My Valuation of Hero Motocorp's Equity

In this post, I provide a valuation of Hero Motocorp's equity. As I have written in my earlier post on the two wheeler market in India, while Hero's market share in the two wheeler sub-segment was above 40% in CY14, it decreased to below 37% in Apr-Nov 2016. However, it can seen to be increasing its spares sales consistently over the past few years.  

Historical and Forecasts

Let us consider the trends in the total revenue, total expenses and the net profit margin. The first two are in crores of rupees, whereas the third is in percentage. 2017 onward, the numbers are, of course, forecasts.

Total revenue increased at a CAGR of 5% between 2012 and 2016, broadly in line with its largest contributor, gross sales of products. Total expenses on the other hand increased at a CAGR of only around 4%. Its largest contributor, cost of materials consumed grew at a CAGR of only 2.7%, but the second largest item, other expenses, grew at a CAGR of 16%. However, due to significant decreases in depreciation and changes in inventory, the growth in total expenses stayed moderate. Consequently, profit before tax grew at a healthy rate of over 11%. However, due to the high CAGR of the tax expenses at around 27%, the profit after tax grew at only 7.1%.

Coming to the balance sheet, reserves and surplus grew at a CAGR of around 17%, leading to the shareholder's equity growing by that much. Among the non-current liabilities, long-term liabilities decreased by 57% and long-term provisions increased by 22%, both on a CAGR basis. This caused the total non-current liabilities to reduce by around 27% on a CAGR basis. Among the current liabilities, the trade payables increased by 4.8% on a CAGR basis, but the other current liabilities and the short-term provisions decreased by 17% and 7% respectively, both on a CAGR basis, leading the total current liabilities to decrease by around 2%, also on a CAGR basis.

On the asset side, tangible assets and capital work in progress increased by 21% and 65% respectively, but intangible assets decreased by 51%, leading the fixed assets to grow at around 4%, all on a CAGR basis. When the double digit CAGR growth of long term investments, long term loans and advances, and other non-current assets gets added to this, the growth of total non-current assets becomes 6.3% on a CAGR basis. High growth rates of trade receivables, cash and cash equivalents and other current assets was kept in check by the moderate decline in current investments, which is the largest component of current assets, to keep the growth rate of current assets at 5.3% on a CAGR basis.           

Forecasts for the income statement and balance sheet items were based on a linear or growth trend as deemed fit for the individual items, keeping in mind their past growth rate.

The Valuation

The FCFE increased to ₹3,867 crore in 2026 from ₹2019 crore in 2016. To find the value due to the FCFEs in the forecast period from 2017 to 2026, these are discounted based on the cost of equity calculated based on the CAPM model. A risk free rate of 6.5% based on the yield of the 10 year Government of India bond is taken. For the country risk premium, two values for India have been calculated by professor Aswath Damodaran of the New York University Stern School of Business. One of these (7.39%) is based on the Sovereign CDS and the other (8.82%) is based on the local currency sovereign rating provided by a rating agency. I find the former more palatable since the ratings agencies have taken flak for giving excellent ratings to the securitization products that brought the U.S. economy down in 2008. The beta of the stock has been taken from an online source and is 0.67. Together, these yield a cost of equity of 11.45%. The terminal growth rate for the FCFEs is assumed to be 5% since the economy is expected to change its growth rate from around 6% in 2016 to around 3% by 2060, but until 2035, grows at over 5%. The automobile sector's contribution to the economy is thus assumed not to change much since it keeps pace with the economic growth.

The Price

The value finally arrived at is ₹2016, which is around 36% lower than the current price of around ₹3160. Hence, the scrip seems highly over-priced. A sensitivity analysis based on slightly different values of the terminal growth rate (TG) and the equity risk premium (RP) can be found below.