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Debt capacity is a very useful mental construct in valuation.

2. “Our research seeks to appraise the
intrinsic value of a share of stock by
estimating its acquisition value, or by
estimating the collateral value of its
assets and/or cash flow.

3. “We believe the process is in many
respects closely related to credit
analysis as we are seeking collateral
net worth in excess of the cost of
our investment.”

4. Type 1 Securities

5. How do High Grade Bonds
contrast with Equity?

6. In Bonds, focus is on
AVOIDANCE OF LOSS
In equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS

7. What’s the best case scenario for
a high-grade bond buyer?

8. Downside risk in bonds
NO offsetting trades
So
It’s better to be safe than
sorry
In stocks, being loss averse can be costly. You have to take calculated risks...

9. You are
SACRIFICING
Profit Sharing
In Exchange Of
A PRIOR CLAIM
and DEFINITE
PROMISE
Bad exchange

10. High Grade Bond
Selection is a
NEGATIVE art
Focus on exclusion

11. “The first chance
you have, to avoid a
loss from a foolish
loan is by refusing to
make it. There is no
second chance.”

12. Graham’s
Principles of
High Grade
Bond selection

13. 1. Safety is measured
not by specific lien or
other contractual rights
but by the ability of
the issuer to meet ALL
its obligations.

14. 1. Lien unreliable
form of safety
1. Lien vs. Ability
Safety is measured not by specific lien or other contractual rights but by the ability of the issuer to meet all
its obligations.
The idea that a lien on the assets is a guarantee of protection independent of the success of the business
itself is in most cases a complete fallacy.
In the typical case, the value of the pledged property is vitally dependent on the earning power of the
enterprise.
Example: ITC
Railroads - lien on property not adaptable to other uses.
Indian Banks' NPAs - emphasis on security rather than ability.

15. Shrinkage of
property
values when
a business
fails.
Difficulty of asserting the bondholders' supposed legal rights.
Delays and other disadvantages incident to a receivership or bankruptcy.

16. http://fundooprofessor.wordpress.com/2012/10/19/virginity/

17. 2. This ability
should be
measured
under
conditions of
depression
rather than
prosperity.
Any bond can do well when conditions are favorable.
e.g. FCCB issues

18. 3. Deficient safety
cannot be compensated
for by an abnormally
high coupon rate.
Yield Trap
Return ON money vs. Return OF money

19. 4.The selection of all
high grade bonds
should be subject to
rules of exclusion
and to specific
quantitative tests.

20. “What’s fascinating . . . is that you could
now have a business that might have
been selling for $10 billion where the
business itself could probably not have
borrowed even $100 million.

21. “But the owners of that business, because its
public, could borrow many billions of dollars on
their little pieces of paper- because they had
these market valuations. But as a private
business, the company itself couldn’t borrow
even 1/20th of what the individuals could
borrow.”
Promoters aren’t borrowing. They are selling.
A sale in the garb of a loan.

22. Two Sources of safety:
A. The character of the industry
(the particular business is immune
from drastic shrinkage of
earnings).

23. B. The amount of protection (the
margin of safety is so large that
the company can undergo a
drastic shrinkage of earnings
without resultant danger).

24. 4. Quantitative Tests
The selection of all senior
securities for investment should
be subject to rules of exclusion
and to specific quantitative tests.

25. “The past ability of
the borrower to
earn in excess of
interest requirements
is counted on to
protect the investor
against loss in the
event of some future
decline in net
income.”

26. “The bond investor does
not expect future
earnings to be the
same as in the past. If
he was sure of that,
the margin demanded
might be small. Nor
does the bond investor
predicts whether
future earnings will be
materially better or
poorer than the past.”

27. “ If he did that, he
would have to measure
his margin in terms of a
carefully projected
profit and loss account
instead of emphasizing
the margin shown in the
past record. The role of
the margin of safety,
therefore, to render it
unnecessary to make
accurate predictions
about the future.”

28. Factors in Bond Selection
1. The nature of the 6. The relation of the
business value of the property to
2. The size of the debt
enterprise 7. The relation of stock
3.The terms of the issue capitalization to debt
4. The record of solvency Debt/Equity
and dividend payments Average Market Value of
5. The relation of Enterprise/Debt
earnings to interest
requirements
Interest Cover

29. Fixed
Charges
Coverage
Fixed charges vs. Interest
Example of leased vs owned outlets in retail operations. Rent is like interest.
Why Fixed charges cover instead of Debt service?
1. Cover demanded is high
2. Assumption of going concern - ability to refinance

30. Graham’s Version of
Debt-equity ratio
Market Value of Enterprise/
Debt ratio:
What is the logic of using this
ratio?

31. “Before paying
standard prices for
bonds of any
enterprise, the
investor must be
convinced that the
business is worth a
great deal more
than what it owes.”
Key term: Business worth a lot more than what it owes.
In this respect the bond buyer must take the same attitude as the lender of money on a house or
a diamond ring, with the important difference that it is the value of the business as an entity
which the investor must usually consider, and not that of the separate assets.
Why not use the conventional Debt/Equity ratio?
What about the silly Mr. Market??

32. “The market value
of stock is generally
recognized as a
better index of the
fair going concern
value of a business
rather than balance
sheet figures.”

33. “The presence of a
stock equity with
market value many
times as large as
the total debt
carries a strong
assurance of the
safety of the bond.”

34. “Conversely, an
exceedingly small
stock equity at
market prices must
call the soundness
of the bond into
serious question.”
Why is this very important?

37. The Graham Standard:
“Minimum stock equity at market
prices for industrial bonds should
be at least 75% of total debt.
This test must be passed both
currently and over the average
of last five years.”

