Valuation in Motion: Goodyear India Valuation

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In his book “Poor Charlie’s Almanac”, Berkshire Hathaway’s Vice Chairman Mr. Charlie Munger talks about an informal speech he gave in 1996, titled “Practical Thought About Practical Thought?“. He warns that not many people understood his talk and it was practically a communication failure. But at the crux of this speech lies hidden a valuation technique that acts a saving grace for those averse to intrinsic valuation methods such as the DCF or the DDM.

Practical Thought About Practical Thought?

The talk by Mr. Charlie Munger began this way:

In a long career, I have assimilated various ultra-simple general notions that I find helpful in
solving problems. Five of these helpful notions I will now describe. After that, I will present
to you a problem of extreme scale. Indeed, the problem will involve turning start-up capital of
$2 million into $2 trillion, a sum large enough to represent a practical achievement. Then I will
try to solve the problem, assisted by my helpful general notions. Following that, I will suggest
that there are important educational implications in my demonstration. I will so finish because
my objective is educational, my game today being a search for better methods of thought.

He then went on to present the five tools he generally uses in problem-solving:

1. Decide big “no-brainer” question first: The first helpful notion is that it is usually best to simplify problems by deciding big “no-brainer”
questions first.

2. Numerical Fluency: The second helpful notion mimics Galileo’s conclusion that scientific reality is often revealed
only by math as if math was the language of God. Galileo’s attitude also works well in messy,
practical life. Without numerical fluency, in the part of life most of us inhabit, you are like a one-legged
man in an ass-kicking contest.

3. Invert, Always Invert: The third helpful notion is that it is not enough to think problems through forward. You must also
think in reverse, much like the rustic who wanted to know where he was going to die so that
he’d never go there. Indeed, many problems can’t be solved forward. And that is why the great
algebraist Carl Jacobi so often said, “Invert, always invert.” And why the Pythagoreans1
thought in reverse to prove that the square root of two was an irrational number.

4. Think in Multi-disciplinary Manner: The fourth helpful notion is that the best and most practical wisdom is elementary academic
wisdom. But there is one extremely important qualification: You must think in a multidisciplinary
manner. You must routinely use all the easy-to-learn concepts from the freshman course in
every basic subject. Where elementary ideas will serve, your problem solving must not be
limited, as academia and many business bureaucracies are limited, by extreme balkanization into disciplines and sub-disciplines, with strong taboos against any venture outside assigned
territory. Instead, you must do your multi-disciplinary thinking in accord with Ben Franklin’s
prescription in Poor Richard: “If you want it done, go. If not, send.”

5. Lollapalooza Effects: The fifth helpful notion is that really big effects, lollapalooza effects, will often come only from
large combinations of factors. For instance, tuberculosis was tamed, at least for a long time,
only by routine, combined use in each case of three different drugs. Another lollapalooza
effects, like the flight of an airplane, follow a similar pattern.

Finally, he went on to present his big problem, which was about creating a $2 Trillion Beverages business from scratch. He used his ‘five tools of problem solving’ to explain how such a business would be created and then likened it to how Coco-Cola is such a great company. However, let’s take these five tools at their face value and attempt to value a company ourselves.

Assume that you are working for a big investment house. You are asked to assess the future business prospects of Goodyear India Limited, the market leaders in Tractor Tyres. You are also informed that the Indian stock market indices, NIFTY and SENSEX, have compounded wealth at the rate of 13% over the long term. So, for you to suggest an investment in Goodyear India, the expected returns for the next decade or so must be several notches above that level.

Disclaimer: I hold Goodyear India in my portfolio. My views on the company may therefore be biased. Trust my inputs only after thorough personal consideration.

Imagining ourselves at least half as witty as Mr. Charlie, this is how we should probably go about completing the task.

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The Big ‘No-Brainer’ Question

The first question we should ask is, “How much are Tractors and by extension, Tractor Tyres demanded in India?” Put another way, it would serve us right to look at the farm mechanization numbers in India and compare it to nations who are better off in agricultural development. Here’s a graph representing the farm mechanization rates in India and a few other countries:

Of course, the percentage of people engaged in agriculture is inversely proportional to the number of machines used in agriculture. As we can clearly see, unlike India and China, many other nations have extremely low level of people engaged in agriculture and a humongous involvement of machines. We are now convinced that there is enough room for growth and we need not worry about demand generation in the long run.

Numerical Fluency

Estimated Growth in Profits

Data from the Ministry of Agriculture tells us that there’s a healthy growth of sales in Tractors over the last decade, representing a 7% CAGR. However, simple google searches should tell you that there’s a massive demand up ahead. Several research firms have pegged the expected growth in the Indian farm mechanization industry at 9% to 15%. But to be conservative, let’s assume that the expectation is a 13% CAGR. This would allow us to project an expected number of Tractor sales in India a decade from now, which I have estimated to be almost 2 Million units.

