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# Archive for April, 2008

## Indian IT Sector

Posted by Yogesh on Wednesday, 30 April, 2008

Dalal Street May 11, 2008 issue has a cover story on IT, some excerpt from it.

Indian IT majors like Infosys, TCS and Wipro still earn more than 62 per cent, 55.2 per cent and 61 per cent respectively of their total IT business from the US.

The global IT spend is estimated to grow to $1296.63 billion by FY11 from$956.90 billion in FY07, entailing a four-year CAGR of 7.89 per cent. As far as global spend on IT services is concerned, it is the US which leads the pack with a huge 45 per cent share of the total IT spend. Next in line is Europe at 33 per cent. Asia Pacific share stands at 15 per cent and the balance 7 per cent comes from the rest of the world. Some of the statistics graph

## EV/EBITDA

Posted by Yogesh Agrawal on Monday, 21 April, 2008

2 interesting articles which compare this ratio :

by Hindu:
————-

How retail investors can profit from EV/EBITDA?

D. Murali

Equity share valuation is all about choosing the suitable multiple, says Mr Sanjiv Agrawal, Partner and National Head – Valuation Services, Ernst & Young. “Across the financial press targeted at retail investors, one factor that strikes a corporate analyst is the focus on price earnings (PE) multiple with minimal importance given to other multiples, enterprise value/earnings before interest, tax and depreciation & amortisation (EV/EBITDA) multiple in particular,” he observes.

Here is Mr Agrawal’s take on a few questions from Business Line.

What is the reason for the common bias towards PE multiple?

This may be attributable to the fact that PE multiple is relatively easier to calculate based on published results of listed companies compared to the EV/EBITDA multiple. In contrast, most analysts would swear by EV/EBITDA multiple.

Why so?

In our view, the EV/EBITDA is a smarter ratio to be used as part of comparable multiples analysis. Smarter, because it is purely driven by business operations of the company unlike PE multiple, which additionally gets impacted by non-business factors of discretionary or non-recurring nature. Non-business factors are usually less predictable from retail investors’ point of view.

PE is so simple to calculate: Price per share divided by the EPS (earnings per share). And you are bashing it?

Simple to calculate, yes; but it has several deficiencies, especially in the Indian context. Most Indian companies’ P&L (profit and loss) accounts feature significant other income’, which is usually not related to business operations and varies a lot from year to year.

Also, by definition, growth drivers and risk factors of other income’ are quite different from income from business operations. A key item is income from investments, which is driven mainly by interest rate scenario, investments sale activity during the year, and also non-market rate related investments made by the company (in related entities).

If we decide to switch to the alternative, that is, the EV/EBITDA multiple, how do we go about the exercise?

It should first be noted that the EV/EBITDA multiple, being a brilliant metric, is more tedious to compute than the PE multiple. EBITDA, the denominator, overcomes all the deficiencies that PE suffers from. But, one needs to make some adjustments…

Such as?

Add back to `net profit after tax’ the charge for depreciation, interest and tax, and also remove the non-operating/non-recurring items of income/expense.

The removal of latter items may not be easily possible as requisite information is not very transparent in annual accounts as per Indian company law format.

Making adjustments to the price, i.e. market cap is a little more tedious in fact. One needs to reduce market value of non-operating assets (e.g. surplus properties, investments, loans to group companies) from market cap. Loan funds borrowed by the company need to be added to the market cap to arrive at EV, the enterprise value.

On how the metric can be put to use.

The EV/EBITDA multiple can be compared to probe real (business) or market imperfection related reasons for differences in EV/EBITDA multiple across various comparable companies. A similar PE multiple analysis will not be amenable to this probing.

For example?

Two companies in a sector may have similar PE multiple but very different EV/EBITDA multiple. A PE multiple analysis may suggest that both are similarly valued by the market whereas in reality EV/EBITDA multiple analysis will highlight use of very different multiples for business valuation of the two companies by the market.

EV/EBITDA multiple analysis may upon further probing suggest that market will likely in future work towards converging both companies’ EV/EBITDA multiple to a similar level (assuming broad operating similarities in the companies), providing basis for buy or sell investment opportunities.

And, in the converse?

On the converse, similar EV/EBITDA multiples but very different PE multiples may not suggest converging of both companies’ PE multiples. The divergence of PE multiples may be due to non-operational reasons.

For instance, the company with lower PE multiple may have invested significant sums in related entities with lower than market returns. And so, the latter will not yield any significant buy/sell opportunity for an investor.

The bottom line, therefore?

EV/EBITDA ratio’s increased usage would benefit capital markets also as retail investors appraise corporate managements more effectively while making smarter investment decisions for themselves.

We need to help retail investors by providing this ratio to them periodically.

