Sunday, February 15, 2009

Cash Flow Statement: Educomp Valuation Example

I have written about cash flow statement and its importance in the previous article. But I would like to illustrate why sometimes it is more important with a recent example. We all have been talking about the high valuation Educomp solutions command and some people do not even look at the scrip. But investors invest in this stock and it commands good premium in this bear market. Let’s see if they are mad or they have some basis to do so.

Current Market Price: Rs. 2097

Before going to the numbers, we will see why it commands such a high valuation in general.

1.It has no peers in the strict sense with respect to content and execution
2.Operating Margin in excess of 50 %
3.India is a huge country and potential for expansion of their business is excellent.

But market is not that crazy to put its weight behind Educomp on the basis of these things. Let’s calculate some numbers to see if there is something else.

Stock Value: Educomp Solutions

People term it as “Intrinsic Value” and I am no Warren Buffet to use those terms. That’s the reason I use the simple term “Stock Value”. Because stock market is a place where nobody can be right always and even the market sometimes. I use certain conservative assumption to calculate stock value which I explain to you as well.

I am going to calculate value of this stock based on the following two ways and list the results.

1.Based on Discounted Earnings per share

EPS = 40
EPS CAGR for last 3 years = 41 %

Assumptions:

EPS Growth Rate for Next 10 Years = 20% 25% 30%
Discount Rate = 5 % (Conservative Bank Yield)
EPS Growth rate is constant for next 10 years

Since, last 3 year CAGR for EPS is 41 %, I opted for one conservative estimate (20 %) and two other values to see what effect it can bring.

Note: CAGR refers to Compounded Annual Growth Rate. Also please note that this assumption is a CAGR value for next 10 years and might not make sense sometimes in the short term.

Stock Value Based on Discounted EPS

If EPS Growth Rate Assumption is 20% then Stock Value = Rs. 897

If EPS Growth Rate Assumption is 25% then Stock Value = Rs. 1180

If EPS Growth Rate Assumption is 30% then Stock Value = Rs. 1552


2.Based on Discounted Net operating Cash Flow

Current Operating Cash Flow = Rs. 680 Million
Operating Cash Flow CAGR = 83 %
Number of Shares = 17.2 Million

Assumptions:

Operating Cash Flow Growth Rate for next 10 years = 30% 35% 40%
Discount Rate = 5% (Conservative Bank Yield)
Operating Cash Flow CAGR is Constant for Next 10 years.

I have calculated the last 3 year CAGR for Net operating cash flow and it stands at 83%. Hence, I assumed a higher growth rate of 30% 35% and 40% for operating cash flow for next 10 years.

Stock Value Based on Discounted Net Operating Cash Flow

If Operating Cash Flow Growth Rate is 30% then Stock Value = Rs.1534

If Operating Cash Flow Growth Rate is 35% then Stock Value = Rs.2018

If Operating Cash Flow Growth Rate is 40% then Stock Value = Rs.2650

If you compare the stock value between these two methods, there is huge difference and in fact the value based on Discounted Net Operating Cash Flow is almost double the value of EPS Based estimate. Why is that? Of course, if I assume same 20% growth for operating cash flow, then the value is Rs. 890 which is similar to EPS Based estimate. But does it make sense to assume 20% growth rate when the company has generated net operating cash flow at CAGR 83% for the last 3 years? I do not think so. Hence, I assumed little higher than what I assumed for EPS growth. What this analysis indicate is that market assumes that Educomp Solutions Net Operating Cash flow would grow at 35% (CAGR)for next 10 years (If my assumption makes sense) and they think that stock value now is atleast Rs.2000 which is what it commands right now. You might ask why did the stock was trading at Rs. 1350 range just few days back? Well, stock price accounts and discounts for many things and I will certainly try to write an article about it in the coming days.

Stock Value based on cash flow gives better idea about the company rather than looking at just EPS. May be that’s the reason, market has put huge premium on this stock. But there is also one more thing. I have in fact calculated the value based on Net Operating Cash Flow which excludes money the company raised through financing which stands at Rs. 3306 Millions as of 2008. A company without strong growth potential and fundamentals would not have raised this much money and may be investors considered that too. But my another question is, would you have found this by just looking at PE Ratio or PC Ratio? Let’s see.

