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Stock Valuation The business opportunity.

performance

creates

the

value.

The

price

creates

the

The valuation of an investment can onl y be accurate when future cash flows are known. Because we can never be certain, or even close to being certain of the future performance of a business, stock valuation is far from being an exact science, but as Buffett says, “I would rather be approximatel y right than precisel y wrong.” While future outcomes are likel y to vary from specific assumptions, the method used must be fundamentall y sound. To overlook the necessity of valuation due to the uncertaint y of future outcomes, would suggest that businesses are incapable of being valued and therefore incapable of being bought and sold with the slightest degree of confidence as to price. While the word valuation has a definitive ring to it, a valuation of any nature is merel y an assessment of worth based on certain assumptions that will vary between valuers with differing opinions. The assumptions used to determine the value will also change over time with changes in the underlyin g fundamentals of the business and its performance if they are deemed to impact on its future prospects. If the business performance and its future prospects are stable and it has the abilit y to reinvest part of its profit at a ROE exceeds the RR; the value will increase with each passing year. In the same way that an insurer needs to increase the premium to compensate for a higher risk contingency, a higher RR, which will produce a lower value, is necessary to compensate for similar investment contingencies. Value can be determined in many different ways and has labels with different meanings. Book Value for instance, is simpl y the director's declaration of the value of the company's net assets, otherwise known as Shareholder's Funds or Equit y as reported in the Balance Sheet or Statement of Financial Position. ‘Enterprise Value’ (EV) is a stock's market capitalization plus interest bearing debt. Some anal ysts will use EV to measure the debt provider’s margin of securit y. If a company’s equit y as measured by market


capitalization is grossl y overpriced and the equit y in the business is incapable of servicing debt, the margin of safet y becomes meaningless. Intrinsic or economic value is the same as investment value in as far as it denotes the value of the business 'as a going concern' to an investor. Independent? valuations: When the directors of a target company are defending a hostile bid, in which retention of ones board seat is likel y to be a high priorit y, they will seek a so-called ‘independent’ valuation in order to show that the bid undervalues the stock. Not onl y do such valuations fail to publicl y disclose the assumptions used to arrive at the value, but failure to publicl y disclose the adopted RR renders them entirel y useless. There is a huge difference between using a RR of 6% and 12%. No one is interested in keeping a stock with all its associated risks if the value is based on a return expectation of 6% per annumyet they are persuaded to do so when their directors produce a figure or a value range for the stock that is unsubstantiated (at least publicl y) by any evidence as to how it was derived. Presumabl y, the name of the valuer who has a financial incentive to produce an acceptable valuation is expected to be sufficient verification of independence and authenticit y. One of the contentious issues is when the valuer relies on information supplied b y management that has not otherwise been publicl y disclosed because of the uncertaint y of its realization. In defending a $2.35 bid from Coca-Cola Amatil, the directors of Neverfail Springwater obtained an ‘independent’ valuation of $2.49 to $2.80. A Neverfail shareholder that accepted the offer, John Singleton, commented: “I sometimes wonder where these independent experts get their numbers from. If it’s worth $2.80 and they are so bloody clever, why weren’t they bu ying the stock when it was trading at $1.80 [pre bid]?” Sadl y, such so-called independent valuations, in serving the agenda of the directors rather than the owners of the business, have so often proven to be costl y to shareholders that have been hoodwinked into not selling on the basis that the offer undervalues the compan y. One of the more infamous cases in Australia in recent years concerned the acquisition b y AMP of GIO. AMP made an offer to acquire GIO shares at a price that was vigorousl y defended b y GIO’s directors on the grounds that the price was inadequate. In support of their defense they obtained an ‘independent’ valuation that concluded that the price offered by AMP was neither fair nor reasonable. PriceWaterhouseCoopers, whose report, while not an audit, concluded that based on the director’s profit forecast, the director’s assumptions were reasonable. The GIO defense was conducted b y


