Equity Valuation

CONTENTS 1. Equity Analysis 2. Profit & Loss Account 3. Pricing & Profit Margins 4. Trends in Deciphering Profit & Loss 5. Balance Sheet 6. Balance Sheet Analysis 7. Cash Flow Statement 8. Intangibles 9. The piecemeal company 10. Dividend Yield 11. Earnings Per Share 12. Is P/E the Holy Grail 13. Growth rates 14. PEG ratio definition 15. PEG and YPEG 16. Multiples 17. Revenues Valuation 18. Price Sales Multiples 19. Shareholders Equity and Book Value 20. Price to Book Value Multiples 21. Enterprise value 22. Return Ratios 23. Enterprise Value /EBTIDA multiple 24. Other ratios 25. What is Solvency 26. What is Interest cover 27. Beware of the Debt Trap 28. Debt Service Cover 29. Value : The Price Paid : Quality : Depth of Knowledge of a company : Time & Returns 30. A Case Study : Dr Reddys Laboratories 31. References 32. Annexure 1: Financials of Dr Reddys Lab 33. Annexure 2 : Valuation Matrix 3 5 8 9 12 15 19 20 22 23 23 23 26 31 33 34 35 36 37 38 39 39 44 46 49 50 50 50 52 53 55 57 60 71

EQUITY VALUATION
So just how do you value the shares of a company? Based on earnings, revenues, cash-flow. . . or something else entirely? Or do you simply apply multiple valuations in order to discern what the fair price for a share of stock might be? Equity is a fancy way of referring to what is actually there. Whether it's tangible things like cash, current assets, working capital and shareholder's equity, or intangible qualities like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow. Traditionally, investors who rely on buying companies with a substantial amount of equity to back up their value are a paranoid lot who are looking to be able to collect something in liquidation. However, as the TV-dominated mass-consumer age has helped intangibles like brand names create powerful moats around a core business, contemporary investors have begun to push the boundaries of equity by emphasizing qualities that have no tangible or concrete value, but are absolutely vital to the company as an ongoing concern. To be able to value equity, we need to first understand how equity is to be analysed. Equity Analysis Finding Information : One of the more perplexing tasks individual investors have to face is where to get information about publicly traded companies. As strangers in a strange land when they first come to the world of investing, they not only face the already daunting endeavor of finding information from a variety of sources, but they also face the even more important task of determining which information is important. Unless facts are placed in a framework that provides meaning, they can be confusing, contradictory chunks of white noise. Getting Data : The lowest form of information is data, which almost always takes the form of numbers. Whether daily stock prices, condensed financial statements, or any of a variety of quantitative tools, fortunately for investors there are a wide array of information available on the World Wide Web, trade journals, magazines, newspapers and annual report of companies. The Quote, Chart, and Financials offerings cover the gamut of current price, recent price history, condensed historical financials, and current earnings estimates. In India, there are separate channels which cater exclusively to business news, they interview key people such as Managing Directors and other important people key people of the company. These interviews give deep insight into certain key events which are going to unfold in the future.

The detailed financials of companies can be got from specific packages which cater to company and industry data. Some of the prominent packages are Capital line OLE and Prowess. Apart from company and industry data these software packages have newsclippings of one year on the required companies and they have a special query package which enables investors to compare peer performance on various criteria. Further there are packages which are specifically designed and have archived news on various companies and industries. A source of online news or realtime news is Reuters, Bloomberg and Bridge news. Companies who have listed their securities on Nasdaq or NYSE have to file their quarterly, half yearly and annual results with Securities and Exchange Commission (SEC) or Edgar online. The above are also available on companys sites. The SEC filings give indepth view on the companys financial and operating performance for the period under review and offer deep insight into what is in store for the company. Chairman's Communication and Director's Report : This is sometimes a mere PR exercise, but it could also be a source of insight into a companys strategy. An example would be Subhash Chandras vision for Zee, which clearly charts out the way he wants the group to grow. The Directors Report and, in some cases, the Management Discussion and Analysis, sets out the managements view of the operations of the company during the year. In a multidivisional company, the performance of the various divisions are analysed in some detail. This would enable you to know which businesses are doing well and which not so well. Compulsory Disclosure norms by SEBI : SEBI has now made disclourse of business wise performance at Sales, PBDIT levels, Gross Profit and Profit Before Tax levels compulsory from December 2001. This gives a view on the performance of the business of the company and lets us know which businesses are a drag on the company. In the case of sell off of unviable or less profitable business, the value of the company will be enhanced, which will have a direct reflection in the value of the share. Analyst Meets, Annual General Meetings : Companies have to conduct annual general meetings once a year. In these meetings companies disclose performance till last month, various initiatives taken on increasing sales, profits, restructuring initiatives being undertaken and the business atmosphere till date. Analyst meets are carried out by more proactive managements who want to address key developments to analysts who in turn communicate the same to institutional and other investors. Key issues on brand performance, domestic growth, overseas growth etc are revealed and queries on operating as well as financial performance are addressed. Analyst meet presentations are carried out on the web site for common investors to have access to these. Conference Calls :

Some of the big market capitalisation companies have conference calls do that management can address critical issues such as performance review, critical developments etc. The excerpts of these are later displayed on the companys web sites so as to enable investors to access these. Now that we are familiar with the process of where to collect important data let us proceed to financial statements. THE PROFIT & LOSS ACCOUNT At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about. INCOME The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits The data collected above should be helpful to the company in projecting sales as this is by far one the most important drivers for projecting revenues for the company. From the data obtained from the annual report and coupled with data obtained from a management meeting, we should be able to split revenues and project it taking into consideration the growth in volumes and realisations per unit. Many Indian companies are taking an outward orientation so as to be able to grow revenues, this is especially true for Pharmaceutical and Software companies who are taking advantage of the opening up of the generic opportunity in pharmaceutical industry and the competitive billing rates coupled with top class software quality which are driving volumes in the software sector. "Other income" is accountant speak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of oneoff income. Operating other income : Operating other income directly relates to the operations of the company. Export incentives received, royalty received, sale of scrap and other income directly related to operations should be clubbed with Net sales and shown as Operating income while there should be separate classification for Non operating income and Extraordinary income. Recurring income which can be directly linked with revenues should be done so as to get a fair picture about future income flows.

Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a companys business operations. The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account. EXPENDITURE : The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. One will notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc. It is important that one can project the past years performance so as to get an idea how is it going to affect the future years performance and what benchmark to take for future years performance. Material expenses will go down in future years if the company has focus on exports as exports will help the company to increase its realisations hence the consequent effect on lower raw material costs. Personnel costs normally tend to increase not as a percentage of sales but at normal inflation rate unless the company is in a growth phase or pays more to retain people in an industry where there is constant poaching and skills are in short supply. This sort of situation did exist in the software industry a year back. Expenses have to be segregated so as to get a clear idea about each expense and how it is going to effect the companys margins. In case of higher focus on exports, the overseas travel expenses will increase and the same has to be factored in the projection so also one has to factor in higher freight and forwarding expenses. Operating Profits indicates Business efficiency : Operating profits is derived after deducting Expenses -Operating Income. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to

only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a companys ability to make money from its core operations. Increasing efficiencies generate higher margins. Whenever revenues increase and expenses are maintained, increase is at inflationary rate or are on a declining trend when compared to the revenues, then margins tend to increase. Hence higher margins, translate into higher profits as depreciation and interest, tend not to increase in the same proportion as actual profits. But that's not all. Interest costs incurred on the company's debts are also included here. The company requires funds to invest in assets and to run its dayto-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumerand more importantly, before money can be realized! These expenses are funded by a mix of shareholders funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others funds. Thus, the company has finance charges like interest and lease rentals. Further, there's an item known as depreciation, is a cost that is charged for use of plants and building. It is not cash expenditure. Any assetbe it a plant or a machineryeventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. For its operations, the company uses capitallike plant and machinery. PBT: After paying for all the expenses, this is what is left in the companys kitty. Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax its contribution to the state kitty. Net profit: Well, home at last! This is one number that summarises the companys operations. PROFIT AND EPS Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholders funds. A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year. Dividends: After paying all the other stakeholders in the business, the company

pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company.

Pricing and Profit Margin

Pricing a product or service to create profits and volume is crucial to the success of any corporation. How well would Coca-Cola have fared had it decided that soda should be sold in eight-gallon jugs at $20 a pop? While it might have made quite a bit from this particular packaging because the container cost less as a percentage of the overall price than any other configuration, it is hard to imagine how much in the way of sales volume Coca-Cola would have generated. The average motorist stopping by a convenience store just doesn't have room in the car for an eight-gallon vat of soda. Purchases of the "Coke keg" would have been restricted to home use, parties, and various entertainment establishments. Pricing has become the realm of "marketing" in the modern corporation. Balancing profitability against volume is the bailiwick of market researchers, promotion gurus, and hard-nosed corporate executives. All the sales volume in the world is meaningless to shareholders if the company cannot manage to turn a profit, though. So pricing a product to be as profitable as possible and generate stable sales growth is the Holy Grail of sales and marketing groups across the business world. The profit margin is one of the easiest ways to assess whether or not this group is meeting the test of the profitability side of the equation. Profit margin is simply earnings (or profits) divided by sales, both measured over the same time period. Profit margins are the money left over after paying all of the costs of running the business. Managements that increase profit margins are controlling costs either by squeezing efficiencies out of the business or cutting out unprofitable ventures. Although management can cut costs too far -- bleeding out necessary research and development spending, for instance -- for the purposes of analyzing the return on equity generated by a business, a higher profit margin means a higher return on equity. Profit margins are also an expression of the amount of competition inherent in the business. Competitive industries like grocery stores or discount chains tend to have very low profit margins. This is because it does not take all that much to get into those businesses. Railroads, which operate with the benefit of semimonopolies on large-scale traffic between points for bulk commodities, tend to have significantly higher profit margins. High profit margins tend to indicate that a company either has a high proprietary good or service, possibly "branded" and therefore able to carry a price premium, or the company is in a business where it has a monopoly or is part of an oligopoly over a particular type of goods or services. Without some kind of "moat" around the basic business, high profit margins tend to get crunched pretty quickly by new competition. A global brand like Coca-Cola with a massive distribution system to get its product to consumers in a variety of packages makes for one heck of a wall to climb for any new competitor. As Cott Corp. discovered in the early '90s, Coca-Cola could lower its prices to a point where Cott faced significant pain getting its product on store shelves profitably, while Coca-Cola milked the other elements of its distribution system, like sales to restaurants or sales overseas, to make up for the pain of maintaining market share.

High profit margins rarely come without the kind of entrenched business model Coca-Cola has or the semi-monopoly or oligopoly status a railroad has. A railroad like Norfolk Southern has very limited competition in the regions of the country where it owns the track. A huge, upfront capital investment has purchased the company a relative monopoly in certain geographical regions. However, as we will explore tomorrow, in the case of Norfolk Southern the high profit margin is complemented by a very low rate of asset turnover, limiting the total return on equity. The vast majority of traditional, high-margin businesses are coupled with low asset turnovers, meaning that they can only do a fixed amount of business without incurring additional costs that would constrict profit margins. Trends : Deciphering the Profit and Loss Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company. That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account. Some financial terms have found a permanent place in every day usage. 'Bottom line' is one such term. A little later the term 'Top line' also started gaining in currency. This is but natural because if there is a bottom line, general expectation is that there should be a top line too. These lines, top and bottom, appear in the income statement of the annual report. In the income statement (also called a Profit and Loss account or simply the P & L account) the bottom line refers to the net profit made for the period under consideration and the top line refers to sales income. Analysis of an income statement starts from the top line, the total sales. It is here that an analyst has to make changes and clarify some of his assumptions. This is necessary because the main objective should always remain in view, which is to gain greater clarity and also to seek easy means of comparison between two or more companies. From an analysts perspective profit increase is always good for the company but if the profit increase is accompanied by sales/revenue increase then it is better as increased sales/revenues have driven profits. Many a times MNCs carry out restructuring activities which tend to show increased profits for a short period of time, but the entire exercise is futile if its is not backed by sales increase. This has been the primary reason why MNC companies pharma companies are being valued at lower multiples compared to Indian pharma companies which are in a higher growth phase as they are derving revenues from the domestic market, exports and royalties compared to their foreign counterparts which derive income only from Indian operations. Generally, in the case of finding investment potential, the objective would be to find the 'true' income of the company. By 'true' we mean that income which has come out of the declared main activity of the company. Though we shall not totally overlook income from other sources, our main aim is to find out how the

company is performing in its avowed activity. So, we shall initially overlook the 'other income' and then make adjustments for any other income, which is not of a recurring nature. Reasons for ascertaining the true income are simple and also logical. Company's profits essentially should come from its main activity. What it earns out of its investment activity is the butter and jam on the bread and not a reward for its own toil and sweat. We are interested in finding out how the company is faring in the existing market on the basis of its product. In other words how it is earning the bread without which the butter and jam are of little value. A downward trend in the income from main activity is a clear indication of trouble in the near future. If the trend continues, chances are that other income will also start sliding leading to further trouble. One more assumption is that past performance is a fair indicator for projecting future earnings. Theoretically, from investment point of view, this may not sound right because while investing in shares we are interested in the future and no one can really predict what the future has in store. Experience, however, suggests that matured companies do not deviate too much from the past. The relationship between income and different expenditure heads shows a relatively stable pattern and a major deviation therefore in any year can easily stand out. Circumstances in the past which led to record performance in either direction become apparent and if similar circumstances are expected to arise again in the future, projections become that much simpler and realistic. With the above logic a format for rewriting the income statement is suggested. The example taken is of Great Eastern Shipping and the idea is developed in two steps. The first step leads to a broad analysis and finer points are seen in the second step. In the first step the other income is taken out and all expenses are deducted from the operating income. The other income is then added back. This method readily shows how much dependent the company is on its other income. In the second step the operating and other income is further investigated to take out non-recurring items that are in the form of one time windfall or such items that are not likely to appear in future statements. Step 1. Rewritten Income statement of GE Shipping. Figures in Rs. Million.
Mar 2000 Income from Operations Less Expenditure Operating Profit Less Interest PBDT Less Depreciation Less Provisions Operating PBT Add Other Income PBT as on P & L Acc. Less provision for tax PAT for the year 608.1 2757.5 1811.7 0.0 945.8 318.7 1264.5 160.0 1104.5 9625.9 6260.3 3365.6 Mar 99 9295.0 5988.9 3306.1 578.2 2727.9 1647.0 50.0 1030.9 513.5 1544.4 280.0 1264.4 Mar 98 9150.5 5435.2 3715.3 650.4 3064.9 1558.1 85.0 1421.8 490.4 1912.2 270.0 1642.2

Note: We advise that in case manufacturing units where sales are inclusive of excise duty, it is a good

practice to deduct excise duty from operating income as well as from expenditure to get a proper feel.

In the case of GE Shipping, by separating the other income from the total income, we find that the company has marginally improved its efficiency. This is not the picture that emerges from a look at the PBT and PAT, which show a continuing slide despite a continuing rise in operating income. Thus, though the slide continues as far as bottom line is concerned, the company has managed to arrest it at the operating level. This, for an analyst, is a very important finding because it tells him that things are not as bad as they look. The above figures also show, with greater ease, that the real culprits are interest, depreciation and lower other income. A view may be taken that higher depreciation is on account of higher investment in plant and equipment that was financed by liquidating some of the investments and additional borrowings, which in turn have given rise to higher interest. It may gladden the heart of the analyst to know that the company is investing in new equipment and is willing to pay the higher depreciation though it may somewhat mar the bottom line. When the market conditions improve the company may be in a position to take full advantage of the added equipment. This view, however, will have to be confirmed by going into further details. A 3.5% increase in operating income has operating profit, which is much better than in operating income of 1.5% had actually operating profits. An important trend resulted in an increase of 1.8% in the previous year where an increase resulted in a decline of 11% in the reversal has taken place here.

The next step calls for a slightly detailed study of the income schedules to find out the non-recurring type of income or income from past events. Examples of such items are settlement of old claims, refund of excess income tax, income through renegotiations, recovery of some bad debts which were earlier written off and any other such items. It is true that generally such items are small in amount compared to the main income yet an analyst has to make sure that any distortions due to oversight are straightened out.

