7. Valuing equity investment

Tuesday, 12th June 2012 11:02 - by David Harbage

Last week’s blog introduced the concept of taking a stake in leading businesses.. by owning a portion of the ordinary share capital – as opposed to receiving a steady income from ‘lending’ money to the company (corporate bond investment), which represents part of its debt capital. This article investigates how we can try to value such equity. Intuitively one can value an asset by reference to its income, naturally placing a higher price on the premium yielding and most reliable producers. But how can an equity investor assess the case of a company whose profits are variable, to the extent of being non-existent in difficult times or a firm in early loss-making start-up mode? For an asset that does not produce income, the surveyor will have to make a judgement about its longer term worth and assess the present day value of that sum. For example one could make a bid today for a sum of £1,000 to be paid in 5 year’s time, by assessing what rate of interest would prevail or be required (the return given up), as compensation between now and the receipt of the capital. If anticipating a 2% return - or compound interest rate - one would place a value today of £906, on an asset expected to have a worth of £1,000 in 5 years’ time. Paying less than £906 would represent an enhanced (more than 2% per annum) return – given an expectation of 100% certainty of receipt of the capital sum of £1,000, and having a benchmark (or satisfaction) level of 2% per annum. Thus a prospective investor in a start-up business could assess its current worth, by reference to its anticipated future value, and demand a higher return (by applying a higher discount rate) as compensation for the potential non-delivery of the expected worth. New projects are similarly assessed (comparing initial and other costs to the eventual outcome); company management will typically refer to the internal rate of return (IRR) on the capital so deployed, before deciding whether to approve the expenditure. The frequently expressed business term adding value becomes appropriate to such an assessment of new spend – which also applies when contemplating an acquisition - when comparing the IRR on the new capital expenditure, with the current return earned across the whole of the company’s capital. Business terms like return on capital employed (ROCE) and returns on invested capital (ROIC) are often quoted in this regard, as useful measures to assess a company’s ability to generate revenue. Enough of that economic or mathematic theory, let’s turn to try and value companies which are profitable and produce revenue, profits and pay a proportion of that income to the shareholders. There is an old adage in business that says, “Turnover is vanity, profit is sanity and cash is reality” to illustrate what really matters to a corporate entity. Sales (also known as revenue or turnover) can be flattered, or indeed may not mean that a business is profitable; some profits can also be misleading, as they could relate to a one-off event (such as a gain arising from the disposal of property) and not be sustainable. Clearly cash is critical – be it from the perspective of an asset on the balance sheet, through to a means of assessing the quality of profits. As regards the latter, investors will be keen to drill down from gross profits (put at its simplest: revenue, less cost of goods) to operating profits (gross profits less administration costs), to assess other expense which necessarily impacts, before the underlying profitability - attributable to the equity owners of the capital – can be assessed. Readers of company accounts will be familiar with the term EBITDA, which refers to Earnings, or profit, Before Interest, Tax, Depreciation and Amortisation - each of which can be significant deductions, according to the individual business concerned. Assessing the quality of underlying profits in EBITDA terms makes for a reasonably level playing field across an industry or the wider market – by stripping out various factors which may cloud a particular business (such as those subject, perhaps temporarily, to a higher tax rate or carrying a heavy debt burden). Take United Utilities, best known as the prime supplier of water services to the north west of England, as an example of a mature company with steady and low growth income, but high capital expenditure on maintaining its pipeline infrastructure, high levels of debt and a high generous payout of earnings. In the year to 31 March 2012, UU generated revenue of £1,565m, spent £680m on regulated capital investment, announced operating profit of £591.5m, but incurred finance expense of £267m and taxation of £86m, to leave underlying profit after tax of £241m of which £209m was paid out to shareholders in the form of dividends. Other businesses may have a completely different model and attributes, for example the online retailer ASOS which is expanding its customer base rapidly overseas. The company boasts high growth in sales (£340m in the year to 31 March 2012) and underlying profits (of £23.8m), with little debt (£0.2m cost) and few assets (£4.9m depreciation) to maintain. However, unlike UU, ASOS reinvests the whole of the surplus cash it generates into the business and does not pay shareholders a dividend. Last year, ASOS incurred a major exceptional cost of £12.9m upon moving to a new warehouse. Investors should take particular note of such one-off items– be they costs, income, losses or gains - when viewing company reports, as such ‘surprises’ can become regular, which would inevitably lower the overall tone or quality of the numbers, as investing institutions wish to see a track record of sustainable earnings. Having examined a company’s underlying profit stream, to better understand the business model and gain comfort on the quality of its profits, what price should the investor pay for the producing asset? We return to our initial starting point that a prime valuation metric for an asset is its income. In the case of a stock exchange listed company’s equity this income could be its profits – perhaps better described as earnings – or the portion of its profits that it pays out to shareholders in the form of regular dividends. Of course, a business might choose to return money to shareholders via an exceptional dividend (a distribution prompted by a windfall receipt of proceeds of the sale of an asset, perhaps), or by repurchasing (also termed a buyback) the company’s own shares. As the means of sharing profits might be haphazard, we prefer to assess earnings - rather than dividend income – as a means of determining a company’s worth. Fund managers and industry analysts typically prefer to assess a company by reference to its EV/EBITDA (placing a value on the whole capital – equity plus debt – and looking at earnings before taking account of certain deductions), to gain a clearer perspective on the overall business, as well as facilitate comparison with its peers. However, the more traditional and commonly used metric of comparing the share price to the actual earnings attributable to the company’s equity also has merit – subject to the caveat that the investor carries out due diligence surrounding the quality of the earnings, and the balance sheet. This price earnings (PE) relationship is expressed as a ratio: for example a company stock priced at £1 or 100 pence, with earnings per share of 12.5 pence, is said to be valued on a PE ratio of 8 times (100p/12.5p = 8). The PE ratio quoted on stock exchange listed companies equity in this website, or in newspaper columns, will normally refer to the last set of declared earnings, which will relate to the previous year. This is known as the historic or trailing PE, and contrasts with the forward PE, which represents a financial analyst’s – or, more usefully, a consensus of analysts’ - forecast of future earnings per share, by reference to the current share price. While future earnings are inherently difficult to predict, especially for fast changing businesses (such as explorers of natural resources, or developers of leading technology), the forward PE ratio – which typically looks no further than two or three years out - is likely to provide a more useful picture of a company’s worth. The extent to which a business is researched, by reference to the number and independence of the industry analysts, is also critical in terms of the credibility of the forward looking projections. Taking a look at the credit rating agencies’ assessment of any debt – back to the EV consideration of the whole business – is also recommended, as well as being mindful of the company management’s own track record of providing reliable guidance in regard to its short term prospects. For your interest, by reference to the previously mentioned examples, pedestrian growth (but 5% dividend payer) UU is monitored by 16 analysts, whose consensual earnings forecast places the stock on a forward looking multiple of 16.3 times in the current year to 31 March 2013, and 15.2x next, as compared with the historic PE ratio of 18.8x. By contrast, rapidly expanding (but no dividend payout) ASOS is researched by 18 analysts, whose average earnings target puts this equity on a forward PE of 33.9 times anticipated earnings this year to 31 March 2013, and 25.4x in the year to March 2014, relative to the trailing rating of 42.6x. Next week we will dig a little deeper into these earnings-based valuations, and that of UK equities as a whole, with a view to better understanding whether or not good value resides in any of these companies or indeed across the overall market. The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.