corporate advisor Macquarie Bank, who ran what was described at the time as the ‘mother of all defenses’. GIO’s declared profit forecast of $250m turned into a $750m loss and all hell broke loose. Shareholders who accepted AMP’s generous offer were laughing while those that had been left stranded were eventuall y mopped up b y AMP at about half the initial offer price. Had the much stronger AMP not taken full control, GIO may have gone the same way as HIH, i.e. down the gurgler. The class action suit that followed resulted in the shareholder’s that rejected AMP’s initial offer being awarded $112 million, of which the part y suffering the greatest injury, AMP, as the new owner of GIO was required to pay half. The other parties to the takeover defense were required to pay the remainder on an agreed apportionment basis. When a compan y makes a hostile offer it must do so without the benefit of ‘due diligence’. The target-company is naturall y not going to divulge what it considers to be sensitive corporate information by opening its books to anyone with a mind to make an offer. Hence, a prospective acquirer must place a great deal of reliabilit y on the authenticit y of the publicl y published figures and the diligence of the auditor’s who endorsed them. The directors of GIO claim that their profit forecast was based on information provided by management who were later discovered to have overstated reserves b y $700m. PWC, the valuer and Macquarie, all say they relied on the director’s forecast, which they believed to be accurate. So who or what was responsible for the fiasco? It has been argued that if directors lack the will or abilit y to check on information provided b y management, they offer no benefit to shareholders and therefore serve no purpose as board members. However, is that a fair and reasonable assumption? If all information provided by management was to be considered suspect, directors would need to be employed full time in managing management; in which event it is questionable as to whether their conclusions would be any better than those whose shoulders they would be looking over. The insurance company HIH went from showing a profit in one year to $5 billion underwater the next. The change in fortunes was not so much due to underwriting misfortune, but the accumulated effect of interpretive accounting corruption. If, as was evidently the case with GIO, the complexit y or uncertaint y of insurance accounting is such that neither management, directors, auditors, valuers nor corporate advisors are able to


get a handle on the true state of affairs, it would seem that until such time that accounting standards and statutory disclosure requirements for insurance companies are sufficientl y transparent to at least allow the auditors to fulfil their obligations, investors should treat the industry with extreme caution. When bullish accounting practices within an industry create an aura of selfdelusion, its pricing of products or services will be less than they need to be to remain solvent. Until such time that the worst offenders self-destruct, the industry will be universall y unprofitable. The point to be made here is that the valuation of a stock is largel y dependent on the assumption that the historical and current figures are reliable. For the same reason you should avoid businesses you don’t understand, you should also avoid businesses whose accounts you don’t understand. It doesn’t mean it isn’t a good business, it simpl y means that avoiding a business you lack confidence to assess is likel y to save a lot a misery. The objective of stock valuation is to estimate a stock’s present value (PV) based on an investor’s future projected cash flow (dividends and assumed future value at which the stock will be sold) during a given holding period. The PV derived from discounting this future projected shareholder cash flow at an adopted RR. While a business does not have a termination date, it would be dangerous to assume that past performance will continue forever. It is therefore necessary to use a fixed time-period. The eight years used in the StockVal equation, while likel y to produce a more conservative estimate, assumes that the adopted assumptions will be good for that period onl y. The value will be greatl y influenced b y the discount rate adopted. Such rate is referred to here as the required rate of return (RR). Equit y investments such as common stocks (ordinary shares) are totall y unsecured and therefore have the highest risk. Bondholders will receive their interest payments before shareholders receive dividends and in the event of liquidation are entitled to a return of capital before shareholders. The adopted RR must therefore be a good deal higher than the interest rate payable to non-equit y interests. It must also be sufficient to provide a margin of safety for volatilit y or variations to the adopted assumptions from which the value will be derived. Other factors that figure in the adopted rate will be the company’s level of debt, qualit y of earnings, consistency of past performance and other attributes that will ensure its longevit y and prosperit y.


