Valuation in Motion: D-Mart Valuation: The 100 P/E Conundrum

Reading Time: 9 minutes

Avenue Supermarts Limited, or D-Mart as it is better recognized, is a curious case. The stock trades on the Indian markets at a staggering P/E of 118. Although absolute P/E levels are nowhere near indicative of undervaluation or overvaluation of a stock, we still have to ask, how much is too much? Today, we will attempt to answer that question.

The Company

D-Mart needs no introduction in India, just as Walmart would need no introduction in the U.S. It is a 16-year old massive hypermarket chain which offers one-stop shop for groceries and other household items. It is owned and operated by its parent company Avenue Supermarts Limited. The most interesting thing about D-Mart, surely, is its founder Mr. Radhakrishnan Damani. He was a well-known investor in Indian equities, even before he built this successful retail empire. His business acumen is so well known that even Mr. Rakesh Jhunjhunwala cites Mr. Damani as his guru. Having had its IPO just last year, Mr. Damani is busy spending the IPO money on aggressive expansion. Couple that with a focus on offering customers “good products at great value” and D-Mart is poised to dominate the Indian retail landscape in a big way.

The Industry

According to a report by the Boston Consulting Group, India is likely to become the third largest consumer economy by 2025. The CAGR expected is 12%, which is higher than the growth rate of the Indian economy. IBEF also expects a similar growth. Out of this, 93% is attributed to the organized retail segment (D-Mart falls under this category) and 7%, of course, to the unorganized retail i.e. mom-and-pop shops.

In line with the opportunity in this space, D-Mart’s MD/CEO, Mr. Neille Noronha has explicitly stated that the company is shifting its corporate strategy to aggressive store expansion. Moving from a historical 10 stores-per-year growth, D-Mart has now reached a 15-20 stores-per-year velocity, according to his own admission. The company is also open to changing its own-and-operate model to lease-and-operate model if it would permit further growth in store count. The company is also making in-roads with the more juicy e-commerce segment with its subsidiary Avenue E-Commerce.

The Numbers

Something specific to note is that, these are Standalone Financial Numbers. Avenue Supermarts Limited (The parent) also owns different subsidiary companies. They have been valued as below and included as ‘Non-operating Assets’:

However be warned that Indian companies do not release Balance Sheet data on Q1-Q3 results. We only get to view the Financial Position during the Q4 results. So, while the Revenue and Profit figures here are up-to-date, the Balace Sheet figures are definitely not (Because they have been taken from the 2017-18 Annual Report). This should not affect our Valuation by a lot, but some minor inconsistencies may exist. Some market-related data have been taken from Prof. Aswath Damodaran’s ‘Useful Data Sets’.

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The Capital Conversions

1. Debt: Avenue Supermart’s outstanding Debt of Rs. 264 Crores have been converted to a Market Value of Rs. 383.25 Crores, assuming a Cost of Debt of 8.5%. You can look at companies having a similar yield in BSE’s Corporate Bond Trading Data and reaffirm whether D-Mart and these companies have the same credit quality.

2. Operating Lease: D-Mart owns most of its outlets. However, it does lease some of its buildings. The Market Value of those leases are calculated to be Rs. 173.09 Crores.

3. Equity Options: Here’s a kicker. According to D-Mart’s 2017-18 ESOP disclosure, it has issued quite some Employee Stock Options at the IPO price of Rs. 299. Considering the monstrous increase in D-Mart’s share price, the Market Value of these Equity Options have increase manifold and currently stands at Rs. 1984.90 Crores: almost 2% of its Market Cap.

The Assumptions

I had discussed shortly about D-Mart’s business in ‘The Company’ and ‘The Industry’ sections. I will now attempt to attach numbers to the stories I narrated.

I have also provided justifications for each set of assumptions, which is the reason why this Valuation model is named ‘Numbers and Narratives’ in the first place. It is only logical that every projection in a model should be linked to a story grounded in reality.

Just to demonstrate how to justify assumptions, I will attempt to justify the ‘Sales Growth’ numbers. In my model, Sales Growth and Capex are inter-linked. So, it holds to reason that if I can justify one of them, the other automatically stands justified. Here goes:

What did I do? I took the Invested Capital of D-Mart from 2009-2018 and used it to calculate Capital Required per Store, based on the CEO’s comment that D-Mart had been growing at a pace of 10 stores per year. I also calculated the Growth in the Cost of Acquisition per store for the period.

