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Is BSE-SENSEX Over/undervalued As of Sep 30, 2009?: To Download Word Document
Is BSE-SENSEX Over/undervalued As of Sep 30, 2009?: To Download Word Document
com
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http://www.scribd.com/doc/20584733/SENSEX-fundamental-valuation-model
Media is inundated with the news of expected correction in the markets, having rallied too
high too quickly. Some say the rally is driven by liquidity, while others claim the optimism in
the global market.
Without doing any more storytelling (abundant in media), I will delve into how much SENSEX
is valued intrinsically. (Readers can do the similar exercise for NIFTY or any other index)
Intrinsic value of any asset is the present value of future cash flows, generated by the asset.
Therefore, SENSEX, backed by 30 stocks, should also have an intrinsic value derived from
the future cash flows of its 30 constituent securities. If one can identify these future cash
flows and calculate the present value, one can conclude the degree of SENSEX
over/undervaluation based on fundamentals.
There is enough literature on the web that does a good job of explaining. In summary,
SENSEX is calculated using a free-floating market cap of its 30 stock constituents. Free-
floating market cap is the product of stock price and the number of shares that can trade in
the market (shares held by promoters or other strategic investors are not included in
calculating the free floating market cap). One can download the free floating multiplier from
BSE web site, to calculate free-floating market cap. I have used the excel file downloaded
from BSE website to do the same.
Lastly, the free floating market cap is multiplied by a divisor that references it to the base
year. But for our purpose of discussion, we will limit ourselves to the estimation of free-
floating market cap, driving the value of SENSEX.
To refresh our memories, I will run you through an example of calculating intrinsic value of a
candle making company (started in 2009 with an investment of Rs. 370). The company plans
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to generate Net income of Rs. 100 next year (2010) and growing hence @15% for next 4
years. At the end of 4 years, we assume that the growth rate reduces to 4% forever.
2010 : 100
2011: 100*(1+.15)=115
2012: 100*(1+.15)^2=132.25
2013: 100*(1+.15)^3=152.08
2014: 100*(1+.15)^4=174.9
After year 5(2014), Net income grows at 4% forever. Therefore, 2015 Net income will be
174.90*(1+.04) =181.89
Growth (%) 15 15 15 15 4 4
(Net income will continue to grow@4% forever after 2015. In the interest of space, I omitted
more years in the table)
Now that we have identified future Net income, let us bring in the concept of Return on
capital. A candle company must invest in the business to drive growth. As mentioned above,
the company started with an investment of Rs 370 in 2009 and is expected to generate Net
income of Rs. 100 in 2010, resulting in return on capital of 100/370=27.00%. The return on
capital (increase/decrease) may change in future years, driven by several factors such as
competition and efficiency. But in our example, we will assume that the company manages
to maintain same ROE forever. In 2011, company’s net income grows by 15% to 115,
requiring reinvestment driven by the formula G=ROC*B
In our example, G=.15 and ROC=.27 resulting in B of 55.55%. The owner should reinvest
55.55% of Net income every year in its business to generate 15% growth rate. So in year
2010, owner should re-invest 55.55% of 100 =Rs. 55.55 in business leaving a cash flow of
Rs. 44.44 to owner. As mentioned above, after year 5 (2014), the growth rate decreases to
4%, resulting in B of .04/.27=14.81%. After 2014, owner should reinvest only 14.81% of Net
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income in the business to generate 4% growth. Now we can identify the cash flow available
to owner after all the reinvestments.
(Available cash row is the cash flow available to the owner that he/she can withdraw from
business. This cash flow is also called at times free cash flow)
Putting back the discount rate into the table, the table looks like:
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Discount rate=12%=.12
We need to discount terminal value to calculate its PV today (2009), so we will multiply by
0.56 resulting in 1099.211. This is the present value of annuity, starting in 2015.
Therefore, the intrinsic value of candle business is the sum of terminal value( 1099.21) and
the present value of first 5 years cash values.
Intrinsic value=39.73+40.79+41.88+43.01+44.16+1099.21=1308.81
Assuming owner has no debt and there are 100 shares in the company, the price of 1
share=1308.81/100=Rs.13.08
Because SENSEX is composed of 30 stocks, we will need to identify future cash flows
resulting from these 30 stocks, adjusted for free floating factor. (SENSEX is calculated using
free-floating method).