The price that the market might appropriate to the business in the future is unknown and therefore immaterial. Our onl y concern is that we make a judgement that is likel y to err on the conservative side and allow Graham’s weighing machine to eventuall y reflect the qualit y of the business. In addition to the adopted RR, the characteristics that determine value are ROE and the ratio of ROE that has been reinvested back in the business. As demonstrated in Table 2.2, the distribution of all profit as dividends is not an indication that the company is not reinvesting a portion of its ROE if it is contemporaneousl y raising new capital. Hence, a compan y that distributes all profits as dividends and raises an equal amount of new capital has the same characteristics as a compan y that retains and reinvests all profits. While the reinvestment ratio might vary considerabl y from one year to the next, if over a five-year period a company distributes say half its profits as dividends and raises a similar amount of new capital, its reinvestment ratio will be 100% of its ROE. By comparing the annual ROE over a period of say five years, an impression is gleaned of the profitabl y of retained profits and or new capital. If a company is retaining profits or raising new capital and ROE is declining, it would indicate that either overall profitabilit y is declining, or more probabl y the new funds are not being as profitabl y employed as the old capital. Alternativel y, if equit y is increasing and ROE is rising, it would indicate that either the new funds are working harder than the old capital or overall profitabilit y is improving. When shareholder’s equit y remains relativel y static by virtue of all profits being distributed as dividends, the stock takes on the characteristics of a perpetual interest bearing securit y and can be valued accordingl y: annual dividends/RR%e.g. $1 dividend/RR10% = value of $10. A common reason for overpricing is that PERs tend to reflect the ROE without considering the reinvestment ratio. While a high ROE is a valuable attribute, it will onl y increase the notional value when the business has the abilit y to reinvest some portion of its profit at a ROE that exceeds the PER. It is important to differentiate between a business with a high ROE that lacks the abilit y to expand b y utilizing additional funds and a company that might have a lower ROE but greater abilit y to emplo y new funds at its historical ROE. For instance, given the choice of buying a stock with a ROE of 40% and no reinvestment potential, at a PER of 10, and another at a PER of 15


and ROE of 20% after reinvesting all profits, or the equivalent thereof in new capital, the latter will prove to be the superior investment. The investment return from a company with a ROE of 40% and a PER of 10 will be 10% (1/PER). Given a constant PER or 15, the investment return from the compan y with a ROE of 20% after reinvesting all profits will be 20%.

Defining the components of business performance The components we need to determine are the probable future ROE and the percentage of that ROE that in the past has arisen from retained profits and or new capital. Leaving aside for the moment what actuall y constitutes profit and how ROE is best determined, lets imagine that over a 5-ye ar period a company’s combined total figures are as follows: Profit: $100m; retained profits and new capital $75m; ROE 20%. The next step is to divide ROE into two parts that we will refer to as ‘net distributions’ and ‘reinvested’. Retained profits and new capital of $75m is 75% of profits so the ‘reinvested’ portion will be ROE 20% % 75% = 15%. The remainder of 5% is allocated to ‘net distributions’. ‘Reinvested’ can never exceed 100%. Therefore, had retained profits and new capital exceeded the profit over five-years of $100m, ‘reinvested’ would be 20% (maximum of ROE) and net distributions 0%. Our performance components are therefore ROE 20%, reinvested 15% and net distributions 5%. The first part of the valuation equation calculates the value of equit y per share in 8 years by escalating the current equit y per share by the reinvestment rate of 15%. If current equity per share is say $10, then 10%1.15^8 = $30.59. (Equit y % 1+reinvestment^8. The ^ s ymbol denotes raising the previous number to the power of the number following the s ymbol.) In other words if $10 were left to compound at 15% p.a. it would be worth $30.59 after 8 years. This figure is then converted to a future notional value b y multipl ying b y the ROE and dividing by the RR. If the adopted RR happened to be 13%, the sum would be: 30.59%20%/13%=$47.06. The second part of the valuation equation is to discount the notional FV back over 8 years to determine the PV. The discount rate will be the RR less an allowance for dividends referred to here as ‘net distributions’ (ND). Although the figure in this example is 5%, it will not be 5% of the escalated future notional value. The value of ND therefore needs to be reduced to


