Opto Circuits India Ltd. -Stock Valuation (16 Dec 2008)

For a firm with an above-average economic moat as Opto Circuits, valuation is likely to be the Achilles' heel in the investment analysis process. Companies like this are rarely cheap, so we need to tread carefully as we decide what a reasonable value would be for Opto's shares. Even though the firm's high growth rate and strong profitability mean that we should be willing to pay up for the shares, we can't pay too much, or we will be unlikely to receive a decent return on our investment.

Opto Circuits Historical Valuation

Comparing a stock’s current ratios with its historical ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.

Opto Circuits Current Valuation

The easiest way to using a P/E ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time. Each of these approaches has some value, as long as you know the limitations.

A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels and growth rates, all of which effect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.

Starting with the basic valuation multiples, we find that Opto is trading at about 12 times the past year's earnings, as of this writing. That's pricey - it's much above the firm's average P/E of ~ 9 over the past 5 years. On a trailing twelve months (TTM) basis, it is trading at ~11.4 times standalone earnings.

Price to Sales, and Price to Book ratios indicate that the stock is trading at slightly higher than its historic average levels, though on a Price to Cash flow basis the stock seems to be available cheaper than its historical averages.

Opto's earnings yield of ~14% and dividend yield of 5.29% point towards Opto Circuits providing decent returns to its shareholders as compared to investments say in risk-free GOI deposits (8% currently). Given Opto's higher risk than a treasury deposit, the high dividend yield and earnings yield from its shares seems to point to decent returns. Besides a not insignificant Cash return of ~3% is also an encouraging factor. Essentially cash return tells you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole company, including the debt burden.

Dividend Sustainability

What about sustainability of dividends? Perhaps a look at historical dividend paying record of Opto can provide some pointers to that.

That’s a pretty impressive dividend payment record. It has increased dividend per share gradually over the years, every year. Dividends over last 5 yrs have grown at a CAGR of ~11% which is a decent record. Dividend payouts (DPS/EPS) have been maintained at roughly 33-36% which is again a decent record. If Opto continues to grow decently, it seems the dividend record will be sustained.

Recent evidence of Insider Buying?

Recent evidence of insider buying/selling can provide some pointers for what the management feels about the stocks current valuation. Sustained buying may indicate that in the management’s eyes the stock may be undervalued.

Warrant Conversion

Update Jan 15, 2009

Opto Circuits promoter shareholding was 30.50% as of Dec 31 2008. On January 12th 2009 another 5,40,000 warrants were converted to an equal no. of shares and alloted to Mr.Vinod Ramnani, CMD and Promoter - Director, OCI at Rs.360 per share -adjusting for the two intervening bonuses in Oct 2007 & Nov 2008 -at ~Rs.140 a share, or a 55 percent premium over Rs.90 -closing market price on Jan 12, 2009.

Why would promoters pay such a hefty premium? Was the company in need of urgent infusion of funds? Or, is this just another indication that the stock may be undervalued -in the eyes of the promoters?

Update 25 Mar 2009

Excerpt from Interview with Mr. Vinod Ramnani, MD Opto Circuits.

Mr. Ramnani, would you clarify why you chose to convert 5.4 lakh warrants at such a high premium. Our estimates show you could have picked up at Rs. 70 from the market

"Unlike how many people think, this was a no-brainer for me. From a principled standpoint, I wanted to honour the commitment. Had the market boomed at the time of warrant conversion, I stood to gain significantly. Why should it be different in the reverse case. The money would accrue to the company if I convert, but would go away to some 3rd party if I bought from the open market.

But be assured it made perfect sense from a financial standpoint as well. Purchasing such huge numbers from the market couldn't be done at prices you mentioned. The whole transaction would have taken prices to significantly higher levels. And don't forget the 10% paid on allotment would have been forfeited. So do you think you would do otherwise for some small gain of Rs. 20-30??"

Check out the 10 questions put to Opto Circuits Management and read the full 2-part Management Interview.

Finally let’s attempt a discounted cash flow analysis for Opto Circuits to try and guage its Intrinsic Value.

Opto Circuits Intrinsic Value modeling

Opto has been generating free cash as percentage of sales at around 4-6% over the years with the occasional dip as in FY 07. That it has been managing this despite investing aggressively in business expansion, goes to its credit.

Opto's long term sales growth stands at over 45% and long term earnings growth at over 60%. The 3yr averages are even more impressive at almost 60% sales growth and over 78% EPS growth. Given the above (and the medium term sustainability of its growth ), if we estimate that Opto will grow sales at 40% for FY09 and the Criticare Systems contribution (1HFY09 sales $20Mn, acquired April 2008) will add another Rs.100 Cr. to the topline, that will mean Rs. 755 Cr sales for FY09. Taking 5% of sales as Free Cash flow generation for FY09,that stands at ~ Rs. 37 Cr. Opto Circuits increasing free cash flow at 20% over FY 08 (Rs.28.96 Cr.), would also imply similar levels of free cash flow for FY09 ~Rs. 34.75 Cr.

Let us also assume that Opto Circuits increases free cash flow at the rate of 20% annually for the next 5 years, slowing to about 15% in yrs 6-10, it will generate about Rs. 817 Cr in free cash flow over the next decade. Discounted back to the present at 13%, the Present Value is about Rs. 380 Cr. Add in Opto circuits' discounted Perpetuity Value of Rs. 560 Cr, and Opto Circuits is worth about Rs.940 Cr, or about Rs. 100 per share is its Intrinsic Value.

We used a relatively low discount rate of 13% -versus a market average of 15%- because Opto Circuits enjoys an above-average economic moat and has a great track record of profitability, strong financial health, and operates from a relatively strong competitive position within the medical electronics industry.

Unfortunately, there is no precise way to calculate the exact discount rate that one should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates. Here's what we want to know for practical purposes. As interest rates rise, so will discount rates. As a firm's risk level increases, so will its discount rate. Putting these two together, we derive the discount rate. We use 15 percent as the discount rate for an average company based on the several factors that are taken into account while estimating discount rates and create a distribution of discount rates based on whether firms are riskier or less risky than the average.

Price levels to get interested in Opto Circuits

How large should your margin of safety, be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average we require a 30 percent to 40 percent margin of safety for most firms.

The set of assumptions as above, results in an estimated intrinsic value per share of about Rs. 100 for Opto Circuits, which is right around where the shares are trading as of this writing. If I assume this to be a reasonable scenario, I would start getting interested in the stock at around Rs. 75, which would be a 25 percent discount to our estimated intrinsic value.

We are not looking for much of a margin of safety because of Opto Circuits' strong balance sheet, excellent industry prospects, and solid profitability all make it less likely that something will go horribly wrong with the assumptions.

For us to believe that Opto Circuits' shares are worth Rs. 100, we have to believe that it can hold off competition and continue to grow at an above-average rate for a long period of time. Companies that can increase free cash flow at an average rate of 17-18% for a decade -which is what our scenario assumes- are few and far between, after all.

Having thought of possible scenarios for Opto Circuits, we now know exactly what assumptions are incorporated in our estimated intrinsic value of Rs.100 per share. Armed with that knowledge, we can make a more informed investment decision - we probably wouldn't know as much about the assumptions needed to believe that the stock is reasonably valued, if we had just looked at the current P/E relative to the historical average P/E, or other such benchmarks.

This brings us to the end of Opto Circuits valuation exercise.

Interested in an in-depth analysis of Opto Circuits? You can find it here.

Return form Opto stock valuation to Stock Research

footer for Opto Circuits page