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EV/EBITDA

EV/EBITDA is one of the most widely used valuation ratios. It is:

EV ÷EBITDA

The main advantage of EV/EBITDA over the PE ratio ratio is that it is unaffected by a company’s capital structure. It compares the value of a business, free of debt, to earnings before interest.

If a business has debt, then a buyer of that business (which is what a potential shareholder is) clearly needs to take account of that in valuing the business. EV includes the cost of paying off debt. EBITDA measures profits before interest and before the non-cash costs of depreciation and amortisation.

EV/EBITDA is harder to calculate than PE. It does not take into account the cost of assets or the effects of tax. As it is used to look at the value of the business in EV terms it does not break this value down into the value of the debt and the value of the equity.

As EV/EBITDA is generally used to value shares it is assumed that debt (such as bonds) that has a verifiable market value is worth its market value. Other debt may be assumed to be worth its book value (the amount shown in the accounts). Alternatively, it is valued in line with the company’s traded debt (for example, with the same risk premium as the most similar traded debt).

Equity can then be assumed to be worth EV less the value of the debt.

The first advantage of EV/EBITDA is that it is not affected by the capital structure of a company, in accordance with capital structure irrelevance. This is something that it shares with EV/EBIT and EV/EBITA

Consider what happens if a company issues shares and uses the money it raises to pay off its debt. This usually means that the EPS falls and the PE looks higher (i.e. the shares look more expensive). The EV/EBITDA should be unchanged. What the “before” and “after” cases here show is that it allows fair comparison of companies with different capital structures.

EV/EBITDA also strips out the effect of depreciation and amortisation. These are non-cash items, and it is ultimately cash flows that matter to investors.

When using EV/EBITDA it is important to ensure that both the EV and the EBITDA used are calculated for the same business. If a company has subsidiaries that are not fully owned, the P & L shows the full amount of profits from but is adjusted lower down by subtracting minority interests. So the EBITDA calculated by starting from company’s operating profits will be the EBITDA for the group, not the company. There are two common ways of adjusting for this:

• Adjust the EV by adding the value of the shares of subsidiaries not owned by the company. The end result is an EV/EBITDA for the group. This becomes complicated if there are a lot of subsidiaries.
• Include only the proportion of EBITDA in a subsidiary that belongs to the company. So if the company has a 75% stake in a subsidiary, only include 75% of the subsidiary’s EBITDA in your calculation. This is simple for companies (such as many telecoms companies) that disclose proportionate EBITDA. Otherwise, it can become difficult if the subsidiaries’ results are not separately available. It also needs the corresponding adjustment to EV. In the example above, only 75% of the subsidiary’s debt would be included in the group EV.

Given these complications, a sum of parts valuation may be considered as an alternative for complex groups. EV/EBITDA could still be used to value each individual part of the group.

EV/EBITDA is usually inappropriate for comparisons of companies in different industries, as their capital expenditure requirements are different. Ideally one would substitute EBITDA minus maintenance capex (capital expenditure required if the business does not expand) for EBITDA. This is difficult. Alternatively, depreciation could be used as an inaccurate but easy proxy for maintenance capex which would mean using EV/EBITA

As with PE it is common to look at EV/EBITDA using forecast profits rather than historical, and similar terminology is then used.

## Rules of thumb

Posted by Yogesh Agrawal on Sunday, 20 April, 2008

Peter Lynch in his One up on Wall Street and Beating the Street has given several rules of thumb:

• Market Capitalization < \$5 billion
• PEG
• Earnings Growth between 15% and 30%
• Debt-to-Equity
• Institutional Ownership between 5% and 65%
• For cyclical stocks only: Buy when P/E is high, sell when P/E is low (i.e.when earnings are peaking)

## Sum Of The Parts (SOTP) valuation

Posted by Yogesh Agrawal on Thursday, 17 April, 2008

• SOTP is regarded as the best tool to value companies with diversified business interests

• It evaluates each business or division of the company separately and assigns a value to its contribution

• This valuation also captures future potential of the new ventures which are not generating revenues right now

• At the end, the value of all the parts (including core business) are added up to arrive at an approximate value of the company as a whole

• SOTP valuation indicates if the company’s value would be increased if it was split into separate business units

SOTP valuation of Bajaj Auto
by Indiainfoline on 13 July 2007

Bajaj Auto (vehicle manufacturing) Rs 933
+
Bajaj Auto Finserv Rs 450
+
Bajaj Holdings and Investment Rs 1,037
=
SOTP Rs 2,420 value > Rs 2,195 Stock price on 13 July 2007

Figures show what different businesses of Bajaj Auto would have contributed to its valuation

## Banking Sector in India

Posted by Yogesh on Wednesday, 16 April, 2008

An overview of Indian banking system
The banking sector in India is broadly divided into two groups: commercial banks and co-operative banks. On the basis of ownership mold, commercial banks are grouped into three categories – state owned or public sector banks (PSBs), private banks under Indian ownership and foreign banks. There are 27 PSBs, which all account for 80 per cent of commercial banking asset.