reflect its impact on reducing the discount rate b y ND/ROE%RR. Hence, 5%/20%%13%=3.25%. The discount rate will therefore be RR13%3.25%=9.75%. If all of the ROE was attributable to ‘reinvestments’ (R I), ND would be zero and the discount rate would be the same as the RR, i.e. 13%. If all of the ROE was attributable to ND (zero R I), the sum would be 20%/20%%13%=13%, and the discount rate RR13%-13%=0%. In this situation the escalation rate as determined b y R I to calculate FV is also zero, so the net effect on the equation when all profits are distributed with no reinvestment is simpl y as previousl y stated, equit y%ROE/RR. Using the figures in the example the net effect of the full equation would reduce the sum to 10%20%/13%=$15.38. In other words, assuming that the investment return from the stock is solel y attributable to an annual dividend of $2 ($10%20%), if bought for $15.38 the yield would be 13%. The second part of the equation that discounts the future notional value as determined b y the first part of the equation is therefore. (1+RR(ND/ROE%RR))^-8. When discounting, the minus sign is used after ^, (^-8). The full equation: So as to avoid negative numbers were a company performance is negative, the maximum of 0 or 1 is introduced into the equation. max is the greater of the two following numbers as separated b y a comma. Excel and Lotus users will be familiar with its application. Were: E=equit y per share of $10; R I=reinvestment% 15%, B=ROE% 20% (or BROE%), RR=required rate of return of 13% and ND=net distributions of 5%. ((E%(1+max(0,R I))^8)%B/RR)%(max(1,1+RR-(ND/B%RR))^-8). Using the figures provided in the example the equation would read: ((10%(1+max(0,0.15))^8)%0.2/0.13)%(max(1,1+0.13-(0.05/0.2%0.13))^-8 = value $22.36. The net effect of the first part of the equation is: 10%1.15^8%0.2/0.13=$47.06. The equation compounds $10 at 15% p.a. for 8 years and multiplies the sum b y the ROE of 20% and divides b y the RR of 13% to produce an FV of $47.06.


After reducing ND from 5% to 3.25% b y ND5%/ROE20%%RR13%, the second part of the equation is $47.06%(0.13-0.0325)^-8=$22.36. Discounting $47.06 by the net discount rate of 9.75% p.a. for 8 years produces a PV of $22.36. Using the same equity per share of $10, ROE 20% and RR 13%, Table 5.1 displays the values that would result from changing the reinvestment % (R I).

Table 5.1 Value of $10 of equity with 20% ROE using 13% RR and variable RI

RI 0% 5% 10% 15% 20%

ND 20% 15% 10% 5% 0%

Value $15.38 $17.60 $19.93 $22.36 $24.88

Value PER 7.7 8.8 10 11.2 12.4

Because the ROE of 20% is higher than the RR of 13%, the higher the reinvestment portion the higher the value. Table 5.2. To show the impact on value of RR and R I, Table 5.2 calculates a range of values based on an equit y per share of $10 and a fixed ROE of 20% with variable RR (left column) and R I in the top row. The NB % is ROE less RI %.


Table 5.2 Value of $10 of equity with 20% ROE using variable RR and RI  Reinvestment  RR 12% 14% 16% 18% 20%

20% $28.94 $21.53 $16.39 $12.71 $10

15% $25.59 $19.66 $15.44 $12.34 $10

10% $22.42 $17.82 $14.48 $11.95 $10

5% $19.44 $16.03 $13.49 $11.54 $10

0% $16.67 $14.29 $12.50 $11.11 $10

Table 5.2 demonstrates that when the RR (left hand column) is less than the ROE, the value increases as the reinvestment % (R I in top row) increases and net distributions (ND as determined by ROE less R I) decrease. If the RR is equal to the ROE (row 5 of values), the split between R I and ND has no impact on the value. Table 5.3 demonstrates the opposite when the ROE is less than the RR.

Table 5.3 Value of $10 of equity with 12% ROE using variable RR and RI  Reinvestment  RR 12% 7% 4% 2% 0% 12% 14% 16% 18% 20%

$10.00 $7.44 $5.66 $4.39 $3.45

$10.00 $7.86 $6.31 $5.15 $4.26

$10.00 $8.14 $6.77 $5.72 $4.90

$10.00 $8.35 $7.12 $6.17 $5.41

$10.00 $8.57 $7.50 $6.67 $6.00

Whereas the highest values in Table 5.2 were in the first column of values that reflected the maximum reinvestment portion, Table 5.3 reflects the opposite. When funds are being reinvested in the business at a ROE that is less than the RR, the greater the reinvestment portion the lower the value. If the ROE is less than the RR, the last thing you want is for the compan y to


