DHFL Case Study : All why's are answered!

“Price is what you pay. Value is what you get.” In other words, don’t focus on short-term swings in price, focus on the underlying value of your investment. “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.” 

Buffett says, “Never invest in a business you cannot understand.” The advice here is obvious but often forgotten, particularly after investors have had some success. The temptation to believe that success in one area you know well allows you to easily analyse another is much greater once you’ve had some good returns, but should be resisted with vigor.

I repeat what I wrote in my previous case of Dhunseri Investments, the stock that I bought at ?125. In my classes, students ask me one simple question. Sir, "who makes more money, a trader or an investor?" People often get fascinated by those small 10%-20% they make in a month or so time horizon but miss the opportunity of growing their money multiple times. I just love this beautiful saying “When we Rest, Returns are active – When we are Active, Returns will Rest”. 

One difference between people who make money and who don’t is of one-word Patience. They don’t know the difference between which stocks they have to keep for long term and which they are opting for short term trading. One trend I have seen generally is they buy stocks for trading and if they are stuck, then they become long term investor. Thus, no preliminary research is done before buying those stocks, which is a wrong approach. One should take stop loss in those cases as that was clearly a short term horizon trade. Smart people do not book profits in a stock when it turns ? 300 which they bought at ? 200, probably yes they will book some profits but not at ? 300 levels, but maybe at ? 2000 or ? 20000 level or may be not. Money is made over their and not if one would have booked it at ? 300. If we look at any smart investor everyone follows this approach. I always mention about Sir Warren Buffet; do you even think he will be selling his stake of Coca Cola or Colgate which he has acquired 20-30 years ago? No, he knows that he has stake in Quality business and when that business is making money, he just needs to have patience to make money with them. Similarly, during Financial Turmoil’s one should pick a good quality business and stick with it patiently to earn. Or imagine I being the owner at Profit Idea - do you think I would sell stake in Profit Idea just because business has increased 10-20-30% after an year or in short term. One must understand, when you buy quality; stick with that quality asset that you bought or you own. I remember picking up stocks like Dhunseri Investments (?125), Tata Investment Corp. (?450), Can Fin Homes (?140), Indag Rubber (?19 - post split), Kovai Medical (?162), Vardhman Holding Limited (?800), Oriental Carbon (?95), Manali Petroleum (?8), PEL (?797), Apcotex (?130), NESCO (?112 - post split), HUL (?347), Asian Paints (?307), Atul Auto (?17 - post split and bonus), etc. I stayed invested to the stock and yes it gave me a decent return or whopping returns.

One of such stock is what I am going to discuss today. A company named DEWAN HOUSING FINANCE LIMITED (DHFL). Like our previous cases, in our study we are going to be analysing on certain defined parameters, so that can help you to understand it on a ground level and also provide you with insights to find any Multi-bagger in future. 

It’s been said that “Debt is like a double-edged sword”, it is great when things are good and horrible when thing turn bad and not anyone wants to be on the wrong side when things go bad. It can act as an obstacle around your neck, leaving long lasting consequences.

Companies with debt are not considered good but a company with good fundamentals despite having a debt can be a multi-bagger. DHFL is one of such company that we are going to analyse. So, I am going to discuss what made me pick this stock at ?230 when it was completely unexplored and what is making me so optimistic about this stock.

“Choose Your Heroes Wisely”   

1) Understanding Debt to Profit

Being debt ridden, there is no harm and if a company can earn the minimum of 10% on its debt, so it could be a good sign. Example: Let’s put Mr X as a company. Mr X borrowed ?100 at 10% interest, that means next year company has to pay ?110 and if company is earning ?120; so that means company will pay ?110 and keep ?10 as a profit in this case, debt is good whereas if Mr. X is earning ?90 in total and needs to pay ?110 so it’s not a good sign and debt is bad.

Let see what is happening is case of DHFL :

Company is earning 111.44% on it's debt. Astonishing! Isn't it :)

What is more interesting is the fact that company is able to replicate this for last 10 years on consistent basis. In life or business, consistency matters.

“I’ve learned from experience that if you work harder at it, and apply more energy and time to it, and more consistency, you get a better result. It comes from the work.”

-Louis C. K.

“The secret of success is consistency of purpose.”

