Finding undervalued stocks –
Few months back I had a look at Deccan Cements – Andhra based cement company. When I noticed this company, it was trading at around INR 560/share, and it has a share capital of 7 crore and face value is 10 rupees.
Total number of outstanding shares = share capital/face value = 7/10 = 0.7 crore
Market cap = 560*0.7 = 392 crore
The company had a debt of around 150 crores when I looked at it.
So if we combine market cap and debt, we get “Enterprise Value”, which measures the total value of the company for all stakeholders (shareholders and banks).
EV = 392 + 150 = 542 crore
The company had a manufacturing capacity of 2.4 MT/year.
EV/capacity = 542/2.4 = 226 crore/MT
If we look at the deals that happened during last year, we will find that most of the cement plants were valued at an Enterprise Value of more than 800 crore/MT. So by that logic Deccan was available at much cheaper valuation.
Now let’s look at its financials –
The company wasn’t planning any capex and the whole operating cash flow was being used in reducing its debt. As you can see, debt came down from 333 crore in 2010 to just 80 crore in 2016.
The company was making decent “cash flow from operating activities” till 2015
I did not know about 2016 numbers at that time(roughly 3 quarters ago). So the company was making an average free cash flow (FCF) of 60 crore which was being used to retire debt + some dividend.
EV/FCF = 542/60 = 9
The company was being valued at an EV/FCF of about 9 which is a reasonable value.
Free cash flow is the actual cash generated by the company after deducting reinvestment, FCF is much more reliable than EPS that is typically used while calculating P/E
Another pertinent point to note is that there is a cement overcapacity in the southern region, so most of the cement plants were operating at 60–65% capacity.
There were some chances of extra demand from the new capital of AP(Amravati) and the cement price had risen recently by INR 50–60/bag. So I expected a conservative cash flow of about 80 crore for FY-16.
Considering the cheap valuation(EV/capacity, EV/FCF and EV/EBITDA), rising cement price and an element of greater capacity utilization, I bought this share as it is certainly one of the undervalued stocks.
Just 2–3 months after I bought it, the share declined to near 500 levels due to negative sentiments. It did not move for 3–4 months.
Sold 60% shares in July at a price of INR 1100/share.
The company reduced its debt to 80 crore(from 150 when I saw it), improved its EBITDA margins and generated an operating cash flow of 140 crore(much greater than my expectations).
So what do you think of this method of finding undervalued stocks? It is the most easiest one and it does work!