PE = 40 Stock Price = 2097 PE Ratio = 2097/40 = 52

PC Ratio = Stock Price Divided by Operating Cash Flow per share

Operating cash flow per share for Educomp = 680 / 17 = 40

PC Ratio = 2097/40 = 52

Wow……Two values are identical and I do not think people would have valued based on this. Hence, I strongly feel that at least few investors if not all have looked at cash flow of Educomp along with few more things I list out here.

Current Ratio is above 5 even though debt equity ratio is greater than 1.
Total Revenue CAGR of 126% for last 3 years.
Net profitability to net sales stands at 26% and I think not many companies have this kind of profit.

Conclusion: I strongly feel investors have done their home work before investing in this scrip. This was my attempt to find out why this stock attracts huge valuation in this tough time and we have found reasonably convincing answer if not completely convincing. Hence, looking at cash flow statement provides more clarity than just looking at PE or general trend. Also, analyzing the stock in totality including PE, PC Ratios, General Trend, Company growth along with cash flow statement and balance sheet gives you much more clear picture which can reduce the risk to an extent. I might not be correct, hence I request readers to share their thoughts in the blog. Thanks.

Caution: This example has been taken only to see if cash flow statement gives any additional information to value stocks and it is based on certain assumptions. Hence,please do not take this as a recommendation.

5 comments:

SUNIL,  February 15, 2009 at 1:09 PM  

Dear Sir,

You are genius....i had gone through millions of stock blog but i dint see an indept analysis like this from any other stock blog.

sir you are one of the best fundamental analyst infact i you are the no 1...i will rate you above krishna...sir you are doing an great work of spreading knowledge.....lot of poor investors will be going to benefited by your suggestion in the future.....good work.

It would be great if you give detailed analysis on these stocks..THESE ARE GOOD STOCKS WITH GOOD FUNDAMENTALS...

IKFTECH
PRAJ IND
MOSERBAER
IDFC
SUZLON
RPOWER
KS OILS
GMR INFRA
AHLUWLAIA CONTRACT
MAX INDIA
XL TELECOM
OPTO CIRCUITS
IVRCL
ASSAM COMPANY


SUNIL

Kumaran February 15, 2009 at 5:07 PM  

Hi Sunil, Please comment on what you have gained from this page and What you would like to know more. Nothing else. I am writing this blog as I have passion in it and please do not compare Krishna with me. He has been blogging for a long time and it needs lot of passion and hard work to do that. It is not as easy as you think and infact Krishna was one who asked me to start blogging in a new blog. Hence, please do not discount his hard work, passion and what he has done in stockmarketguide. It is one of the best blogs and I have a long long way to go with your wishes...

Sunil,  February 15, 2009 at 10:30 PM  

Ok sir...sir i would like to know the detailed analysis of the above mention stocks,it would be great if you give the analysis.

Sunil,  February 17, 2009 at 1:33 AM  

Dear Sir,

Sir pls explain us what the investor can know from PE AND EPS ratios?

What PE is and what does it tell us?PRICE TO EARNING RATIO MEANS?pls explain us in the simple sentences...

Report card of GMR INFRA.....PE ratio is above 200...what does it tell us...if the stock is fundamentally strong then we dont have to look for PE...what u say?if the investor invest in the stock for long term....



PE ratio 230.01 16/02/09
EPS (Rs) 0.34 Mar, 08
Sales (Rs crore) 37.45 Dec, 08
Face Value (Rs) 2
Net profit margin (%) 60.21 Mar, 08
Return on average equity 1.11 Mar, 08

nannu,  July 19, 2009 at 6:15 AM  

Kumaran,

Really appreciate the explanation, but what i am confused is with the way you calculated the Stock Value using Discounted Cash Flow and Discounted EPS. I don't get it. Please could you throw more light on this

Regards,
Nannu

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