Let me preface this note by stating emphatically that I am an economics novice. But I’m going to take a stab at this problem because it’s crucial for the individual investor. Please let me know if I’ve made glaring errors in the facts.
The theoretical definition for intrinsic value = present value of all future cash flows.
For this we need the amount and timing of all future cash flows, and the long-term risk-free interest rate.
We can assume the long-term risk-free interest rate to be the rate on 10-year Indian government bonds since they’re free from risk of default (the government just needs to turn on the printing press) and the 10-year are reasonably well-traded implying a closer approximation to the actual cost of money.
This rate stands at about 8.3% (27th June, 2011) and can be plugged in our present value calculations.
But the other two variables – amount and timing of future cash flows are the difficult items.
So, how can we, as individual investors get a handle on it?
Obviously this will vary from business to business but what reasonable estimates can we make about the general expected growth rates of cash flows for the typical profitable Indian company over the next 10 years.
I would argue that this would approximate estimated real GDP growth + expected inflation rate.
I say this because GDP growth is going to be contributed by business and a dominant proportion of Indian business is listed. Moreover, I believe businesses, overall, should be able to pass on rising costs to the end consumer to a large extent (although not perfectly) and hence, cover a large part of inflation as well.
Based on my understanding of consensus estimate – a conservative estimate for real GDP growth over the next 10 years should be 8%+ (based on current growth rates and an assumption that the demographics, consumer buying power and current state of politics will continue as the last 10 years) and inflation should be at most 5-7% (based on RBI determination to bring down current rates of 9% and establish some sensible real yield for the 10-year bond).
This equates to nominal growth rates of 13%-15% per annum.
This is obviously subject to substantial risk of change as economic factors vary. This growth rate should, however, serve as a reasonable benchmark to value profitable Indian businesses on an overall basis.
what a good post man....can you tell what will be expected growth rate of banking industry...is it 13-15% or more than that...somewhere close to 20--25 % ...please throw some thought...because somewhere i have read that banking industry have to grow faster than others in order to keep economy moving as they are the source of credit...
ReplyDeleteThanks for your remarks. You ask an interesting question.
ReplyDeleteUnfortunately, I am not an expert on the banking industry. I tend to avoid banks for the moment because I don't yet have a grip on the loan/investment portfolios and management quality of individual banks. These are vitally important given their leverage and small errors tend to wipe out (or materially dilute) banks' equity.
I would think that banks' equity growth (as other industries) would largely be a function of Returns on Equity x Retention Rates (assuming future profitability is similar to past). And obviously, these growth rates are likely to vary widely between banks.
I don't think there is a necessity that they would have to grow faster than the rest of the economy because that would be a function of increased penetration of credit within Indian society and that is not a certainty (although it is forecast).
On receiving your comment, I came across reports that forecast above average growth (>13-15%) for private sector banks, presumably as a result of their greater profitability and efficiency, and average growth (as well as below average growth) for public sector banks for the opposite reasons.
That's the best I have on the banking industry at the moment - and I'm open to correction of glaring errors in my statements above.