67% which

is extremely unlikely given the stable nature of the business the company is into.

Paradoxically, the dangeroushabit of smoking translates into safetyfor the

prudent bankers loan to the company.

We have now arrived at an important number of Rs 300 cr as the debt capacityof

VSTs operating business. Notice this debt capacity has been arrived at without

considering the surplus cash of Rs 190 cr in possession of the company. This Rs

300 cr, is the amount of loan that you, the prudent banker, would happily lend

against the collateral of VSTs operating assets and their cash flow.


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Vantage Point # 3: Ben Graham, Smart Value Investor

Now lets put ourselves in the shoes of a smart value investor someone like

Ben Graham who wrote the book on Security Analysis. How would Ben think

about this?

This is how he would think:

Well, the business analyst has done some useful work and determined that VST

is capable of delivering a cash flow of Rs 81 cr a year, and the prudent banker

has determined the debt capacity of VSTs operating business to be Rs 300 cr.

What if, instead of lending money to this business, I could buy the whole

business, orparts of the business called shares, at less than debt capacity?

After all it was Ben Graham, who wrote in his book Intelligent Investor:

An equity share representing the entire business cannot be less safe and less

valuable than bonds having a claimto only a part thereof.

And, in his book, Security Analysis Ben wrote:

There are instances where an equity share may be considered sound because it

enjoys a margin of safety as large as that of a good bond. This will occur, forexample, when a company has outstanding only equity shares that under

depression conditions are selling for less than the amount of the bonds that could

safely be issued against its property and earning power. In such instances the

investor can obtain the margin of safety associated with a bond, plus all the

chances of larger income and principal appreciation inherent in an equity share.

When it comes to VST, Ben is thinking:

The prudent banker will lend Rs 300 cr to VST. The business delivers Rs 81 cr of

cash flow a year. Interest on that loan would be Rs 27 cr. So the prudent banker,

by virtue of his loan, would have a claim on only ONE -THIRD of its cash flow.

What if, I could buy into VST, a debt-free company, and acquire a claim on ALL

of its cash flow for less than 300 cr? After all, if the prudent bankers claim on


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only ONE-THIRD of its cash flow alone is worth Rs 300 cr, then my claim on ALL

of its cash flow must be worth a lot more than Rs 300 cr.

Ben would visualize that hidden inside the stock of debt-free VST, is a bond

component, which I can independently value and that value comes to Rs 300 cr.

If I can buy the whole business for less than 300 cr, then something good should

happen to me.

And so, Ben would take the debt-capacity of VSTs operating business (Rs 300

cr) determined by the prudent banker. Then he would add the surplus cash of Rs

190 cr on the companys balance sheet and arrive at Rs 490 cr. He would then

divide this number by 1.54 cr shares outstanding which comes to Rs 318 per

share.

Ben Graham, the smart value investor, would be pleased to buy VSTs stock at

less than Rs 318 per share.

Did the stock fall below Ben Grahams desired acquisition price? Take a look at

the chart below:
http://fundooprofessor.files.wordpress.com/2011/04/stock-price-chart.jpg


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In the bear market of 2008-09, VSTs stock price did fall to below the level of its

debt-capacity per share, estimated by Ben to be Rs 318. At that price, the stock

was a bargain.

Notice that the smart value investor Ben Graham never valued VST. All he did

was to determine a price at which it was a bargain. He thought along the

following lines: I dont know how much its worth. But I do know, it CANTbe

worth less than what a prudent banker would lend to it.

There is an important lesson here. Smart value investors dont always value

stocks or businesses. Rather they seek a margin of safety. They know that the

question ,How is much its worth, is tougher than the question, Is this likely to

be worth a lot more than my price? Smart value investors keep away from

making elaborate predictions. Instead, they focus on protectionin the form of a

margin of safety.

Vantage Point # 4: Bond Fund Manager

How would a bond fund manager think about VST? Well, we know one thing

about him. He certainly wont think out of the box like Ben Graham did.

If VST did have bonds worth Rs 300 cr outstanding, the bond fund manager

would happily invest in those bonds. But if Ben Graham approached him and

said: Hey look at debt-free VST. If it had bonds of Rs 300 cr outstanding, youd

gladly buy them because they would be safe. This safety would come from a

large size business, very stable cash flows, and an interest-cover of 3 times. But,

you would have a claim on only one-third of itscash flows. Youd value that claim

at Rs 300 cr. Why not buy the equity of this debt-free company instead for an

effective price of less than the same Rs 300 cr, and get a claim on all of its cash

flow?


