Tracking Indian Value Investors – Ajay Piramal

Billionaire Ajay Piramal runs a successful listed company in India. He has generated massive 26% returns for his shareholders over the long term – 28 years to be precise. In the latest annual report of his operating company, he talks about his thoughts of generating long term value for shareholders in the future.

Following are the key takeaways for investors from his latest annual report:

1.    Virtual Companies: Mr.Piramal’s operating company is currently in three businesses – pharmaceuticals, information management and financial services. According to him, they have now grouped these three businesses as three virtual companies. This mindset has helped in a) execution discipline in the form of focus on achieving near term goals, milestones and budgets in each of these virtual companies, and b) Prioritization in use of available capital.

2.   Efficient Capital Allocation: The cornerstone of value creation is efficient capital allocation. Piramal is committed to efficiently allocating capital while undertaking controlled risk, to consistently generate higher profitability and deliver superior shareholder returns. The company has undertaken various steps during the year towards this like a) bolt-on acquisitions in different businesses, b) enhanced minority stake in Shriram Group, c) Deleveraged balance sheet, d) Returned capital to shareholders and e) Significantly scaled down the high-risk high-reward New Chemical Entity Research Programme.

3.      Partnerships: Piramal highlights that he company is the first port of call for global majors for partnerships in various businesses and co-investments. He highlights that since its inception, they have practiced and maintained the highest standards of ethics, integrity and corporate governance in each of its business dealings. The result is that the company has forged relationships with global partners like CPPIB (for co-investment in real estate funding), APG Asset Management (co-investment in Infrastructure funding), Vodafone (historically invested in Vodafone India), Abbott (sold pharma business to Abbott) and Allergan (has a local JV for pharmaceutical business).

4.   Minority but ‘Strategic’ Investments: While Mr.Piramal’s about $700mn minority investments in the Shriram Group appear passive, they have been repeatedly been referred to as ‘Strategic’, along with the mention that Mr.Piramal is now the non-executive chairman of Shriram Capital, the financial services holding company of Shriram Group. Thus, there may be an intention to take active participation in these minority investments in future.

Important quote from the annual report highlighting long term shareholder value creation:

“Over the last three decades, we have demonstrated our entrepreneurial abilities by allocating capital efficiently in high-potential businesses and operating them well, thereby creating long term value for our shareholders.  In 1988, we moved out of textiles and into pharmaceuticals through the acquisition of the 48^th ranked pharma company. Over the next two decades, we transformed into a top 5 pharma company through both organic and inorganic means. Five years ago, we sold our Domestic Formulations business at an attractive valuation to Abbott to generate substantial value for our stakeholders, a large part of which was returned through dividends and buyback.”

EV/EBITDA Ratio – The Good and The Bad

One of the problems of investing is the multitude of tools and techniques available to analyze companies and the resultant confusion in making decisions. No single ratio or method in isolation can be used to pick promising stocks for investment. However, some of these ratios – like the beloved EV/EBIDTA - are more popular and hence it is important to know what are their advantages and disadvantages.

So what EV/EBIDTA mean? Lets understand in plain English. EV/EBITDA stands for Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation and Amortization.

Enterprise Value (EV): To calculate EV, you start with a company’s market capitalization (the number of shares outstanding multiplied by its current market price). You then add the amount of total debt they hold, both short-term and long-term and then subtract the amount of cash and cash equivalents (like investments in liquid mutual fund units, etc) they have.

EBITDA: This is simply as the name suggests the company’s profits before deducting items like interest, taxes, depreciation and amortization.

That is all about the math, which is straight forward and simple. The reason this ratio is so popular is because it can be applied to almost any company - except airlines and banks. Thus, a company making losses at the net profit level is far easier to value compared to its peers based on EV/EBIDTA. The reason why EBIDTA is crucial is because it helps explain a business’s operating profitability. It vaguely helps gauge the contribution margin. It removes the impact of financial leverage and hence lends itself to comparison across various companies within and outside the company’s sector. Also, businesses which are in the nascent stage of build-out incur huge costs related to depreciation and interest expenses, which results in losses at net profit level. However, EBIDTA might help gauge the true margin power of the business.

However, the good news ends here. The ratio has been a subject of abuse in many valuation reports and M&A explanations. Thus, while it is important to look at EBIDTA to judge the margin potential, we cannot exclude depreciation out of the picture, as it is an implicit cost to use the fixed assets. Just imagine, would the business be able to operate without the use of fixed assets? Thus, ‘sustainable’ margin potential can only be judged using EBIT (Earnings Before Interest and Taxes) margin.

The second most common mistake is to judge the valuation of a company using the absolute EV/EBIDTA number. Thus, while a 6x EV/EBIDTA might look cheap, it might that the company has low return on assets and uses a large asset base to generate the EBIDTA. Thus the ratio totally ignores the impact of return on assets and can give an incorrect picture of profitability.

According to us, EV/EBIT is a far superior ratio than EV/EBIDTA as it does away with most of the disadvantages of the latter. It gives due respect to cost of using assets, takes into account impact of return on asset and at the same time irons out the impact of financial leverage to lend itself to comparison.

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I am a capital market professional with passion for equities. I intend to vent my thoughts on various issues related to value investing, asset allocation, theoretical aspects of investing, etc on this blog. Comments from like-minded individuals are invited. Equity Pundit.