We then estimate how much the Revenues of Goodyear India is dependent on the sale of Tractors. We should logically have a rough clue about this, and it turns out that the actual correlation between Tractor sales in India and the Revenues of Goodyear India is almost 90% (To be frank, no surprises there). This means that we can pivot with a ratio like ‘Revenues per Tractor sold in India’ and use that to arrive at the estimated Sales figure for Goodyear India in 2027. The long-term average ‘Revenue per Tractor sold in India’ for our company is roughly Rs. 26,000. Multiplying the former and the latter gives us the figure of Rs. 5100 Crores as the Revenue target of Goodyear India for 2027.

Finally, we plug in the missing piece of the puzzle: the margins. We know for a fact that Goodyear India is the market leader in Tractor Tyres and hence, they command some Pricing Power. In fact, the company had Net Margins of just 3.5% in 2009, which has since improved to 8.42% in 2017, representing a growth of 11.61% for the decade. Even if we assume that these Margin levels are nearing some peak, we can afford to compound it at something as low as 3% over the period (Essentially, only 25% the growth of the previous decade), leaving us with a Net Margin target of 11.21% by 2027.

All of this would leave us with a Net Profit of Rs. 570 Crores by 2027. Compared to the current (TTM) Net Profit of Rs. 127 Crores, this would represent an expected CAGR of 18.22% over the period. This is how this whole ordeal can be summarized:

Estimated Exit Multiple

Of course, to value our business in 2027, we will require a ‘Multiple’. Since we’ve established the expectations for the Net Profit in 2027, let’s attempt the estimate the simpler P/E Ratio.

Goodyear India is a debt-free company and so, whatever Cost of Equity it has ideally has to get translated into Cost of Capital as well. We also know that in the long term, the growth in companies tends to gravitate towards the long-term Credit Yields. Using this information and the simple Annuity formula for a company i.e. (1+g)/(r-g), we can estimate the upper limit P/E and an average P/E level for Goodyear India, which can be used as an Exit Multiple.

If this line of reasoning is too difficult for you, consider the fact that Goodyear India had a P/E of just 5 a decade back. It currently has a P/E of almost 18 (Down from 21.5 just a year back). So, it’s not too far-fetched to assume that it will get ‘re-rated’ to the 25-30 P/E levels once industry headwinds pick up. I personally don’t agree with simple adjustments like this, hence I’ve tried to explain this phenomenon fundamentally above. I’ll leave it to you to decide which one makes more sense.

Invert, Always Invert

Now that we’ve set the target, the next best thing would be ask ourselves “What sort of actions would deter the company from achieving these goals?” and answer branching questions from there. Now, we have established that the sector size is massive and that demand is naturally arriving soon. Hence, all the skeptical questions should be targeted to towards the other part of the equation: the margins.

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Is the company watchful of the Margins?

Since we have assumed that there will be further improvement in Margins, it is only logical to ask the question:

Is the company doing anything by way of value addition to their existing line of products?

Once again, the answer is a resounding yes. Goodyear India has patented technologies like RunOnFlat, SilentArmor Tripple Tred, CommforTred and so on. They have also won several innovations awards along the way, including a “Top 100 Global Innovations Award” in 2012. Goodyear India partners with Goodyear Tire &
Rubber Company’s Innovation centers in Akron, USA
and Luxembourg, EU in research and development
activities to introduce new products and improve
its existing product line to meet the customers’
expectations and requirements.

Videos like this one give you the sense that the parent company, which holds a 74% stake, is very mindful of R&D and in a sense, reduces the R&D requirements for its subsidiary.

Thinking in Multi-disciplinary Manner

Of course, a good part of understanding a business comes from understand the end users of the products or services offered by the company. Assessing their motivations is key to understanding the future economics of the business itself.

Should farmers encourage mechanization of agriculture?

Yes, they should, says the data:

There’s a proven direct relationship between farm power availability and farming yields. The savings are pegged at 15-20% for Seeds, 15-20% for Fertilizers and 5-20% for Cropping Intensity. Apart from this, mechanization is also proven to reduced the man-hours required in agriculture and helps prevent losses.

Are farmers able to purchase farm equipment easily?

Yes and no. While there is a no dearth of availability of farm equipment, the availability of credit to enable farmers to make these purchases leaves a lot to be desired. However, being a quasi-social country, every ruling party has only tried to make this easier. Several schemes exist and are currently being propagated by the government and the bankers to help out the poor farmers. Here, we also have to make a comment on the impressive credit growth in India, which is likely to continue as the economy expands.

