Debt capacity

  • Published on
    22-May-2015

  • View
    632

  • Download
    2

Embed Size (px)

Transcript

<ul><li> 1. 2 1D 6 4ebt2C 7apac 3i8 5ty 1Debt capacity is a very useful mental construct in valuation.</li></ul> <p> 2. Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimating the collateral value of its assets and/or cash ow. 3. We believe the process is in manyrespects closely related to creditanalysis as we are seeking collateral net worth in excess of the cost of our investment. 4. Type 1 Securities 5. How do High Grade Bondscontrast with Equity? 6. In Bonds, focus is onAVOIDANCE OF LOSSIn equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS 7. Whats the best case scenario fora high-grade bond buyer? 8. Downside risk in bondsNO offsetting tradesSoIts better to be safe than sorryIn stocks, being loss averse can be costly. You have to take calculated risks... 9. You are SACRIFICINGProt SharingIn Exchange OfA PRIOR CLAIM and DEFINITE PROMISE Bad exchange 10. High Grade Bond Selection is a NEGATIVE artFocus on exclusion 11. The rst chance you have, to avoid aloss from a foolishloan is by refusing to make it. There is nosecond chance. 12. Grahams Principles ofHigh GradeBond selection 13. 1. Safety is measurednot by specic lien orother contractual rights but by the ability of the issuer to meet ALLits obligations. 14. 1. Lien unreliable form of safety1. Lien vs. AbilitySafety is measured not by specic lien or other contractual rights but by the ability of the issuer to meet allits obligations.The idea that a lien on the assets is a guarantee of protection independent of the success of the businessitself is in most cases a complete fallacy.In the typical case, the value of the pledged property is vitally dependent on the earning power of theenterprise.Example: ITCRailroads - lien on property not adaptable to other uses.Indian Banks NPAs - emphasis on security rather than ability. 15. Shrinkage of property values whena business fails.Difculty of asserting the bondholders supposed legal rights.Delays and other disadvantages incident to a receivership or bankruptcy. 16. http://fundooprofessor.wordpress.com/2012/10/19/virginity/ 17. 2. This abilityshould bemeasuredunderconditions ofdepression rather thanprosperity.Any bond can do well when conditions are favorable.e.g. FCCB issues 18. 3. Decient safetycannot be compensated for by an abnormally high coupon rate.Yield TrapReturn ON money vs. Return OF money 19. 4.The selection of allhigh grade bondsshould be subject torules of exclusion and to specicquantitative tests. 20. Whats fascinating . . . is that you couldnow have a business that might havebeen selling for $10 billion where the business itself could probably not haveborrowed even $100 million. 21. But the owners of that business, because itspublic, could borrow many billions of dollars ontheir little pieces of paper- because they had these market valuations. But as a private business, the company itself couldnt borroweven 1/20th of what the individuals could borrow.Promoters arent borrowing. They are selling.A sale in the garb of a loan. 22. Two Sources of safety: A. The character of the industry(the particular business is immune from drastic shrinkage of earnings). 23. B. The amount of protection (themargin of safety is so large that the company can undergo adrastic shrinkage of earningswithout resultant danger). 24. 4. Quantitative TestsThe selection of all seniorsecurities for investment should be subject to rules of exclusionand to specic quantitative tests. 25. The past ability of the borrower to earn in excess ofinterest requirements is counted on to protect the investoragainst loss in theevent of some future decline in netincome. 26. The bond investor doesnot expect futureearnings to be the same as in the past. If he was sure of that,the margin demanded might be small. Nor does the bond investor predicts whetherfuture earnings will be materially better or poorer than the past. 27. If he did that, he would have to measurehis margin in terms of a carefully projected prot and loss account instead of emphasizingthe margin shown in thepast record. The role ofthe margin of safety, therefore, to render itunnecessary to make accurate predictionsabout the future. 28. Factors in Bond Selection1. The nature of the6. The relation of the business value of the property to2. The size of the debtenterprise7. The relation of stock3.The terms of the issuecapitalization to debt4. The record of solvencyDebt/Equity and dividend paymentsAverage Market Value of5. The relation ofEnterprise/Debt earnings to interest requirementsInterest Cover 29. Fixed Charges CoverageFixed charges vs. InterestExample of leased vs owned outlets in retail operations. Rent is like interest.Why Fixed charges cover instead of Debt service?1. Cover demanded is high2. Assumption of going concern - ability to renance 30. Grahams Version of Debt-equity ratio Market Value of Enterprise/ Debt ratio:What is the logic of using thisratio? 31. Before payingstandard prices forbonds of anyenterprise, the investor must beconvinced that thebusiness is worth agreat deal morethan what it owes.Key term: Business worth a lot more than what it owes.In this respect the bond buyer must take the same attitude as the lender of money on a house ora diamond ring, with the important difference that it is the value of the business as an entitywhich the investor must usually consider, and not that of the separate assets.Why not use the conventional Debt/Equity ratio?What about the silly Mr. Market?? 32. The market valueof stock is generally recognized as abetter index of the fair going concern value of a businessrather than balancesheet gures. 33. The presence of astock equity with market value manytimes as large asthe total debt carries a strongassurance of thesafety of the bond. 34. Conversely, an exceedingly small stock equity atmarket prices mustcall the soundnessof the bond into serious question.Why is this very important? 