keep your share of the profit and reinvest it at a lower rate than your return expectation. In this situation the higher the dividend payout the better. Again, we see that when the ROE is the same as the RR, the split between RI and ND has no impact on the value. The tables also provide further evidence that PERs bear little relevance to value or investment returns. By adjusting the RR until the value equals the price, the market RR can be determined to decide if the stock is worth bu ying on the return ex pectation. To automate this calculation an iterative process similar to the method b y which IRR is calculated is required. Time period: When the ROE exceeds the RR and part of the profit and or new capital is reinvested at a rate that exceeds the RR, the longer the timeperiod given to the higher rate used to determine the FV, the greater will be the PV when the FV is discounted at a lower rate. Conversel y, when the RR is greater than the ROE and part of the profit is reinvested at a lower rate than the RR, the calculated value will decline as the time-period is extended. Buffett expresses this principle in simple language: “Time is the friend of a wonderful business, the enem y of the mediocre.� A wonderful business can be described as one that has the abilit y to expand b y reinvesting profits at a return that exceeds a reasonable expectation. When profits, instead of being paid out as dividends are reinvested at a low rate of return, the opposite is true. In general, companies with a history of low ROFE or ROE, irrespective of an enticingl y low PER, should be avoided at any price. To put this into perspective lets consider the investment return from Berkshire over a 36-year period. As mentioned earlier, the price increased over a 36-year period at 27.3% p.a. from $12 to $71,000. Presuming that the $12 price represented fair value at the time, what would the annual return have been had the stock been bought for twice its price, i.e. $24 a share rather than $12? The 100% overpayment would have marginally reduced the annual return over 36 years from 27.3% to 24.86%. However, notwithstanding the small apparent difference in return, at $24 onl y half the number of shares could be bought for the same outlay, so the return in total dollar terms would have been 50% less. If one had known that the price in 36 years was going to be $71,000, an investor seeking a 10% annual return would have happil y paid $2,296.79 per share.


The present value of money that has the abilit y to compound at a high rate is evidenced by the fact that had Buffett invested $10,000 less in Berkshire it would have cost him over $59 million 36 years later. Another way to look at it is to assume that had paid an extra $10,000 to furnish his home, thereb y reducing his investment in Berkshire by $10,000, the furniture which would be worth next to nothing today, would have cost him $59 million dollars. Can you blame the man for watching his expenses? Fortunatel y for Berkshire shareholders, Buffett’s frugal habits rubbed off on the business. A lesson perhaps when considering the habits of those we intend to entrust our money to. I am sometimes asked as to the significance of using an eight-yea r time frame in the equation. The onl y reason that 8 years is used is that extensive testing suggests it to be the most appropriatenot very scientific, but in the absence of certaint y of future performance, neither would the adoption of an y other time period.

Determining the ROE, and RI to be used While ROE has been used in the examples as the business performance criteria, it is a variable that will not remain constant. It is therefore important to ensure that the adopted figure is representative of what the longer-term future performance of the business is likel y to be. The IRR (as described in Chapter 2) based on the previous five years will not onl y provide a more reliable average annual figure, but also enable the determination of the split between R I and ND over the five-year period in which IRR is calculated. Furthermore, it provides evidence of the return achieved from reinvested profits and new capital (R I). For instance, if the annual ROE has been reasonabl y stable and the 5-ye ar IRR is 20% and the equivalent of 50% of profits over the period have been retained in the business, we know that retained profits and new capital has been reinvested at 20%. If there is no reason to expect that this will change in the future, we can use these figures with a reasonable degree of confidence in assessing the value. The figures required to produce the 5-year IRR will also provide the ROE for each year from which a trend can be determined, viz. stable, declining or increasing. A small business with little capital might have a disproportionatel y high IRR resulting from a high ROE in earlier years. As


equit y in the business increases the ROE is almost certain to decline, in which case past performance is not indicative of future performance. Irrespective of whether you adopt the IRR or a lower current ROE, it needs to be discounted to more conservativel y predict future performance. The equation used by StockVal to reduce the ROE or IRR to produce the ‘adjusted performance criteria’ (APC) is as follows: min(0.5,if(ROE<=0.15,ROE,ROE-((ROE-0.15)%min(0.5,(sqrt(ROE0.15)/1.6))))) The equation is saying the APC will be the lesser of 50% or the figure derived from the following calculation, and if the ROE is less than or equal to 15%, then use the ROE figure, otherwise discount the ROE as follows.

