As a business analyst its extremely crucial to understand the opportunity size/target Addressable market that's available in front of a company to grow. Everyone wants a big and growing market. Although this term is used directly in the start up space the listed market professional use it in a different way i.e. long runway of growth which simply means company's potential to achieve higher revenues should not get saturated quickly. The companies which are smaller in size, run by great management with no cooperate governance issues and Huge opportunity size in front of them with competitive advantages getting build generally get "out of the park" valuation multiples by the market 😀😀
To quote Charlie Munger "Invert, always Invert" - Does it than mean that being a Big fish (large company) in a small pond (small/medium industry size) a bad thing? The answer is a straight NO!
There are tremendous examples of companies which started with focusing on a Niche (one product/one segment/one consumer problem) and have scaled up really well over the years by becoming dominant players in their niches with higher market shares and entering into similar adjacent territories like Vinati Organics, Symphony Coolers, Astral, Eicher Motors to name a few.
Specifically if we see the case of Eicher:
"Eicher could have competed with the large fish (Hero and Bajaj) in a large pond (100cc market), but chose to carve its own niche and decided to become a big fish in a small pond (300cc segment). That has paid off for Eicher. Despite a volume market share of just under 4 per cent, its profit market share is 20 per cent. And the markets have rewarded it handsomely for that (27 per cent of industry market cap)."
Now Let's understand various angles to why the phrase " We have a big opportunity size" by promoters keeps money managers super excited & such companies become "hot" stories to invest in:
First Logic - The Simple math
Expected Revenues = Expected Quantity you can sell * Price per unit
OR with a different angle it can also be written as
Expected Revenue = Industry Size * Market Share
Hence a large customer base/Industry Size provides an opportunity to sell more quantity by increasing Market Share.
Second logic - "Even if We capture 1% of this market we will become a billion dollar company" Cliché
If in an industry of size 1,00,000 crs even if you are able to capture a 5% market share that turns out to be a 5,000 crs revenue run rate business easily putting you among the top quartile in terms of scale in India.
Whereas even if we have 50% market share in a 1000 crs industry that gives you a revenue run rate of just 500 Crores per Annum.
Third Logic - High Potential Topline = Market going nuts = High valuation metric = Easy Equity Dilution
Let's assume a company is entering into a new segment and you are trying to identify the market size of the new segment. Assume it comes out to be 5000 crores. After reading company’s action plans you come to a conclusion that can the company gain sizeable market share (lets say approx 15-20%) in next 10 years?
Your confidence on management based on their past execution will guide you here. imagine after doing this you conclude - yes, management will be able to capture market share.
Assuming industry remains at the same level even after 5 years from now at 5,000 crores this means that a company would be generating approximately 750-1000 crores additional revenue in next five years (5000*15% - 5000*20%).
Now you estimate what margins the company will be able to maintain given company's product quality & competition in the industry to arrive at the incremental profit the company can generate and that will lead to valuations.
For example you believe the company can maintain 10% margins on this incremental topline you can have additional profits of 75-100 crores from this new segment (10% * 750-100 crores).
After which through help of exit multiple (to understand how it should be derived read our valuation series blog) you decide what incremental market cap this company can obtain. (Note: We have kept concept like conglomerate discount, Sum of total parts and incremental Capex requirement calculations etc out of this discussion for time being).
Let's say the exit multiple to this segment is 20. So we derive at the incremental Market cap of 1500-2000 Crs.
Now, Do one thing increase the market size of new segment company is entering to 10,000 crs and the the additional valuations you can get rises to 3000-4000 crs!!!
Got it why market gets excited if some capable management announces it plans to enter into a new segment which has huge opportunity size
The entire process sounds so simple right? - Trust us it's not! We are just trying to simplify it to the maximum extent possible.
Fourth Logic - The "Re-investment" Headache
As explained in our valuation series too the valuation of a business depends a lot of whether it has re-investment opportunities. No one, especially in a growth economy like India, likes a dead cash throwing business or a business which has achieved it's steady state growth i.e. growing around GDP+1/2%.
Ps: please don't quote Warren Buffett's Coca-Cola Investments 😀, we will get to that in later posts of why for him that investment may have made tremendous sense.
So when a business has big opportunity size it can re-invest great amount of capital back into the business to achieve that potential. This give investors a peaceful sleep as the capital allocation by the management, one of the main problems in Indian capital markets, is taken care of. Investors mainly fear management not ploughing back money into it's main business (Condition Applied: It's growing with ROIC's above cost of capital😀) as it leads to
Cash getting accumulated on Balance sheet which basically destroys ROCEs/ROEs as cash yields/returns are much lower than core operating business.
Wrong usage of Cash: Related Party Loans given to promoter's private entities, parking money into Mutual funds like an investment vehicle, unrelated segment diversification, not providing dividends to shareholders.
Cash being used for inorganic growth in acquiring companies (very problematic if it's the acquisition are also into unrelated industries) at unreasonable high valuations leading to excessive goodwill on balance sheet.
Markets de-rating of the PE Multiple of your stock due to lower re-investment opportunities. (Please read our Valuation Driver series for the same OR watch our Valuation series on YouTube)
Fifth Logic - "No one want to run on a treadmill"
Also growth in industry is desired because no one wants to grow market share just to maintain the topline. Imagine an industry is currently at 10,000 crs and you have a 10% market share but the industry is shrinking and as per estimates 5-10 years down the line the industry will be at 7000-8000 crs. Just to maintain the topline you will have to grow your market share to approx 15%. Promoters & investors hate this.
