Author: Nitin Garg

What’s my blog “Terms Simplified” all about?

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According to The Economic Survey, Year 2014–15 witnessed hyper-growth in Technology start-ups and software product landscape with India ranking fourth among the world’s largest start-up hubs with over 3,100 start-ups. Software products and services revenue is estimated to grow @ 12-14 % in the fiscal year 2015–16.

Year 2014 also witnessed the largest ever Venture Capital infusion into the Indian start-up ecosystem. With an increase of 47.7% from the previous year, Venture Capitalists invested $2.1 billion with 1,108 deals. E-commerce, consumer web and payments dominated the funding in the country, whereas technology start-ups formed the spinal cord, playing a vital role in economic growth of India.

I have discovered that most of the young Business Leaders lack the understanding of the terminologies that are prevalent in the VC circle. My blog “Terms Simplified” makes a sincere effort to educate the young Entrepreneurs on the most frequent jargon prevalent the investor community. I’ll add a series of articles in this category over a period of time that focuses on Venture Capital and Terms Sheet. I’d love to hear your thoughts and views regarding my endeavor.

Stay tuned…

Where do I find company’s capital structure?

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A company’s financial health is indicated by the balance sheet, and can be evaluated by 3 broad categories:

  1. Working Capital
  2. Asset Performance, and
  3. Capital Structure

Capital structure depicts a company’s debt and equity mix. A healthy proportion of equity and debt represents a healthy capital structure. Equity capital consists of Preferred Stock, Common Stock and Retained Earnings, which are summed up to form ‘Total Shareholder’s Equity’ in the Balance Sheet. Debt Capital generally comprises of short-term borrowings, long-term debt and current portion of the long-term debt. Equity capital is always costlier than the debt capital because the company shares its profit with the investors. The debt capital burdens the company with periodic interest payments, but the owners earn a tax rebate on the interest, with no profit sharing with the debt holders. But a highly leverage company can become a watchdog since the investors put restrictions to its activities. During economic downturn, if a competitive business is not able generate enough cash flows from its operations, it might have to file Chapter 11 Bankruptcy.

There is no magical debt levels defined. A company debt-to-equity ratio varies according to its stage of development, industry it operates in, and the lines of businesses it has. Analyst use various debt measuring ratios (debt-equity ratio, leverage ratio, EBITDA/interest, liquidity ratio, solvency ratio, to name a few) to analyze the financial health of the company. Various credit rating companies (like S&P, Moody’s, Fitch) evaluate a company’s ability to repay the principal along with the interest on debt obligations before awarding any rating. Capital Structure affects EPS (earnings per share) depending on whether it’s simple or complex. If the company has dilutive securities (complex capital structure), its diluted EPS is lower than the basic EPS; if it’s simple, then basic EPS equals diluted EPS.

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Key metrics that reflect Technology industry’s fundamentals

Nitin Garg28 Comments

ITTechnology companies form an idea, commercialize it through various resources (including Sales & Marketing) and then engage in R&D for further enhancement and innovation. They follow various compliance standards and government regulations across countries. India harbors one of the largest technology hubs in the world and supplies its technology offerings to the developed nations like US and Europe and emerging markets including herself. So, its fundamentals will be reflected by (not necessarily in this order of precedence):

  • Supply and demand of experienced and talented human resources in India
  • Cost of resources in India
  • Supply and demand of technology across borders
  • Political stability across borders
  • Cost of production in India (including proprietary technology)
  • Cost of distribution from India (including mobile technology)
  • Cost of R&D in India
  • Cost of data processing in India
  • Access to capital in India
  • Valuation of highly cyclical technology companies like semi-conductor
  • Access to high-speed, uninterrupted internet connectivity across borders
  • Sales of hardware equipments and accessories in India
  • Resource utilization
  • Other metrics like utility cost, real estate sales, etc.

You may also want to read my article on Information Technology Industry here.

If you wish to gain any privilege to this blog, please write your message to the author through the page “CONTACT ME” by filling in the required details in the form, OR by dropping an e-mail to him at nitin@gargfinanceblog.com

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Management’s CapEx forecast: Where and how to find it?

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Research reports are a good place. Else, we need to attend the investor meetings, presentations and conferences hosted by the company. We can try in MD&A section to get a hint (for example, a statement that says “$150M wind farm being built by 2020”), but generally, management does not disclose such information in a usable format (like public 10-K/Q reports) unless it’s a major project for them. There are some Oil and Gas and many utility companies that discloses such information. Oil and Gas highlights it as it impacts their production growth directly; it’s a big driver for them. Analysts need to see if Oil and Gas companies are generating enough FFO over CapEx needed to sustain or grow their production.

If I were to guess, I’d look at asset replacement based on the life of the existing assets and replacements values. And then, the cost of the expanded capacity they may highlight elsewhere. If they are forecasting a 15% growth on higher units, there will be a likely event of CapEx, assuming no under-utilization of capacities.

Common-size statement analysis to identify trends: We can also try to derive the capital expenditure by looking at the company’s historical financial statements (balance sheet, income statement and cash flow statement). Usually, companies in an industry spend in a proportion to their sales or EBITDA. If the sales are growing, using the same ratios (as in the past) can help derive the figure. Similarly, if the revenue / EBITDA estimates are flat, reducing the CapEx in proportion to the sales will help arriving at the estimate.

If you wish to gain any privilege to this blog, please write your message to the author through the page “CONTACT ME” by filling in the required details in the form, OR by dropping an e-mail to him at nitin@gargfinanceblog.com

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What is CAPM? How do you calculate the return of a stock?

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Capital Asset Pricing Model (CAPM) is one of the models used to estimate the cost of equity. CAPM, developed by William Sharpe, the Nobel Laureate in Economics, defines a stock’s risk as its sensitivity to its market. In other words, when we invest funds, we expect a rate of return against the risk taken. CAPM helps us derive the investment risk and the return we can expect on our allocated fund. As an analyst, CAPM should be used to decide the price the investor should pay for a particular stock. If Stock A is riskier than Stock B, Stock A should be priced lower to compensate investors for the increased risk.

CAPM defined by the following formula, says that the expected rate of return on any security equals the sum of risk-free rate and the security’s Beta times the market premium risk

                                                          E(Rs) = Rf + Bs * [ E(Rm) – Rf ]
Where,

E(Rs) = Expected return of the security, s
Rf = Risk-free rate
Bs = Stock’s sensitivity (how the stock and the market move together)
E(Rm) = Expected return of the market

In CAPM, the Rf and the market risk premium, E(Rm) – Rf), remains common to all companies, but it is the Beta, Bs, that varies – Bs is the stock’s incremental risk. While it’s not absolutely clear, the CAPM says that the only reason an investor should gain more from Stock A compared to the Stock B is the increased risk taken on Stock A.

Few points noteworthy:

  • To estimate the risk-free rate, we use highly liquid long-term government bonds like 10-year zero coupon STRIPS, US Treasury bills, etc. as a proxy.
  • Beta: If a stock price exactly replicates the market, its Beta is 1. A stock with a beta of 1.2 means it’s theoretically 20% more volatile than the market.