Is Nestle a good buy ?

Nestle company analysis

COMPANY ANALYSIS

RTI For Money, Lillaney

7/20/20231 min read

Let’s try to make an educated guess about what could happen to Nestle India Ltd. by 2 methods.


  1. Quality investing method

  2. Growth investing method


  1. Quality investing method


The best way to think about Nestle India Ltd., according to me, is the way Terry Smith thinks about investing. He is a fund manager in the UK who only invests in quality companies and has the following rules for investing in companies where he ideally intends to invest and hold forever.


Rule 1 : Invest in only quality companies which earn high returns on capital.


He often quotes the below from Charlie Munger who is Warren Buffett’s right hand:


"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."


Rule 2 : Don’t overpay


Although there are various studies done where it is shown that the starting price does not matter that much if you invest for the long term (think decades not years) he tries to still try and not overpay by comparing the free cash flow and dividend yields of the companies he is investing in with the following:


  1. Other companies in the same industry/sector

  2. Other companies in the same market

  3. The market itself

  4. Bond yields


Rule 3 : Do nothing


He says that after you have found a good company by following rule 1 and invested following rule 2 during downturns in the stock prices the toughest thing to do is to sit back and let the companies do their thing. This is because human beings are designed to be active all the time whether it is productive or not.


Let’s try to apply the above rules for Nestle India Ltd..


Rule 1 : Invest in only quality companies which earn high returns on capital.


To understand if a company is a high quality company we need to look at the following ratios.


  1. Return on capital employed / Return on equity

  2. Profit margins

  3. Cash Conversion

  4. Debt / Equity

  5. Interest coverage


Lets see how Nestle India Ltd. fares on the above ratios.


  1. Return on capital employed / Return on equity


Return on capital employed has been between 28.61 and 59.24 percent for the last 10 years.


Return on Equity has been between 19.98 and 103.12 percent for the last 10 years.


Ideally the returns on capital / equity should be higher than the 10 year bond yields and the market / index returns for the last 10 years.


India’s 10 Y bond yield is nearly 7% and the Sensex has compounded at around 11.5% over the last 10 years.


  1. Profit margins


Profit margins have been between 6.88% and 15.91% in the last 10 years.


Ideally the profit margins should be high enough to withstand downturns.


  1. Cash Conversion


Cash conversion has been between 71% and 99% with an avg. at 83% in the last 10 years.


Ideally this should be at more than 100%.


  1. Debt / Equity


Debt / Equity has been between 0.54% and 58.38% in the last 10 years.


Ideally the debt should be as low as possible.


  1. Interest coverage


Interest coverage has been between 18 and 429 times.


Ideally the interest coverage should be more than 2 times.


Based on the above data it seems like Nestle India Ltd. has been a good company as its returns on capital / equity are good and its profit margins are good too.


The cash conversion is good.


The leverage ratios of debt / equity and interest coverage are good too.


Rule 2 : Don’t overpay


To determine if the stock is overpriced or not we need to look at the free cash flow yield and dividend yield of the company.


Free Cash Flow = Operating Cash - Capex


Free Cash Flow = Rs.2,737.00 Cr - Rs. 550.00 Cr


Free Cash Flow = Rs.2,187.00 Cr


Market Cap = Rs. 221,466.93 Cr


Free Cash Flow Yield = Free Cash Flow / Market Cap


Free Cash Flow Yield = Rs. 2,187.00 Cr / Rs. 221,466.93 Cr


Free Cash Flow Yield = 0.99%


Dividend Yield = 0.96%


Based on the above data of free cash flow yield and dividend yield it seems that the stock price is high.


Comparing the Free Cash Flow Yield to a bond which will give me a 7% return compounded over a 10 year period this stock seems to be a worse bet.


Comparing the Free Cash Flow Yield to Sensex which has given 11.5% return compounded over a 10 year period this stock does not seem to be a better bet.


Based on the above rules of Terry Smith it seems that Nestle India Ltd. is highly priced at the moment although it is an average company as the return on capital is between 8 and 16 percent over the last 10 years.


If you would like to know more about Terry Smith and his methods you could read it in his book Investing for Growth which you can buy here -> https://amzn.to/42tZNbL


Let’s try to see it from another point of view.


  1. Growth investing method


Nestle India Ltd. sales and profits have grown at least 7% compounded for the last 10 years which means its earnings could double every 10 years if it continues at the same pace.


Current earnings - say x

Earnings in 10 years - 2x

Earnings in 20 years - 4x

Earnings in 30 years - 8x


At the end of Dec 2022 , EPS was around Rs.250 and price was around Rs.20000 giving a P/E of 20000/250 which is equal to 80.


If the above assumptions are correct the EPS in Dec 2052 would be 250 * 8 = Rs.2000.


Assuming a P/E of 80 the price would be 2000*80 = Rs.160000 which is 8 times the price of Rs.20000 at the end of Dec 2022.


If we consider a price increase of 8 times in 30 years it indicates a growth of between 7.0-7.5% which is an average return.


If you would like to know more about growth investing, you can do so by reading the books below:


  1. Common Stocks Uncommon Profits by Phil Fisher - https://amzn.to/420BrGY

  2. Buffettology by Mary Buffett - https://amzn.to/3AU7cWw


Conclusion:


Based on the findings from both the methods above I would not recommend a buy in Nestle India Ltd. if you have a short term view of a year or two. If you plan to hold it for longer the returns could be average if the company continues to perform as it has done in the last 10 years.