Sixth Logic - "The Magic of a Story & The Ease of raising Money"
How much you may dislike the fact money by fund managers in the market is raised based on two things - the past returns and some stock ideas where the opportunity seems endless, effortless and where huge sums of money can be deployed now.
The basic pitch of fund raise goes like this 😀 :
"The trend has just started in terms of consumer behavior change or industry dynamics and this can easily continue for more 15-20 years hence we can invest large sums of money here and we than can forget about market volatility as come what may this stories can grow for 15-20 and obviously this is backed by DCF hence high valuations are awarded to this business as market can pay for coming 10-15 years of growth today".
The above paragraphs highlights nothing bad, nothing good - We are just stating a simple truth.
So, does market only rewards Huge Opportunity size? Well like in all things in life the right answer is - It Depends.
Markets provide crazy love to business which can meet cut-off of economic profitability i.e. earning ROCE/ROEs above cost of capital and growing Revenues in 10-15% range or Operating Profits in higher double digit range of 20-25% combined with an opportunity to continue the same run for foreseeable future.
To summarize, Market will love a 20-25% ROCE business growing operating profits at 20-25% than a 50-100% ROCE business unable to grow its topline or NOPAT in single digits.
You can clearly see the difference in how market treats some great businesses. Lets look below some case studies
Example 1: Hawkins Cooker
Hawkins Cookers Limited is an Indian Listed company which manufactures pressure cookers and cookware. Average ROIC for Hawkins for 10 years is around 48% but Reinvestment rate for Hawkins has gradually declined over the years shown in snapshot below. Exception 2016 and 2020.
Now let us see how market has rewarded this stock by looking at their P/E charts and Stock price chart shown in snapshot below.
Hawkins Stock Price Chart. Source: Screener
Hawkins Price to Earnings chart. Source: Screener
Example 2: Castrol India
Castrol India Limited is an automotive and industrial lubricant manufacturing company. Average ROIC for Castrol India for 10 years is above 300% but when it comes to reinvestment rate there is only one year where company was able to reinvest (%wise) in double digit shown in snapshot below.
Despite having high ROIC company wasn't able to reinvest as the Industry is saturated. Now let us look how market has rewarded this company shown in snapshot below.
Stock Price Chart. Source: Screener
Price to Earnings Chart. Source: Screener
From both of the above examples we can see that market hasn't rewarded some of the great businesses too because because there was low/no growth opportunity (Low Reinvestment rate).
Now let us move forward and see another 2 examples of Indian Listed companies whose ROIC is also greater than WACC and business has reinvestment opportunity too.
Example 1: P I Industries
PI Industries Ltd is a leading player in the Agro-chemicals space having strong presence in both Domestic Agri Input and Global CSM Export market. P I Industries has increased their industry size over the years which led to high reinvestment rate. Majority of revenue for P I industries in 2011 was coming through Agri-inputs business but they expanded their business in CSM segment which was a higher growth & higher margin business and in 2020 majority of revenue was contributed by CSM segment shown in Snapshot below. We have also explained how we collected this data in detail in our valuation series blog. To read more Click here
PI Industries also tried to enter into API business (Pharma) by acquiring IND-swift's API business though the deal hasn't worked out and termination of contract took place but management has shown intent towards expanding API business which again increased their opportunity size.
Average ROIC for PI industries over 10 years is approx 20% (low compared to above 2 examples, but still a good ROIC) differentiating factor for PI Industries and from above 2 examples is reinvestment rate. Hawkins and Castrol ROIC's were too good but their reinvestment into business was lower. Now let us see P I Industries reinvestment shown in snapshot below.
P I Industries average Reinvestment rate for 9 years is about 143% which portrays that there is still lot of opportunity for an business to grow. Now let us look how market has rewarded this company shown in snapshot below.
Stock Price Chart. Source: Screener
Price to Earnings chart. Source: Screener
P I Industries P/E as well as stock price has increased over the years as their ROIC was high than cost of capital provided they are having a consistent higher re-investment rate.
Example 2: Page Industries
Page Industries is an Indian manufacturer and retailer of innerwear, loungewear and socks. Page Industries holds exclusive licensee of Jockey brand in India. Page Industries in the initial days (1995) started its business and was catering to men's inner-ware which was approximately 10,000 crore industry as on 2019. Page industries has evolved their product category under the brand "Jockey" over the years and now they are catering women’s innerwear, leisurewear, and kidswear along with men's inner-ware. The Industry size has increased from 10,000 crores to 40,000 crores. Now let us see Page industries reinvestment rate and ROIC over the years how they have moved.
Average Reinvestment rate for Page industries is 56% over 9 years. Now let us see how market has rewarded this company.
Stock Price Chart. Source: Screener
Price to Earnings chart. Source: Screener
Again this point is proven that a bigger market + management intention to capture the market through higher re-investment rate + above average ROIC is Holygrail of Investing.
In some business you may find a pattern that even though opportunity size is huge But still re-investment rates are low and yet market is still providing them excellent valuation multiples. Think Asset Management Industry (AMC) even though AUMs & revenues of these companies are growing at excellent pace the characteristics of this business is such that no money is stuck in working capital or gross block leading to negligible re-investments in business and yet achieving high growth rates.