Valuing Companies Part 2

You may have noticed I do a lot of 2 part posts.  The reason being is that I start off with a short sharp investing principle I think readers might enjoy, and by the time I’ve typed it out, it runs to 3 pages and is too big for a single post.

So here is part 2 of ‘Valuing Companies’.  The substance of this part is driven by an e-mail I received from one of the readers, who was talking about some of their favourite companies, and asked me what I thought about the value of their current prices.  The three companies are CSL (CSL Limited, the old Commonwealth Serum Laboratories, which is now a broader pharmaceutical company), COH (Cochlear, a manufacturer of hearing implants/medical devices) and CPU (Computershare, a registry manager).  Without valuing these, I know right away, the 3 are outstanding companies, with able, shareholder focussed management and good businesses with fine prospects.  This alone is not a sound basis for an investment decision, to get to that point, we also need to determine that they are selling below their intrinsic value, and is it far enough to justify an investment.

I should point out this, to obtain these valuations, I used a discounted cash flow analysis (DCF), which takes my view of their likely earnings (and exiting share price) forward 10 years, then discounts them back into today’s $ value according to 2 metrics (7% & 12.5% as explained below)

Using a 'risk free' hurdle rate of 7% (this is about what I expect average term-deposit rates over the next 10 years will be), I produce a valuation of $64.80 for CSL, their current price is $36.96 (time-of writing), now this doesn't mean I believe you should rush out and buy them, just that if the only viable alternative 10 year investment (I always use a 10-year view for intrinsic valuations) was a term deposit at 7% p.a, you would choose CSL instead.  Using my preferred 'market' hurdle rate of 12.5% (30 year average ASX return of about 8.1% capital growth & 4.4% dividends), I produce a valuation of $42.41, on this basis, if the valuation is above the current price; it implies my expectation that the valued stock to outperform the indices (in this case by 1.38% annually over 10 years).  To arrive at this, I assume CSL's P/E ratio will compress to about 18x over the next 10 years.  To put this into context, over the last 10 years, CSL’s P/E ratio has averaged 34.8x and over the last 5 years, it has averaged about 22.8x.  Their EPS growth has averaged 25.6% over the last 10 years and 20.86 over the last 5.  The clear demonstration is that the rate of EPS growth is slowing; therefore the P/E ratio should continue to shrink.

On the same basis as above, for COH, I derive $106.34 & $69.77.  Given their current price of $77.14, this means I expect COH to underperform the market by 1% pa over the next 10 years.  I assume a P/E in 10 years of 22x.  Their P/E ratio has averaged about 33 over the last 10 years.  COH trade on a higher P/E than CSL due to the market viewing (with some valid reasons) their immediate future earning prospects as superior.

For CPU, I derive $17.06 & $11.30.  With a current price of $9.80, I rate CPU (only just) as the best of the 3 nominated.  With a probable 1.43% pa outperformance over the next 10 years. I used a P/E of 16x.

As I said, these are superior businesses, but on my assessment, at current prices, they are not particularly cheap.

Basically, in order for me to commit capital, I usually need to be convinced of an intrinsic valuation at least twice the current share price on the 'market' hurdle rate, or closer to 3x on the 'risk free' hurdle rate.  So before I would become interested, CSL would need to hit about $21.20 (a fall of about 42%), COH about $35 and for CPU about $5.65.  Because these are excellent companies, you might allow some leeway on this point, but not even plumbing the depths of the recent downturn, did these companies reach these valuations (though CPU got close).  By contrast, I bought shares in other sound companies at ¼ or less of IV over the same period.  I seek this margin of safety, so wide, that if there are deficiencies in the valuation, the errors have to be very large before I risk significant loss of capital.

Among the other caveats are the usual vagaries of the market, just because I say on my calculations COH will underperform the market over 10 years, doesn't mean they won't beat the market by a handsome margin over the next 12 months and that if some new information comes to light, an acquisition an issue of shares etc, valuations can move considerably based on this new information.  Similarly, despite my rating them 1. CPU, 2. CSL & 3. COH, doesn’t mean that CPU might not perform most weakly of the three over a measured period, in-fact their relative closeness in valuation would leave me relatively agnostic if asked to make a selection.  The important concept here is that despite my assessment that these are excellent businesses, with good prospects, I don’t rate them as sufficiently cheap to reach for my wallet, so the search continues – Tony Hansen 27/02/2011
P.S. Warren Buffett's always outstanding 2010 letter to Berkshire Hathaway shareholders.