Extraordinary income : Occasionally we also find some windfall items. A company may decide to sell its holding in other affiliated company during a particular year. The profit from sale of such an investment is definitely a non-recurring type if it exceeds average of earlier years. One example that comes readily to mind is of Kirloskar Oil Engines Limited when it sold a part of its holding in Kirloskar Cummins Limited. For income from earlier years it is a good practice to deduct it from the year in which it is reported and add it to the year to which it pertains. For windfall income it is better if it is deducted from the single year but maintained in the long-term analysis. Coming back to Great Eastern Shipping we find two items of the type mentioned above in the annual report for year 1999-2000. The schedule for other income shows Rs. 7 Million as 'Doubtful advances written off in earlier year now recovered' and Rs. 42.5 Million as 'Provision for diminution in value of long term investment written back'. As per our discussions, therefore, Rs.49.5 Million should be deducted from the income of 99-2000 and added to the income of 98-99. The corrected values should therefore appear as given below

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Mar 2000 Operating PBT Add O/Income (Adjusted) Total PBT 945.8 269.2 1215.0

Mar 99 1030.9 563.0 1593.9

Mar 98 1421.8 490.4 1912.2

Please note that in this case the changes are in the other income only and therefore the operating PBT is left unchanged. A securities analyst has to find out the company's ability to generate sales and retain maximum amount out of it. What it earns out of its own muscle power is what is of main interest and the rest is to be treated as secondary. The above format allows the analyst to study this ability. If one considers Sales as the driving pump for the financial system then it is worth our while to know how much is pure water and how much is air out of all that is pumped. Both are useful but one is more important than the other is. The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement. The Balance Sheet: The Balance Sheet gives you a picture of the size of the company's assets and liabilities, and the sources and uses of the company's funds Unlike the P&L account, which shows the profit or loss a firm has incurred over a period of time, the balance sheet is a snapshot of the firm at A POINT OF TIME. As on a particular date, the last date of the accounting period, the assets and liabilities of the firm are all added up and presented in the balance sheet. The capital and reserves are added to the liabilities side to balance the two sides. In other words, Capital + Liabilities = Assets. To illustrate, let us take the Balance Sheet of Reliance Industries.
As at 31st March 1999 Rs. SOURCES OF FUNDS : Shareholders Funds Share Capital - Equity Share Capital - Preference Reserves and Surplus Securitisation/Advance Against Future Recievables Loan Funds Secured Loans Unsecured Loans 5,477.64 5,207.65 10,685.29 TOTAL APPLICATION OF FUNDS: Fixed Assets Gross Block Less:Depreciation 18,650.33 6,691.93 17,848.33 4,944.47 24,019.65 933.39 252.95 11,183.00 12,369.34 965.02 2,736.78 5,510.55 8,247.33 20,529.93 931.90 187.95 10,862.75 11,982.60 300 Rs. As at 31st March,1998 Rs. Rs.

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Net Block Capital Work-in-Progress

11,958.40 3,437.83 15,396.23

12,903.86 2,069.43 14,973.29 4,282.33

Investments Current Assets, Loans and Advances Current Assets Interest Accrued on Investments Inventories Sundry Debtors Cash and Bank Balances 25.61 1,408.61 457.10 4,897.60 6,788.92 Loans and Advances 1,676.26 8,465.18 Less: Current Liabilities and Provisions Current Liabilities Provisions 3,591.98 544.37 4,136.35 Net Current Assets TOTAL Significant Accounting Policies Notes on Accounts

4,294.59

21.07 1,343.96 642.72 2,133.51 4,141.26 991.05 5,132.31

3,382.01 475.99 3,858.00 4,328.83 24,091.65 1,274.31 20,529.93

You'll notice it's divided into two broad sections- Sources of Funds and Application of Funds. Sources of funds What are the sources of funds? Obviously share capital is one of them. In the Reliance balance sheet, there are two types of share capital-- equity and preference. Equity shares are ordinary shares. Preference shares, on the other hand, are so called because they get preferential treatment when it comes to paying dividend. Preference shareholders are paid a fixed dividend, unlike ordinary shareholders, whose dividends vary according to how well the company has performed. However, preference shareholders, because they opt for the security of fixed dividend payments also forgo capital appreciation -their shares are typically redeemed at a fixed price (often no different what they paid for it). Profits retained by the business over the years are also a source of funds. These are included under the head "Reserves and Surplus". Loans, secured and unsecured, constitute the other source of funds. Secured loans are those in which the lender has a charge on the company's assets as security, while unsecured loans are those where there is no security, for example fixed deposits from the public.

There's yet another source of funds. You'll find, towards the bottom of the balance sheet, an item called Current Liabilities and Provisions, which are deducted from Current Assets. Current Liabilities are things like Sundry Creditors, or those to whom the company owes money. In other words, you owe

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someone money, but you haven't paid him yet. So he becomes a source of funds. The other item, Provisions, is a bit trickier. These are sums set aside but payments have not been made. In other words, you need to pay income tax, wealth tax, dividend, leave encashment etc, and make provisions for them, but because you haven't yet paid these sums, they become a source of funds. Uses of funds Now we come to the applications side of the balance sheet. Here we have the uses to which all those funds, which have been sourced, have been put. There are two broad classifications--fixed assets and current assets. Fixed assets are things like plant and machinery. Total depreciation on these assets (see section on P&L account) is deducted from gross assets to arrive at net assets or net block. To that is added capital work-in-progress, that is, the projects going on at the balance sheet date. Investments in stocks or bonds are another way in which funds can be used. And lastly we have current assets, so called because they form part of the working capital cycle which transforms raw materials to finished goods. Current assets consist of inventory, people who owe the company (sundry debtors) and cash and bank balances. Loans and advances given to others is also a use for funds. How do you use this information? Now you have all this information about where the company has got its money from and how it has used it. But what use is it? You'll notice there are two columns in the balance sheet, with the previous year's figure also being given. Comparing the two sets of figures leads to some insights. For instance, in the Reliance balance sheet, the amount of secured loans has gone up from Rs2736cr to Rs5477cr. How did it use this money? The balance sheet shows that part of it went towards increasing gross block, part towards the higher capital work-in-progress a bit on inventories and a large part was held in cash and bank balances. You can make a similar analysis for every source and use of funds, checking out how funds were sourced and how it was spent during the year. For instance, if a company siphons out money by giving loans to associate companies, the balance sheet will tell that to you. A snapshot as on a particular date One important caveat. The balance sheet is a snapshot, as on a particular date. For instance, if you had checked the balance sheet a few days earlier, the cash and bank balances may not have been so high. Or a company may have repaid a loan just for a few days to show lower indebtedness as on a particular date. Doing up the balance sheet in this fashion is known as window dressing. So now that you can read a balance sheet, keep a pinch of salt handy. The Auditor's Report & the Notes to the Accounts Let's start with the Auditor's Report and the "Notes to the Accounts." The Auditor's Report will tell you what the auditor thinks about how the accounts have been drawn up. If he thinks that some accounting treatment is a bit dicey, and would affect the profits, he makes what is called a qualification to the accounts. In plain words, what he's doing is drawing your attention to the fact that the profit would have been different if the accounts had not been massaged. Usually, the auditor also tells you what impact the faulty accounting policy has on the

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firms profits. The Notes to the Accounts contain some fine print that is well worth studying. For instance, the notes to Reliance Industries' accounts point out that inter-divisional sales of Rs3929cr are included in the company's sales figure. Inter-divisional transfers are sales between one division of the company to another. This amount, therefore, should not be included in the total sales figure. Or take another example. The Notes point out that RIL has changed its method of depreciation, with the result that the profit for the year has been understated. So if you didn't look at the Notes, you could be misled. Some Relevant Information : Also included is quantitative information such as installed capacity, its utilisation, volumes sold etc. This will enable you to find out whether an increase in sales, for example, is due merely to higher prices, or to increase in volume of goods sold. Since the quantities of products produced are given, you will be able to get information about the trends in volumes of the different products. Another important figure which needs to be looked at is figures for imports and the foreign exchange earned. That'll enable you to gauge the impact, for instance, of a depreciation in the currency. Balance Sheet Analysis : Cash Is King?" Sure, you have heard the cliche. You will be talking to another investor about the latest addition to your portfolio and the conversation will turn to how each of you picks stocks. The other investor will smile at you and wink, cryptically saying, "Cash is king." Although somewhat perplexed, you don't dare ask for clarification for fear of looking like a fool. But what the heck does that really mean? Publicly traded companies are designed to make money. The conventional way of scoring this pursuit is by looking at the company's ability to grow various flavors of earnings -- operating earnings, pretax earnings, net income and earnings per share are all common measures. However, this is not the only way to determine if there is real value in a company's stock. A company's real earnings are the earnings that make it from the Consolidated Statement of Earnings to the Balance Sheet as a liquid asset. Shareholder value ultimately derives from liquid assets, the assets that can easily be converted into cash. A company's value is determined by how much in the way of liquid assets it can amass. There are two ways to think about this. The first is to look at terminal value, which assumes for the sake of calculating potential return that at some future point a company will close down its operations and turn everything into cash, giving the money to shareholders. The second is to look at where tangible shareholder value comes from -- returns on invested capital generated by the company's operations. If a company has excess liquid assets that it does not need, it can deploy those assets in two ways to benefit shareholders -- dividends and stock buybacks. Current Assets : The first major component of the balance sheet is Current Assets, which are assets that a company has at its disposal that can be easily converted into cash

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within one operating cycle. An operating cycle is the time that it takes to sell a product and collect cash from the sale. It can last anywhere from 60 to 180 days. Current assets are important because it is from current assets that a company funds its ongoing, day-to-day operations. If there is a shortfall in current assets, then the company is going to have to dig around to find some other form of short-term funding, which normally results in interest payments or dilution of shareholder value through the issuance of more shares of stock. There are five main kinds of current assets -- Cash & Equivalents, Short- and Long-Term Investments, Accounts Receivable, Inventories and Prepaid Expenses. Cash & Equivalents are assets that are money in the bank, literally cold, hard cash or something equivalent, like bearer bonds, money market funds. Cash and equivalents are completely liquid assets, and thus should get special respect from shareholders. This is the money that a company could immediately mail to you in the form of a fat dividend if it had nothing better to do with it. This is the money that the company could use to buy back stock, and thus enhance the value of the shares that you own. Short-Term Investments are a step above cash and equivalents. These normally come into play when a company has so much cash on hand that it can afford to tie some of it up in bonds with durations of less than one year. This money cannot be immediately liquefied without some effort, but it does earn a higher return than cash by itself. It is cash and investments that give shares immediate value and could be distributed to shareholders with minimal effort. Accounts Receivable, normally abbreviated as A/R, is the money that is currently owed to a company by its customers. The reason why the customers owe money is that the product has been delivered but has not been paid for yet. Companies routinely buy goods and services from other companies using credit. Although typically A/R is almost always turned into cash within a short amount of time, there are instances where a company will be forced to take a write-off for bad accounts receivable if it has given credit to someone who cannot or will not pay. This is why you will see something called allowance for bad debt in parentheses beside the accounts receivable number. The allowance for bad debt is the money set aside to cover the potential for bad customers, based on the kind of receivables problems the company may or may not have had in the past. However, even given this allowance, sometimes a company will be forced to take a write-down for accounts receivable or convert a portion of it into a loan if a big customer gets in real trouble. Looking at the growth in accounts receivable relative to the growth in revenues is important -- if receivables are up more than revenues, you know that a lot of the sales for that particular quarter have not been paid for yet. We will look at accounts receivable turnover and days sales outstanding later in this series as another way to measure accounts receivable. Inventories are the components and finished products that a company has currently stockpiled to sell to customers. Not all companies have inventories, particularly if they are involved in advertising, consulting, services or information industries. For those that do, however, inventories are extremely important. Inventories should be viewed somewhat skeptically by investors as an asset. First, because of various accounting systems like FIFO (first in, first out) and LIFO (last in, first out) as well as real liquidation compared to accounting value, the value of inventories is often overstated on the balance sheet. Second, inventories tie up capital. Money that it is sitting in inventories cannot be used to sell it. Companies that have inventories growing faster than revenues or that are unable

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to move their inventories fast enough are sometimes disasters waiting to happen. We will look at inventory turnover later as another way to measure inventory. Finally, Prepaid Expenses are expenditures that the company has already paid to its suppliers. This can be a lump sum given to an advertising agency or a credit for some bad merchandise issued by a supplier. Although this is not liquid in the sense that the company does not have it in the bank, having bills already paid is a definite plus. It means that these bills will not have to be paid in the future, and more of the revenues for that particular quarter will flow to the bottom line and become liquid assets. Current Liabilities are what a company currently owes to its suppliers and creditors. These are short-term debts that normally require that the company convert some of its current assets into cash in order to pay them off. These are creditors or accounts payable from whom raw materials are purchased as well as all bills that are due in less than a year. Simply put, a bill that needs to be paid, liabilities are also a source of assets. Any money that a company pulls out of its line of credit or gains the use of because it pushes out its accounts payable is an asset that can be used to grow the business. There are five main categories of current liabilities: Sundry Creditors, Accrued Expenses, Income Tax Payable, Short-Term Notes Payable and Portion of Long-Term Debt Payable. Accounts Payable is the money that the company currently owes to its suppliers, its partners and its employees. Basically, these are the basic costs of doing business that a company, for whatever reason, has not paid off yet. One company's accounts payable is another company's accounts receivable, which is why both terms are similarly structured. A company has the power to push out some of its accounts payable, which often produces a short-term increase in earnings and current assets. Accrued Expenses are bills that the company has racked up that it has not yet paid. These are normally marketing and distribution expenses that are billed on a set schedule and have not yet come due. A specific type of accrued expense is Income Tax Payable. This is the income tax a company accrues over the year that it does not have to pay yet according to various federal, state and local tax schedules. Although subject to withholding, there are some taxes that simply are not accrued by the government over the course of the quarter or the year and instead are paid in lump sums whenever the bill is due. Short-Term Notes Payable is the amount that a company has drawn off from its line of credit from a bank or other financial institution that needs to be repaid within the next 12 months. The company also might have a portion of its LongTerm Debt come due with the year, which is why this gets counted as a current liability even though it is called long-term debt -- one of those little accounting quirks. Debt & Equity : The remainder of the balance sheet is taken up by items that are not current, meaning that they are either assets that cannot be easily turned into cash or liabilities that will not come due for more than a year. Specifically, there are five main categories -Total Assets, Long-Term Notes Payable, Stockholder's/Shareholder's Equity, Capital Stock and Retained Earnings. Total Assets are assets that are not liquid, but that are kept on a company's books for accounting purposes. The main component is plants, property and

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equipment and encompasses any land, buildings, vehicles and equipment that a company has bought in order to operate its business. Much of this is actually subject to an accounting convention called depreciation for tax purposes, meaning that the stated value of the total assets and the actual value or price paid might be very different. Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation. Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets. Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-in-progress. Long-Term Notes Payable or Long-Term Liabilities are loans that are not due for more than a year. These are normally loans from banks or other financial institutions that are secured by various assets on the balance sheet, such as inventories. Most companies will tell you in a footnote to this item when this debt is due and what interest rate the company is paying. The last main component, Stockholder's or Shareholder's Equity, is composed of Share Capital and Retained Earnings. Frankly, this is more than a little bit confusing and does not always add all that much value to the analysis. Share Capital is the par value of the stock issued that is recorded purely for accounting purposes and has no real relevance to the actual value of the company's stock. In Shareholders Equity we need to exclude Revaluation Reserves which is basically derived from Revaluation of Land & Buildings and in effect is just an entry. Retained earnings is another accounting convention that basically takes the money that a company has earned, less any earnings that are paid out to shareholders in the form of dividends and stock buybacks, and records this on the company's books. Retained earnings simply measures the amount of capital a company has generated and is best used to determine what sorts of returns on capital a company has produced. If you add together capital stock and retained earnings, you get shareholder's equity -- the amount of equity that shareholders currently have in the company. We do this to derive some rather compelling information about how well the company manages its assets and whether or not the company represents a bargain based on the assets it has at its disposal.

Reconciliation with US GAAP Thee days, with an eye on the ADR market, many companies have started reconciling their accounts with the accounts according to the US generally accepted accounting principles (GAAP). For Reliance Industries, you will notice that the profit under US GAAP is much lower than the profit under Indian accounting norms. That's because of deferred tax. There is sometimes a difference between the year in which a transaction affects taxable income and the year in which it enters into pre-tax income. For instance, higher depreciation is

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permitted under tax laws as compared to the Companies Act. Over time, however, such differences are ironed out. The benefits of higher depreciation, for instance, are lost over a period of time. So unless accounting is made for deferred taxes, there could be sudden shock in the year when the tax shelter is withdrawn. Accounting for deferred tax smoothens out such fluctuations. The Cash Flow Statement The cash flow statement reconciles the opening balance of cash (and money in the bank) with the closing balance. It shows the effect on cash of the various transactions. Since profit is often dependent upon the accounting policies you adopt, the cash flow statement is a more transparent way of showing a company's operations than the P&L account. It provides additional data. For instance, while the change in the debt outstanding can be gleaned from the balance sheet, the cash flow statement will tell you how much of borrowings have been repaid and how much fresh borrowing has been resorted to. The cash generated from operations is an important indicator. If that figure is negative, it means that cash is being sourced from external sources to fund existing operations. That's certainly not sustainable in the long run. Cash Flow Valuation : Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA).

Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, CYBEROPTICS enjoyed a 15% tax rate in 1996, but in 1997 that rate will more than double. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits. As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength. When and How to Use Cash Flow

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Cash flow is most commonly used to value industries that involve tremendous upfront capital expenditures and companies that have large amortization burdens. Cable TV companies like TIME-WARNER and TELECOMMUNICATIONS INC. have reported negative earnings for years due to the huge capital expense of building their cable networks, even though their cash flow has actually grown. This is because huge depreciation and amortization charges have masked their ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition, thus it makes sense for investors to use it as well. The most common valuation application of EBITDA, the discounted cash flow, is a rather complicated spreadsheet exercise that defies simple explanation. Economic Value Added (EVA) is another sophisticated modification of cash flow that looks at the cost of capital and the incremental return above that cost as a way of separating businesses that truly generate cash from ones that just eat it up. The most straightforward way for an individual investor to use cash flow is to understand how cash flow multiples work. In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. Some counsel selling companies when their cash flow multiple extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBDITA Intangibles

Brand is the most intangible element to a company, but quite possibly the one most important to a company's ability as an ongoing concern. If every single MCDONALD'S restaurant were to suddenly disappear tomorrow, the company could simply go out and get a few loans and be built back up into a world power within a few months. What is it about McDonald's that would allow it to do this? It is McDonald's presence in our collective minds -- the fact that majority the people forced to name a fast food restaurant would name McDonald's without hesitating. The company has a well-known brand and this adds tremendous economic value despite the fact that it cannot be quantified. Some investors are preoccupied by brands, particularly brands emerging in industries that have traditionally been without them. The genius of INTEL and MICROSOFT is that they have built their company names into brands that give them an incredible edge over their competition. A brand is also transferable to other products -- the reason Microsoft can contemplate becoming a power in online banking, for instance, is because it already has incredible brand equity in applications and operating systems. It is as simple as Hindustan Levers soaps requires minimum advertising to build up sales. The real trick with brands, though, is that it takes at least competent management to unlock the value. If a brand is forced to suffer through incompetence, such as AMERICAN EXPRESS in the early 1990s or Coca-Cola in the early 1980s, then many can become skeptical about the value of the brand, leading them to doubt whether or not the brand value remains intact. The major buying opportunities for brands ironically comes when people stop believing in them for a few moments, forgetting that brands normally survive even the most

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difficult

of

short-term

traumas.

Intangibles can also sometimes mean that a company's shares can trade at a premium to its growth rate. Thus a company with fat profit margins, a dominant market share, consistent estimate-beating performance or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Although intangibles are difficult to quantify, it does not mean that they do not have a tremendous power over a company's share price. The only problem with a company that has a lot of intangible assets is that one danger sign can make the premium completely disappear.

The value of a brand name

One of the critiques of valuation is that it fails to consider the value of brand names and other intangibles. The approaches used by analysts to value brand names are often ad-hoc and may significantly overstate or understate their value. Firms with well known brand names often sell for higher multiples than lesser-known firms. The standard practice of adding on a 'brand name premium', often set arbitrarily, to discounted cashflow value, can lead to erroneous estimates. One of the benefits of having a well-known and respected brand name is that firms can charge higher prices for the same products, leading to higher profit margins and hence to higher price-sales ratios and firm value. The larger the price premium that a firm can charge, the greater is the value of the brand name.

In general, the value of a brand name can be written as: Value of brand name ={(V/S)b-(V/S)g }* Sales (V/S)b = Value of Firm/Sales ratio of the firm with the benefit of the brand name (V/S)g = Value of Firm/Sales ratio of the firm with the generic product Illustration : Valuing a brand name: Kelloggs The following is an analysis of brand name value at Kellogg Corporation. The estimates for Kellogg were obtained from 1994 financial statements. The aftertax operating margin for the generic substitute was obtained by looking at a private-brand cereal manufacturer. Expected growth in after-tax operating income = Retention Ratio * Return on Assets

Kellogg's
Pre-tax Operating Margin After-tax Operating Margin Return on Assets Retention Ratio Expected Growth Length of High Growth Period 22.00% 14.08% 32.60% 56.00% 18.26% 5

Generic Substitute
10.50% 6.72% 15.00% 56.00% 8.40% 5

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Cost of Equity E/(D+E) D/(D+E) Value/Sales Ratio

13.00% 92.16% 8.50% 3.39

13.00% 92.16% 8.50% 1.10

Value of Kellogg Brand Name = ( 3.39 - 1.10) ($6562 million) = $15,026 million Value of Kellogg as a company = 3.39 ($6562 million) = $22,271 million Approximately 67.70% ($15026/$22271) of the value of the company can be traced to brand name value

The danger of double-counting the value of a brand name The value of a brand name results in higher growth and higher value for the firm owning it. There are some analyses where the brand name value is double counted. To provide an illustration of how this could happen, assume that Coca Cola is valued using a discounted cashflow model and that the expected growth rate used in the valuation is 29.55%. This value already incorporates the value of the brand name through the use of the high growth rate. If an additional value is now assigned to the brand name, the brand name value is double counted.

The Piecemeal Company

Finally, a company can sometimes be worth more divided up rather than all in one piece. This can happen because there is a hidden asset that most people are not aware of, like land purchased in the 1980s that has been kept on the books at cost despite dramatic appreciation of the land around it, or simply because a diversified company does not produce any synergies. Larsen & Turbo, Wockhardt are all worth a heck of a lot more broken apart as separate companies than they ever were when they were all together. Keeping an eye out for a company that can be broken into parts worth more than the whole makes sense, especially in this day and age when so many 1970s conglomerates are crumbling into their component parts. A classic example is that Wockhardt unlocked the value of its pharmaceutical business after the company split its hospitals, IV fluids and other capital intensive business into a separate company and the high margin, high ROE business, brand business into a separate company. Dividend yield A dividend yield is the percentage of a company's stock price that it pays out as dividends over the course of a year. For example, if a company pays $1.00 in dividends per quarter and it is trading at $100, it has a dividend yield of 4%. Four quarters of $1 is $4, and this divided by $100 is 4%. Yield has a curious effect on a company. Many income-oriented investors start to pour into a company's stock when the yield hits a magical level. The historical performance of the Dow Dividend Approach supports the general conclusion buttressed by Jim O'Shaugnessey's work that shows that a portfolio made up of large capitalization, above-average yielding stocks outperforms the market over time.

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Some, like Geraldine Weiss, actually invest in stocks based on what yield they should have. Weiss measures the average historical yield and counsels investing in a company's shares when the yield hits the edge of the undervalued band. For instance, if a company has historically yielded 2.5% and is currently paying $4 in dividends, the stock should trade in the $160 range. Anyone interested in learning more about Weiss's yield-oriented valuation approach should check out Dividends Don't Lie.

Earnings Per Share : The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS). You arrive at the earnings per share by simply dividing the rupee amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Ltd. has one million shares outstanding and has earned one million rupees in the past 12 months, it has a trailing EPS of $1.00. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported. Rs 1,000,000 -------------1,000,000 shares

= Rs 1.00 in earnings per share (EPS)

The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, XYZ Ltd was currently trading at Rs 15 a share, it would have a P/E of 15. Rs 15 share price ---------------------------= 15 P/E Rs 1.00 in trailing EPS

Is the P/E the Holy Grail?

There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this group of unFoolish investors blindly plunge ahead armed with this one ratio, purposefully ignoring the vagaries of equity analysis. Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value), the P/E has been oversimplified by those who only look at this number. Such investors look for "low P/E" stocks. These are companies that have a very low price relative to their trailing earnings. Also called a "multiple", the P/E is most often used in comparison with the current rate of growth in earnings per share. The assumption is that for a growth company, in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth.

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In our example of XYZ Ltd., for instance, we find out that XYZ Ltd grew its earnings per share at a 13% over the past year, suggesting that at a P/E of 15 the company is pretty fairly valued. Many believe that P/E only makes sense for growth companies relative to the earnings growth. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months, the P/E becomes less useful than other valuation methods we will talk about later in this series. In the end, P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error. The Price-to-Earnings Ratio -The P/E ratio (often simply referred to as the "P/E") shows the relationship between a stock price and its company's earnings (or profits per share of growth)

Let's just get our hands dirty from the outset and calculate the P/E for Cindy's Snowshoes. Your daily paper shows you Cindy's stock trading at $20 per share. Your broker informs you that last year the company earned $1.00 per share. The P/E ratio is 20. Fine, you could do such calculations till the sun dips below the horizon, but just what the heck does the P/E mean?! Well, for starters, note that the ratio expresses the stock price in terms of the earnings per share (EPS). The P/E ratio is a common measure of the value of stocks. Thus, we deduce (correctly) that the P/E uses the earnings of a company to value that company's stock. Simple and profound. By incorporating the P/E ratio into our model, we're asserting the validity of this notion. That is, we do think the level of a company's stock price should largely be based on that company's profit-in-hand (here defined as total profits over the past 12 months). The P/E ratio is such a widely used measure that the Market is obviously inclined to agree with us. Earnings are indeed at the heart of the matter of valuing a company's stock. Other measures exist, of course. You might wish to value a real-estate company's stock not off its earnings but off the value of its land. Or take dividends, the annual payments made by a company to holders of its stock. You might wish to value a company that pays a large dividend more off of the value of its dividend than its earnings. Other exceptions exist as well. But they are only exceptions. Users of the P/E ratio have a simple tool at hand that quickly values a company off of earnings. OK, why earnings per share, then? Why not just consider earnings? Remember that our ultimate goal is to value a stock, not a company. Stocks are priced per share. If the number of shares of a given stock suddenly inflates, all other things remaining equal, what will happen to the stock price? It'll drop. Same thing happens to earnings, of course. And if earnings growth becomes outpaced by share growth, that's tainted growth, from an investor's point of view. That's often a losing situation. Always look at earnings per share. So we close this section having learned how to calculate the P/E multiple, and having learned that many use earnings per share as a starting point for valuing stocks.

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Are Low P/E Stocks Really a Bargain?

With the advent of computerized screening of stock databases, low P/E stocks that have been mispriced have become more and more rare. When Ben Graham formulated many of his principles for investing, one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. Today, all you have to do is punch a few buttons on an online database and you have a list as long as your arm. This screening has added efficiency to the market. When you see a low P/E stock these days, more often than not it deserves to have a low P/E because of its questionable future prospects. As intelligent investors value companies based on future prospects and not past performance, stocks with low P/Es often have dark clouds looming in the months ahead. This is not to say that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -- you still can and it happens all the time. Rather, you need to confirm the value in these companies by applying some other valuation techniques. PRICE EARNINGS MULTIPLES Why is the PE ratio used so widely? it is an intuitively appealing statistic that relates the price paid to current earnings. it is simple to compute for most stocks, and is widely available, making comparisons across stocks simple. it is a proxy for a number of other characteristics of the firm including risk and growth. Potential for misuse use of PE ratios is a way, for some analysts, to avoid having to be explicit about their assumptions on risk, growth and payout ratios. they are much more likely to reflect market moods and perceptions but this can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors.

Estimating PE ratios from fundamentals PE Ratio for a stable firm A stable firm is a firm growing at a rate comparable to the nominal growth rate in the economy in which it operates.

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Relative PE Ratios
The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market. Relative PE = PE of Firm / PE of Market While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market. Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.

Relative PE: Summary of Determinants

The relative PE ratio of a firm is determined by two variables. In particular, it will o increase as the firms growth rate relative to the market increases. The rate of change in the relative PE will itself be a function of the market growth rate, with much greater changes when the market growth rate is higher. In other words, a firm or sector with a growth rate twice that of the market will have a much higher relative PE when the market growth rate is 10% than when it is 5%. o decrease as the firm s risk relative to the market increases. The extent of the decrease depends upon how long the firm is expected to stay at this level of relative risk. If the different is permanent, the effect is much greater.

Relative PE ratios seem to be unaffected by the level of rates, which might give them a decided advantage over PE ratios. Growth rates : Many investors make the mistake of viewing the P/E ratio alone, in a vacuum, as if the numbers 17, or 5, or 43 could serve as effective valuation tools on their own. You'll occasionally hear such an investor say something like, "I don't buy stocks with P/E's over 30." To our Foolish ear, that sounds identical to, "I don't buy hydrogenated milk; I am born in May." In other words, it's contextless random drivel. Another person, wise fellow, will state emphatically, "Will you look at that P/E of 75?! The stock is OUTRAGEOUSLY overvalued!" To our ear, that's kind of like saying, "Look at the thermometer; the temperature is 75!" But unless we know what season it is, and what are the average outdoor temperatures during that season, we have nothing to relate the comments to. . . they are non sequiturs. P/E's need to be placed in a context that gives them meaning. And here's where the aforementioned rule of thumb comes in handy: "In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share." Imagine this scenario. Your mother, who always did love a good hamburger, wants you to put some of her money at play in the fields of fast-food. As you've

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been entrusted with the responsibility of picking stocks for her retirement account, you'll have to do some prospecting. Your efforts unearth these two: Best By Far Burgers Int'l: Price $40, EPS $1.00, P/E 40 Your Typical Burger Corp.: Price $20, EPS $1.00, P/E 20 OK, now which would you pick? Your Typical Burger, right? After all, both companies have generated the same earnings per share (EPS), meaning that the same amount of profit per share backs each stock. One is trading at half the price of the other. Certainly you should buy the lower-priced. Unfortunately, that answer is not as simple as that. Now, if one did fall on the wrong side of the law in that last one, let's look at the mistake. Simply put, one erred in accepting a P/E valuation without hearing anything about the two companies' growth rates! Investing involves more than a sound knowledge of a company's past and good analysis of its present. What awaits us in the future far exceeds the importance of both combined. In this context, the future means a company's expected rate of growth. So perhaps Best By Far Burgers is expanding into California, with loads of cash to do so, and an excellent management in place, while the "apparently cheaper" Your Typical Burger is having trouble competing in every one of its markets and has no growth projected for it over the next 3 years. No wonder, then, that even though both companies have the same $1.00 of earnings per share, one stock is trading at twice the price (and therefore P/E) of the other. All of that is to say that the P/E generally reflects the market's expectations for the growth of a given company (or industry. . . because you can in fact do P/E ratios for whole industries). In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share. And we can therefore come to value stocks as having traded up or down in different degrees toward that full, fair value. The growth rate is the subjective piece of the pie. The P/E ratio is hard fact, reported everywhere. Thus, what'll eventually force a person in this scenario is the analysis of a company's growth.

Calculating the Growth Ratio : We've already mentioned that when we talk about growth rate, we're talking primarily about the future earnings per share (EPS) growth rate. The most relevant numbers -- earnings estimates -- are the ones that haven't been reported yet. A whole industry has sprung up to guesstimate those numbers and provide them to investors. The future EPS growth rate for a single year is quite simple to calculate. Let's say XYZ has just reported EPS of $0.60 this year, and analysts estimate that it will earn $0.90 EPS for the upcoming year. The one-year growth rate, a straight percentage gain calculation, is 50%.

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How did we calculate that? By using a simple formula, we can figure out the single year future EPS growth rate: (Earnings Est. for upcoming year -Current Earnings) Current Earnings This is really easy maths So let's figure out the one-year growth rate in earnings per share. First we need our earnings numbers. Remember, the earnings estimate for the upcoming year is $0.90 per share and current earnings are $0.60 per share. Plugging those numbers into the above formula, we get a one-year growth rate of 50%: ($0.90 - $0.60) $0.60 x 100 = 50% x 100

Let's go through this formula step-by-step. First take the earnings estimate for the upcoming year ($0.90) and subtract what XYZ earned over the past year ($0.60). This gives us the expected increase in EPS ($0.30). We want to compare the expected increase in EPS to current earnings. To do this, we divide the difference in earnings ($0.30) by the current year's earnings ($0.60). The result is 0.5. Multiply 0.5 by 100 to express the growth rate as a percentage. Voila! We get 50%. Estimated Earnings $0.90 Current Earnings $0.60 Increase in Earnings $0.30 Divided by Current Earnings: $0.30/$0.60 = 0.5 Convert to Percentage: 0.5 times 100 = 50% So what does this really mean? In this case, the company is currently earning $0.60 per share and we expect that to grow by 50% over the coming year to $0.90 per share. But normally many investors among us generally try to look forward at least two years when calculating annual growth rates. This makes the math a teensy bit more involved. Let's check out XYZ 's projected earnings for the next two years, then work up a two-year annualized growth rate: 1996 (current) $0.60 1997 (estimated) $0.90e 1998 (estimated) $1.35e To perform the calculation, you first need to find the total percentage growth from 1996 to 1998. We use the same formula we used above for the one-year growth, except that we use the earnings estimate for the most distant year -- in this case, from 1998. The key thing to remember here is that since we are looking at growth over two years, we also need to annualize our result to determine the average growth rate per year. Investors tend to talk about growth rates on an annual basis unless otherwise specified. To calculate the total expected two-year growth rate:

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Estimated Earnings Current Earnings Increase in Earnings

$1.35 $0.60 $0.75

Divided by Current Earnings: $0.75/$0.60 = 1.25 Convert to Percentage: 1.25 times 100 = 125% Is this right? Let's check it. If we multiply the current earnings ($0.60) by the total growth (1.25 +1=2.25) we should get the estimated earnings. So $0.60 x 2.25 = $1.35. We added 1 to 1.25 to get 2.25 for total growth. When multiplying by a percentage, we add 1, or 100%, so that the original amount is included in the answer. (It is just like adding in tax. If tax is 5%, you can multiply by 5%, which is the same as .05, and then add that to the original amount to find the total cost... or you can just multiply by 1.05.) For this example it would be: $0.60 x 1.25 (which is the same as 125%) = $0.75 + $0.60 = $1.35. Now, to make sense of this total growth of 125% and to be able to compare it to other companies' growth rates, we need to annualize it. Now, it gets tricky here. First, you can't just divide the total growth by two. Let's try that and see what happens. 125% divided by 2 = 62.5%. Is that correct? Well, let's apply it to the earnings and see what happens. Year 0 EPS = $.60 x 1.625 = $0.975 Year 1 EPS = $0.975 x 1.625 = $1.58 Year 2 EPS = $1.58 -- I don't THINK so! Now, we might have noticed that what we are doing is multiplying each year's EPS by the same number -- the presumed average annual growth rate. Another way to write that would be 0.60 x 1.625 x 1.625 = 1.58. Even though the rate we are using gives us the wrong answer, it also gives us a clue to how to find the right answer... If one notices that 1.625 x 1.625 is the same as 1.625 squared (we write that as 1.625^2) and 1.625 is the square root of 1.625^2. But when we used the 62.5% figure we didn't arrive at the correct earnings estimate. Eureka! The correct annual growth rate must be the square root of whatever number, multiplied by the current EPS, will give us the estimated EPS two years from now. And we already know what number we multiply the current EPS by to get the estimated EPS -- the total growth! (Actually, the total growth plus one, so that the original EPS is carried into the answer.) $0.60 x 2.25 = $1.35 So the average annual growth rate must be the square root of 2.25! Let's try it. The square root of 2.25 is 1.5, or 50% annual growth (remember, we have to subtract 1). Let's check and see if it works: Year 0 EPS = $0.60 x 1.5 = $0.90 Year 1 EPS = $0.90 x 1.5 = $1.35 Year 2 EPS = $1.35 -- Bingo! If one is lucky enough to have earnings estimates that go out 3 years, the average annual growth rate would be the cube root of the total growth -- for 5 years it would be the fifth root. But what if one is in the middle of the company's

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fiscal year so that it's not a nice clean two years until the estimate? Can you say fractional roots? In many cases the time period between your current earnings ($0.60 in this example) and your estimated earnings ($1.35 above) will not be exactly two years. Hence, for ANY time period, the root one takes to annualize the growth rate is exactly the number of years from present value to future value. Thus, if we were dealing with three years, one would use the 3rd (or cube) root; five years, the fifth root, and for one and a half years we'd use the 1.5 root, etc. (NOTE: When you have a simple situation like our example above where you have only 2 FULL years, you can estimate the average annual growth rate by simply averaging the individual years' rates. But when you are dealing with fractional years or estimates several years out, that method is not very accurate.) One can figure out the fractional roots by finding out exactly how many quarters it will be to the furthest-out estimate. If we are using annual earnings that include the first quarter of fiscal 1996 and we have estimates for fiscal 1997, then there will be seven quarters between estimates. One can just divide the number of quarters by 4 (the number of quarters in a year) to convert to a fraction. In this case: 7/4 (seven-fourths). Now, most calculators won't take a 7/4 root, but many calculators and all spreadsheets will take something to any power. To find the x root of a number, you simply raise it to 1/x powers (the reciprocal). So the square root of 4 would be written as 4^(1/2) meaning 4 to the power of one half. (The reciprocal of a fraction is just the fraction reversed.) The 7/4 root of 2.25 would be written 2.25^(4/7).