This allowed me to project the Capital Invested per store from 2019-2018. Then, working backwards with this information and my own assumptions of Invested Capital, I calculated that from 2019-2028, D-Mart will grow at an average of 19 stores per year. This coincides with the CEO’s vision of boosting D-Mart growth from 10-ish to 15-20-ish in the next decade or so. Hence, my set of assumptions for Sales Growth stands justified and so do the Capex figures (Because they are linked).

Fine-tuning and justifying your assumptions holds the key to making or breaking a Valuation. Every time, before attempting to justifying my assumptions, I recall something funny mentioned by Prof. Aswath Damodaran in one of his lectures. A student at the Professor’s class at NYU valued Netflix for one of his projects. He had this feeling that something was wrong, so he approached the Professor with his model. The Professor was, of course, quick to point out that he had simply drawn out the Sales Growth assumptions for several years without realizing that it meant in 15 years, almost the entire world would be subscribers to Netflix. While that’s hilarious, the story underlines the danger of projecting numbers on a model without attempting to justify them with common sense.

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The Diagnostics

No red flags to consider. Let’s move ahead.

The Cash Flows

Here is how D-Mart’s Cash Flows will evolve based on the assumptions made above:

Of course, you will immediately notice that, according to my assumptions, D-Mart will bleed money in the short term, evident through the negative Free Cash Flows upfront. It recoups its Value by earning massive Free Cash Flows in the later years, towards maturity. If you think this feels unrealistic, you should check out D-Mart’s actual Cash Flows from the past few years:

It is obvious that D-Mart has been either spending from its Operating Cash or raising more Debt to invest aggressively (Negative Cash Flow from Investments), so much so that it has had a net Negative Total Cash Flow in several of these years. Hence, the assumption that D-Mart will not be Cash Flow-positive for 10 more years isn’t far-fetched. It is only a natural progression of its current business strategy.

The Value

All roads lead to the Value. Here’s my estimate of D-Mart’s Intrinsic Value:

I believe that D-Mart is fairly valued at about Rs. 1110, signifying a 46% overvaluation. However, this should not come as a surprise at all. Lest we forget, the IPO price of D-Mart was a mere Rs. 299. Only a year and a half has passed since the IPO in March 2017 and the price has been catapulted 5x times and more. Even assuming that the Investment Bankers were careless while pricing the stock and were asked to be conservative by Mr. Damani, it does not justify such a large gap in consensus. Explanations can range from consumption growth to a very high promoter holding, but if I didn’t know any better, I’d say that this is quite simply a case of Irrational Exuberance.

The Sensitivity of Value

The Sensitivity of Value tool shows a range of possible values for the stock, with the more plausible values populated around the center.

The Monte Carlo Simulation

It is my usual practice to question my own assumptions. I perform a ‘stress test’ of sorts to see how changes in my assumptions can impact the final value. However, given the stark overvaluation in this case, I will not spend time on a trivial simulation which is going to tell us what we already know – that there’s a stark overvaluation and maybe.. just maybe a tiny chance of fair valuation.

The Model

I understand that this post will make a lot of investors in D-Mart very upset or angry. But, I have nothing to hide. I stand by my Valuation. If you disagree with me, feel free to download the model for yourself and re-narrate the story whichever way you see fit, as long as you can justify each number you enter. After all, we can always exchange notes for our mutual benefit.

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Downloads can be made from ‘File -> Download As’. If your value differs from mine, let me know in the comments. We can perhaps start an interesting conversation.

A few months back, I made a post about buying high P/E stocks. I argued that markets are short-sighted. That they ignore cash flows from far away or discount them too much. P/E Ratios, I said, are misleading. However, I concluded by saying that only the Value in relation to the Price mattered the most. Clearly, in D-Mart’s case, both of these are red flags.

But how, you will ask, does one decide what’s “attractive?” In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

If you do not want to believe in a humble student of valuation like myself, I urge you to place your trust on a veteran such as Mr. Buffet. D-Mart’s motto might be to deliver value to its customers, but at this level, the company does not have much left by way of value to deliver to its investors.

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Dinesh Sairam

Dinesh Sairam

Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME
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