Valuing Companies Part 1

Without going into enormous lengths, I thought I would talk a little this week about my process in deriving intrinsic valuations of companies I consider for investment.

Like most value-based investors, my methods draw heavily in most cases from using discounted cash-flow (DCF) analysis.  I have heard using DCF described as more art than science, where the cash flows can be accurately forecast, this is not the case, but in the case of forecasting earnings for companies, this is rarely the case.  Calculating intrinsic valuations based on blue-chip companies are generally easier than when focussing on the small end of the market.  The big 4 banks for example or ASX20 companies like Woolworths, Origin, Telstra, Brambles or AMP are quite stable and can be extrapolated forward with some confidence. Others in the ASX20 might be a little more troublesome, CSL for example has had meteoric (but slowing) growth, picking future growth and a suitable multiple is troublesome.  QBE as an insurer can be hard to assess and the miners (BHP, RIO & NCM) can be harder to predict because of commodity prices and currencies across multiple countries of operation.  These are the 20 biggest public companies in Australia and the market still misprices them regularly.  I have been a long-term bear on Telstra, though their price is much fairer now.  I have been for a good while bullish on QBE. QBE have struggled a little over the last couple of years with the strong AU$.  Putting the currency aside, it’s an outstanding business, run by able and shareholder-oriented management, trading a good measure under what I would consider their intrinsic value.  Despite this, it takes the recent announcement by QBE of an acquisition, which in terms of the size of the company is far from material and is unlikely to change EPS going forward by more than about 1% and since then, their share price has run up 10.5% (at time of writing).  Go and search globally and see how many insurance companies of comparable size and security you can find that are currently 1. Yielding over 7%, 2. Trading at a multiple of 13x or less, 3. Have doubled their EPS in the last 5 years, 4. Have a combined ratio of consistently less than 90% and 5. Provide a return on equity of 20%.  If you find such a company, I’d like to hear about it.  That said, as always, I state, despite being clearly undervalued, I maintain, far more deeply undervalued companies exist in the smaller end of the market.

DCF, coupled with consideration of underlying asset values and myriad other qualitative factors helps me arrive at my assessment of a company’s intrinsic value.  The ability to completely independently assess intrinsic values has proven critical to defending and then substantially growing my family’s assets through the recent downturn.  I will not go into too much more detail than that (I will expand a little next week).  Plus the methods I use are something of a proprietary knowledge of mine, which we will share with others through the establishment very shortly of EGP Fund No. 1.

What led me to decide to talk about valuations was my fairly recent purchase of a tiny parcel of shares in a company called Astron (Ticker code - ATR).  I have been following this company since 2007, when they sold their business in China and started to move from being an end user of mineral sands products to a mineral sands producer.  When a company completely changes its direction, the market is usually understandably cautious.  If you scour through the companies at the smaller end of the market, it is not difficult to find companies that went from being technology focussed around 2000, to becoming pharmaceutical or biotech companies after the ‘tech wreck’, that have again morphed into mining exploration companies since the mining boom started.  Astron are different.  For starters, they hold a bank balance of $166.5m in cash.  The market capitalisation of the company (at time of writing) is $160m.

Basically, when you buy $1 of ATR, you are buying $1.04 of cash.  What you get ‘for free’, are substantial Chinese business interests/contacts and a JORC resource nearly half the size of Australia’s largest Mineral Sands producer Iluka resources (ILU – a $3.94b company), or only marginally smaller than Mineral Deposits Limited (MDL – a $315m company), a Senegalese prospect at a similar stage of development, on the point of preferred placement, I concur with Dorothy of Oz, “There’s no place like home”.  ATR face challenges, it will cost about $300m to develop the Donald Mineral Sands into production, but given their good cash balance and relationships with big players such as POSCO (third largest steel manufacturer in the world), it would seem pretty likely that the project gets off the ground.  To my mind, the fact that ATR is trading up over 30% on its 12-month lows is evidence the market frequently gets it wrong (i.e. they traded at less than 2/3’s of the cash they held).