35. The Graham Standard:Minimum stock equity at marketprices for industrial bonds shouldbe at least 75% of total debt.This test must be passed both currently and over the averageof last ve years. 36. Interest coverage and debt-equity ratios Do you see any similarity? What does interest-coverageratio measure?Cash ow available for interest/Interest 37. They are very similar, therefore,they should produce similar conclusions.i.e. if a company is creditworthy,it must be a lot more than what it owes. EV should be several times its debt 38. Suppose, the minimum standard for interest-coverage ratio is barely metbut the stock-value ratio is considerably higher than the minimum prescribed.Under such circumstances, the bond should be accepted as investment. Why? 39. But what if they producecontradictory conclusions? 40. If interest coverage ratio is ample but the stock-value ratio is substantially below the minimum required.Under such circumstances, the purchaser of the bonds will have toassume that the price of the stock is too low.This could happen for good or badreasons 41. Good Reason: Stock market is rightyou fool! - there are bad daysahead, the earnings are suspect, orthere may be a fraud!Credit rating agencies vs. the stock market as predictors of distress. 42. Bad reason: Stock market is wrong - the stock is a bargain - buy itinstead! - its cheaper and safer! In either case, the investor should not buy the bond as a type-Isecurity. 43. Time for some backward thinkingLets do some reverse engineering 44. Recall The Graham Standard:Minimum stock equity at marketprices for industrial bonds shouldbe at least 75% of total debt.This test must be passed both currently and over the averageof last ve years. 45. For Graham, if a company iscreditworthy, then its stockshould be worth at least 75% ofthe value of its debt.(Business is worth at least 175% of debt)Equity Value &gt; 0.75 x Debt Capacity 46. A Valuation RuleAn equity share representing theentire business cannot be less safe[and less valuable] than a bond havinga claim to only a part thereof. 47. There are instances where an equity share may be considered sound because it enjoys amargin of safety aslarge as that of agood bond. 48. This will occur, forexample, when a company has outstanding onlyequity shares that underdepression conditions are selling for less than the amount of the bonds that could safely be issued against itsproperty and earning power. 49. In such instances theinvestor can obtain the margin of safetyassociated with a bond,plus all the chances oflarger income andprincipal appreciationinherent in an equityshare. 50. Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimating the collateral value of its assets and/or cash ow. 51. We believe the process is in manyrespects closely related to creditanalysis as we are seeking collateral net worth in excess of the cost of our investment. 52. A bondholder can enjoy noright or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, theowner (stockholder) can write out his own bonds, if hepleases, and give them to himself. 53. VSTs Bonus Debentures 54. Hidden inside the stock of a credit-worthy company is a bond... 55. Recent Cases of Debt Capacity Bargains 56. Satyam Effect 57. At Rs 60 in march 2009, market cap was R 190 cr. Surpus cash = Rs 70 cr.Rs 120 cr for a business which generated average operating cash ow of Rs 56 cr. p.a. over last 4years. 58. At Rs 60 in March 2009, market cap was Rs592 cr Surplus cash = 100 cr. Rs 492 cr for a businesswhich generated Rs 120 cr. average annualoperating cash ow over last 5 years. 59. Indias largest provider of inland transport by railusing containers. 60. Midterm Exam Question 61. Exercise done in Oct 2011Total cash ow for ve years = Rs 4,896 cr.Average = Rs 979 cr.Interest expense = 979cr/3 = Rs 326cr.Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.Minimum intrinsic value of the company = 5,705+2,000 cr= Rs 7,705 crMinimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per shareDid it fall to this level? 62. At 560, stockwas a debt-capacity bargain 63. Average cash ow from operations after W/C changes: Rs 1,000 cr.Interest expense = 1000cr/3 = Rs 333cr.Debt business can easily support = Rs 333 cr./0.10 = Rs 3,333 cr.Minimum value of business = Rs 3,333*1.75=Rs 5,833 cr. 64. Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 crMinimum intrinsic value of equity = Rs 7,333cr/13cr shares = Rs 564per shareNow lets get REALLY creative 65. At 560, stock was a debt- capacity bargainTHIS is what we mean by FAVORABLE ODDS 66. Value Investing in Las VegasThe casino is a value investor because of:1. Favorable odds on each bet2. Lots of play (diversication)3. Cap on maximum bet (protection from negative black swan) 67. In American roulette there are 38 slotsnumbered 1-36, 0, and 00. Pay-out is 35:1 68. If you bet Re 1 on your lucky # 8 and if theba" lands on # 8, you win Rs 35, otherwiseyou lose Re 1. 69. You wager Rs 1,000 on a single number, say number 7.Probability of ba" landing on 7 = 1/38 = 2.63%.Probability of not landing on 7 = 37/38 = 97.37% 70. Event Payoff Probability Expected Value Ball lands on 7 36,000 2.63%947.37 Ball does not land on 70 97.37% 0 947.37Amount Bet-1,000NPV -52.63What happens when Margin of Safety is -ve and you practice wide diversication?Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to spread your risk 71. Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to spread your riskWhat happens when Margin of Safety is -ve and you practice wide diversication? 72. Event PayoffProbability Expected ValueBall will land on one of your947.37 100%947.37numbers (=26.32*36)Amount Bet -1,000.00NPV-52.63Lesson: Diversication does not work when Margin of Safety is absent. 73. Thank you</p>

Recommended

View more >