Investment Strategies that compare PE to the expected growth rate

If we assume that all firms within a sector have similar growth rates and risk, a strategy of picking the lowest PE ratio stock in each sector will yield undervalued stocks. Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify under and overvalued stocks. o In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. o In its more general form, the ratio of PE ratio to growth is used as a measure of relative value.

Problems with comparing PE ratios to expected growth

In its simple form, there is no basis for believing that a firm is undervalued just because it has a PE ratio less than expected growth. This relationship may be consistent with a fairly valued or even an overvalued firm, if interest rates are high, or if a firm is high risk. As interest rate decrease (increase), fewer (more) stocks will emerge as undervalued using this approach.

PEG Ratio: Definition

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The PEG ratio is the ratio of market price to expected growth in earnings per share. PEG = PE / Expected Growth Rate in Earnings

Definitional tests: o Is the growth rate used to compute the PEG ratio on the same base? (base year EPS) over the same period?(2 years, 5 years) from the same source? (analyst projections, consensus estimates..) o Is the earnings used to compute the PE ratio consistent with the growth rate estimate? o No double counting: If the estimate of growth in earnings per share is from the current year, it would be a mistake to use forward EPS in computing PE

PEG Ratio: Reading the Numbers The average PEG ratio for the software sector is 1.77. The lowest PEG ratio in the group belongs to BancTec, which has a PEG ratio of 0.76. Using this measure of value, BancTec is the most under valued stock in the group the most over valued stock in the group What other explanation could there be for BancTecs low PEG ratio?

PEG Ratios and Fundamentals: Propositions Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate. Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently. Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns. Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks. Corollary 3: PEG ratios do not neutralize the growth effect.

The PEG Ratio, developed a few years back, is a pleasingly simple bit of mathematics and, since its inception, has winningly valued small- and mid-cap growth stocks in most industries. The premise upon which this stratagem is based is rather simple. It's an

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investment valuation rule of thumb, actually: In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share. Taking that as a given, the Ratio neatly and numerically summarizes a stock's P/E ratio in relation to its company's growth rate. But one should remember, that PEG is only ONE indicator of a stock's potential value. Before buying any stock, one should make sure to comb through the company's financials. PEG on! The PEG Ratio brings together a new, simple, and terribly meaningful configuration. It numerically expresses the relationship between a stock's current price-to-earnings multiple and the rate of the company's growth. Let's take the show to Maui, home of the waves, the babes, and get-rich-on-realestate infomercials. Maui Joe's Luau Supplies is a tiny niche company with a highflying stock that over the past 6 months has tripled to its current level of $9 per share. Having called the company and obtained the only up-to-date report by any analyst one first learns that Maui Joe's EPS over the past 12 months has been $0.50. Which makes the P/E ratio 18. We furthermore discover that the analyst projects Maui Joe's to have earned 75 cents per share a year from now and $1.15 the year after. Well, we already have the P/E. We need the growth rate. We come up with 52% for the 2-year annualized growth rate. "What's the PEG on the stock?" Shouldn't be too difficult to figure out. We have the P/E and the growth rate. Now just find the ratio of the P/E to the percentage rate of growth. (18 divided by 52 equals 0.35.) So 0.35 is the PEG on this stock. Trading therefore at just 35% of its full, fair, value, Maui Joe's might make you some money. Like most numbers, the PEG Ratio needs a context before it can take on meaning. That's what we're here for. Here's the context in tabular form: With the PEG Ratio .50 or less .50 to .65 .65 to 1.00 1.00 to 1.30 1.30 to 1.70 Over 1.70

Tend To Buy Look to buy Watch (or "hold") Look to sell Consider shorting Short

These numbers indicate, "Tend to buy stocks when their P/E's are half their growth rates; tend to sell stocks when their P/E's equal their growth rates; tend to sell short stocks when their P/E's exceed their growth rates by 30% or more. We actually prefer to find our shorts among stocks with PEG Ratios of 1.70 or more.

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The PEG Ratio is one of the useful tools. We think it is very useful, giving many investors a much-needed guide to the best prices to buy and sell stocks in which they're interested. The Ratio often imposes a trading discipline that is sorely lacking in many of us. It can be terribly hard to ignore buying a favorite stock of yours whose PEG Ratio is 0.60. It can be terribly uplifting (and profitable) when, a week later, a short-term decline in this stock brings its PEG below 0.50. Pouncing, you snap up the stock more than 15% below what you would have paid for it, increasing your profit potential that much more. Every tool has its limits. We regard The PEG Ratio levels included in the table above as a guide only. A useful guide, we believe, but still just a guide. The price of a stock may go down substantially even if it has a PEG ratio of 0.50. Maybe earnings estimates were downgraded, or the company reported a surprise loss, or the market crashed, or whatever. There's a lot more to security analysis than merely calculating PEG Ratios -- learning how to obtain and understand financial statements is also essential as was explained earlier. Also, one should note that the PEG Ratio should not be applied to every situation. We ignore the PEG Ratio (and generally these stocks as well) for the following industries: airlines, banks, brokerage houses, leasing companies, mortgage companies, oil drillers, and real-estate companies. (The list may not be complete, since new industries spring up from time to time.) These industries, for their different reasons, have low P/E's that virtually never reach their growth rates, mainly because their companies are valued off assets they hold (like oil deposits and real estate) rather than operating earnings. The PEG Ratio also has nothing to say about companies with negative earnings, since no P/E exists and determining growth rates (if any) often involves too much guesswork. And finally, the larger the company, the less we rely on the PEG Ratio to guide us. That's because, again, the bigger a company is, the less likely it is to be valued purely off of earnings. In closing, the greatest beauty of the PEG Ratio is its ability to confer to the average investor a sense of at what price a given stock is a good buy and at what price a good sell. We view this as profoundly important, since the Ratio can ultimately help guide its fans into both long and short positions, seeking to profit up and down at the same time with different stocks.

The PEG and YPEG

The most common applications of the P/E are the P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG). The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable to both an acquirer and a shareholder seeking either dividends or free cash flow to fund stock buybacks, this makes some degree of intuitive sense. Only looking at the trailing P/E is kind of like driving while looking out the rearview mirror. If a company is expected to grow at 10% a year over the next two years and has a P/E of 10, it will have a PEG of 1.0. P/E of 10 ----------------------

1.0 PEG

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10% EPS growth A PEG of 1.0 suggests that a company is fairly valued. If the company in the above example only had a P/E of five but was expected to grow at 10% a year, it would have a PEG of 0.5 -- implying that it is selling for one half (50%) of its fair value. If the company had a P/E of 20 and expected growth of 10% a year, it would have a PEG of 2.0, worth double what it should be according to the assumption that the P/E should equal the EPS rate of growth. While the PEG is most often used for growth companies, the YPEG is best suited for valuing larger, more-established ones. The YPEG uses the same assumptions as the PEG but looks at different numbers. As most earnings estimate services provide estimated 5-year growth rates, these are simply taken as an indication of the fair multiple for a company's stock going forward. Thus, if the current P/E is 10 but analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5 and the stock looks cheap according to this metric. As always, one must view the PEG and YPEG in the context of other measures of value and not consider them as magic money machines.

Multiples
Although the PEG and YPEG are helpful, they both operate on the assumption that the P/E should equal the EPS rate of growth. Unfortunately, in the real world, this is not always the case. Thus, many simply look at estimated earnings and estimate what fair multiple someone might pay for the stock. For example, if XYZ Corp. has historically traded at about 10 times earnings and is currently down to 7 times earnings because it missed estimates one quarter, it would be reasonable to buy the stock with the expectation that it will return to its historic 10 times multiple if the missed quarter was only a short-term anomaly. When we project fair multiples for a company based on forward earnings estimates, one starts to make a lot of assumptions about what is going to happen in the future. Although one can do enough research to make the risk of being wrong as marginal as possible, it will always still exist. Should one of your assumptions turn out to be incorrect, the stock will probably not go where you expect it to go. That said, most of the other investors and companies out there are using this same approach, making their own assumptions as well, so, in the worst-case scenario, at least one would be the research fraternity. A modification to the multiple approach is to determine the relationship between the company's P/E and the average P/E of the S&P 500. If XYZ Corp. has historically traded at 150% of the S&P 500 and the S&P is currently at 10, many investors believe that XYZ Corp. should eventually hit a fair P/E of 15, assuming that nothing changes. This historical relationship requires some sophisticated databases and spreadsheets to figure out and is not widely used by individual investors, although many professional money managers often use this approach.

Revenues Valuation : Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Whether or not a company has made money in the last year, there are always revenues. Even companies that may be temporarily losing money, have earnings

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depressed due to short-term circumstances (like product development or higher taxes), or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price/sales ratio, often simply abbreviated PSR. The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company XYZ Ltd . has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either.

Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt
The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization. Say XYZ Corp. had $200 million in sales over the last four quarters and currently has no long-term debt. The PSR would be: (10,000,000 shares * $10/share) + $0 debt PSR = ----------------------------------------$200 million revenues

= 0.5

The PSR is a measurement that companies often consider when making an acquisition. Sometimes deals are being done based on a certain "multiple of sales," you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition, many simply expropriate it for the stock market and use it to value a company as an ongoing concern.

Uses of the PSR

As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 in order to find value stocks that the market might currently be overlooking. This is the most common application of the PSR and is actually a pretty good indicator of value, according to the work that James O'Shaughnessey has done with S&P's CompuStat database. The PSR is also a valuable tool to use when a company has not made money in the last year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern's sales are being valued at a discount to its peers. If XYZ Ltd. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that,

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if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers. There are some years during recessions, for example, when none of the auto companies make money. Does this mean they are all worthless and there is no way to compare them? Nope, not at all. You just need to use the PSR instead of the P/E to measure how much you are paying for a dollar of sales instead of a dollar of earnings. Another common use of the PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E in order to confirm value. If a company has a low P/E but a high PSR, it can warn an investor that there are potentially some one-time gains in the last four quarters that are pumping up earnings per share. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings. Why is price-to-sales a useful measure of value? Basically, this ratio shows how much stock markets values every rupee of sales. Obviously, a company that can generate a lot of profit from every dollar in sales is going to receive a higher valuation per sales dollar than a company that generates very little profits from each dollar in sales. When using price-to-sales ratios, it is important to put the numbers in some context. The best way to use the numbers is within industries. For example, let's say you want to compare two computer software makers. If one company has a much higher price-to-sales ratio than the other, it means that stock markets is affording a higher valuation per sales rupee for that company. This should cause you to ask yourself the following questions: Does stock markets optimism concerning the stock with the higher priceto-sales ratio seem valid? Is the company with the lower price-to-sales ratio showing improving profit margins? Does the company with the lower price-to-sales ratio have the ability to boost its profitability per sales rupee?

Of course, a price-to-sales ratio is just one piece of data and should not be the only statistic used to evaluate a company. However, when used in conjunction with other information and ratios (price-to-earnings ratios, dividend yields), price-to-sales ratios can help fill out a fundamental examination of a stock and its appreciation prospects relative to its peers.

PRICE-SALES MULTIPLES
Issues in using price-sales multiples Advantages of using price-sales multiples Unlike price-earnings and price-book value ratios, which can become negative and not meaningful, the price-sales multiple is available even for the most troubled firms. Unlike earnings and book value, which are heavily influenced by accounting decisions on depreciation, inventory and extraordinary charges, revenue is relatively difficult to manipulate.

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Price-sales multiples are not as volatile as price-earnings multiples, and hence may be more reliable for use in valuation. The price-sales multiple provides a convenient handle for examining the effects of changes in pricing policy and other corporate strategic decisions.

Some Important eye openers in P/S ratio :

a) Net Profit Margin: Earning per share / Revenue per share. The price-sales
ratio is an increasing function of the net profit margin. (b) Payout ratio during the high growth period and in the stable period: The PS ratio increases as the payout ratio increases. (c) Riskiness (through the discount rate r): The PS ratio becomes lower as riskiness increases. (d) Expected growth rate in Earnings, in both the high growth and stable phases: The PS increases as the growth rate increases, in either period. As a consequence of the new lower-price strategy, the price-sales ratio will decline. Unless the sales/book value ratio increases by an equivalent margin, the value of stock will decrease. In the case where profit margins decline by this magnitude and the sales/book value is not expected to increase, the value will decline.

Shareholder's Equity & Book Value

Shareholder's equity is an accounting convention that includes a company's liquid assets like cash, hard assets like real estate, as well as retained earnings. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -- whether those assets are office buildings, desks, old Tshirts in inventory or replacement vacuum tubes for ENIAC systems. Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. To calculate book value per share, take a company's shareholder's equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book ratio. Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value is actually somewhat skeptically viewed in this day and age, since most companies have latitude in valuing their inventory, as well as inflation or deflation of real estate depending on what tax consequences the company is trying to avoid. However, with financial companies like banks, consumer loan concerns, brokerages and credit card companies, the book value is extremely relevant. For instance, in the banking industry, takeovers are often priced based on book value, with banks or savings & loans being taken over at multiples of between 1.7 to 2.0 times book value.

The utility of Price to Book Value has waned in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. The fact that Microsoft doesn't have very much in the way of book value doesn't mean the company is overvalued -- it just means that the

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company does not need a lot of land and factories to make a very high-margin product.

PRICE BOOK VALUE MULTIPLES

General Issues in estimating and using price-book value ratios Measurement The book value of equity is the difference between the book value of assets and the book value of liabilities. The measurement of the book value of assets is largely determined by accounting convention. Book Value versus Market Value The market value of an asset reflects its earning power and expected cashflows. Since the book value of an asset reflects its original cost, it might deviate significantly from market value if the earning power of the asset has increased or declined significantly since its acquisition. Advantages of using price/book value ratios It provides a relatively stable, intuitive measure of value which can be compared to the market price. Given reasonably consistent accounting standards across firms, price-book value ratios can be compared across similar firms for signs of under or over valuation. Even firms with negative earnings, which cannot be valued using PE ratios, can be evaluated using price-book value ratios. Disadvantages of using price-book value ratios Book values, like earnings, are affected by accounting decisions on depreciation and other variables. When accounting standards vary widely across firms, the price-book value ratios may not be comparable across firms. Book value may not carry much meaning for service firms which do not have significant fixed assets. The book value of equity can become negative if a firm has a sustained string of negative earnings reports, leading to a negative price-book value ratio. Looking for undervalued securities - PBV Ratios and ROE Given the relationship between price-book value ratios and returns on equity, it is not surprising to see firms which have high returns on equity selling for well above book value and firms which have low returns on equity selling at or below book value.

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The firms which should draw attention from investors are those which provide mismatches of price-book value ratios and returns on equity - low P/BV ratios and high ROE or high P/BV ratios and low ROE.

Enterprise Value :
I also use something called Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed. The enterprise value (EV) to shareholder's equity (SE) looks like this, then: (Shares Out * Price) + Debt - Cash EV/SE = -----------------------------------Shareholder's equity

This number will get you a simple multiple, much like the price/earnings ratio or the price/sales ratio. If it is below 1.0, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will shun any companies that trade above 2.0 times book value or more.