38. Interest coverage and
debt-equity ratios
Do you see any similarity?
What does interest-coverage
ratio measure?
Cash flow available for interest/
Interest

39. They are very similar, therefore,
they should produce similar
conclusions.
i.e. if a company is creditworthy,
it must be a lot more than what
it owes. EV should be several
times its debt

40. Suppose, the minimum standard for
interest-coverage ratio is barely met
but the stock-value ratio is considerably
higher than the minimum prescribed.
Under such circumstances, the bond
should be accepted as investment.
Why?

41. But what if they produce
contradictory conclusions?

42. If interest coverage ratio is ample but
the stock-value ratio is substantially
below the minimum required.
“Under such circumstances, the
purchaser of the bonds will have to
assume that the price of the stock is
too low.”
This could happen for good or bad
reasons

43. Good Reason: Stock market is right
you fool! - there are bad days
ahead, the earnings are suspect, or
there may be a fraud!
Credit rating agencies vs. the stock
market as predictors of distress.

44. Bad reason: Stock market is wrong -
the stock is a bargain - buy it
instead! - its cheaper and safer!
In either case, the investor should
not buy the bond as a type-I
security.

45. Time for some backward thinking
Lets do some reverse engineering

46. Recall The Graham Standard:
“Minimum stock equity at market
prices for industrial bonds should
be at least 75% of total debt.
This test must be passed both
currently and over the average
of last five years.”

47. For Graham, if a company is
creditworthy, then its stock
should be worth at least 75% of
the value of its debt.
(Business is worth at least 175%
of debt)
Equity Value > 0.75 x Debt Capacity

48. A Valuation Rule
“An equity share representing the
entire business cannot be less safe
[and less valuable] than a bond having
a claim to only a part thereof.”

49. “There are instances
where an equity
share may be
considered sound
because it enjoys a
margin of safety as
large as that of a
good bond.

50. “This will occur, for
example, when a company
has outstanding only
equity shares that under
depression conditions are
selling for less than the
amount of the bonds
that could safely be
issued against its
property and earning
power.

51. “In such instances the
investor can obtain the
margin of safety
associated with a bond,
plus all the chances of
larger income and
principal appreciation
inherent in an equity
share.”

52. “Our research seeks to appraise the
intrinsic value of a share of stock by
estimating its acquisition value, or by
estimating the collateral value of its
assets and/or cash flow.

53. “We believe the process is in many
respects closely related to credit
analysis as we are seeking collateral
net worth in excess of the cost of
our investment.”

54. “A bondholder can enjoy no
right or protection which the
full owner of the business,
without bonds ahead of him,
does not also enjoy. Stated
somewhat fancifully, the
owner (stockholder) can write
out his own bonds, if he
pleases, and give them to
himself.”

55. VST’s “Bonus Debentures”

56. Hidden inside the stock of a credit-
worthy company is a bond...

60. Recent Cases of Debt Capacity Bargains

61. Satyam Effect

62. At Rs 60 in march 2009, market cap was R 190 cr.
Surpus cash = Rs 70 cr.
Rs 120 cr for a business which generated average
operating cash flow of Rs 56 cr. p.a. over last 4
years.

63. At Rs 60 in March 2009, market cap was Rs592 cr
Surplus cash = 100 cr. Rs 492 cr for a business
which generated Rs 120 cr. average annual
operating cash flow over last 5 years.

64. India’s largest provider of inland transport by rail
using containers.

65. Midterm Exam Question

66. Exercise done in Oct 2011
Total cash flow for five years = Rs 4,896 cr.
Average = Rs 979 cr.
Interest expense = 979cr/3 = Rs 326cr.
Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)
Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.
Minimum intrinsic value of the company = 5,705+2,000 cr= Rs 7,705 cr
Minimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per share
Did it fall to this level?

67. At 560, stock
was a debt-
capacity bargain

68. Average cash flow from operations after W/C changes: Rs 1,000 cr.
Interest expense = 1000cr/3 = Rs 333cr.
Debt business can easily support = Rs 333 cr./0.10 = Rs 3,333 cr.
Minimum value of business = Rs 3,333*1.75=Rs 5,833 cr.

70. Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 cr
Minimum intrinsic value of equity = Rs 7,333cr/13cr shares = Rs 564per share
Now let’s get REALLY creative

71. At 560, stock
was a debt-
capacity bargain
THIS is what we mean by FAVORABLE ODDS

73. Value Investing in Las Vegas
The casino is a value investor because of:
1. Favorable odds on each bet
2. Lots of play (diversification)
3. Cap on maximum bet (protection from negative black swan)

74. In American roulette there are 38 slots
numbered 1-36, 0, and 00. Pay-out is 35:1

75. If you bet Re 1 on your lucky # 8 and if the
ba" lands on # 8, you win Rs 35, otherwise
you lose Re 1.

76. You wager Rs 1,000 on a single number, say
number 7.
Probability of ba" landing on 7 = 1/38 = 2.63%.
Probability of not landing on 7 = 37/38 = 97.37%

77. Event Payoff Probability Expected Value
Ball lands on 7 36,000 2.63% 947.37
Ball does not land on 7 0 97.37% 0
947.37
Amount Bet -1,000
NPV -52.63
What happens when Margin of Safety is -ve and you practice wide diversification?
Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”

78. Suppose you bet Rs 1000/38 or Rs 26.32 on
each of the 38 numbers to “spread your risk”
What happens when Margin of Safety is -ve and you practice wide diversification?

79. Event Payoff Probability Expected Value
Ball will land on one of your 947.37
100% 947.37
numbers (=26.32*36)
Amount Bet -1,000.00
NPV -52.63
Lesson: Diversification does not work when Margin of Safety is absent.

81. Thank you