Table 5.4 ROE or IRR reduced to APC by the equation ROE 0-15%

20%

30%

40%

50%

60%

70%

80%

85% plus.

APC 0-15%

19.3% 26.4% 32.2% 37.1% 41.1% 44.5% 47.5% 50%

Future profit projections When the current year’s profit projections are known and considered reliable, they should be included in the profitabilit y table. Projections for other future years can be included, but if they increase the equit y per share beyond its present level, the value will be overstated. In any event, unless they differ widel y from the historical performance, they will not tell you an ything you don’t already know. Future optimistic projections that differ widel y from past performance should be treated with a great deal of caution.

Beneficial earnings Even when the declared profit is fairl y stated, it is necessary for adjustments to be made to reflect shareholders’ economic benefits. For instance, dividends are more valuable when they include tax imputation credits. Such tax credits are added back to beneficial earnings (BE). While accounting


standards might require the amortization of goodwill to be expensed to revenue, it is not an operating cost and should be added back to the declared profit as part of ‘beneficial earnings’ (BE). Some changes in reserves also need to be included in BE. For example, part of the true earnings or losses of a property trust or an equit y fund are revaluation of assets. Such changes are normall y reflected in the reserves in the ‘Statement of Financial Position’ (Balance Sheet) rather than revenue. Alternativel y, a company that is under-providing for depreciation and therefore declaring false profits will eventuall y rectify the under-provision b y an asset write-down in the Balance Sheet. The write-down must therefore be debited to BE rather than being treated as a legitimate abnormal. Abnormal business profits and losses must treated similarl y. In order to clarify the adjustments they are divided into two categories: Beneficial Earnings (BE) Unadjusted: Includes, amortization of goodwill plus grossed up dividends (dividends plus tax imputation credits if applicable) plus retained profits and other changes in reserves. When retained profits is shown as a separate item in the balance sheet, the figure for changes in reserves is automaticall y calculated as opening equit y, plus retained profit, plus new capital, less capital redemptions. This figure should agree with the figure in the published accounts. These are the actual figures produced by the company’s accountants without adjustments and reflect the declared shareholder benefits or losses for the accounting period. Beneficial Earnings Adjusted: This figure is derived b y adding back to ‘BE Unadjusted’ abnormal losses debited to revenue and negative abnormal changes in reserves. Abnormal profits included in revenue along with abnormal positive changes in reserves are deducted from BE Unadjusted. This adjustment is simpl y made b y entering a positive or negative figure in the abnormal row as shown in Table 5.6. If no such adjustments are made, the changes in reserves as per the Balance Sheet will be automaticall y included as part of BE Adjusted, in which case BE Adjusted and BE Unadjusted will be the same. The process of deciding what is and what is not an abnormal can be subjective. Most companies will provide a breakdown of what might be referred to as ‘significant items’ i.e. unusual or abnormal costs and income. As mentioned, write downs and revaluations, as normall y reflected in reserves, that are due to lack of adequate provisioning in previous years should not be written back as abnormals.


When expenses are capitalized as an asset, profit is enhanced by a like amount. Some capitalized expenses that enhance the declared profit need to be deducted as an abnormal gain. Changes in reserves from provisions such as foreign currency translation gains and losses that are not a true reflection of positive and negative operating attributes of the business should be included as negative or positive abnormals. The profitabilit y of the business is measured by dividing BE Adjusted by the average equit y employed during the financial year. The resultant percentage is known as BROE—‘Beneficial Return on Equit y’. Because BE is a better indication of shareholder earnings than declared profit, BROE is a more reliable indicator than ROE of the company’s true performance.