-Benjamin Disraeli

2) Understanding certain important Ratios

Understanding a company’s fundamentals is a very important criteria based on the industry in which it operates, its competitive position, strategy and execution—a number of financial measures derived from the company’s principal financial statements are analysed.

Analysts calculate a number of ratios to assess the financial health of a company, identify trends and compare companies across an industry to get a gist of relative creditworthiness.

Now, we will categorize the key credit analysis measures into three different groups and discuss them in detail:

• Coverage
• Leverage
• Profitability and cash flow

Leverage ratios

There are a some of the measures of leverage used by analysts. Most common are the debt/capital, debt/EBITDA or cash flows/debt ratios. Many analysts adjust a company’s reported debt levels for debt-like liabilities, such as underfunded pensions, retiree benefits, as well as operating leases. When adjusting for leases, analysts will typically add back the interest to various cash flow measures.

a) Debt/capital. Capital is calculated as total debt plus shareholders equity. This ratio shows the percent of a company’s capital base that is financed with debt. Lower percentage of debt indicates lower credit risk. This ratio is generally used for investment-grade corporate issuers. Goodwill or other intangible assets are significant (and subject to obsolescence or impairment), it is often informative to also compute the debt to capital ratio after assuming a write-down of the after-tax value of such assets.

Debt/Capital  =   81,264.50/ 89260.3 =  91.04%

b) Debt/EBITDA. This is a common leverage measure. Analysts use it to look at trends over time and at projections and to compare companies in a given industry. A higher ratio indicates more leverage and thus higher credit risk. This ratio can be very volatile for companies with high cash flow variability, such as those in cyclical industries and with high operating leverage (fixed costs).

Debt/EBITDA =   81264.5/ 10066.56 = 8.07x

Coverage Ratios

Coverage ratios measure an issuer’s ability to meet or to cover it’s interest payments. Generally there are EBITDA/interest expense and EBIT/interest expense ratios.

a) EBITDA/interest expense - This measurement of interest coverage is a bit more liberal than the one that uses EBIT because it does not subtract out the impact of non-cash that is depreciation and amortisation expense. A higher ratio indicates higher credit quality.

EBITDA/Interest = 10,438.29/6,653.61 = 1.57x

b) EBIT/interest expense - As EBIT does not include depreciation and amortisation, it is considered a more conservative measure of interest coverage. This ratio is now used less frequently than EBITDA/interest expense.

EBIT/Interest = 10414.99/6653.61 = 1.565x

Profitability Ratios

a) Net profit ratio = (Net profit after tax / Net sales) × 100

The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognised.

• NPR = (2896.45/10821.19) x 100 = 26.77%

b) Operating Profit Margin = (Operating Profit/Sales) x 100

Operating margin is a measure of profitability. It indicates how much of each rupee of revenues is left over after both costs of goods sold and operating expenses are considered.

• OPM = (10043.26/10821.19) x 100 = 92.81%

Having calculated some of the key ratios, we can see DHFL has considerable debt but this debt is supported with good margins that company is able to maintain. Moreover, it is into NBFC space & all companies in this space will have considerable amount of debt. What is more interesting is the fact that these numbers are best in the industry. One of the leaders in this industry is HDFC. If we look at all these numbers of HDFC & compare; DHFL is much ahead in margins and has better ratios.

3) Understanding Low PE supported by high earnings

One of the key parameters to understand the numbers is to check the PE of the company. The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple. 

The P/E ratio can be calculated as:

Market Value per Share / Earnings per Share

To help you understand my point, let me help you with relative valuation on the stock :

If you see the image above, it reveals some interesting facts.

1. DHFL has the lowest PE among it's peers.
2. It is still priced lowest as per price to BV after HUDCO. When I bought it at 230, it was cheapest among it's peers.
3. Price to graham value for the stock is still cheapest in the industry. Making it attractive even at current levels.
4. Stocks price to intrinsic value is also lowest in the industry. Making it attractive even now. When I bought it last year, it was too cheap to get in.
5. Looks at Quarterly sales growth figures. It is increasing sales at 23% & that is second highest, but interestingly this is done at lowest PE.

Now let me show you something even better :

Current TTM Earning(Net Profit) for the company is ?2955.54 Cr. Which translates into EPS of = Net Profit/No. of O/S Shares = 2955.54/31.36 = 94.25

It's Current Price today, at the time of writing of this case is ?534/-

Hence, PE = Price/EPS = 534/94.25 = 5.67x

Therefore, even at this price stock looks really cheap in comparison to it's earnings and peers.