Return Ratios :
Return on Equity : Return on equity is a measure of how much in earnings a company generates in four quarters compared to its shareholder's equity. It is measured as a percentage. For instance, if XYZ Corp. made a million dollars in the past year and has a shareholder's equity of ten million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. COCA-COLA, for instance, does not require constant spending to upgrade equipment -- the syrup-making process does not regularly move ahead by technological leaps and bounds. In fact, high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. This is why a pharmaceutical company like MERCK can grow at 10% or so every year but consistently trade at 20 times earnings or more. From our Indian perspective, Hindustan Lever is a classic example whereby HLL outsources a lot of the stuff and is a negative working capital with return ratios quoting at above 40-50 %, hence even during bad or recessionary times HLL commands a premium in the markets compared to the growth in profits(earnings).

Return on Equity : Getting into the details

Disarmingly simple to calculate, return on equity (ROE) stands as a critical weapon in the investor's arsenal if properly understood for what it is. Return on equity encompasses the three main "levers" by which management can poke and prod the corporation -- profitability, asset management, and financial leverage.

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By perceiving return on equity as a composite that represents the executive team's ability to balance these three pillars of corporate management, investors can not only get an excellent sense of whether they will receive a decent return on equity but also assess management's ability to get the job done. Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder's equity for that year. The earnings can be taken directly from the last annual report. They can also be figured using the average of the last five or ten year's earnings, or they can simply be annualized based on the last quarter's results. (Investors should be careful not to annualize the results of a seasonal business where all of the profit is booked in one or two quarters.) Shareholder's equity can be found on the balance sheet and is simply the difference between the total assets and total liabilities, as it is assumed that assets without corresponding liabilities are the direct creation of the shareholder's capital that got the business started in the first place. Shareholder's equity is an accounting convention that represents the assets that have actually been generated by the business. The most common way that investors see shareholder's equity displayed is as a per share value called "book value." Book value is the amount of shareholder's equity per share, or the accounting book value of the business outside of its market value or intrinsic economic value. A business that creates a lot of shareholder equity is a business that is a sound investment, as the original investors in the business will be able to be repaid with the proceeds that come from the business operations. Businesses that generate high returns relative to their shareholder's equity are businesses that pay their shareholders off handsomely, creating substantial assets for each dollar invested. These businesses are more than likely self-funding companies that require no additional debt or equity investments. One of the quickest ways to gauge whether a company is an asset creator or a cash consumer is to look at the return on equity that it generates. By relating the earnings generated to the shareholder's equity, an investor can quickly see how much cash is created from the existing assets. If the return on equity is 20%, for instance, then twenty cents of assets are created for each dollar that was originally invested. As additional cash investments increase the asset side of the balance sheet, this number ensures that additional dollars invested to not appear to be dollars of return from previous investments. If return on equity is simply: One year's earnings ROE = ------------------------Shareholder's Equity ...then how is it that we can see the profit margin, asset management, and financial leverage through this one calculation? If we expand the equation, we can start to take into account other variables.

ROE = One year's earnings ----------------------- * One year's sales

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One year's sales ----------------------- * Assets Assets ----------------------Shareholder's Equity Because the sales and the assets are both in the numerator and the denominator of the entire equation, they cancel one another out. When we break the equation apart in this manner, the three component parts of return on equity come to light. Earnings over sales is profit margin, sales over assets is asset turnover, and assets over equity is the amount of leverage the company has. Each will be discussed on its own merits. After we have completed this analysis, we will come back to return on equity and how this composite number can be used to evaluate a particular company, as well as exploring its limitations as an analytical tool.

Profit Margins :
In the last installment, we examined the concept of return on equity (ROE) and looked at one way to break the number apart into three separate components. Return on equity is one way to measure the return an investor receives on the capital that has been invested in the business. Simply by taking a year's worth of earnings and comparing it to the amount of shareholder's equity on the balance sheet, you get a percentage measure of how much was returned for each dollar of equity that has been created by the business. Thus ROE can be defined as: One year's earnings ROE = ---------------------Shareholder's Equity However, by manipulating the equation yesterday we discovered that ROE could be redefined the following way:

ROE = One year's earnings ---------------------- * One year's sales One year's sales ---------------------- * Assets Assets ---------------------Shareholder's Equity This redefinition isolates the three key tools management has at its disposal to affect the returns of the business: pricing, asset management, and financial leverage. Return on equity then becomes a measure not simply of how much of a return the company is generating off of the equity it has created, but also of how successfully management has been in running the corporation.

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Return on assets (RoA) is a lesser-known sibling of return on net worth (RoNW) and return on capital employed. Rarely will you find it springing out of research reports, quite unlike the limelight friendly RONW and ROCE. But do not underestimate RoA. It treads in where RoNW and RoCE falter and in its own niche it turns out to be much more powerful then either of them. RoA is defined as net profit divided by the total average assets Look at the components of RoA and its concept will be clearer. Net profit is the net of all types of income and all types of expenses. Total average assets are what the company has had working for it during the course of its business. (Do you notice that total assets is also a reflection of the total capital that has been employed in the business?) It is more prudent to take an average of assets of two years since the balance sheet gives a snapshot of the financials as on a particular date. What we are interested in is getting to know of the assets that have been in use for the entire year.

RoA tells us how much return has the company ultimately earned on every Re1 of asset that it has. (After all, ability to generate cash flows is what defines an asset). That's RoA in a nutshell. Now the questions that present themselves are: What does it do? And what does it not do? There is RoNW that indicates what is the ultimate return that a business earns by utilising the shareholders' funds in the business. Then there is RoCE that keeps its focus on a company's operating excellence (or the lack of it). Return on net worth = profit after tax / net worth Return on capital employed = net operating profit less adjusted taxes / total capital employed Return on assets = net profit /total average assets Between the two of them, they give a good perspective of the profitability and capital efficiency of most companies--whether it makes soaps or drugs or heavy equipment or oil or cement. What about banking ? A bank has money as its raw material and money as its finished goods. It accepts deposits from people like you and me, and pays us some interest. And then it uses these funds as leverage-meaning it loans out the funds at a higher interest. The difference between the interest that it pays to the depositors and the interest that it gets from its loans-also called 'spread'-is the money that the bank makes for itself. So unlike any other company a bank does not have clearly distinct operating and investing cash flows.

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To calculate operating profit, one needs to distinguish between the interest expense towards depositors and towards others. Similarly computing capital employed is also not so easy. Since deposits are used for commission, they are not strictly capital employed in banking activities unlike the shareholder's funds and other borrowings. Plus the provisions and other liabilities towards bad debts should be excluded from capital employed for a bank. Since operating profitPBDITA-is difficult to isolate and capital employed in the business need to be computed differently, RoCE is not so useful while valuing banks.

What about RONW ? A bank operates at high leverage. It's liabilities-its deposits--run into crores of rupees. They are far higher than the net worth of the bank. Its debt:net worth (D/NW) is in the region of 13-17 (incomparable to any other business). But mind you, there is nothing wrong with this per se-that's the way the business is. D/NW has little relevance in a bank. Sneak a glance at the table. Table: Interesting features that distinguish a bank Xx State Bank of India Bank of Baroda Corporation Bank HDFC Bank ICICI Bank Debt/NW (x) 17.0 16.0 12.7 13.3 9.0 NW / TCE 4.6% 5.5% 6.8% 6.4% 9.5% RoNW 18.2% 16.4% 21.9% 22.0% 14.4% RoCE 20.9% 27.8% 38.0% 25.7% 15.9% RoA 0.8% 0.9% 1.3% 1.5% 1.1%

** Note:- NW=Net worth; TCE=Total capital employed; RoNW=Return on net worth; RoCE=Return on capital employed; RoA=Return on assets

This also means that net worth is but a small portion of total capital (less than 10%) that has been employed in the bank. Taking only return on net worth (RoNW) as a measure of capital efficiency would not at all give a complete picture. What more, given the quantum of loan that the bank extends on its borrowed funds if loans go bad, then it can endanger its net worth. Thus due to the peculiar nature of a bank's operations and due to the way RoNW and RoCE are defined, these two measures are inadequate by themselves in revealing the operating capabilities of a bank. That's where RoA enters and fills in the gap It takes the net profit-that includes the impact of interest spread, the operating efficiency and the risk profile. And compares it against the total assets that the bank has given out as loans. What it shows is the profit that the bank has earned on its assets-which is essentially the capital that has been put at risk. What makes RoA a suitable tools for evaluating a bank? The asset that the bank has is the loan portfolio-that is earning a commission by way of interest. Thus the profits made should be examined in relation to the total capital. Like RoCE and unlike RoNW, RoA concerns itself with total assets (which is nothing but equal to the total capital employed). Thus, RoA is a better proxy than RoCE. Secondly, since borrowing and lending is the basic business model of a bank, interest expense and interest are a part of its operations. It is difficult to distinguish between operating, investing and financing activities. Hence it makes

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sense to take the net profit instead of the operating profit. Like RoNW and unlike RoCE, RoA takes the net profit. Therefore, RoA steps in to fill a gap. And hence proves to be a more powerful and useful performance yardstick in evaluating a bank. Taking the principle to a generic level, RoA is useful in a business where most of the funds are deployed in assets that have been loaned out and are earning a commission. Can you think of some other industries or companies where RoA finds utility? Now we know why RoA is not so widely used. The NBFCs that have banking like activities can obviously be judged using RoA. Or think of a leasing company where equipment are leased out. Or a company like Hitech Drilling that has two rigs, which are used by oil exploration companies like ONGC. Its gross fixed assets stand at Rs134 crorethese are old and hence highly depreciated taking the net fixed asset to Rs70 crore. The total asset is Rs132 crore. This reflects the business model of Hitech Drilling-the company's assets (the rigs) are hired out to the companies in return for a fee that is called as a rig rate. Should you want to measure the business prowess of Hitech Drilling, you need to check the return on assets. Summing it up, RoA is very useful in a niche-businesses where the entire asset earns a commission.

ENTERPRISE VALUE/EBITDA MULTIPLE (Value/EBITDA) What is it?

Enterprise Value(EV): Market Value of Equity + Market Value of Debt + Market Value of Other Securities EBITDA: Earnings before interest, taxes and depreciation The No-Cash Version

Enterprise Value: Market Value of All Securities - Cash & Marketable Securities EBITDA: Earnings before interest,taxes and depreciation - Interest Income from Cash & Marketable Securities

Reasons for Increased Use

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1. The multiple can be computed even for firms that are reporting net losses, since earnings before interest, taxes and depreciation are usually positive. 2. For firms in certain industries, such as cable, which require a substantial investment in infrastructure and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio. 3. In leveraged buyouts, where the key factor is cash generated by the firm prior to all discretionary expenditures, the EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term. 4. By looking at cashflows prior to capital expenditures, it may provide a better estimate of optimal value, especially if the capital expenditures are unwise or earn substandard returns. 5. By looking at the value of the firm (inclusive of debt) and cashflows to the firm (prior to debt payments) it allows for comparisons across firms with different financial leverage. Effect on Value/EBITDA mulitple 1. Tax Rate

Implications As tax rate increases, multiple decreases. As tax rates increase, Value/EBITDA multiples should go down. Firms which are riskier and use lower leverage should have lower Value/EBITDA multiples. For a given level of capital expenditures, firms which report higher depreciation will have higher multiples. Firms which generate growth more efficiently (i.e., by taking projects with higher returns or from existing investments) will sell for higher Value/EBITDA multiples.

2. Cost of Capital As cost of capital increases, multiple will decrease.

3. Depreciation/EBITDA

As depreciation increases as a proportion of EBITDA, Value/EBITDA multiples will increase.

For a given growth rate, firms with higher capital expenditures will sell for lower Value/EBITDA multiples.

4. Growth and Capital Expenditures/EBITDA

Other Ratios : A business can actually be assessed on the basis of several parameters profitability (whether it is making money), efficency (if its making the best possible use of its resources), leverage (whether it has the right mix fo debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash

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to meet its day to day needs) etc. All these point to the overall health of the company and hence to the health of its shareholders. It is here that the important ratios come into play and give us different indicators. Current Ratio : The first tool you can use is called the Current Ratio. A measure of how much liquidity a company has, this is simply the current assets divided by the current liabilities. For instance, if XYZ Ltd s has $10 million in current assets and $5 million in current liabilities, you get: $10 million Current Ratio = ------------- = 2.0 $5 million

As a general rule, a current ratio of 1.5 or greater is normally sufficient to meet near-term operating needs. A current ratio that is too high can suggest that a company is hoarding assets instead of using them to grow the business -- not the worst thing in the world, but potentially something that could impact long-term returns. You should always check a company's current ratio (as well as any other ratio) against its main competitors in a given industry. Certain industries have their own norms as far as which current ratios make sense and which do not. For instance, in the auto industry a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession. As regards inventories, they are not necessarily worth what they are on the books for. This is particularly true in retail, where you routinely see close-out sales with 60% to 80% markdowns. It is even worse when a company going out of business is forced to liquidate its inventory, sometimes for a marginal amount of the amount invested in inventories. Also, if a company has a lot of its liquid assets tied up in inventory, it is very dependent on the sale of that inventory to finance operations. If the company is not growing sales very quickly, this can turn into an albatross that forces the company to issue stock or take on debt. Because of all of this, it pays to check the Quick Ratio. The quick ratio is simply current assets minus inventories divided by current liabilities. By taking inventories out of the equation, you can check and see if a company has sufficient liquid assets to meet short-term operating needs. Say you look at the balance sheet of XYZ Ltd and find out that they have $2.5 million of their current assets is sitting on inventory. You now can figure out the company's quick ratio: (Current Assets - Inventories) Quick Ratio = -------------------------------- = Current Liabilities $10 mm - $2.5 mm = ------------------ = 1.5 $5 mm

Looks like XYZ Ltd makes the grade again. Most people look for a quick ratio in excess of 1.0 to ensure that there is enough cash on hand to pay the bills and keep on going. The quick ratio can also vary by industry. As with the current ratio, it always pays to compare this ratio to that of peers in the same industry in order to understand what it means in context.

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Finally, some investors will use something called the Cash Ratio, which is the amount of cash that a company has divided by its current liabilities. This is not a common ratio, however, so I know of no general guideline to use when you want to check it. It is just another method to compare various companies in the same industry with each other in order to figure out which one is better funded.

Working Capital :
The best way to look at current assets and current liabilities is by combining them into something called Working Capital. Working capital is simply current assets minus current liabilities and can be positive or negative. Working capital is basically an expression of how much in liquid assets the company currently has to build its business, fund its growth, and produce shareholder value. If a company has ample positive working capital, then it is in good shape, with plenty of cash on hand to pay for everything it might need to buy. If a company has negative working capital, then its current liabilities are actually greater than their current assets, so the company lacks the ability to spend with the same aggressive nature as a working capital positive peer. All other things being equal, a company with positive working capital will always outperform a company with negative working capital. I cannot emphasize enough how important working capital is. Working capital is the absolute lifeblood of a company. About 99% of the reason that the company probably came public in the first place had to do with getting working capital for whatever reasons -- building the business, funding acquisitions or developing new products. Anything good that comes from a company springs out of working capital. If a company runs out of working capital and still has bills to pay and products to develop, it has big problems. A valuation that I am coming to like more and more is comparing working capital to the company's current Market Capitalization. Market capitalization is the value of all the shares of stock currently outstanding plus any long-term debt or preferred shares that the company has issued. The reason you add long-term debt and preferred shares (which are a special form of debt) to the market capitalization is because if you were to buy the company, not only would you have to pay the current market price but you would also have to incur the responsibility for the debt as well. If you take a company's working capital and measure it against a company's market capitalization, you can find some pretty useful stuff. You can compare working capital to market capitalization by dividing working capital by that market capitalization. For instance, if we use XYZ Ltd again, we know that it has $10 million in current assets and $5 million in current liabilities. If you know that XYZ Ltd has no debt, one million shares outstanding and each share is $10 a pop, you can figure out the working capital to market capitalization ratio.

Working Capital (Current Assets - Current Liabilities) --------------- = -------------------------------------Market Cap. (Shares Out * Share Price) + Debt $10 mm - $5 mm = ---------------------(1 mm * $10) + $0 mm $5 mm ---------$10 mm

0.5

50%

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What all of that math tells us is that 50% of the market's valuation of XYZ Ltd s is backed up by working capital. Theoretically, if you were to liquidate XYZ Ltd tomorrow, you would get 50 cents on the dollar just from working capital alone. This is a tremendous amount of money to have at your disposal and really very nice for XYZ Ltd. Basically, if you see working capital to market capitalizations of 50% or higher, things are pretty good. Also, you might want to net out the inventories from working capital and check that percentage just to make sure that the number is not all that different, especially for retailers and clothing manufacturers. You do this by simply subtracting inventories from working capital. The power of Cash Like to buy a dollar of assets for a dollar in market value? Ben Graham did. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits -cash can fund product development and strategic acquisitions and can pay highcaliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand.

