Magical Numbers Part III — Intrinsic Value of the Company

Thank you my subscribers friends for supporting me in my mission of sharing financial knowledge for financial freedom especially for people from my generation. As I had promised in the last post that, I would start sharing my investment ideas here in the weekly blog, so here are my thoughts on the market. The NIFTY yet again has been successful in closing the week at a high of 15,175 level probably because of reducing numbers of COVID cases. What ever the reason may be, along with jubilation, it is now the time to be cautious in our investments. At higher price, even the best of the shares become risky and requires extra caution. Though, I had dropped some hints in my previous blog about the companies which I am tracking currently, I think it is time to discuss them in little detail here. I have been considering Dixon Technologies and Indiamart Intermesh for investment. Both these companies have sound financials and I also believe that these companies will benefit from ‘Make in India’ policies and are likely to perform better once the lockdown is eased. The only negative in both these companies is that they are still trading much higher than my comfort prices. Below is the graph of Dixon Technologies and in that I have highlighted recommended buying zone as per me. As I have covered in earlier posts too, that, it is highly possible, that the price never drops to the desired level and I miss out on the trade, but thats OK by me. I would rather make a sound investment at profitable levels to have mental peace instead of making a risky investment which might give me some returns.

If your are not able to follow the chart or are a little confused about indicators below the chart, please do not feel disheartened. These too we will cover in detail, once we complete our Fundamental Analysis and are on to Technical Analysis.

Guys, back to our topic for this post which is in continuation of the previous two posts on the similar subject. If you recall, in previous two posts, we had discussed why financial ratios are needed and how they can be beneficial in quick comparison of multiple companies at one go. For ease of understanding, we had grouped them in four distinct groups, of which the first group was ‘Share Price in Relation to Profits’ and under which we had discussed EPS (Earning per Share), Price-Earnings (P/E) Ratio, Price-Earnings Growth (PEG) Ratio and though not strictly related to profit, Price-to-Book Value (P/BV) Ratio to help compare financial companies. Now is the time to move on to second group, which is Intrinsic Value of the Company and under this part we will see whatEV/ EBITDA, EV/ Sales and Price/ Sales ratios mean and how to use them in our analysis. But before proceeding any further, lets first decode, what Intrinsic Value means. In simple words, it is the total worth of the company and it takes into account its moveable and immovable assets, its market capitalisation, state of its core business or any other factor which may have any direct or indirect affect on its valuation.

If I tell you that there are very easy means to calculate present and future intrinsic value of any company, won’t that be super exciting????? Would it not give a fair idea of current share price, that it is under or over valued as well as how much growth you may expect over a definite period of time??? If you ever had these questions in your mind before investing, now is the time to focus on the answers and the answer lies in finding out the ‘Intrinsic Value of the Company’. Let us quickly discuss the ratios which cover this part, one by one.

EV/ EBITDA- the most common ratio to determine intrinsic value isEV/EBITDA. Both these terms we have discussed in previous posts, but to refresh, EV stands for Enterprise Value which is total market capitalisation (number of shares issued by any company X current price of each share) + existing loans — available cash and EBITDA is Earnings Before Interest, Tax, Depreciation and Amortisation. While EV may be taken as net worth of the company, EBITDA represents profitability of the company. Similar to P/E ratio, lower the value of EV/EBITDA = more potential for investors to earn profit. For example HUL has this ratio of 45.75 while our target company for investment Dixon Technologies has this ratio of 87.87, almost double of HUL. This indicates that the present share price is too high.

Pro Tip:- EV/ EBITDA ratio below 10 is considered healthy and most companies in S&P 500 have this ratio between 11 to 14 with aggregated average as 14.20.

EV/ Sales — Another popular ratio for determining intrinsic value is EV/ Sales. It is very similar to EV/ EBITDA discussed previously and the only difference being a change in denominator. While EBITDA represented the profitability, sales represents the core means to create profit by generating revenue and is taken as aggregate for last 12 months. Therefore, higher and higher sales figures are what investors are looking for. This in turn means, lower the ratio of EV/ Sales = more profitable investment opportunity. Lets again compare HUL and Dixon for easy understanding of this ratio. EV/Sales for HUL for year ending 2021 is 12.41 while it is 3.65 for Dixon. Yet again Dixon emerges as a better investment idea based on this parameter.

Pro Tip:- Typically a EV/Sales ratio between 2 to 4 is considered a good investment opportunity. However, it may get misleading as different sectors may have different average ratios, therefore, always compare this ratio with peers to analyse, if a stock is overpriced or undervalued.

Price/ Sales (P/S)-This too is often used to determine the intrinsic value and compare different companies for investment opportunities. In this ratio too, similar to P/E, Price refers to total market capitalisation calculated by multiplying current share price to total number of shares. While Sales is the total value of sales (revenue generated by core business activity) over the 12 months period. Similar to P/E ratio, it represents how much an investor values each rupee earned the firm by means of sales and tells us whether the company is under or over valued. Back to our comparison of HUL and Dixon, lets see the figures for both these companies which is 12.41 and 3.65 respectively. Don’t they seem similar to EV/ Sales figures????? Absolutely right……P/S and EV/ Sales in most cases would be identical. The difference would be noticeable only for companies with huge debt burden.

Pro Tip:- In many cases P/S and EV/ Sales ratios would be identical. However, while analysing debt burdened companies, EV/ Sales may provide a clearer picture.

Let me once again emphasise that never make a mistake of getting lured just by one figure or ratio. Always try to compare the complete picture. It would be best, if you create a priority wise blank table template in which you keep adding analysis of one share at a time. With in no time, this sheet would act as a master sheet for comparison of any stock you might be interested in. Always ensure to select at least one parameter from various categories of Fundamental and Technical Analysis. For example, from Ratios — Group II, you must include at least one parameter in your master sheet.

I have deliberately left out valuation models based on the ratios covered in this post as these may become a little complex for understanding of everyone. However, valuation figures can easily be obtained from a free website Smart-Investing.in . The valuation figures by this website based on the three ratios above, calculates fair price of Dixon Technologies as Rs 897.53 against the last trading price of Rs 3944.85, approximately at a premium of 400%.

We have been so far successful in keeping the discussions here within 8th standard maths with some common sense. However, due to inclusion of investment idea this post is a little longer and now may take upto six minutes as against intended five minutes. Guys please bear with me on this count.

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