I hold only 7.5% of my family holdings in ‘speculative’ stocks – everyone needs a little excitement in their lives.  I think by ATR meeting my definition of a speculator, you get some comprehension of my idea of risk management.  By the way, if anyone has a $100,000 term deposit, I would be happy to buy it from them for $96,100, which is the virtual equivalent of buying ATR, except I don’t get substantial mineral and business potential thrown in for free. – Tony Hansen 21/02/2011.

Shareholders Best Interests Part 2

Before I start, I want to add a caveat on comments I make when describing/valuing companies.  About 3 months ago, in my post here, I described the big 4 banks as having 2 classes, with WBC & CBA representing better value than ANZ & NAB.  Since then, the share prices of CBA & WBC (including dividend to WBC) have appreciated by 14.04% and ANZ & NAB have appreciated (including dividends to both) by 4.97%.  Under these circumstances, you must be sure to note the time when comments were made allow for any share price movements in the intervening period.  To clarify my position here, I would say that despite their combined $275b girth, you could now throw a blanket over them in valuation terms.  I would say it is improbable that the 4 will outperform the indices over the longer term (5 or more years).  I would be disinclined to single one out, but with a gun to my head, I would probably nominate WBC as most likely to lead the pack over the medium to long term.

Back to best interests… For Australian listed companies (who earn a substantial proportion of their profits at home), another routinely mishandled (by management) area is franking credits.  Franking credits are worthless to the companies that own them, but enormously valuable to the majority of shareholders, in particular retail holders with a marginal tax rate of less than 30% and super funds.  The most commonly cited franking credit hoarder is HVN (Harvey Norman), whose franking credit account held about $620m, or about 58.5 cents per share.  In order to pay out this full balance in the form of a fully franked dividend, they would need to pay about a $1.36 dividend.  This seems hardly practical based on a share price of $2.97 at time of writing, so obviously another tack needs to be found.  I suspect that Gerry Harvey had expected that his forays into foreign markets would solve this problem.  That is to say with a substantial proportion of profits earned overseas, the balance would be eroded by continuing to pay fully franked dividends.  These ‘International Profits’ have evidently been harder to come by than expected, though in time this choice may work out.

One outstanding recent example of a clever application of capital management, which successfully found a way of returning substantial franking credits to shareholders, whilst still enhancing shareholder value was this recent initiative by WOW (Woolworths) here. Now granted, Woolworths are facing some headwinds in the way of a rejuvenated Coles and weaker retail conditions, but you would be hard pressed to find an ASX50 company that has used capital management to better effect for its shareholders over the last 10 or so years.  To contrast, about 3.4% of WOW share price sits in the franking account, whereas about 19.7% of HVN share price is in the franking account. I stress, these credits are worthless to the companies, but invaluable to many shareholders.  I have no financial interest in WOW (or HVN) by the way.

To explain the benefits of the WOW plan, I will lay it out in brief. At the time the share-price was trading at about $29.80, the buyback was conducted at a 14% discount ($25.62), so shareholders who elected not to participate were immediately benefited by having a portion of the shares eliminated at below market cost to the company.  Those who elected to participate received $3.08 in capital component (so if you’d bought your shares at $15.08, you had a $12 per share capital loss to use against future gains).  They then received the remainder as a $22.54 per share fully franked dividend, which of course, carried a $9.66 franking credit.  This means holders who took this option received $35.28 (18.4% above market prices) in total value.  This was obviously chiefly beneficial to shareholders in lower income tax brackets and superannuation funds, but as I pointed out, longer-term shareholders also benefited by eliminating shares at a discount to prevailing market prices, thereby strengthening, or concentrating their shareholding.

