Know drivers of value creation to value a business
If you are a long-term investor, it is far more important for you to understwhat drives a company’s value creation than its managerial competence, stock price returns performance. In the long run, creating sustainable value is not just a function of only exceptional managerial skills. Competitive forces drive returns towards the cost of capital or expected returns. Two key determinants of evaluating the potential of a business for sustainable value creation are the industry it operates in the opportunity size it holds.
To analyse how or whether a company can create value sustainably, the industry is the correct place to start with. Each every investor should be able to easily estimate an industry’s annual growth quantify the industry size at least 10 years from now.
For instance, let us consider the asset management company (AMC) business. India’s AMC industry has assets under management (AUM) of ₹35.15 trillion as of 2021. Say, that of the population of 139.58 crore in the country, the segment that can invest ranges from 20 to 50 years, that is, about 50% of the population. This means per capita AUM is about ₹50,000, i.e., India’s total AUM divided by its investible population.
Now, if we expect the industry to grow at a 15% annual rate over the next 10 years till 2030, the projected per capita AUM in that year is about ₹2 lakh.
Then, we proceed to understthe following: Will India’s population growth slow down substantially over the next decade? Will financial literacy increase the age of the investible population? With answers to these questions, one can easily project the industry’s opportunity size as well in 2030.
Once we have the industry’s estimated opportunity size, it is time to further study the industry’s growth drivers. With extremely poor financial literacy, the penetration of various financial products in India is much lower compared with the world average other developed nations. According to some articles, while the AUM in the US is more than the country’s GDP at 103%, it is only 15% in India.
Moving on to the company, let us not forget that sustainable value creation is also largely a result of company-specific factors usually driven by the moat of a business or a competitive advantage such as their internal strategies for self-improvement. Irrespective of whether a company is the industry leader or not, this is important to determine a company’s growth potential within the respective industry in the years to come. Then ask yourself whether the market share of the company will increase, by how much? With reference to moat other opportunities in the industry, you can arrive at 2030 revenues, i.e. (industry’s size multiplied by the picked company’s market share).
Again, taking reference to the industry’s earnings before interest tax margins (evaluated through operating, financing combined leverage), we can easily calculate the company’s operating profit deduct from it the projected capital expenditure required to sustain this growth or to increase market share in the industry. Finally, this brings us to free cash flow the business would earn in 2030, which when discounted back at the cost of capital (required rate of return of the business or long term average RoE), gives us the value of the business as of 2021.
Koushik Mohan is fund manager, Moat PMS.
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