Few weeks back we wrote about how to value any business and what different models are available to value them (click here to read). Of course, there was no perfect answer to which model to use to value any business, but we concluded that post by showing the importance of right variables to punch in any equation to derive rational value or its spectrum. In continuation to that post, we will talk about earnings growth in this article and what price are investors paying for the growth.

In this post we will be talking about another variable that comes up while calculating any business intrinsic value, “earnings growth rate”. How can we calculate the growth rate of earnings? If you open any standard text book on valuations, the typical equation used to calculate future earnings growth rate is the following.

Growth rate % = Return on Equity X (1 – Dividend payout ratio)

Again, there is no perfect answer, but there are several observations we can make that should assist in making rational estimate.

Last year (2015), 106 companies that we follow, the average dividend payout ratio was 31%. This year that number had marginally fell down to 30%, but same time we had seen many businesses had bought their own company shares, for example Wipro, which is similar to dividend (paying back to shareholders by different means). We will not go more in detail on ‘buyback’ topic and leave it for another day to discuss about it.

Many businesses have also given special dividend in 2016 financial year compare to last year. Overall we came to conclusion that dividend payout ratio for 2016 was little higher to 2015.

You will always find the relationship between earnings growth and price of the asset. What I mean over here is, that if the earnings growth rate of company is high then investors will be willing to pay more for that company and vice versa. To see if this relationship exist, what we did is picked up few IT businesses that we follow and punched in our variables in the above formula and see if that relation exist.

 

Earnings growth Rate %

P/E ratio (2016 earnings)

Valuations

hcl

22.10%

14.50

Cheap

hexaware

7.14%

16.43

Expensive

infy

19%

19.80

Expensive

mindtree

15.12%

17.75

Expensive

tcs

27.3%

20.90

Expensive

tech mahindra

15.12%

16.30

Fair value

eclerx

39.6%

17.06

Expensive

Once we get the earnings growth rate as per text book formula it doesn’t mean the companies will grow its earnings by that percentile. For example, Eclerx is expected to grow its earnings by almost 40% as per formula, if that is true then its valuations should come up as ‘cheap’ rather than ‘expensive’. This is why we say valuing any business is art rather than science where you punch in the variables and get the answer.

The valuations is actually more of spectrum. Across the spectrum valuation change from low case to high case depending on high/low growth rate as a function of real world.

To use that formula in a right way (rationally), we find what ‘today’s market price’ of the security in the market is pointing to its earnings growth and where in the spectrum that growth stands. That is, we ask ourselves what growth rate in earnings are incorporated into the market price. Ideally, we aim to buy companies when their prices are at the lower end of the valuation spectrum but with high likelihood that events justify prices towards higher end.

TCS is the right example from the above list where we found its valuation spectrum in range of Rs 2200 – 2700 on its expected earnings growth rate and we bought it when it was trading at lower end of spectrum and there is high likelihood when it comes out with more facts and figure, its price to jump at higher end of spectrum.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise you to take professional advice before going ahead with our views.