4) Understanding Graham Number

Benjamin Graham was a British-born American investor, economist, and professor. He is widely known as the "father of value investing," and wrote two of the founding texts in neoclassical investing: Security Analysis (1934) with David Dodd, and The Intelligent Investor (1949).

What is the 'Graham Number'

The Graham number is a figure that measures a stock's fundamental value by taking into account the company's earnings per share and book value per share. The Graham number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham number is considered undervalued, and thus worth investing in. The formula is as follows:

It is used as a general test when trying to identify stocks that are currently selling for a good price. The 22.5 is included in the number to account for Graham's belief that the price to earnings ratio should not be over 15 and the price to book ratio should not be over 1.5 (15 x 1.5 = 22.5).

Graham Value = (22.5*23.36*263.32)^(1/2) = ? 747.30/-

Interesting, the company was available at ?230 per share on 23rd Nov, 2016. So it was trading .3079X of GV. Which was at 69.21% discount to Graham Value. I love shopping during discounts. And why not :)

Even now at 534, stock is .7149x of GV. Still 28.51% discount is available.

5) Understanding Time Machine Valuation

To apply this valuation technique, we must check the PBT(Profit before tax numbers) from income statement.

PBT for FY16-17 is ?3371.82 Cr. Also if you note, company is growing on an average of 35% for sales growth & Profit growth. For keeping the valuation parameter simple & conservative, let me assume only 15% growth rate YOY. Ah, you will say why to do so? But lets be conservative and see what we get. I am assuming discounting factor for my model to be 12% by keeping in mind the inflation & interest factor on debt. And assuming only 2% growth rate after 2022. Right now, we are in 2017. Let's see what should be the price of DHFL.

If I simply increase the earning by 15% yearly i.e., 3371.82*1.15 = 3877.59 and so on & discount the earning for today, DHFL is grossly underpriced. Stock must be valued at ?1812 & I see that in long term this must be achieved. Moreover, keeping in mind the long term objective of the stock for 5 year - I would not be surprised if I happen to see this stock at ?3000/-

Note : Assumption with models can go 100% wrong, but that's what analysing stock market is all about. No one can guarantee 100% success.

"An investment in knowledge pays the best interest." - Benjamin Franklin

6) Understanding Sales vs Capital Employed

Sales is found at the top line of any business. This is the most important number from which all calculations originate. Sales or Revenue is simply the total amount of cash generated by the sale of products or services associated with the company's main operations.   

Capital employed, also known as funds employed, is the total amount of capital used for the acquisition of profits. It is the value of all the assets employed in a business and can be calculated by adding fixed assets to working capital or subtracting current liabilities from total assets.

Sales for DHFL is ?10821.19 Cr. whereas capital employed is only ?7,611.36 Cr. Hence, Sales > Capital Employed.

For any company, whether it is having debt or debt free but if sales are increasing then it is really a good sign plus if a company is having sales which are greater than Total Capital Employed then it is a wonderful indication.

"Know what you own, and know why you own it." - Peter Lynch

7) Understanding Return on Equity

A type of profitability ratio calculated as net income available to ordinary shareholders (i.e., after preferred dividends have been deducted) divided by the average total book value of equity. It is the primary measure that equity investors use to ascertain whether the management of a company is effectively and efficiently using the capital they have provided to generate profits. It measures the total amount of net income available to common shareholders generated by the total equity capital invested in the company

ROE can be calculated as follows:

                 Net income/Average Stockholder’s Equity

OR

The DuPont allows us to decompose ROE into components such as Net Profit Margin, Asset Turnover and Financial Leverage.

ROE = (Net profit margin: Net earnings/Net sales) × (Asset turnover: Net sales/Average total assets) × ( Financial leverage : Average total assets/Average common equity)

I personally prefer stocks with Return on equity of greater than 12.

DHFL 2017 Net income ?2,896.45, Total stockholders’ equity ?7995.8

ROE = Net Income/Total stockholders’ equity = 2896.45/7995.8 = 36.22%

8) Understanding CROCI or CROIC (Cash Return on Invested Capital)

Cash return on invested capital should be greater than 100 in companies having Debt. This helps us to see how well management utilises the cash that isn’t part of the business. It is considered to be a great way to measure the skills of the managers. I find this to be the ultimate performance metric as it shows so clearly how effective management is and the strength of the business.