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The bond fund manager would be aghast! He will politely tell Ben that he is not

allowed to buy equitiesand that he is only a bondfund manager. Then Ben will

tell him:You know there is a hidden bond component inside the stock of VST,

and that alone is worth Rs 300 cr, so how can the stock be worth less than that?

Such an argument, which to me is verypersuasive, wont be so to our bond fund

manager for he thinks in terms of silos. He goes by titles(like bonds and

stocks) and not byeconomic substance.

Vantage Point # 5: Henry Kravis, LBO Artist

You are Henry Kravis, who virtually invented the leverage buyout. How would

you think about VST?

Imagine its March 2009. The world is apparently ending, and VSTs stock price

has crashed to Rs 220 per share. With 1.54 cr shares outstanding, the market

cap is Rs 338 cr.

You have done your homework. You know that the companys business can

generate a sustainable cash flow of Rs 81 cr a year. You also know that the

company has Rs 190 cr of surplus cash. Relying on the work done by the

business analyst and Ben Graham, you know that the minimum value of the

stock is Rs 318 per share. Thats puts a minimum value of Rs 490 cr on the

company.

Its time to act. Very quickly, you incorporate a company. Lets call it Acquirer.

You, Henry Kravis, inject Rs 490 cr into that company, of which you borrow 90%

or Rs 441 cr. The balance Rs 49 cr is your money.

What do you do with the Rs 490 cr in this new company? Well, you use it to

make a tender offer to all the shareholders of VST at Rs 318 per share. Since the

stock is quoting at 220, your offer price is 45% above the stock price.


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Imagine that all shareholders of VST tender their shares to the Acquirer. What

does the balance sheet of Acquirer look like after the acquisition? The cash on

the asset side is replaced by a 100% ownership of VSTs shares. On the liability

side, there is debt of Rs 441 cr, and equity of Rs 49 cr.

VST is now a 100% subsidiary of Acquirer. The entire operating business of

VST plus its surplus cash would now belong to Acquirer. You would

immediately make VST borrow Rs 300 cr from the prudent banker. The cash on

VSTs balance sheet would now become Rs 490 cr.

You then merge VST into Acquirer. What would be the net result of this

merger? The cash of Rs 490 cr, the operating business, and VSTs debt of Rs

300 cr will become part of the balance sheet of Acquirer.

The Acquirers balance sheet would now have cash of Rs 490 cr. and debt of Rs

441 cr + Rs 300 cr or a total debt of Rs 741 cr. You would immediately use all the

cash to retire debt. As a result, the balance sheet of Acquirer would now consist

of debt of Rs 251 cr (Rs 741 cr Rs 490 cr). It would have no surplus cash, but

would own 100% of VSTs operating business.

You, Henry Kravis, would then change the name of Acquirer to VST

Industries.

What have you accomplished? Well, you have used the un-utilized debt-capacity

of VST along with its surplus cash to acquire it, by putting up only Rs 49 cr of

your own money! Granted that the balance sheet has Rs 251 cr of debt, but we

already know that this level of debt can easily be serviced from the operating

cash flow of Rs 81 cr a year. You can dedicate all surplus cash flow towards debt

reduction and pay it all off in just six years, as the table below shows:


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In six years you, Henry Kravis, would own 100% of VST, which would now be

debt free. You would have bought the company from its stockholders by paying

them 45% more than what the stock market was valuing the company for. And

yet, your owninvestment for this acquisition was just Rs 49 cr!

In other words, in just six years, by putting up only Rs 49 cr, you would end up

owning a 100% stake in a business capable of delivering Rs 81 cr

of unleveragedcash flow a year. And youve have accomplished this by buying

out the business at a 45% premium to its prevailing market price!

Not bad at all!

And, so much for market efficiency!

There is an important lesson here: Control value investors dont worry about

macro events that cause prices of great, stable, debt-free, cash rich businesses

to drop to below the levels of their debt capacities. When such businesses

become available at those bargain prices, they act fast. They do not allow the

environment of uncertainty and fear prevailing at the time to shift their focus from

what really matters the fundamentals. They go by Warren Buffetts advice,

who famously wrote: Fear is a foe of the faddist, but a friend of the

fundamentalist.
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Vantage Point # 6: Modigliani & Miller, Finance

Academics, Nobel Laureates

If you look at what Henry Kravis did to VST, from the vantage point of Modigliani

& Miller (MM), you would say its impossible for one of MMs famous theorem was

on the irrelevance of capital structure.