Days Sales Outstanding or Debtor Days is a measure of how many days worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use, getting an edge on the competition. To figure out DSO, you first have to figure out Accounts Receivables Turnover. This is: Sales for period A/R Turnover = ----------------------Average A/R for period

Sometimes you will only be able to get the accounts receivable from the last fiscal year, and therefore will have to use the revenues from the last fiscal year. However, the fresher the information, the better. What this ratio tells you is how many times in a year a company turns its accounts receivable. By "turn," I mean the number of times it completely clears all of the outstanding credit. For this number, higher is better. To turn this number into days sales outstanding, you do the following: Current accounts receivable -------------------------------Sales for period divided by days in period

DSO =

This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the

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same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business. The same is true of Inventory Turnover. The less money you have tied up in inventory in order to fill your distribution channels, the more money you will have to do all the other things a company needs done -- marketing, advertising, research and development, acquisitions, expansions, and so on. You want a company to turn its inventories as often as possible during the year in order to free up that working capital to do other things. To figure out how much a company is turning its inventory, you need to find out the Cost of Goods Sold (COGS) for the past 12 months. COGS is the second entry in the Consolidated Statement of Earnings right below the revenue line. Costs of Goods Sold Expense Inventory Turnover = ----------------------------Average inventory for period

If two companies are the same in every way but one is turning over its inventories more often, the one with better inventory management is the one that is going to be able to grow faster. Inventory management actually is a bottleneck for growth if it is not efficient enough, tying up a lot of working capital that could be better used elsewhere. If you can find out a company's DSO and inventory turns relative to its peers, you will have an incredible view into how well the company can fund its own growth going forward, allowing you to make better investments. What is solvency? After a company has figured out its debt and equity mix, we, as investors, need to evaluate the decision. Why? Because capital structure has a strong bearing on the very solvency of the company. Now, what's that? Simply stated, solvency means whether a company can smoothly service all its debt-related obligations. There are some tools that help us evaluate the state of solvency of a company. These are simple methods to know whether the current operations of a company are capable of meeting all its requirements for debt servicing. For example, let us look at some broad financials of a company - Bellary Steels and Alloys. Bellary Steels and Alloys : The Financials (Rs. Cr) Debt Net Worth D/E (x) PBDIT Depreciation PBIT Interest Interest cover (x) 1999 706 182 3.9 29 7 22 28 0.8 1998 520 123 4.2 59 10 49 30 1.6 1997 206 146 1.4 77 31 46 18 2.5 1996 109 66 1.6 43 5 38 16 2.4

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Net Operating Cash Flow Investment Cash Flow Financing Cash Flow Increase in Equity Increase in Debt Understanding interest cover

-50 -142 194 5 189

32 -376 338 27 311

4 -23 21 5 16

3 -8 4 3 1

A ratio called interest cover tells us how many times the company's profits cover its interest payments. After all, the profit before interest (PBIT) must at least adequately cover the interest obligations. To get this ratio, just divide PBIT by the interest. The number that you get shows how many times PBIT can meet the company's interest burden. In our example, we see that from 1997 onwards, the company has been unable to maintain a balanced debt-equity ratio. Due to higher addition of debt in its capital structure, its financials were getting hit very hard. (The pinch is more severe during hard times when the operating profits fall). Its interest costs have shot up in the subsequent years, thus proving a drain on its cash flows. So much so that in 1999, its profit before interest and taxes do not adequately cover even the interest payments. In 1999, one does not even need to calculate the net profit (or to be precise the net loss!)! Beware of debt trap! And look at the cash flows! A lion's share of its capital requirements is getting funded with debt. In 1999, even the operations are funded by debt. Obviously, the company needs more and still more debt to even service its interest costs (it has little option!). This lands companies like the one mentioned above in a catch-22 situation. A time comes in their life when they need to borrow more even to pay interest on earlier debt. This vicious cycle continues, and the situation is called a debt trap. Debt service cover But interest is just one part of the story. A company has to pay installments towards the repayment of debt. A small modification in the previous formula is all that is required to see if it can service all these repayments. However, to calculate this ratio, one needs to know the repayment schedule of the company. Just add the installment due for a given period to the interest. Divide PBIT by this number. And in a jiffy, you know how adequately PBIT meets the total obligations. In our example, the company has not yet started paying off its huge debt (its cash flows are so fragile!). So, let us make some assumptions to understand the debt service cover ratio. Let us assume that the loan amount needs to be repaid over a 5-year period in equal installments and the company will not take more debt. Its average interest cost on the loan amount in the past four years is 8%. We assume this to be the interest rate.

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Debt Repayment Interest Total towards debt service Debt service cover

1999 2000 2001 2002 2003 2004 706 565 424 282 141 0 141 141 141 141 141 28 45 34 23 11 0 186 175 164 152 141 0.1

The total amount that the company needs to set aside for servicing debt is the sum of interest and repayment. The debt service cover is 0.1, which shows the hopeless inadequacy of the company in meeting its debt-related obligations in the next five years. There is another interesting way of looking at debt cover. Debt service cover is a simple ratio - PBIT/(installment + interest). What if we reverse this formula? It will then look like (Installment + interest)/ PBIT. This reciprocal has something interesting to tell us. If the profits of the company remain constant, this is the number of years the company needs to repay all its financial obligations. So, we had said that Bellary Steel looks saddled with debt. The five-year schedule that we assumed is over-optimistic, to say the least. When will it be able to repay its debt? If all goes well, and if its profit remains at the current levels (without deteriorating further), the company should take 10 years (=1/0.1) to repay its debt. Thus, a debt service ratio of 0.1 implies two things: * First, it means that the company's PBIT can cover just 10% of its financial obligations. * Second, it means that provided its PBIT remains constant, it will take 10 years for the company to repay all its debts (= 1/0.1)! Solvency concerns everybody - investors in debt (lenders) as well as those in equity (shareholders). Growth, capacity expansion, acquisitions et al are the ends that a company needs capital for. However, a company should not stretch beyond its means. And, equally important are concerns about how a company sources its capital (means to the ends). Hence, the solvency calculation tools come in handy and tell us about the prudence a company has exercised in determining its capital structure.

Value : The Price Paid

Rule 1: When you buy a business, the price you pay should relate directly to the cash you expect the business to generate. Rule 2: It is critical to understand a company's economic model on its own terms, in relation to industry peers, and in relation to the business environment as a whole. Rule 3: Valuation determines future returns.

As much as purely quantitative criteria outside of any business context alarm me, valuation is probably the most important parameter to consider when committing capital to a business. The reason for this is the underlying and indisputable logic for purchasing publicly traded businesses. Aside from any superficial psychological benefit to owning shares in various corporations, when you purchase a stock you are buying that business because you believe the future

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value of the cash the business will generate will end up being worth more than the current value of the dollars you are paying. Literalists might wince at this description, given that with publicly traded companies you rarely receive all of the cash that they generate, but I must again stress the axiomatic assumption made in the last installment -- "Investing in businesses makes the most sense when it is business-like." Whether or not you actually receive the stream of cash, were you to buy the whole company you would have absolute discretion over what to do with all of the money that the company made. As we are assuming the same rigor in buying portions of a company as when we buy the whole thing, the fact that if you only own shares you don't actually get the earnings or the cash flow the company generates is an entirely moot point. A business exists to generate profits using whatever assets it has. After generating these profits, the business can decide to reinvest, make acquisitions, pay dividends, or repurchase portions of itself from other owners. The earnings you can reasonably assume to make over the lifetime of the business put in today's dollars is the value of a company at any given space in time. Current events and wild speculation may change the perceived amount of these cash flows, but in the end, the business is worth the cash it can generate with its assets, whether they be tangible, like a factory, or intangible, like a tradename. Ever wonder why the price/earnings ratio has become the Holy Grail for investors? Sure, you may use it all of the time, but why is this even relevant? Why not the price/inventories ratio? Or the price/depreciation ratio? Both of those are concrete financial factors that almost every business can report. The reason is that the price/earnings ratio tells you how many years it will take at the current rate of earnings for you to make all of your money back. Nothing more, nothing less. If a company has a price/earnings ratio of 10, that means if the earnings stay constant you will make back in earnings the money paid to buy the stock in ten years. The price/earnings ratio is ubiquitous because it uses the same inescapable logic that any actual acquirer would apply to a business being acquired: How long will it take to make my money back? What is the current value being placed on the future earnings power of this company? Certainly earnings are not the only variable we can use to approximate the actual cash a business can generate. In fact, sometimes earnings can become distorted due to temporary factors, making other numbers that correlate directly with the cash a company can produce -- like sales, cash flow, liquid assets, or even subscribers -- make more sense. The point is not to use a special, sacred tool to figure out what a company is worth -- the point is just to understand a company's economic model and with that understanding select the tool that best represents the value that the company can create in the form of cash generated. In this regard, the actual value of the company at any given moment in relation to a host of factors can be deemed important or not important depending on the type of company. For a manufacturer after-tax earnings are critical. While the valuation method used depends on the company you are valuing, the ultimate impact of that valuation is indisputable. The wider the gap between the current value and the intrinsic value, the higher the return. Current valuation defines future returns, with higher valuations decreasing future returns by a proportional amount. If you overpay for the future earnings, you will either lose money or suffer through mediocre returns until the point where the valuation becomes attractive relative to the intrinsic value. The shares of stock can only increase in value if there is a significant difference between their value today and

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the cash they are going to generate in the future. If there is no difference, or if the shares have actually overestimated the cash that will be generated, they cannot mount a sustainable increase in value unless you assume that all parties involved will remain irrational. While some like Jack Welch have argued that for large acquirers like General Electric, increased equity value can translate into higher future cash-flows through acquisitions -- meaning the property can never be overvalued -- there are several assumptions in this premise that are just not true. The first is that an organization can attain infinite size without sacrificing efficiency. The second is that there is an ample supply of skilled, motivated management to actually run these acquisitions. The third is that the supply of potential acquisitions that would actually affect the bottom line is infinite, which is simply not the case. Finally, acquisitions are a two-way street. The party being acquired has to believe that the shares of the acquirer reflect rational expectations about future cash flows or they will not accept them as tender. In fact, one could argue that valuation means a heck of a lot more to the acquired than to the acquirer, as the acquirer is always happy to do a deal when its shares are overvalued. Valuation matters because valuation is an expression of the future cash that a company will generate. As buying at current prices gives you a right to that future cash, the price you pay today determines the returns that you can expect tomorrow. At some point, although it is arguable exactly when, a company can and will reflect an accurate valuation or an over-estimation of the cash it can reasonably generate over the foreseeable future. In the end, the higher the price you pay, the more likely your returns will either converge with the market returns for a significant period, or fall below them if you not only overpay but also buy a low-quality business. In the next section we will examine some aspects of business quality.

Quality :
Rule 4: Cheap stock may still not be worth it. Rule 5: Excess returns come from buying moderate to high quality businesses at low to moderate prices. Rule 6: Higher-risk excess returns come from selling low quality businesses when they attain high prices.

Much of the investing media is preternaturally intent on valuation. The price/earnings ratio and growth rates routinely grace the pages of even the most podunk and picayune business section, but very little ink is spilt on the issue of business quality. This may be the result of "quality" being a much more esoteric and diffuse issue than valuation. Or it simply may be out of ignorance. While all you need to do valuation is the numbers and a calculator, determining the underlying quality of the enterprise actually requires that you know more than simple math. It requires that you understand what a business is and how it functions as a conceptual, capitalist construct. Valuation as a discipline benefits the most from the systematic exposition found in Ben Graham's seminal text Security Analysis -- a text that even today is widely used in business schools across the country. Unfortunately for students of business quality, there has been no similar work that neatly circumscribes the issue of business quality. A few books and other publications cover the major issues -- the most readable and comprehensive of which include Phil Fisher's Common Stocks and Uncommon Profits, G. Bennett Stewart's Quest for Value,

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and Robert Higgins' Analysis for Financial Management. Many more books exist beyond this, as the emphasis on business quality has enjoyed many fathers -with maybe a mother or two thrown in for good measure. What kinds of measures look at business quality? Certainly Pierre DuPont's breakdown of return on equity is the most comprehensive, but the development and widespread use of return on invested capital in the '60s and the emergence of Economic Value Added (EVA) consulting in the '80s have focused investor attention on quality issues in the last decade or two. Widely used asset management ratios like inventory turns, days sales outstanding, overall asset turnover, growth, margins, leverage, and interest coverage also contribute equally to the qualitative picture. In fact, every ratio you are familiar with that does not neatly fall under the category of "valuation" is a business quality ratio. Business quality is important because in the end, cheap is not enough. Investors who routinely buy shares because they trade at low price/earnings ratios or low price/sales ratios often find that the earnings are in a state of decline or the sales are quickly disappearing. Although various studies indicate that you can marginally beat the market if you buy a diversified basket of distressed securities at low valuations (a la Ben Graham), gigantic returns like those posted by the patron saint of investing, Warren Buffett, come from buying high quality businesses at low to medium prices. Taking the last few puffs from a cigar butt you find in the street might seem like a good deal, but actually getting a case of premium cigars for a relatively moderate price is not only more sanitary, it creates more in the way of value. Surprisingly, business quality is not hard to evaluate once you understand the basic principles. The important inputs are the amount of cash required to run the business and the amount of cash the business spits out relative to that cash. Return on equity, for instance, just measures the after-tax earnings a company generates relative to its net investment in assets. Return on invested capital tries to be even more precise, tracking the actual dollars invested in a company through the proxy of total assets less non-interest bearing liabilities and compares this number to the after-tax earnings. Even inventory turns and days sales outstanding end up being measures of how much money is tied up in the business at any one time. If you carry a lot of inventories or don't collect your receivables very quickly, you have to put more into working capital than a similar business operated more efficiently. Not all qualitative factors are reducible to cash in versus cash out, although they are related. Leverage, for instance, simply tells you how much you have borrowed to get the cash out that you are enjoying. Interest leverage tells you how affordable this debt is. Growth of sales, cash flow, and the various flavors of earnings tell you how quickly the cash out is increasing. The various margins tell you how much cash out you are getting relative to every dollar taken in. Despite the fact that none of these are as obviously a measure of cash in versus cash out as return on equity, return on invested capital, return on assets, or return on capital, they are all intended to demonstrate how efficient the company is in deploying capital and collecting the returns. To these clear measures I normally also consider "intangibles" like proven (not perceived) management savvy, the conservative value of trademarks or brand, and the soundness of the company's capital allocation policy. Capital allocation, in short, is how a company uses the money its creates -- acquisitions, dividends, share buybacks, debt repayment (all good), or if they just leave that cash sitting on the balance sheet.

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Intuitively, it seems clear that investors should assess valuation and compare this with business quality. While this is a process that is difficult to completely convert into numbers, it may not be all that awful to leave human judgment squarely in the process. While much has been made of mechanical models and automated trading strategies in the computer-crazed 1990s, the consistent and patient application of intelligence to the process of value creation is what creates millionaires according to the actual statistical evidence. If you only draw one lesson out of Stanley and Danko's The Millionaire Next Door: The Surprising Secrets of America's Wealthy, it is that these people own quite a bit of common stock, they apply the same logic to buying this stock as to running the small businesses most of them control, and they do not really trade all that often. In the world of human judgment (judgment that we must parenthetically emphasize sits squarely behind Shakespeare's entire corpus, Beethoven's symphonies and Einstein's Theory of Relativity), the comparison between valuation and quality is quite straightforward. Just do the math on the valuation side and determine whether the stock has a low, moderate, or high valuation. On the quality side, do the math there as well, add in whatever bias you want for management savvy, trade brand value, or market dominance, and assess this as being low, moderate, or high as well. Then compare the two with an eye toward buying companies that carry low valuations that are of moderate or high quality or, if you are a little more of a risk taker, buying companies that have medium valuations that carry high quality. Conversely, a great sell is a company of low business quality with a high valuation. By comparing valuation and quality, you identify areas where excess returns -returns over and above the market average -- are possible. The next article looks at how to pinpoint even more finely where to make investments by considering the depth of your knowledge about a company.

Depth of Knowledge of a company :

Rule 7: Buy what you really understand. Rule 8: Don't buy what you marginally understand or what just floats your boat -- you will intermittently lose enough money to make this ultimately lead to below market returns.