DHFL management utilises the cash in effective manner & has been able to generate good return on invested capital.

9) Understanding Consistency in Earnings & CAGR

Look at the consistency of DHFL with operating margins & net profit margins.

Also, if we see the CAGR(Sales) from 2006 to 2017; it comes out to be 42.17, CAGR(Operating Profits) 43.07% and CAGR(Net Profits) 47.03%. Good companies often have one thing in common, they replicate their bottomline CAGR better than their top-line CAGR. DHFL is able to do that over 11 years period. It shows the consistency of the company over a period of time. It's operational efficiency is amazing.

"The stock market is filled with individuals who know the price of everything, but the value of nothing." Phillip Fisher

10) Understanding Buffett Retention Test

An important parameter while judging any company for an investment purpose. If for any company its retention ratio is increasing we find it really good sign. Here, in this scenario we have to see PBT on Net Worth and if it is growing continuously, so it is a positive sign and shareholder’s wealth is increasing. 

So, What is Net Worth??

It is the sum of Share Capital and Reserves & Surplus. And how do we calculate Return on Net Worth?? 

Return on Net Worth = PBT/Net Worth. On the excel file with the help of previous data we can able to come up with the figures. As far as share prices are concerned we can get it from any chart website or NSE and market capitalisation (market cap) can be calculated as current market price*number of outstanding shares.

The Number of Outstanding shares can be calculated as Share capital divided by the Face Value of a share. 

Afterwards, we will calculate change in market cap which is going to be calculated as a difference of Current Year market cap and Market cap of that particular year. Following which we are going to see a ratio named Retention Ratio. This is the ratio on which Sir Warren Buffet picks up the stocks. So, for retention ratio of that year we are going to have Changed in market cap in the numerator and in denominator we are going to sum PBT from that specific year to this year.

For analysis purpose one can analyse on 10 years, 5 years, 3 years data.

After summing this on excel, here is what we get. DHFL successfully passed the retention test of Sir Warren Buffett. If retention ratio is greater than 1, that means company is able to justify it's earnings & stock is worth holding.

“It’s Easier to Look Back Than to Look Into the Future” -Warren Buffet

11) Understanding Sales Growth & Profit Growth

DHFL is one such company which is way ahead in this parameters. Only few Indian Companies such as Eicher Motors, Tasty Bites, Bharat Rasayan, Bajaj Finance, Can Fin Homes, Stovec Industries, etc are able to replicate this performance. All these companies have one thing in common i.e., their sales growth & profit growth is compounding each year by 20% or more.

Now interesting, what happens with this is something that most people could not have imagined. Shares prices of such companies compounds even faster than what the people could have expected. Resulting into potential multi-bagger in future. Here are some key numbers for DHFL :

Sales Growth number above speaks for themselves. They depict a true story, that why DHFL is able to enjoy re-rating after re-rating over time.

Here is a look at Profit Growth Numbers

The key is company is able to bring Sales Growth to Profit Growth. Most companies can have sales growth by increasing capital but they are not operationally efficient and are not able to convert sales growth to profit growth. But in case of DHFL, it is able to do that task wonderfully over a time span of last 10 years. Again, something that I focussed while writing this case since starting i.e., "CONSISTENCY". It is the key for identifying potential multi-baggers.

At the end I would like to conclude by saying that:

“Invest Only in Companies You Know and Trust”

DHFL is showing its great performance over last couple of months. On all the parameters we discussed DHFL, is looking like a gem and one can buy this stock and keep in the portfolio, which I did at ?230. I have topped up more on the recent fall at ?525/-. Recent fall has given good opportunity to buy this quality stock.

“Buy It Thinking You Will Hold It Forever”

And we all know that Patience is the key to making money. Main focus with such rigorous study was not to buy a stock and then sell it immediately but to see this stock rising & give huge return.

Note : I might be 100% wrong, this post is more for educational purpose and understanding stock valuations applying security analysis.

Thank you so much for your precious time in reading the case. Do post your feedback. Honest feedback would be really great.

Special Thanks to Ritwik Singh Gahlot, my student at Profit Idea for helping me compiling my class notes for everyone to understand security analysis. Proud of you Ritwik.