There are 2 ways one can identify the next 10 years growth rate:
1. Using predictions for Indian economy growth rate – Mckinsey in its recent research
report estimated Indian economy to grow at a CAGR of 10-12% in the next 10 years.
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Because SENSEX represents the Indian market, Indian growth rate can be a good
substitute for SENSEX growth rate.
2. Using analyst EPS growth rate estimates of SENSEX companies - Analysts estimate
the long term growth of public listed companies. Using the mean value of such
estimates, one can derive the SENSEX long term/10 year growth rate. Because
SENSEX uses free floating multiplier, index growth rate is the free-floating earnings
weighted average of growth rate of 30 index components. For example, let us
assume that SENSEX is composed of only 2 stocks: A and B. Analyst estimate for
forward EPS for A and B is 10 and 12 respectively. Also, analysts’ long term growth
rate estimates for A and B are 10% and 12% respectively. Additionally, we are given
the outstanding shares of A and B to be 100 and 200, and the free-floating multiplier
to be .5 and .4, resulting in a free-floating number of shares of 50 and 80. The growth
rate of SENSEX will be (10*50*0.1+12*80*0.12) /(10*50+12*80)=11.3%.
If one does the similar exercise for 30 SENSEX stocks using estimated forward EPS for
next year and their long term growth rates, SENSEX long term growth rate comes out
to 13.722%.
This is determined by the risk free rate or GDP growth rate in the terminal period. Indian 10
year yield on Sep 30, 2009 is 7% and the country holds a BBB- Moody’s credit rating,
resulting in country risk premium of ~3.5%. This results in Indian risk free rate of 7-
3.5=3.5%, or the terminal growth rate of 3.5%.
We calculate ROE of SENSEX for last 5 years and use the maximum ROE in the last 5 years
as an estimate of ROE for the next 10 years. The max ROE for SENSEX is 23.06% in 2007.
ROE for SENSEX is calculated using the Book Value weighted average of ROE of index
components.
2 We will use this number as an estimate for SENSEX long term growth rate in calculating
SENSEX intrinsic value
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Cost of Equity
This is determined by the Indian risk free rate, Indian country risk premium and the equity
market risk premium. India holds a BBB- Moody’s rating corresponding to 3.5% country risk
premium. The Indian 10 year yield at the time is 7% and the average historical market risk
premium is 5%. Because SENSEX beta is 1, the cost of equity=7+5=12%.
It is estimated that India’s Moody’s rating will improve 10 years from now, attributed to
improved country’s economy. In terminal period, India’s risk premium will reduce by 200bp
resulting in cost of equity of 10%.
Retention ratio
Earnings are not the free cash flow because growth is driven by reinvestment. Using
G=ROE*B, we can calculate the retention ratio for high growth phase and terminal growth
period. Using growth rate of 13.72% and ROE of 23.06% in high growth phase, SENSEX
needs to retain 60% of its earnings resulting in a payout ratio of 40%. In terminal growth
phase, payout ratio is 65%.
With future EPS, growth rates and pay-out ratio of SENSEX, we can calculate the Free-cash
flow to equity generated by SENSEX. Calculating the present value of these cash flows will
give us the intrinsic value of SENSEX, indicating SENSEX is overvalued by 26.31%
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Earnings
714.4 812.5 924.0 1050.8 1195.0 1358.9 1545.4 1757.5 2068.6
628.26 1998.73
( Rs. 8 2 2 1 1 5 8 5 9
billion)
ROE (%) 23.06 23.06 23.06 23.06 23.06 23.06 23.06 23.06 23.06 23.06 10.00
Retentio 3
(53.00) 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 35.00
n (%)
FCFE
289.3 329.0 374.2 1344.6
960.19 425.56 483.95 550.36 625.89 711.77 809.45
(Rs. 5 5 1 5
Billion)
TV (Rs. 20686.
Billion) 86
Discount
0.89 0.80 0.71 0.64 0.57 0.51 0.45 0.40 0.36 0.32
factor
PV
230.6 234.2 237.8
857.31 241.47 245.19 248.96 252.79 256.67 260.62
(Rs. 7 1 2
Billion)
6660.61
Est. free
float
mkt cap 9726.32
(Rs.
Billion)
Actual
free
float 12285.5
mkt cap 1
(Rs.
Billion)
Overval
26.31%
ued
Assumptions:
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