Apart from monetary benefits, are there social benefits to owning or using a Tractor?

There are several. Tractors help in:

  • Converting waste land into cultivable land
  • Decreased workload on women
  • Ensuring farm safety
  • Encourages young people to get into farming, increasing productivity

Are there positive associations with the product in question?

In line with Pavlovian Psychology, farmers often associate Tractors to their persona, much like how an urban youth may associate his social persona with a stylish bike or a clothing. I cannot provide immediate proof of this, of course. But interactions with a handful of farmers owning tractors should clarify your doubts immediately.

Lollapalooza Effects

Considering all the above discussions, we can be assured that the numbers we came up with are safe estimates. In fact, considering all the positives, we could even allow ourselves to imagine a situation where the company will out-perform our expectations. The right approach, then, is to do a Scenario Analysis, where we come up with probabilities estimates for each of the worst, good and great scenarios playing out and calculate the final output based on that. It would go down like this:

We have three cases here:

  1. A pessimistic case, where the company grows its profits only at 10% per year for the decade and ends up getting a Terminal P/E of 15, earning a paltry 8% CAGR over the period. The probability of this is very low, as we saw above. We still allocate a 10% probability to the event.
  2. A base case, where our actual assumptions play out (I used a 25 P/E, since I couldn’t input something like 23.33 in my model). Since we have taken the pain to arrive at these assumptions, I have given it a generous 60% chance of playing out.
  3. An optimistic case, where the company exceeds our expectations, owing to the numerous growth drivers listed above, netting an impressive 26.35% CAGR over the decade. Keep in mind that Goodyear India is also making in-roads into the CV Tyres segment, so this could definitely be another driver for growth. I have given this scenario a nominal 30% probability (Well, it’s not so much as I ‘gave’ this probability, but it was rather calculated automatically based on my previous two inputs).
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The ‘Practical Thought’ model allows you to automatically view the Expected Returns as a Lallapalooza of all the scenarios put together. Here, it is a respectful CAGR of 20.05% over the decade. That is to say, according to my estimates, at the CMP of Rs. 981.15, the stock offers a chance to compound wealth at 20.05% over 10 years, substantially beating the expected index performance of 13% over the same period. You can then go back to your boss with the happy news.

The ‘Practical Thought’ Valuation Model

When I purchased Goodyear India about 9 months back, I did so when the EPS was at Rs. 56.34 and the Market Price at somewhere around Rs. 880. Following a similar procedure, I would have arrived at an Expected Returns of almost 22% over the decade, which I thought was phenomenal, so much so that I allocated almost 45% of my portfolio to the scrip. Post the mid-cap crisis, I picked up a bunch of other stocks, but Goodyear India remains the highest allocation of my portfolio at 23% or so.

Do you prefer this valuation method over a Discounted Cash Flow model? Do you disagree with some of my assumptions? You can always download the model for free and try it out yourself (Downloads can be made from ‘File -> Download As’):

In fact, the model contains the option to value a company using other famous Multiples as well, such as the Price to Free Cash Flow (P/C), Price to Book Value (P/B) and Price to Sales (P/S). Feel free to try out any of these.

Closing Notes

Before I forget, I first came across Charlie Munger’s “Practical Thought About Practical Thought?” speech on Prof. Sanjay Bakshi’s ‘Relaxo Finale‘ lecture. He performed a similar valuation, except he used the Price to Free Cash Flow ratio instead. I suggest you check it out. It’s amazing.

I made this post to let everyone know that I respect the thought process of anyone who values companies using some other valuation model, especially if they’re as thorough as Mr. Munger was with Coco-Cola. At the end of the day, I still believe that a Discounted Cash Flow model is the least inefficient way of valuing a company. Just to reiterate my devotion to using a Discounted Cash Flow model, let me quote Mr. Warren Buffet from the 2002 Annual General Meeting of Berkshire Hathaway:

The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it’s not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business’s economic characteristics.

Some critics of DCF often bring up the fact that Warren Buffet will never use a computer or an excel to value a company. That’s because he’s a mathematical genius capable of running numbers in his head like cake walk. A quick look at some of his interviews and AGMs should tell you that much. Once, even Charlie Munger quipped “I’d never seen Warren Buffet do a DCF“, to which Mr. Buffet quickly retorted, “I do, in my mind.”

Let me assure you that it does not matter whether you believe in Charlie Munger or Warren Buffet. Decide, truthfully, which line of thought allows you to be the most thorough. Follow that line of thought religiously, until it becomes a second nature for you. That’s the best course of action.

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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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