According to MMs proposition on capital structure, under certain assumptions,

the value of a firm is independent of its capital structure. One of the assumptions

is that the markets are efficient. If the markets were efficient, then there is no

difference between price and value and there are no bargains. There can be no

Ben Graham, and no Henry Kravis either.

MMs proposition on capital structure means that in March 2009, when VSTs

stock price was Rs 220 per share and its total market value was Rs 338 cr, then

that value was correct because the market is always right.

The MM proposition on capital structure states, that if you make VST borrow Rs

300 cr the value of the firm will rise from Rs 338 cr to Rs 638 cr, comprised of

debt of Rs 300 cr and equity of Rs 338 cr. The total cash with the company would

now stand at Rs 490 cr. (Rs 190 cr + Rs 300 cr).

Then, MM proposition on Capital Structure states, that if you were to withdraw

this cash of Rs 490 cr from VST, which is exactly what Henry Kravis did, then the

value of the equity will simply drop from Rs 638 cr to Rs 148 cr.

Recall that the business generates Rs 81 cr of annual average cash flow and the

first years interest at 9% on total debt of Rs 300 cr, would come to Rs 27 cr. MM

on Capital Structure says that VSTs shares after the LBO, will be worth Rs 148

cr even though the business would have earned Rs 54 cr of cash flow after

interest in that year!

Isnt this baloney? Well, I certainly think it is.


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People like Henry Kravis laugh at academics who concocted theories like MM on

Capital Structure, a theory that all of you have read and I guess, so far assumed

it to be correct. Well my advice to you is to dump MM and to pick up lessons from

Ben Graham and Henry Kravis instead

Vantage Point # 7: Value-Oriented Manager

Imagine that you are a value-oriented manager who runs VST and its March

2009 and the companys stock is languishing at Rs 220. You know that your

companys business is capable of delivering an annual average cash flow of Rs

81 cr. You also derive comfort from absence of debt and presence of Rs 190 cr

as surplus cash on the balance sheet. And yet your company is being valued by

the market at only Rs 338 cr.

What can you do about this? Well, you can do many things but lets just talk about

three of them.

Special Dividend

You make VST borrow Rs 300 cr. Add to this the existing surplus cash of Rs 190

cr, and you now have a total of Rs 490 cr. Thats Rs 318 per share. Then, you

simply declare a special one-time dividend of Rs 318 per share! Remember, the

stock price is Rs 220 per share!

WTF?

What about MM on Dividend?

Recall from your earlier work in this MBA program that MM also had a famous

proposition on dividends. According to this proposition, under certain conditions(the primary one being the assumption of market efficiency), the value of a firm is

independent of its dividend policy. The proposition states and all finance

textbooks swear by this as if its the holy grail of finance that if a company pays

a dividend then on ex-dividend date its value will simply fall by the amount of the


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dividend paid. The theory further states that investors should be indifferent

between dividends and capital gains because what they get by way of dividends,

they will lose by way a decline in the market value of their shares. And if a firm

does not pay a dividend, they will have equivalent capital gains on the stock.

Well, lets apply this theory to VST. If VSTs stock price before the dividend

announcement was Rs 220 per share, then after the payment of Rs 318 per

share of dividend, its stock price should become negative Rs 98! Is that

possible? Can stock prices be negative? Of course not. Ok, lets grant MM this.

Lets say since the price cant be negative, but because MM on dividends is holy

grail, we have to grant to MM that the stock price of VST post dividend of Rs 318

will go to zero!

WTF?

How can this be? Lets just do the math again.

Recall that what the company paid out as dividend consisted of its surplus cash

(which, by definition it does not need to generate its annual average cash flow of

Rs 81 cr) and Rs 300 cr borrowed. This Rs 300 cr borrowed can easily beserviced the operating business. We already know this from the work done by the

business analyst earlier. We also know that the first years interest expense at

9% interest rate on Rs 300 cr of debt will be Rs 27 cr, leaving the company with

cash flow for equity of Rs 54 cr. (Rs 81 cr gross cash flow less Rs 27 cr of

interest). How can a business that earns Rs 54 cr of cash flow after meeting

interest requirement be worthless?