Valuation and quality form the length and width of the investment world. These two dimensions indicate in the end what the size of the investment return will be. Like everything else in life, our ability to use these tools successfully has finite limits. In fact, our ability to measure valuation or quality is actually fairly limited, despite the seeming precision that the numbers offer us. Although we always have the option of leaving an extra "margin of safety" in a purchase by being conservative in our assessments of the valuation and underlying quality to try to offset our human limitations, properly assessing another dimension of the investment process -- depth of knowledge -- is probably even more vital to avoiding mistakes. Depth of knowledge is a straightforward concept despite the fact that it is erratically employed. Simply put, it is a measure of how well you understand the company's economic model -- the way it interacts with customers, suppliers, distributors, and investors as part of its daily operations. The reason true depth of knowledge is erratically employed is because of the capacity most investors have for self-delusion. This is particularly true among investors who attempt to expand their idiosyncratic experience as a customer beyond its logical limits, allowing this

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impressionistic vantage point to color their perception of the company's overall economic model. Understanding a business can be as complicated as the business itself, mitigated by our own personal knowledge and experience. The basic manufacturing model is probably the simplest business going. A company makes something, distributes it to the customer through set channels, and collects money from the customer in return. Another fairly simple model is the retailer, which receives manufactured goods from other companies and sells them directly to consumers. Or you can mix it up and have the hybrid manufacturer that not only makes products but also markets and sells them. With the exception of natural resources, financial, and real estate companies, almost all companies involve some combination of the manufacturing or retailing format. Digging down deeper than this simple understanding of how sales are converted into cash is essential. Who are the company's customers? Who are the company's suppliers? What factors affect end-user demand for the company's products or services? What is management's strategy for growing the business and creating shareholder value (not always one and the same)? The maxim "Buy what you know" is insufficient -- it should really be "Buy what you understand." Heraclitus probably said it best when he quipped, "Much learning teaches little understanding." Actual concrete understanding of what a business is is fairly rare. More often than not, it degenerates into a superficial sense of what the products are and how exciting they might be, or a idiosyncratic consumer familiarity with the product inflated into a purported understanding of the company's economic model. Understanding goes beyond just reading the annual reports, quarterly earnings and business scenario, routine boilerplate warnings about potential pricing irrationality in a market just don't have the same power as the concrete and real experience of seeing the price for hard disk drives dive in the spot market. Many times true understanding comes from months, or even years, of following a company before making your purchase. The first few times you look at a company's financial statements over the course of a year or two might be better conceived of as a "getting to know you" sort of engagement rather than a "Hey, let's go out" kind of thing. While just twiddling around with preliminaries can be boring, many investors will tell you that their best investments were not necessarily their first investments, but the companies that they bought after years of watching them closely. While one can argue that buying the stock on the first inclination that it might be cheap would have been better in that situation, I can think of a dozen other situations where having patience and trying to learn more about a company through trade magazines, analyst reports, and a variety of other online and offline sources would have created a big enough picture to make buying as riskfree as possible from an information standpoint. The fact that there is no set number that measures your knowledge of a company is probably the main reason why many investors fail to consider this important variable before investing. While you can assess the relative strength of a stock by glancing at a copy of Investor's Business Daily, assessing your own knowledge level is a much more introspective, difficult, and sometimes brutally honest process. While knowledge is important, it should not be taken out of context with valuation and intrinsic business quality. The appearance of detailed knowledge about a

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company without a genuine understanding of how much cash the company will generate in the future can be as catastrophic an investment scenario as looking at valuation only and ignoring the company's underlying economic model. It is depth of knowledge combined with low valuation and high quality that make for outstanding investments. Any deviation from these three dimensions involves taking on the distasteful risk of losing money. This is not the end, however. When you combine this fully functional, three-dimensional investment model with an appropriate philosophical framework and add the concept of time, you can engage in full-fledged security analysis. In the final installment, we will look at time and its impact on the investment process.

Time and returns :

Rule 9 : Cite all past and future investment returns in a consistent unit of measure. Rule 10: Time heals many, but not all, self-inflicted valuation wounds.

Concentrating on valuation, quality, and depth of knowledge allows the investor to pick companies that are most likely to appreciate significantly in value. The returns an investor earns by owning the shares of a publicly traded company depends as much on the time the security is held as any of these other factors. The amount of time over which a price change occurs makes the difference between a stunning investment and a sub-par investment. In order to invest successfully, individuals must understand the critical role that time plays in determining returns and they must develop reasonable expectations about what sort of returns to expect over a given period of time. Say we have done our homework and bought shares of XYZ Ltd. After some interval, you discover to your delight that the shares have doubled in price. A real home run, right? Not necessarily. Depending on how long it takes to earn them, 100% returns can be either market trouncing or embarrassing. Just as in physics, you want to be careful to keep all of the units of measure in a problem the same or else you will get bizarre results. Thinking about all of your investment returns in one unit of measure -- annualized returns -- is critical to making informed decisions about which investments have been and will be the most attractive. In our example of the 100% returns, if this 100% was earned over the course of a year it is a staggering return. However, if it took you ten years to double your money, you have only earned 7.1% annualized returns over the whole period. Although 7.1% ain't exactly shabby, with the BSE Sensex doing about 17% per year with dividends reinvested during the same time period, you can see why 7.1% might seem a little anemic by comparison. Whether you are quoting past returns in your portfolio or you are looking at what you might earn two years out should a company trade at your conservative valuation, you have to convert these numbers back into annualized returns in order to compare and contrast efficiently. Simply learning to take nth roots by using the "^" function in your computer's built-in calculator or spreadsheet would do the job. Beyond the necessity of using a consistent unit of measure when discussing returns, time also has a much more powerful and salutary effect on the investment process. You see, time heals many investment errors that are related to valuation. While certainly time does not heal all of the damage, nor does time matter a fig if an investor loses patience, the amount of time you hold an asset does decrease the valuation risk inherent when you purchased the asset. What that means in English is that if you bought a great company but paid too dear a price, over time that valuation mistake is going to be overcome by the

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compounded earnings growth that the company delivers. This is why focusing on quality during the investment process is so critical -- if you buy quality, then time is your friend. If you buy low quality or dirt stock, time doesn't matter at all. Citing exaggerated lengths of time over which to invest your money has actually become quite faddish of late, with 5 or 10 year time frames often cited. Although investing in companies with this kind of time frame is perfectly reasonable, the assumption that even this length of time wipes out all valuation risk is not. Even the highest quality company purchased at an excessive price can deliver submarket returns over 5 or 10 year time frames. This is particularly true if the company in question experiences a decelerating rate of earnings per share growth, as is typical of large companies growing larger. While small companies grow earnings by 15 % or 20% much of the time, many large companies that have already gone through years of process reengineering to enhance productivity may find that they have reached their zenith. If EPS grows 10% per year along with sales and you purchased the stock at 10 times sales, the resulting shareholder return over the next 5 years stands a chance of being sub-optimal. Someone might not take the shares off your hands at 10 times sales and 50 times earnings 5 years out. If the P/E multiple contracts to something more like 15 times earnings, the 20-year return would be minimal. Time decreases the chance of making a valuation mistake, but it does not remove it all together. The principal reason that Valuation came before Quality, Knowledge, and Time was because in the end -- even considering Time -- it is the primary determinant of investment returns. If you buy a great company that you know a lot about and hold for decades, you can still underperform the market if the great company experiences decelerating earnings growth and you bought it at a super-premium valuation. Although the majority of the so-called Nifty Fifty stocks have done fine over the past two decades, investors who bought names like Silverline Industries will probably never reach breakeven with their original investment. While in retrospect Silverline Industries may seem like one of the bad ideas of the bunch, keep in mind that in the year 2000, the software euphoria a decent balance sheet and a growth software company with good business people could falter. Another death knell for the industry was the bust of the Dot-com business coupled with the slowdown in the American economy which contributed to majority of revenues of software companies including Silverline Industries. To conclude, the investor who purchases low- to medium-valued companies of medium to high quality where they actually have some kind of knowledge about the company and who have reasonable expectations about annualized returns will probably do quite well, regardless of the market environment. In the Buy & Hold Apocalypse, we saw that with longer and longer time frames, stocks had a better and better chance of outperforming any other asset class. What is true of the flock is true of a single bird. The more you concentrate on becoming a long-term owner in a quality business that you purchased at a low valuation and know quite a bit about, the more likely you are to tell your friends about the shares of a Rs 2000 or Rs 3000 stock you own where your cost basis is measured in rupees. Although much attention is placed on the stocks that double or triple in a year, going up 10 or 20 times in a decade is where stocks really create wealth. By following the 10 fairly simple rules laid out in this series, I think investors heartily would increase their odds of being able to value stocks and make investments at reasonable prices and end up with wealth generation in the long run.

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A CASE STUDY : Dr Reddys Laboratories Ltd

COMPANY BACKGROUND Dr Reddys Lab (DRL) is a leading pharmaceutical company engaged in business of bulk drugs and formulations. DRL was predominantly into manufacture, sale and export of bulk drugs. Over the years, the company has changed its orientation from bulk drugs to formulations. The company currently markets formulations in 25 countries. With the completion of the merger with Cheminor Drugs in February 2001, DRL once again derives more than 40 % of the turnover from bulk drugs. DRL has recently merged American Remedies with itself, a company engaged in manufacturing nutraceuticals with a product portfolio of 57 products. Dr Reddys has been one of the pioneers of basic research in India, and started its own drug development activities in 1992 through Dr Reddys Research Foundation. The company completed its US $ 132.8 mn ADR issue in April 2001.

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The company plans to use $30 mn of the proceeds for drug discovery and development and $ 90 mn for acquisitions and establishment of marketing operations in USA. HIGHLIGHTS Export orientation Dr Reddys increased emphasis on exports will be reflected in the 40 % growth in exports in the next couple of years. The companys policy of derisking export earnings will go a long way in ensuring steady cash flows for the company. US generics potential The US Generics market is another potential area, which can give huge margin upside to the company. The Fluoxetine 40 mg capsule ( market size - $ 275 mn) six-month exclusivity is likely to be a major revenue earner for the company in FY2002. The other sources of major upsides are the exclusive approvals for Ciprofloxacin in FY2004. Best R & D pipeline in the Industry The company has the best R & D pipeline in the industry with eight NCEs. Two NCEs are in Phase II trials with Novo Nordisk, one new NCE (anti diabetic with other indications) has been licensed out to Novartis while the company is conducting phase I trials on the anti-cancer molecule. Consolidation and growth in the domestic business With the acquisition of American Remedies, the company is placed at No 7 slot as per ORG rankings. The company achieved a growth of 22 % in fiscal 2001 as against 8.8 % industry growth. Dr Reddy has 7 products in the top 300 and 2 products in the top 50. With focus on high growth segments and acquisitions, the company targets the No 3 position in the domestic formulations market within the next three years.

EXPORTS TO SET GROWTH TREND Sales Matrix FY2000 FY2001 Q1FY2002Q1FY2001 % Sales % Sales % Sales % Sales Domestic Formulations Domestic Bulk Export Formulations Export Bulk Generics Emerging Business Table Source: Company Data 32.1 22.5 54.6 11.0 31.3 42.4 0.0 3.1 100 31.3 15.9 47.2 14.1 32.1 46.3 3.4 3.2 100 33.1 11.5 44.5 16.3 27.4 43.7 9.2 2.6 100 37.5 21.6 59.1 11.4 26.7 38.1 0.05 2.8 100

The above sales matrix indicates that the companys growth has been more export driven due to increased focus on international markets and US generics.

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Increased registrations and regulatory approvals will drive export growth. US generics is expected to show exponential growth due to market exclusivity for Fluoxetine in FY 2002 and thereafter due to the expected approval of ANDA filings. The company has defocussed on domestic bulks as it is a highly volatile and competitive business. Sales Mix SBU Q1FY02 1 API Domestic Intl Formulations Domestic Intl Generics Emerging Business 2838 4664 2430 1104 326 778 1399 938 461 261 74 Q2FY02 2 1089 466 623 1623 1109 514 1841 111 Q2FY01 3 1030 367 663 1303 1036 267 22.1 75 49 (Rs mn) Growth % (2/3) 6 27 -6 25 7 93

From the above table it can be seen that there has been degrowth in International API sales. The US generics sales (excluding fluoxetine sales) have also moved down from Rs 260 mn to Rs 220 mn in Q2 FY2002. These are signs of concerns. Exports The Key Revenue Driver Exports at Rs.4.46 bn constituted almost 50% of companys turnover in FY 2001, which has further increased to 64 % (including six month exclusivity for generic fluoxetine sales) of the total turnover in Q2 FY 2002. With increasing number of registrations and greater market width, the companys export orientation is expected to increase further. Dr Reddys reliance on exports as a source of revenues and profits will occupy a pivotal position alongwith research in the near future. High Formulations growth will aid margin expansion Formulations exports, which constituted 14 % of total revenues of finished dosages, witnessed a growth of 61 % to Rs 1.27 bn as against Rs 790 mn recorded a year ago. The main driver in formulations growth has been Russian markets where the company clocked a growth of 59 % in FY 2001 while other markets witnessed a growth of 63 %. The high growth in the Russian markets can be attributed to low base in the previous year as Russia was recovering from the currency crisis. Russian markets constitute 51 % of formulations exports of the company. Three of the companys products Enam, Ciprolet and Omez are brand leaders. The company is in the process of strengthening its systems in

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Russia. DRL now sells 70 % of its products through top three distributors on a 30day credit basis and the rest is routed through their joint venture partner. DRL has 162 product registration in the CIS and is ranked 12th in Russia. The growth momentum has been maintained in Q1 2001 with Russian markets showing a growth of 201%. The company has commenced operations at its China JV in fiscal 2001 with sales of US $ 0.7 mn. The JV is marketing 4 products and is in the process of galvanising its operations with a marketing staff of 100 people. Brazil, the eighth largest market in the world has seen a shift from branded to unbranded generics. The company has clocked a turnover of $ 2 mn in this market in FY 2001. DRL is repositioning itself to adjust to the changes in this market by forging alliances with local companies so as to access the unbranded generics market. The Q1 2002 showed a degrowth in Brazilian markets due to the shift from branded to unbranded generics. In fiscal 2001 the company entered the markets of Sudan, Ghana, Iraq and Kyrgyztan. In Q1 FY 2002 Kazakhstan, Ukraine and Sri Lanka are other markets, which have shown a growth in excess of 65 %. With 646 registrations in place across various markets, strengthening of therapeutic areas, focus on brand building, rationalisation of products, increased focus on high value products, geographical expansion of markets and systemic de- risking all of these will aid high export growth. Going forward it appears that the company will be able to achieve a growth of 40 % plus for the next two years for all markets, where the company should be able to achieve a growth of 20 % on a conservative basis. Q2 FY2002 : In case of International formulations business Russia constituted 65% of the total business (Rs 514 mn) with a growth of 145%. The company commenced operations in Thailand and Philippines. DRL is looking at markets outside the Russia and CIS and is in the process of launching high value added products in the CIS. Generics Scorching growth ahead The US generics market is estimated to touch USD 30.5 bn by 2004 at a growth rate of 12 %. Generics account for 40 % of the pharmaceutical sales volumes and 10 % in terms of value. The Schumer McGain bill is expected to help the generics business in US markets as it is expected to encourage generics imports from developing countries. DRL had signed an agreement with Par Pharmaceuticals of USA to market 17 generic drugs. Currently Par has an agreement to market Ranitidine 150/300 mg caps, Famotidine 20/40mg tablets. The agreement with Par Pharmaceuticals envisages full participation in marketing decisions and negotiations with key clients. The company has further signed alliances with Liener for OTC version of Rantidine and an alliance with Warrick for Oxaprozin. US generic sales Product FY2001 Q1FY2002

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Ranitidine Ranitidine Ranitidine Famotidine Famotidine Oxaprozin Others Total Sales

75 mg 150 mg 300 mg 20mg 40mg 600mg

51% 18% 6%

48% 7% 13% 5%

16% 9% Rs 303 mn

26 % Rs 261 mn

Seven of the companys facilities have been approved by the FDA to produce products or sale in the United States. These certifications enable DRL to market the products in highly developed markets. The company is in the process of getting all its plants approved by USFDA. DRL has filed six ANDAs in the USA in 2000-01. The company has received two final and three tentative ANDA approvals in 2000-01. The company has finally got the approval for the six-month market exclusivity for Fluoxetine 40 mg, which has enabled DRL to access the US markets for generic Fluoxetine from August 03, 2001. The other notable developments an ANDA filing for Olanzapine 20 mg tablets (Para IV certification). DRL has submitted 28 approvals across various regulated markets such as USA, Canada, Europe, Australia, South Africa and New Zealand and has obtained 8 final approvals and 2 tentative approvals. The potential is quite huge considering that 9 products are awaiting USFDA approval with a market value of US $ 10.4 bn. The company is in the process of filing 11 ANDAs in FY 2002 with a brand market value of $ 8.9 bn. The advantage, which Dr Reddys possesses, is that the company has the infrastructure in place and will be able to time the market well due to marketing alliances in place. Update on the Patent Challenges Dr Reddy has started selling the fluoxetine 40 mg from August 3,2001 after a court judgement invalidated the December 2003 patent on Eli Lilys Prozac and consequent USFDA approval for generic players. Prozac (fluoxetine) had global sales of $ 2.6 bn in 2000. Dr Reddys has been the first to file for the 40mg strength and will have a market exclusivity policy for 180 days. The company will be the only generic player besides the innovator Eli Lily for six months. Hence the price erosion should not be drastic and the company should garner a reasonable market share. The 40mg capsule has sales of $ 275 mn prescription sales. On a price discount of 50 % and a 40 % market share for the first generic producer the company will be able to generate export sales of Rs 1.3 bn for the six month exclusivity as against Rs 303 mn of generics sales in the previous financial year. In the case of Omeprazole exclusivity the company has lost out as the patent expiry on the molecule took place before the time to market the product. The company had not filed for the remaining patents hence the Omeprazole 40 mg exclusivity has gone to Andrx who has the right to market all the dosages for the six month exclusivity period. This is a huge

