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.