Analysing the assumptions

One approach to analysing stocks, bonds or even real estate is to look at the valuations and figure out the assumptions built into the price. It helps to analyse these assumptions and check if you buy into them. It also helps if one has a good sense of history and asset values in the past.

Let me take the example of the top tier IT companies like infosys, Wipro etc. These companies sell at a PE of 30+. So in effect the market seems to be ‘assuming’ the following
a) return on capital of 40%+ for the next 10 years
b) A compounded growth of 18%+ for the next 10 years
c) Maintenance of margins in the 20%+ range

Now it may be possible that these companies would achieve some of these expectations. But to justify their valuations they have to achieve all of them. Ofcourse the top tier IT companies are atleast doing fairly well and may even deserve a high valuation. One can find a number of mid-cap and small cap companies which are riskier, but valued at even higher valuations. The current earnings growth is being projected for quite a few of these companies well into the future. The same is being done for commodity companies like cement, steel too.

Lets take another example outside the stock market. Lets look at the current investment favourite ‘real estate’. Now if you believe like me that the value of any asset is the sum of all cash flows to eternity, an apartment selling at 60 lacs for an area of 2000 sqft would have the following assumption (3000 rs / sqft is not a very high rate these days)

a) 6% rental yields on the capital invesment of 60 lacs.
b) Growth in the yield (read rentals) at around 8-9% per annum
c) Terminal sale of the property after 30 years with a 9% appreciation per annum, with a discount of 10% for the older property.

What all of the above means is that
a) rental of Rs 30000 per month
b) A hike in the rental of around 8-9% per annum
c) The property will sell for 7.2 crs after 30 years (net present value is 95 lacs with an inflation of 7% per annum)

So for an apartment to justify a return of 8-9% total return at the current prices, the above should hold true. Whether it does or not, depends on ones view of the above ‘expectations’ in terms of rentals

Analysing the assumptions

One approach to analysing stocks, bonds or even real estate is to look at the valuations and figure out the assumptions built into the price. It helps to analyse these assumptions and check if you buy into them. It also helps if one has a good sense of history and asset values in the past.

Let me take the example of the top tier IT companies like infosys, Wipro etc. These companies sell at a PE of 30+. So in effect the market seems to be ‘assuming’ the following
a) return on capital of 40%+ for the next 10 years
b) A compounded growth of 18%+ for the next 10 years
c) Maintenance of margins in the 20%+ range

Now it may be possible that these companies would achieve some of these expectations. But to justify their valuations they have to achieve all of them. Ofcourse the top tier IT companies are atleast doing fairly well and may even deserve a high valuation. One can find a number of mid-cap and small cap companies which are riskier, but valued at even higher valuations. The current earnings growth is being projected for quite a few of these companies well into the future. The same is being done for commodity companies like cement, steel too.

Lets take another example outside the stock market. Lets look at the current investment favourite ‘real estate’. Now if you believe like me that the value of any asset is the sum of all cash flows to eternity, an apartment selling at 60 lacs for an area of 2000 sqft would have the following assumption (3000 rs / sqft is not a very high rate these days)

a) 6% rental yields on the capital invesment of 60 lacs.
b) Growth in the yield (read rentals) at around 8-9% per annum
c) Terminal sale of the property after 30 years with a 9% appreciation per annum, with a discount of 10% for the older property.

What all of the above means is that
a) rental of Rs 30000 per month
b) A hike in the rental of around 8-9% per annum
c) The property will sell for 7.2 crs after 30 years (net present value is 95 lacs with an inflation of 7% per annum)

So for an apartment to justify a return of 8-9% total return at the current prices, the above should hold true. Whether it does or not, depends on ones view of the above ‘expectations’ in terms of rentals