Another recent example of cleverly returning capital to shareholders was in the recent special dividend by FFI Fresh Food Industries (disclosure – my wife has a small holding of FFI).  They announced a fully franked 50 cps special dividend, with a new DRP at a large 10% discount, virtually forcing all shareholders to participate, but when a management can average an 18.1% return on equity through the GFC, you have reason to believe they will be able to put the additional equity to work at reasonable returns.  They put about 1/3 of their franking balance where it belonged (in shareholders hands) and substantially improved liquidity on a small and fairly illiquid stock.  This type of owner oriented action is what I scour the bourse for, and it usually comes in situations like FFI, where the board and senior executives are substantial owners, take salaries that are eminently reasonable and consistently act with the best interests of shareholders at front of mind.  If you enjoy reading annual reports (there are only a few of us), I can commend you to this one (FFI’s) as it displays, in my opinion a clarity and directness in communication that you see too infrequently with leading Australian corporations - Tony Hansen 14/02/11

Shareholders Best Interests Part 1

To many people, the biggest issue with regard to CEO’s and Board’s of listed companies acting outside of shareholder interest is ‘Executive Remuneration’.  I admit I have never been a particularly strident critic in this area.  By this I mean that though I do think CEO pay packets tend to be higher than justifiable, I respect the market mechanism that makes the decisions and I am mindful that on a global scale Australian CEO’s are generally in the lower percentile bands for remuneration (for companies of comparable market cap).  If shareholders become agitated enough, there is change. There are many flaws in this area, but I don’t agree it is as out of control as people (mostly the popular press) think.  If there is one aspect of executive pay that does make my blood boil, that is the re-pricing of options.  If a CEO makes an agreement about their pay, there should be no prospect of re-pricing the terms of that agreement at a later date, if conditions turn out to be more challenging than was thought at the time of negotiation.

For Australian listed companies, my number one bone of contention is capital management.  In a well-run and profitable established business, substantial cash flows will be produced and the decision as to what to do with these funds (in combination with strategy) is probably the CEO and board’s greatest responsibility.  Invariably, CEO’s will default toward the prospect of mergers and acquisitions (M&A), and it is in this area the greatest folly usually occurs.  Integrating two businesses, if done well can substantially enhance results, for even when a full price is paid for a business, there are usually substantial savings to be garnered through eliminating duplicated functions.  However, there is substantial evidence that the majority of M&A fail to generate anywhere near the expected benefits.

The reason CEO’s still default to M & A, despite the difficulties is often ‘empire building’. Empire building is a human instinct and is usually very powerful among the type of individuals who run corporations.  It is not only the empire building instinct, but a dose of self-interest, caused by the fact that a CEO who runs a $500m corporation that earns $2 per share in profits will inevitably have a larger pay packet if he grows his company to a $2b company, even if it still only earns $2 per share.  This is where the board must do its job and ensure the incentivisation of executives enhances earnings per share, but pays minimal interest in growth for growths sake.

One outstanding recent example of a clever capital management strategy, which caused me to choose this blog topic is the “Bonus Share Plan” – BSP announcement described here in the announcement by CWP (Cedar Woods Properties).  I should disclose here that my wife owns shares in CWP.  Disregarding my opinion that they represent very good value (even though their share price has nearly doubled in the last 6 months), the reason I like this announcement is because of the flexibility it gives shareholders in how they receive their funds from the business.  You can either use the BSP to add new shares to your original cost base, which is what you would do if you were in an Income Tax bracket that was higher than the corporate tax rate.  Alternatively you can take the dividends or use the Dividend Reinvestment Plan, in which case you would receive the franking credits, which you would obviously do if your shares were in a super fund, or you were in a tax bracket below the corporate rate.  It would require considerably more explanation here just why this sort of option is a massive boon for shareholders, but suffice it to say this sort of shareholder-oriented action periodically strengthens my faith in corporate Australia.

The thing I found singularly most upsetting at the lows of the financial crisis was the dearth of share buy-backs and opportunistic acquisitions by those companies that had been foresightful enough to retain cash (rather than having every penny of leverage their permissive lenders would allow).  Boards and CEO’s seem to have a perverse need to have their decisions justified by a buoyant market, when of course the best results would be achieved when moods are more subdued. - Tony Hansen 07/02/11