Monday, March 26, 2012

What do you price an overpriced

This story is about a company that is celebrating 100 years of business in India and whose EPS has crossed just over 100. Nestle started its India operations in 1912 by importing and trading milk products and chocolates. The net profits of the company compounded at 17.5% every year over the previous years. The stock price catapulted from Rs 285 in the year 2000 to Rs 4500 in 2012 (not withstanding the 160% average 18 dividend payments) with laser focus to deliver Strong operating cash flows. Nestle’s net profit grew at a CAGR of 21% per year from Rs 118 crore in 2000 to Rs 961 crores in FY 2011. The eps also grew from Rs 12.30 on year 2000 to Rs 100 in 2011, again a CAGR 21% (per year). This is too good to be true. It’s heartbreaking to miss being part such a company that is a true wealth generator through innovation, unparalleled distribution and invaluable brands. How many companies can we recall that have survived for 100 years? Hardly any. NestlĂ©’s recall has been painstakingly built over 100 years. This is a feat that is not easily replicable by simply making large investments. Hence one can safely expect that this growth of Nestle will far continue into the future on the back of the strength of its brands and popularity of its products.

But look beyond and we will learn some lessons. When nestle has grown at a compounding rate of 21 % over the past 12 years and if it is guaranteed to continue its growth engine for many more years into the future, investors will quite naturally overpay for the stock and make it expensive. The markets will overprice such businesses having demand and with a moat. Nestle's intrinsic value is around Rs 25,000 crore when I last calculated while it is quoting now at Rs 43,000 Crore making it highly overpriced. When such growth engines like Nestle are overpriced, how can future returns be possible? The returns on our investments are proportional to the price we pay to buy them. We can't over pay a growth story and expect to make great returns. In the recently held IPL Auctions, Ravindra Jadeja was bought by CSK for Rs 9.72 crores plus a secret tie breaker amount. Would CSK have been ready to bid 10 times more than that as tie breaker amount? Would it have made business sense? Jadeja has a finite value to the CSK’s IPL business and would be bought at a commensurate value that makes business sense. If the price paid for an investment is high, it would diminish the returns on the investment. Investors must factor this Margin of safety which tells us how cheap is the going rate over the actual valuations. A 25% margin of safety ensures we never over pay.

Like many paradox in life, we are very optimistic about a stock generally when it is overpriced and are pessimistic when they are undervalued. The capital goods, infrastructure and power stocks trade at very low p/e multiples today because the market considers future prospects of this industry very bleak. Just yesterday they were poster boys of the stock markets.

No one can make an accurate forecast of the future of the market in general or an industry or stock in particular. Future as ever shall continue to surprise the one who is absolutely sure about it. As an investment expert said “The worst the financial market’s future look, the better they will turn out to be". Keep investing in little, over time and stay invested.

1 comment:

Rahul Paliwal said...

Cheap remains so, and Excellency come with a price! Decision is ours. Market always pays extra for certainty, its like paying premium for Undisputed Land. Best way I see is to Buy on any 10% + decline from TOP. Your comments WC, Dear Naresh!