Monday, April 20, 2015

Valuation of very high quality companies

As per popular demand I will get back to the getting conviction: Fundamental factors - points to watch out for later. Lets cover another very interesting topic for now.

The aforementioned concepts are the basics of valuation but as you might have noticed there are few subjective questions that remain unanswered:

  • How do you find the right discount rate?
  • How do you find the right growth rate?
In addition you will never find a hindustan lever or a dabur or a Britannia trading in single digit P/E multiples - despite the mood swings of Mr. Market. Does that mean the intelligent investor never buys into these wonderful companies?

Warren Buffet I think only invests in companies where his confidence of the earnings growth is very high. In these cases you can easily use a discount rate similar to the corporate bond yield net of tax. A rule of thumb could be corporate bond yield net of tax divided by the confidence percentage in the earnings.

In order for your confidence in a company to be high it needs to be a high quality business. A high quality business is defined by:

  •  Low rate of change in the industry
  • Willingness of customers to pay higher for a brand
  • Ability of a company to control all aspects of its economics – supplier prices, customer prices, productivity
  • Very difficult for new competition to show up or a great moat
  • High rate of expected growth in demand for the current or future products.
  • Very high returns on capital (north of 30%)
I will cover the details of each of these characteristics in future articles.

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