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loss of opportunity for the company and the company has lost a Rs 2100 mn opportunity in FY 2003. In case of the Ciprofloxacin patent challenge, the lower court has rejected the hearing and DRL has initiated appeal to the Federal circuit. The companys plan for US generics is to forge alliances with top tier companies capable of capturing 25 % + market share, build a critical mass through product depth and breadth. DRL plans to focus on patent challenge products as they entail huge margins for the company during the six-month exclusivity period. Further timely product launches, benefits from patent challenges and a strong sales and marketing organization in USA are the other initiatives being undertaken by the company to generate revenues for the company. Q2 FY2002 :US generics ( Rs 1841 mn market) Fluoxetine upside : US generics has been driven by fluoxetine which contributed 89 % of the total generics sale. Sales increase of 96 % was driven primarily by sales of Fluoxetine ( Rs 1639 mn ) and international formulation sales of 514 mn which had a growth of 93 % vis a vis the corresponding previous quarter. Excluding Fluoxetine, sales increased by 25 %. US as a market now contributes 43 % of sales. Fluoxetine 40 mg capsules contributed 89 % to the total generics turnover and the conversion rate currently stands at 80 %. During the year, the company received final approval for Famotidine tablets 10,20 & 40 mg and Enalapril Maleate HCTZ tablets 5-12.5 mg & 10-25 mg. The company has a total basket of 14 ANDA filings including 5 Para IV filings (inclusive of Fluoxetine). DRL is on track to file a total of 10 ANDAs for the current fiscal. Post February 2002 (expiry of the exclusivity period) the company is planning to sell other dosages of Fluoxetine 10mg and 20 mg. The current marketing arrangement is on a profit sharing basis of 80: 20 (DRL : Par ) which is likely to be changed to 50: 50 after the exclusivity period. At present there is only one another company which has got the approval to sell 40 mg capsules in USA after the exclusivity period. The US generics sales (excluding Fluoxetine) for Q2 FY 2002 is Rs 200 mn as against Rs 260 mn in the Q1 FY 2002. The degrowth in QoQ growth can be attributed to lower sales of Rantidine 75 mg and Rantidine 150 mg tablets not taking off and lower offtake of Oxaprozin. Bulk Drugs
FY2001 Exports API USA markets % of Total API sales 67% 2887 Growth % 29% 76% Q1FY2002 778 356 70% Growth % 36 110 %

International bulk actives contributed 32 % of the companys turnover in FY 2001 up marginally from 31.3 % of the companys turnover in the previous year. The US markets accounted for 12 % of the bulk drug exports while European markets accounted for 10 % of the bulk drug exports in FY 2001. Sales to US grew by 76 % in FY 2001 as the company has a broad relationship with top tier players such as Teva, Mylan, Genpharm and Ivax. The US sales in Q1 2002 constitute 32% of

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total API exports, which is a vindication of a more focussed approach to US markets. The relationship has been strengthened by entering into long term contracts with these key players in the US markets, which will protect the company from the wild swings in the bulk commodity prices. The high volume, high margin US business, which comprises 32 % of revenues, is expected to be strengthened further on the back of sustained margins. Q2 FY 2002 There has been a decline in sales due to drop in quantities relating to product development in USA in Q2 FY02 vis-a-vis Q1 FY02. API (International ) contributed 57% of the total API sales for the current quarter as against 64 % in the corresponding quarter. Outlook : API exports The company wants to improve its presence in the regulated markets of US and Europe through improved processes for product selection, IPR and delivery in terms of timing the market. DRL wants to be the first source generic alternative to top tier generic players for a minimum 6 products every year with a target market share of 30 % plus. The company wants to develop novel and noninfringing routes for 5 products every year and be the first to launch the product. POSITIVE NEWS FLOW ON R&D R&D spend has gone up to Rs.610 mn in 2000-01, a growth of 87% over the previous year. The companys R&D budget now accounts for almost 7% of turnover up from 4.5% last year. Dr Reddys Lab had announced the licensing of its diabetes molecule DRF 4158 to Novartis for $ 55 mn (Rs 258 crore). With the licensing agreement, Novartis will secure rights for worldwide commercialisation of the drug. The payment for the same will be staggered. This is the third diabetic molecule that has been licensed by DRL to a Multinational. DRF 4158 is for the potential treatment of Type 2 diabetes, diabetes dyslipidemia, hypertension and obesity. The licensing agreement is subject to regulatory clearance in the US. The molecule is currently undergoing preclinical evaluation and clinical trials are expected to commence end 2001. The USFDA clearance of DRF 4158, the anti-diabetic drug licensed by DRL to Novartis, has triggered the payment of $ 5 mn from Novartis, which will be reflected in the companys books in Q2 FY 2002. The expected launch of DRF 4158 is 2007. DRF 4158 Novartis has commenced development work on this molecule. Dr. Reddys has contracted clinical trials in the UK for DRF 4832, a molecule for treating cardiovascular complications Anti-cancer compound DRF 1042 is undergoing Phase I clinical trials in India. The company is currently exploring licensing opportunities. DRF 1644- An anti-cancer molecule, completed regulatory toxicology studies in the Netherlands. Dr Reddys has filed an IND application for conducting clinical trials in India. The drug, codenamed NN622 by Novo Nordisk, shows promise in simultaneously lowering lipids and sensitising the bodys insulin receptors to the circulating hormone, and is among the first of its kind in the world. Novo Nordisk makes milestone payments to Dr Reddys laboratories based on the progress of the drug through various phases of trials. DRF 2725 licenced to Novo Nordisk has

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moved to Phase III trials after the attractive action on Lipids with increase in HDL cholesterol of 18-30 % and a substantial decrease in levels of triglycerides and free fatty acids. Anti-diabetic product DRF 2593 is in late phase II trials. DRF 4848 a Cox II inhibitor is undergoing additional studies due to adverse implications on the Cox II inhibitor segment. The company is confident of maintaining its R & D expenses at the current levels. DRL is hopeful of finding one new molecule every year.

REVITALISING DOMESTIC OPERATIONS Domestic Operations

Formulations : (33 % of the Q1 FY 2002 turnover) FY 2001 Domestic Formulations Products introduced ORG ranking Top 10 Brands turnover (%) % of Total formulation sales (%) ORG Growth % Dr Reddys Lab Industry Growth 2812 10 15 67 69 FY2001 14.4 8.9 Growth % 22% Q1FY2002 938 7 8 54.5 67 Q1FY2002 7.1 7.9 (Rs mln) Growth % 17%

With 7 products in the Top 300, 2 brands in the top 20 the company is ranked 8 th as per ORG June 2001 and 4th as per CMARC (March 2001 prescription audit). The company has a market share of 2.55 % as per ORG June 2001 and 3.7 % as per CMARC (prescription audit March 2001). Omez, Nise, Ciprolet, Stamlo, Enam, Stamlo-Beta and Reclide are in the top 300 brands list of ORG with the first two featuring in the top 20. The financial year 2001 was one of consolidation for Dr Reddys with the Cheminor merger and the introduction of American Remedies brands. Acquired brands constitute 9.6 % of the companys turnover in Q1 2002. DRL believes in bigger brands rather than having a basket of small brands. The company therefore has not flooded the domestic markets with brands every year, but would rather have big brands. Dr Reddy focuses in offering wider number of drugs in a therapeutic segment eg Omeprazole and Pantaprazole in the antiulcerant segment and achieve leadership. The company plans to introduce lifestyle drugs, which enable the company to get closer to the customer. With focus on high growth segments and acquisitions, the company plans to occupy the No 3 position in the domestic formulations market in the next three years. The companys current ranking as per ORG is No 8 (Post merger with American Remedies). The company is expected to maintain growth rates of around 20 % for the next two years in the domestic formulations market.

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Domestic Formulations Good growth in key Brands

Brand Nise Omez Stamlo Enam Reclide Riflux Becelac Vitamins Keterol Norilet TOTAL Quinolones Therapeutic Category Pain Management Anti-ulcerants Calcium Channel Blocker Ace inhibitors Oral antidiabetics % of Sales FY2001 16 16 10 8 5 3 2 2 2 2 67 Growth (%) FY2001 30 20 -1 29 27 37 33 20 -3 -30 18 0.92 2.00 1.78 Growth (%) Q1FY02 29 15 -39 9 6 6 Market Share (%) 5.06 10.61 3.44 12.47 11.75 3.70

Ciprolet Quinolones

Source: Company, Industry ( March 2001) Growth for Q1 2001 indicates percentage change for Q1 2002

The growth drivers for the company have been Pain Management, anti-ulcerants, Cardiovascular, anti diabetes and Vitamins while Quinolones has registered negative growth due to generic competition. On the domestic sector, the companys performance in key brands is slowing down which is being replaced by some other high growth formulations. Overall the companys performance on the domestic formulations front has been below its peers. Q2 and H1 FY2002 : Sales in India for DRL at Rs. 1109 million recorded a growth of 7% in line with industry growth rate (ORG MAT Sep01). As per ORG Sep01, the Company is currently ranked 7th in the Indian formulations market with market share of 2.54%. The prescription audit, CMARC (March-June 01) ranks Dr Reddys 4th in the Indian industry. The sales growth in the second quarter has been below the companys expectations on account of - Lower growth of Companys large brands viz. Omez, Stamlo and Enam. However, this slide was partially offset by double digit growth rates of other brands viz. Nise, Stamlo Beta and Antoxid There has been a decline in the sale of anti-infective brands due to de-growth in the anti-infectives segment. Specifically, degrowth in Ciprolet, Lomaday and the change in the Clamp combination had a major impact on the segment. Conscious efforts are being made by the Company to broadbase its therapeutic portfolio and thereby derisk the business model. Niche segments such as Cardiovasculars (22%), pain management (20%) and gastrointestinal (18%) together contributed 60% to the total business. The Companys exposure to anti-infectives, a segment prone to industry cyclicalities and heavy genericization has come down to 12%. The companys MAT ranking in the domestic market has moved up from 8th in July 2001 to 7th in September 2001.

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In the domestic market, the company has launched three products in the September quarter and the company has re-structured its sales force which should start showing results from the third quarter FY 2002. Domestic formulations should grow at a single digit for Q3 and new products introductions coupled with re-structuring of sales force should show improved performance in the medium term. The industry growth has moved up beyond the double digit mark in October 2001 and Dr Reddy has out performed this. Domestic Bulks Business Revenues from the domestic bulk actives business was Rs.1.43 bn against Rs 1.61 bn in 1999-2000. The company is defocusing on domestic bulk due to the commodity nature of the bulks business in India. Domestic Bulks business is expected to decline over a period of time so as to give greater emphasis to export of APIs. Domestic APIs have shown a degrowth of 29% for Q1FY2002. However the Indian market has shown a growth of 27 % to Rs 466 mn in Q2 FY2002. The improved sales were due to Ciprofloxacin, Sparfloxacin, Sertaline and Clopidogrel. This has been primarily due to fallout on the export of bulk drugs. Emerging Businesses (Critical Care, Diagnostics and Biotechnology) Revenues from this business were higher by 31% at Rs.288 mn against the previous years sales of Rs.220 mn while Emerging businesses grew by 21 % to Rs 74 mn in Q1 FY2002 and 49 % to Rs 111 mn in Q2FY2002. The Critical Care business contributed Rs 183 mn in fiscal 2001 and Rs 51 mn in Q1FY2002. The company launched three new brands in the oncology segment in FY2001, which have shown commendable performance. Among the pharma companies, DRL is ranked 2nd in the oncology segment. BETTER RESULTS FROM DR REDDYS Financial Highlights FY2001 DRL declared good results for FY2001 as against the figures for the consolidated entity of Dr Reddys and Cheminor Drugs last year. Sales of Rs 8.99 bln translates into a growth of 25 %. OPM increased by 500 basis points to 27 %, while net profits have increased by 54 % to Rs 1.34 bln. The main driver of margin expansion was the lower raw material cost, better realisations and volumes growth from exports of API, formulations and generics. The company achieved a 32% growth in formulations with revenues of Rs.4.08 bln compared with Rs.3.09 bln in 1999-2000 while the bulks or the active pharmaceutical ingredients (API) managed a growth of 12 %. The US generics made a beginning in the current year with a sales turnover of Rs 303 mn while emerging businesses including critical care managed a growth of 31%. The companys EPS for FY 2001 stood at Rs 42.5. American Remedies (AR) results were not included in the present financial results. AR reported a net sale of Rs 850 mn as against Rs 940 mn in the previous year and a net profit of Rs 110 mn for FY 2000-01 as against a loss of Rs 120 mn for the previous year.

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The key drivers of the current year would be exports (formulations, APIs and generics), which constituted 50 % of the companys turnover in FY2001. Q2 RESULT HIGHLIGHTS Dr Reddys Lab posted sales growth of 96 % to Rs 4461 mn in Q2 FY02 while operating profits zoomed by 288% to 2442mn on the back of doubling of margins thanks to high margin Fluoxetine sales. Material costs have dropped from 36.5% of sales to 22%. Net profits have moved up by 236% to Rs 1436mn after write off to the tune of Rs 951mn (deferred write off Rs 932 mn and provision for diminution in the value of investments to the tune of Rs 152 mn and an extraordinary forex gain of Rs 132 mn). DRL was a negative tax paying company for Q2 FY 2002 due to a deferred tax benefit of Rs 201.07 mn as against a taxation provision of Rs 193.45 mn. One of the highlights for the quarter was receipt of milestone payments of Rs 236 mn and contract research fees of Rs 42 mn. For H1FY2002, revenue growth is 67.2% to Rs 7097 mn. Operating profits are up 198% to Rs 3096 mn on the back of margin expansion from 24.5 % to 42 %. Profits after extraordinaries have increased by 191 % to Rs 1969 mn. Capex The company is planning to incur Rs 400-500 mn in capex. This excludes acquisitions, if any. The company has huge Cash surplus which it wants to deploy on acquisitions in Europe and the US, on a drug discovery centre at Bangalore, on R & D, product development and expansion of product portfolio. The company will henceforth write off research, product development, market development expenditure during the period in which it occurs. This is a very positive step taken by the company. DRL will henceforth announce US and Indian GAAP nos at the same time.

OUTLOOK Increased emphasis on exports will be one of the key value drivers. Formulation exports, which contributes 14 % of the companys turnover, coupled with the companys policy of de-risking earnings by geographical expansion and strong brand equity will pay off in the medium term. Stringent credit norms in the risky Russian markets and other developing countries will check bad debts and the consequent cash flow problems. On the API exports, the company is in the process of restructuring its brands portfolio which will allow it to concentrate on high value products. Tie ups with top tier generic players for API exports will de-risk the earnings as DRL will not be subject to price fluctuations of the bulks business. The company is concentrating on the regulated markets where registration process is difficult but it is a price premia and high margin market for the company. The US generic majors like Ivax are in the process of developing alliances with Indian majors to source bulk drug or formulations for 21 products during the six month exclusivity period and thereafter. The deal in many instances is likely to be on a profit sharing basis. Companies with whom there is a possible talk of a tie up include Wockhardt ,

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Nicholas Piramal, Cadila Healthcare and RPG Life Sciences. This will have an effect on Dr Reddys ability to supply the bulk to Ivax and others as similar deals are also being negotiated with other players. Generics is another major potential area which is expected to change the export domestic ratio as the patent challenge molecules can generate high margin, high volume business. Increased regulatory submissions and approvals are signals for better things to come in the future. Fluoxetine (Prozac) was major success for the company in which the company achieved a Rs 1630 mn sales for the first two months of the exclusivity period in the 40 mg segment where Dr Reddy was the only player besides the innovator in the six month exclusivity period. The company achieved a 80 % conversion to their brand. The PBT margin of the company was 88 %. But the company losing the exclusivity of Omeprazole to Andrx was a big blow as the company would stand to lose revenues of Rs 2100 mn during the six month exclusivity period and profits before tax exceeding 85 % of Rs 2100 mn in FY 2003. This has been a major dampener for the company. The company is planning to sustain earnings on the domestic formulations front through organic growth in the core therapeutic areas through investment and acquisitions. Critical care is another lucrative area, which is a low investment high margin area. The company has repaid loan of Rs 2.70 bn out of the ADS proceeds and DRL is expected to be a debt free company by FY 2002. This will substantially reduce the interest outflow for the company in FY 2002. The repayment of loans extinguishes the companys present liability but the companys present lines of credit are always open for acquisitions in India and abroad. DRL does foresee raw material costs at current levels and should incur normal capex of Rs 500 mn every year for the next couple of years. At the current rate of Rs 900 (face value Rs 5), the company has generated returns in excess of 100 % in a span of 8 months since April 2001. Given the sharp run-up in the stock price in the last eight months on the back of continuous positive new flow we could see some correction in the short term to medium term. We believe that the company Fluoxetines upside is more or less factored in the price. The loss of the Omeprazole exclusivity has been a huge dampener to the stock and the major short to medium trigger is not there. The issues in the future that will make a substantial difference to the companys prospects include 1) Recovery in other US generics sales 2) Recovery in API exports to US markets and 3) Receipt of milestone payment on the start of Phase III trials of DRF 2725. The company has adopted a high risk high return model It would however now solely depend on litigation outcomes which is beyond the control of the company. The company has a series of Para IV filings (market exclusivity for six months) which are likely to unfold in FY2004 (Ciprofloxacin), CY2005 (Ondansetron) and Olanzapine. But as is the case with Para IV filings any litigation can delay the launch of the product as it had happened in Omeprazole where the company eventually lost the exclusivity. In such a case the earnings expectations might suffer and delay the upside. The second quarter performance has been one of the best the company has so far put up and it will be difficult for the company to replicate the performance. We are positive on the companys prospects in the medium term to long term as it quotes at P/E of 15.17 x FY 2002F and 15.5x FY2003F considering its focussed long term strategy on research and US markets. Peers like Cipla and Ranbaxy are quoting at 30-35 x FY 2002 and CY 2001 and 26 x FY 2003 and 20 x CY2002 respectively considering a lot of revenue generating opportunities are expected to unfold in the medium term for Cipla and Ranbaxy.

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Note : Financials of Dr Reddys Lab and Valuation Matrix are in the Annexures enclosed

References : Aswath Damodaran Peter Lynch Ben Graham Phil Fisher G Bennet Stewart Robert Higgins Pierre Dupont Warren Buffet

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