Subhendu Mishra

Though past results don`t guarantee the future results, they are an
indicator of the high quality and competitiveness of the business. Growth
in the following factors must be observed during growth analysis:

• Net Profit
• Revenue
• EPS
The goal of any business is to make money. Net Profit is the money that
is left out of revenue after meeting all kind of expenses, interest, and
taxes. Growth in net profit is the ultimate aim of any company.

Net profit is also referred to as the bottom line, net income, or net
earnings. The formula for net profit is as follows:
Total Revenue -Total Expenses = Net Profit
If a company is able to sell more goods or at a higher price, its sales
will increase and thus its net profit should also increase provided
that the expenses are controlled. The simultaneous growth in
Revenue and Net Profit is the most sustainable kind of growth. If the
Net Profit grows but revenue doesn't grow in the long term, that kind
of growth may be difficult to sustain.
Sometimes due to dilution in Equity (by issuance of more number of
shares), a shareholder’s stake in the profit of company may decrease
to such a level that he may not be able to benefit from the company’s
profit growth. Even though Profit growth is a measure of business’s
performance, it is the EPS growth which actually matters for a
shareholder and thus makes a difference to the Share price.
If for stock, all of the above metrics have grown by more than 15%
growth rate in last 5 to 10 years, then we can say that it is a
wonderful company from the growth perspective.
The performance of a company may be gauged by the following
metrics:
Return on Equity
Net Profit Margin
Free Cash Flow
It is the measure of Net Profit/Net Worth. A high return on equity
denotes high reward for the shareholders. A business with RoE>15% can
be considered good business. An increasing RoE is a highly positive sign.
 Net Profit Margin is equal to Net Profit/Revenue. A growing NPM is a
measure of growing competitiveness. There is no standard measure of
NPM as it varies across the industries. It can be compared for companies
from same industries and its growth is considered a positive sign.
FCF is the amount of cash left from Operating Cash after meeting all
capital investments. This is the amount that can be taken out of the
company without hurting its operations. A consistently positive and
growing FCF is again a good sign. A company may be investing too
heavily in its capital for future growth and for such companies it may
be negative temporarily. One must investigate such cases and decide
accordingly.
Thus, from the above metrics, one can gauge the increasing or decreasing
competitiveness and quality of the company.
If a company does well on all kind of analysis: Safety, Growth and
Performance, then it can be said to be a wonderful business.
Once we have determined a company to be a wonderful business, now we
should try to determine whether it is available at a fair valuation.
It is a well-known fact that quality demands premium. This means
that for a high quality business, we shall have to pay more than for
low-quality ones. But for stocks, the stock price is not the correct
measure of the cost of the business because different companies issue
a different number of shares. Thus comparing the prices of 2 stocks
won`t tell us which stock is expensive or which one is cheap.
In order to compare the valuation of 2 stocks, we must compare
valuation ratios such as:
• PBV Ratio, i.e. Price to Book Value Ratio
• PE Ratio, i.e. Price to Earnings Ratio
It is a well-known fact that quality demands premium. This means that
for a high quality business, we shall have to pay more than for low-
quality ones. But for stocks, the stock price is not the correct measure
of the cost of the business because different companies issue a
different number of shares. Thus comparing the prices of 2 stocks
won`t tell us which stock is expensive or which one is cheap.
In order to compare the valuation of 2 stocks, we must compare
valuation ratios such as:
• PBV Ratio, i.e. Price to Book Value Ratio
• PE Ratio, i.e. Price to Earnings Ratio
A high PE ratio denotes that the market is ready to pay a high premium
for this stock. Valuation Analysis is all about determining whether that
stock actually deserves such premium valuation.
.
e.g. Companies like ITC or HDFC Bank may deserve a PE Ratio of 25
because of their high-quality balance sheet, their power to grow their
earnings and cash flow as demonstrated in past etc. However, a
company like Gitanjali Gems may not deserve a PE ratio of 5 because of
its high debt, pledged shares, past bad performance etc.
In order to attempt to gauge whether the company is fairly valued,
there are a few valuation models which analyze the valuation of the
company from different perspectives:

• PE Valuation
• Graham Valuation
• EPS Growth Valuation
• DCF Valuation
This model compares the Median PE with the current PE. If the current
PE is much higher than the Median PE, you should be careful and see
whether the company has gained any real competitive advantage
recently.
This model is based on the current standing of the company, i.e. its
current Net Worth and profits. It does not account for growth possibility.
Usually, the good businesses trade higher than Graham value because
they hold a promise of large growth which is ignored by Graham
Valuation.
This model is based on the predicted EPS Growth on the basis of past
EPS Growth and assuming that the business will be available at least
at the median PE valuation.

The method is to estimate EPS growth over a period of years, then

place a hypothetical earnings multiple on the EPS figure at the end of
that period, and compare that hypothetical stock price to the current
stock price, which can allow for quick calculation of expected rate of
return over that period. There are three components to the final
value:
1) The final stock price at the end of the period.
2) Cumulative dividends received over that period.
3) The impact of cumulatively reinvesting those dividends.
This model is based on the predicted growth in Free Cash Flow. It makes
an account of total Free Cash that will be accumulated over the coming
years of operations of the business and uses that to value the business.

The formula for dscounted cash flow analysis is:

This model is based on the predicted growth in Free Cash Flow. It makes
an account of total Free Cash that will be accumulated over the coming
years of operations of the business and uses that to value the business.

The formula for discounted cash flow analysis is:

DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 ...+ CFn/(1+r)n

Where:
CF1 = cash flow in period 1
CF2 = cash flow in period 2
CF3 = cash flow in period 3
CFn = cash flow in period n
r = discount rate (also referred to as the required rate of return)