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Is BSE-SENSEX over/undervalued as of Sep 30, 2009?

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Excel valuation model

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)

What do I mean by the intrinsic value of SENSEX?

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.

How is SENSEX CALCULATED?

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.

How do you calculate intrinsic value of an asset?

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.

Let us first identify the future Net Income of the company.

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

2010 2011 2012 2013 2014 2015 2016

Net 100 115 132.25 152.08 174.9 181.89 189.17

Income(Rs)

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

G – Growth in Net income

ROC – Return on capital

B – How much of Net income to retain/reinvest to generate G growth

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.

201 201 2012 2013 2014 2015 2016

0 1

Net Income(Rs) 100 115 132.25 152.08 174.9 181.89 189.17

Re-investment rate 55.5 55.5 55.55 55.55 55.55 14.8 14.8

(%) 5 5

Re-investment(Rs) 55.5 63.8 73.39 84.40 97.06 26.92 27.99

5 2

Available cash(Rs) 44.5 51.1 58.85 67.67 77.83 154.97 161.17

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(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)

To estimate the intrinsic/fundamental value of candle business, we need to calculate the

present value of all future cash flows. Let us assume that the discount rate for this business
is 12%. (Discount rate is driven by the riskiness of business, identified by Beta). The
discount factor for 2010 will be 1/(1.12) and for 2011 be 1/(1.12)^2 and so on.

Putting back the discount rate into the table, the table looks like:

201 201 2012 2013 2014 2015 2016

0 1

Net Income(Rs) 100 115 132.25 152.08 174.9 181.89 189.17

Re-investment rate 55.5 55.5 55.55 55.55 55.55 14.8 14.8

(%) 5 5

Re-investment(Rs) 55.5 63.8 73.39 84.40 97.06 26.92 27.99

5 2

Available cash(Rs) 44.5 51.1 58.85 67.67 77.83 154.97 161.17

7

Discount factor 0.89 0.79 0.71 0.63 0.56 0.50 0.45

PV (available 39.7 40.7 41.88 43.01 44.16

cash*disc) 3 9

(Omitted years after 2016)

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Let us introduce the concept of terminal value. As mentioned above, it is assumed

that starting 2015, Net income will grow @4% forever. The value of such annuity in
year 2014 is:
(annuity cash flow in 2015)/(discount rate – annuity growth rate) ---- This is formula of
infinite Geometric progression series

Annuity cash flow in 2015=154.97

Discount rate=12%=.12

Annuity growth rate=4%=.04

Annuity value in 2014=154.97/(.12-.04)=1937.19

This annuity value is also referred to as Terminal Value.

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

Intrinsic valuation of BSE SENSEX

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).

We need to identify below mentioned parameters to calculate present value of SENSEX:

– Growth rate for next 10 years and Terminal growth rate.

– Return on Equity during next 10 years and in Terminal growth period.

Growth rate for next 10 years

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.

1 The precise discount factor is 0.5674, resulting in 1099.21

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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%.

Terminal growth rate

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%.

Return on Equity for next 10 years

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.

2009 (Until- 2008 2007 2006 2005

Mar)

SENSEX-ROE 18.32 20.36 23.06 22.42 21.00

(%)

2 We will use this number as an estimate for SENSEX long term growth rate in calculating
SENSEX intrinsic value

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ROE in terminal period

No company can continue to maintain excess returns forever, as it will encourage

competition and hence whittle away the excess returns. Similarly, Indian markets can’t
continue to maintain excess returns forever, as it will encourage more FIIs to invest in India,
increasing the valuations and reducing the excess returns. According to Mckinsey school of
thought, terminal excess return should be zero, resulting in ROE equal to cost of equity. The
SENSEX valuation will assume terminal excess return of zero, resulting in terminal ROE of
10% equal to cost of Equity.

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%.

SENSEX forward EPS- 2010

Using analysts estimates of 30 index components, free-floating weighted average of forward

EPS is calculated resulting in next year earnings of Rs. 628264.71m. (Free-floating
earnings= fwd EPS*free-floating-multiplier*shares-outstanding)

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%.

Intrinsic valuation of SENSEX

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%

SENSEX Discounted Cash flow model

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2011 2012 2013 Termi

2010E 2014E 2015E 2016E 2017E 2018E 2019E
E E E nal

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:

1. High growth=13.72% ; Terminal growth=3.50%

3 2009 ROE is 18.32%. Growth=ROE*B+change-in-ROE. The change in ROE in 2010 from

2009 led to this negative retention.

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2. ROE in high growth phase=23.06% ; Terminal ROE=10.00%

3. Cost of equity in high growth=12% ; Terminal cost of equity=10%