In the previous post, I had tried to value the sugar business of Triveni Engg using the technique of relative valuation. This post is trying to dig deeper into the pros and cons of that valuation technique.
The argument was- Since other companies are trading at a much higher ratio (of EV/crushing capacity), Triveni's sugar division is a bargain. But there is a serious flaw to that thinking.
Lets understand the situation by humanizing it. Imagine you have a known, Ms. Triveni. She approaches you for 100k for a 50% stake in her new business venture. What will you ask her before deciding whether to invest or not? Business details, growth potential, expected profit every year, ROI and bla bla bla. Imagine her replying this- "Hey don't worry! You know Renuka! She had a similar business and she has sold it for 400k (twice that of this plan). And Balrampur. He idea was same to same and he raised 150k for 50% stake. So, you are getting much cheaper."
Your reply would be- "!!!!!!!". Why? Because you don't care about Renuka and Balrampur and their partners. You want return of and on your investment. If Triveni's business can't generate at least 15% returns, then you wouldn't give her your money. Simple. Right?
But what's wrong with Triveni's thought process. Well, clearly, she is suffering from ENVY- the deadliest of the seven deadly sins. Without caring for absolute return, she is just thinking about relative returns- which is obviously wrong.
Coming back to Triveni Engg.'s sugar business, to deserve 2000crs of EV, it needs average Profit of atleast 200 crs (if not more) and not relative cheapness to its peers. So the question is- Will it be able to earn 200 crs every year? Well who knows... Depends on sugar cycle and supply and demand. However, historically, it has earned more than 200 crs in just 1 year out of past 8 years and average is about 50 crs per annum. So, I guess, timing of the sugar cycle is the key here.
Another use of this relativity approach is in the calculation of Relative performance. Mutual funds compare their relative performance against a benchmark and then judge themselves on this relative performance. So, even if a MF loses 10% of your money, it considers itself good if Sensex loses 20% in the same time which clearly is illogical and silly.
On the other hand, value investors argue that if I can earn a good return every year- good enough to make me rich over time- why should I care what return has Sensex or Gold or Dollar has given in that time. If I can double every penny that I have five times in my entire lifetime, I will be rich. Why should I worry about Sensex's return in this time?
Relative performance is another form of ENVY, which you should avoid.
With this, lets come to the Investor's Theory of Relativity- Relativity (Relative Valuation, Relative Performance) is noting but ENVY- the deadliest of the seven deadly sins. Comparing yourself with others and then feeling good or bad about it based on the outcome is ENVY and its the deadliest sin. Save yourself from this SIN. [Time can be relative, Mr. Einstein, but not performance or valuation.]
P.S- The double five times concept was given to me by my friend cum colleague Mr Vivek Turaga.
The argument was- Since other companies are trading at a much higher ratio (of EV/crushing capacity), Triveni's sugar division is a bargain. But there is a serious flaw to that thinking.
Lets understand the situation by humanizing it. Imagine you have a known, Ms. Triveni. She approaches you for 100k for a 50% stake in her new business venture. What will you ask her before deciding whether to invest or not? Business details, growth potential, expected profit every year, ROI and bla bla bla. Imagine her replying this- "Hey don't worry! You know Renuka! She had a similar business and she has sold it for 400k (twice that of this plan). And Balrampur. He idea was same to same and he raised 150k for 50% stake. So, you are getting much cheaper."
Your reply would be- "!!!!!!!". Why? Because you don't care about Renuka and Balrampur and their partners. You want return of and on your investment. If Triveni's business can't generate at least 15% returns, then you wouldn't give her your money. Simple. Right?
But what's wrong with Triveni's thought process. Well, clearly, she is suffering from ENVY- the deadliest of the seven deadly sins. Without caring for absolute return, she is just thinking about relative returns- which is obviously wrong.
Coming back to Triveni Engg.'s sugar business, to deserve 2000crs of EV, it needs average Profit of atleast 200 crs (if not more) and not relative cheapness to its peers. So the question is- Will it be able to earn 200 crs every year? Well who knows... Depends on sugar cycle and supply and demand. However, historically, it has earned more than 200 crs in just 1 year out of past 8 years and average is about 50 crs per annum. So, I guess, timing of the sugar cycle is the key here.
Another use of this relativity approach is in the calculation of Relative performance. Mutual funds compare their relative performance against a benchmark and then judge themselves on this relative performance. So, even if a MF loses 10% of your money, it considers itself good if Sensex loses 20% in the same time which clearly is illogical and silly.
On the other hand, value investors argue that if I can earn a good return every year- good enough to make me rich over time- why should I care what return has Sensex or Gold or Dollar has given in that time. If I can double every penny that I have five times in my entire lifetime, I will be rich. Why should I worry about Sensex's return in this time?
Relative performance is another form of ENVY, which you should avoid.
With this, lets come to the Investor's Theory of Relativity- Relativity (Relative Valuation, Relative Performance) is noting but ENVY- the deadliest of the seven deadly sins. Comparing yourself with others and then feeling good or bad about it based on the outcome is ENVY and its the deadliest sin. Save yourself from this SIN. [Time can be relative, Mr. Einstein, but not performance or valuation.]
P.S- The double five times concept was given to me by my friend cum colleague Mr Vivek Turaga.
Wonderful post. But if Relative Valuation is a sin then how would you keep a check on opportunity costs? I mean the market always comes up with a better bargain than what you already own and wouldn't it make sense to do a check on relative valuation to determine if the situation warrants a swap?
ReplyDeleteHi MG, Just relative valuation is a sin. You can compare two or more opportunities only if they are making sense on an absolute scale first. Would like to highlight this- "Without caring for absolute return, she is just thinking about relative returns- which is obviously wrong."
ReplyDeleteHere is my blog on stock ideas
ReplyDeletehttp://indiavaluestock.blogspot.com/
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