This is an example of proof by contradiction, something you read about when you

were in school. Well, its a trick, I advice you to use more often in much of

everything you do.

We can never really prove anything. Nassim Taleb says if you want to prove the

propositions that all swans are white then you cant prove it by looking for white


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swans. If, for example, you see thousand swans and all of them are white, that

does not prove the proposition that all swans are white. You can see a million

a billion swans and if all of them are white that does not prove that all swans

are white. But a single sighting of a black swan disproves the notion that all

swans are white. So, you just have to learn this trick of disprovingmuch-loved

but wrong ideas in finance and other fields by looking for contradictions.

The example of VSTs special dividend is the functional equivalent of the black

swan. Its a contradiction thatkillsthe MM Proposition on dividends, isnt it?

Share Buyback

You have Rs 190 cr of surplus cash plus you have debt capacity of Rs 300 cr

which you utilize and now you have Rs 490 cr. You want to teach the stock

market a lesson by valuing your company for only Rs 338 cr.

You are feeling angry at the market and you are feeling bold. You know your

companys stock is worth a lot more than its current price of Rs 220. You

announce a buyback at Rs 500 per share!

WTF? Are you crazy?

Lets find out by doing the math. How many shares of the company can be retired

at Rs 500 per share by using all of the cash of Rs 490 cr. Divide Rs 490 cr by Rs

500 per share and you get 0.98 cr shares, which out of the total existing 1.54 cr

shares amount to 64% of the equity.

Lets imagine that you go and implement this bold buyback plan and assume that

its executed successfully. What will be the consequences?

The company would be left with only 0.56 cr shares. All the cash would be gone.

There would be a debt of Rs 300 cr. But the company would still possess the

operating business capable of delivering annual average operating cash flow of

Rs 81 cr. Reduce first years interest of Rs 27 cr on the debt, and we are left with


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Rs 54 cr of cash flow for equity. Divide that by the remaining 0.56 cr shares

outstanding, and you get cash flow of Rs 96 per share!

If MM is correct, then post buyback the value of the firm should simply fall by Rs

500 cr used for the buyback. The value of the firm before buyback was Rs 338

cr. Then it took Rs 300 cr of debt and the value rose to Rs 638 cr. Now, post

buyback, according to MM, the value of the firm should fall to Rs 148 cr. But

since there is debt of Rs 300 cr, according to MM, the stock price should become

negative and since thats impossible, then it will surely go to zero.

Will the markets really value a stock capable of delivering a cash flow per share

of Rs 96 at zero? So, perhaps, a buyback at 500 at more than double the

prevailing stock price, wont have been as crazy as it looked, after all

Bonus Debentures

You have Rs 190 cr of surplus cash. You can borrow Rs 300 cr but you dont do

that. Instead of actually borrowing the money, you go and create bonus

debentures worth Rs 300 cr and allot them proportionately to your stockholders!

WTF?

Let me explain. We already know that the company can easily service Rs 300 cr

of debt. But we dont need the company to actually borrow money. We can simply

create a debt instrument out of thin air and distribute it to our stockholders. Lets

say the face value of every debenture we create is Rs 100. So there will be a

total of 3 cr debentures. Lets say the interest rate VST will pay on thesedebentures is 9% a year.

The company has 1.54 cr shares outstanding. These shareholders will receive 3

cr debentures. This means that for every one share, 1.948 debentures would be

simply be given to the stockholders as bonus debentures.


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If a stockholder owns 1,000 shares, their market value before the bonus

debentures was Rs 2.2 lacs. Now this stockholder will receive a total of 1,948

debentures. How would the bond market value these debentures?

Since these debentures have a face value of Rs 100, a coupon of 9% a year

which is the going rate of interest, and since the company would be very credit

worthy even after these debentures were created, we can safely say that these

debentures would be priced by the bond market at Rs 100 each. The aggregate

market value of these debentures in the bond market will be Rs 300 cr.

The stockholder who owns 1,000 shares in VST worth Rs 2.2 lacs would receive

1,948 debentures, which would have an independent market value of Rs

1.95lacs, and he would still own all the shares!

The value-oriented manager did not change anything on the asset side of VSTs

balance sheet. All he did was to create a prior claimand transfer it on a piece of

paper called debenture. This debenture would be valued by the bond market

independently. The bond market would correctly value 1,948 debentures at Rs

1.95 lacs and all of the 3 cr debentures at an aggregate value of Rs 300 cr.