Today, in the deregulated market, banks decide on their lending and borrowing rates. In the competitive money and capital markets, the inability to offer competitive market rates adds to the disadvantage of marketing and building new business. In the face of the deregulated banking industry, an ideal competitive working will be reached when the banks are able to earn adequate amount of non-interest income to cover their entire operating expenses.

http://content.icicidirect.com/research/sectorwatch.asp

Posted in Corporate News, Sector Spotlight | 1 Comment »

## Fundamental Analysis

Posted by Yogesh Agrawal on Monday, 14 April, 2008

# P/E ratio

The reciprocal of the P/E ratio is known as the earnings yield.

$\mbox{P/E ratio}=\frac{\mbox{Price per Share}}{\mbox{Annual Earnings per Share}}$

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12 month period, divided by number of shares outstanding

If one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment.

P/E10′ uses average earnings for the past 10 years. There is a view that the average earnings for a 20 year period remains largely constant, thus using P/E10 will reduce the noise in the data.

Enterprise value divided by the EBITDA is another ratio used by some investors which is somewhat similar to P/E.

Assuming that two stocks have the same earnings growth, the one with a lower P/E is a better value

 N/A A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be mathematically determined. Either the stock is undervalued or the company’s earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets. For many companies a P/E ratio in this range may be considered fair value. Either the stock is overvalued or the company’s earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future. A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

The PEG ratio, Price/Earnings To Growth, is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company’s expected future growth.

PEG Ratio = $\left ( \frac{Price/Annual\ Earnings}{%Annual\ Growth} \right )$ or

PEG is a widely used indicator of a stock’s potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.

A lower ratio is “better” (cheaper) and a higher ratio is “worse” (expensive). A PEG ratio that approaches two or goes higher than 2 is believed to be too high. This means that the price paid appears to be much too high relative to the estimated future growth in earnings.

If a company is growing at 30% a year, then the stock’s P/E could be 30 to have a PEG of 1. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns

Keep in mind that the numbers used are projected and, therefore, can be less accurate. Also, there are many variations using earnings from different time periods (i.e. one year vs five year). Be sure to know the exact definition your source is using.

It also appears that unrealistically high future growth rates (often as much as 5 years out, reduced to an annual rate) are sometimes used. The key is that management’s “expectations” of future growth rates can be set arbitrarily high; a self-serving ploy, where the objectives are to keep themselves in office, and to make the stock artificially attractive to investors! A prospective investor would probably be wise to check out the reasonableness of the future growth rate, by checking to see exactly how much the most recent quarter’s earnings have grown, as a percentage, over the same quarter one year ago. Dividing this number into the future P/E ratio can give a decidedly different PEG ratio, and perhaps a more realistic one.

The PEG ratio can offer a suggestion of whether a company’s high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.

The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.

Price-To-Book Ratio (P/B Ratio)

A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.

Also known as the “price-equity ratio”.

Calculated as:

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.

This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.

Return on Equity. A measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year’s after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage. It is used as a general indication of the company’s efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. investors usually look for companies with returns on equity that are high and growing.

EV/EBITDA

enterprise value/earnings before interest, tax and depreciation & amortisation

Typically this ratio is applied when valuing cash-based businesses.
An advantage of this ratio is, its numerator EV (Enterprise Value)includes the value of debt as well as equity, it is unaffected by a company’s capital structure. Another one is that its denominator is not influenced by taxes.

## Technical Analysis

Posted by Yogesh Agrawal on Friday, 4 April, 2008

Moving Average levels are interpreted as support in a rising market, or resistance in a falling market.

All moving averages are lagging indicators and will always be “behind” the price. If the price of a stock is trending down, the simple moving average, which is based on the previous 10 days of data, remains above the price. If the price were rising, the SMA would most likely be below.

Because moving averages are lagging indicators, they fit in the category of trend following indicators. When prices are trending, moving averages work well. However, when prices are not trending, moving averages can give misleading signals.

### When to Use

Because moving averages follow the trend, they work best when a security is trending and are ineffective when a security moves in a trading range. With this in mind, investors and traders should first identify securities that display some trending characteristics before attempting to analyze with moving averages. This process does not have to be a scientific examination. Usually, a simple visual assessment of the price chart can determine if a security exhibits characteristics of trend.

In its simplest form, a security’s price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.

P.S. In finance training, a health insurance matters a lot more than a car insurance and to avoid loans, one should use his business cards with caution.