If you were to believe MM on Capital Structure, however, the value of the

investors 1,000 share would drop by Rs 1.95 lacs, from Rs 2.20 lacs to Rs 0.25

lacs and end up selling for Rs 25 per share.

The stock would drop to Rs 25, says MM, because there was no change on the

asset side of the balance sheet! There was no new cash coming into VST or

going out of VST.

MM on Capital Structure says that if the total value is to remain unchanged, and

if we create debentures out of thin air, then the value of the equity shares must

simply shrink by the exact amount of the value of the debentures. If MM is right,

then the creation and distribution of 3 cr bonds worth Rs 100 each, should result


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in the drop in the value of the equity by exactly Rs 300 cr that value would drop

from Rs 338 cr to Rs 38 cr or Rs 25 per share.

And yet,this Rs 38 cr market cap company would be capable of earning cash

flow for equity of Rs 54 cr. (see our computations in Special Dividend section

above).

Do you really think that the market would value a firm capable of earning Rs 54

cr a year for Rs 38 cr?

How can the bond market value a claim on only ONE-THIRD of cash flow for Rs

300 cr, but the stock market value a claim on ALL of the cash flow for only Rs

338 cr, which still having surplus cash on balance sheet of Rs 190 cr?

Dont you see the contradiction here?

Either the bond market is right, or the stock market is right. Both of them cant be

right! That would be impossible isnt it?

Sherlock Holmes said: When you have eliminated the impossible, whatever

remains, however improbable, must be the truthImprobable as it may sound, ladies and gentleman, our method of analysis

shows that its the bond market was right by valuing a smallpart of VST at Rs 300

cr and that stock market was wrong by valuing the wholeof the company at Rs

338 cr, not evening counting Rs 190 cr of cash!

The important lesson from the three examples of special dividend, buyback, and

bonus debentures is this: A value oriented manager can always do these things

to force the stock market to correct its valuation mistake. Moreover, one does notneed a Henry Kravis to take VST private using an LBO and enjoy all subsequent

benefits for himself. The value oriented manager can achieve the same objective

using bonus debentures, allowing the companys stockholders to benefit from the

creation of leverage on VSTs balance sheet.


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Recall also that Ben Grahams abstract idea of ahidden bond component inside

the stock of VST.Well, the value oriented manager can literally use that idea to

deliver to his companys stockholders anactualbond instrument having

an independentmarket value, thereby forcing the market to correct its valuation

error.

Vantage Point # 8: The Civilization

We have come quite far in our investigations. But there is still one vantage point

left that of civilization.

None of the witnesses we have met so far have looked at the company from the

civilizations viewpoint by incorporating what Charlie Munger calls virtue and

vice effects.

I said earlier, that youll get closer to the truth by having access to several

vantage points. So lets examine this last vantage point. Zoom out a bit and look

at whats really happening here. How does VST make money? What do you see?

I will tell you what I see. I see that VST makes money essentially by selling

something that kills people. I know its legal to do it, otherwise VST would not be

in the business of selling tobacco. But that does not change reality does it?

Consider this: If tobacco was discovered today, and the world knew about its

horrible effect on the health of smokers, would it be legal to sell it?

Of course not.

You see, things carry on, becausethey have carried on. The tobacco business is

legal because its been around for so long and societies have this status-quo

bias, this inertia which prevents them from change. Moreover, the tobacco

lobbyists, who dont want this change, are very powerful. Plus, of course, the

government depends on the tax revenues.


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What are the realcosts of tobacco? I think we all agree that the real cost of

tobacco is hardly in the cigarettes sticks. The real cost comes the form of disease

and misery caused to smokers and their loved ones when they die from cancer.

That real cost is borne not by the tobacco manufacturers, but by society.

Privatized benefits and socialized costs is what makes VST prosper.

How long will this last? I cant say.

Will you buy the stock? I dont know. Its really up to you.

If you see this from the vantage point of a Ben Graham or a Henry Kravis, then

maybe, at aprice, you will. If you see it from another vantage point, perhaps, you

wont at anyprice.

The choice really is up to you. Moreover, you can rationalize whatever you

choose. Man, after all, is not a rational animal. Rather he is a rationalizing one.

I do know, however, that you get closer to the truth by having multiple vantage

points.

Having just onevantage point in a detective story is not good

enough.Having eightis rather cool.

Isnt it?

Thank you for inviting me!

Stock Valuvation

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