Table 5.5 $millions

Year

Amortization of Goodwill

A

Abnor mal Gains (Negati ves)

B

Declared Profit Di vidends

1

2 1

3 1

4

5

Total

1

1

1

5

5

(6)

5

4

10

12

15

12

20

69

5

6

6

6

10

33

% Franked Di vidends Grossed up di vidends at 30%

C

5

6

6

6

10

33

Opening Equit y

D

50

57

61

75

79

50

Retained Profits

E

5

6

9

6

10

36

New Ordinar y Share Capital

F

2

6

13

Capital Redemptions

G

Change in Reser ves

H

Closing Ordinar y Equity IRR Adj usted Beneficial Earnings Unadj usted Beneficial Earnings Adj usted BROE Adj usted

5 2

2

4 5

5

100

100

I

57

61

75

79

-50

3

8

1

8

J

11

13

16

13

26

75

11

13

11

19

21

79

105 22.5%

21.6% 23.3% 17.3% 25.7% 25.6% 22.7%


IRR Adjusted: The first figure in this row (-50) is the closing equit y for the year preceding year 1. The figures in years 1 to 5 are C-F+G, plus in year 5 Closing Ordinary Equit y plus total amortization of goodwill less total abnormals for the period. Hence, shareholders cash flow is measured from the perspective of owning the whole business. In excluding the impact on Closing Equit y of amortization of goodwill and abnormals, they are treated as if they never existed. Changes in Reserves is the residual of: D+E+F-G+H-I Beneficial Earnings Unadjusted: A+C+E+H Beneficial Earnings Adjusted: J-B BROE Adjusted: Redemptions)/2))

BE

Adjusted

/

(Opening

Equit y+((New

Capital-

If the IRR of 22.5% is adopted as the performance criteria its APC will be 21.2%. The portion of this figure to be attributed to ‘net distributions’ (ND) and ‘reinvestment’ (RI) is calculated as follows: In determining ND, the total of (grossed up dividends less new capital plus capital redemptions) is divided b y BE Adjusted and multiplied by APC. Viz. Grossed Adj%APC.

up

dividends

=D:

max(0,min(D,D-newcap+capred))/BE

The max and min ensure that the result is not less than zero and that the amount to be divided b y BE Adjusted doe not exceed the actual amount for grossed up dividends. The net effect in determining ND is therefore: (33-13+4)/79%0.212=6.44%. RI will therefore be 21.2%-6.44%=14.76%. Given an equit y of $10 per share and a RR of 13%, the value will be $24.53 reflecting a PER of 11.57. A lot of the mathematical detail in this chapter is provided for academic purposes and to show how the ‘reinvestment principle’ works in practice. The last thing I would suggest is that you devote your waking hours to doing stock valuations. It is important to remember that while a high ROE is desirable, it is the reinvestment abilit y of the business that makes it valuable. Is the business profitabl y reinvesting earnings and or new capital, or is it like perpetual interest bearing securit y that simpl y spits out all profits as dividends? While stock valuation is used to compare price and value, the validit y of the value is dependent on assessment of the sustainabilit y of past performance.


While the RR should be adjusted to allow for variations and uncertainties, one must feel comfortable with the nature and soundness of the business. Further information and a valuation service for Australia and New Zealand stocks can be found at www.stockval.com.au.

Alternative methods of determining earnings The diversit y of accounting interpretations and tendency for management to guild the lil y necessitates the use of alternative methods to determine the true benefits derived b y the owners of the business.

Cash flow The annual report provides a breakdown of various cash flow sectors within the business. The sector of most interest to investors is the ‘Operating Cash Flow’ that designates the cash generated and consumed b y the core operating activit y of the business during the previous 12 months. While timing of payments and receipts and other factors can cause the operating cash flow to be unrelated to the true results for the trading period, it is nonetheless a useful reference when aggregated over several years to smooth out the bumps. As a broad guide, it is useful to calculate the operating cash flow less capital expenditure (‘capex’) over a period of, say, five to ten years, and compare it with the declared profits over the same period. If the declared profits are substantiall y greater and the business is not expanding, one needs to rethink the profitabilit y of the business.

Owner earnings In the absence of accounting provisions for replacement cost, investors can calculate what Buffett calls ‘owner earnings’; which are determined b y adding back depreciation and amortization as non-cash expenses to net aftertax profit, and deducting capital expenditure on assets required to run the business.


If an operating asset has a reasonable economic life, the sinking fund provision created b y depreciation is unlikel y to be sufficient to meet the inflated cost of replacement. It should be noted that the replacement cost of imported assets would be further increased if the country’s currency had devalued against that of the country of importation. As discussed in Chapter 9, an asset-intensive business is likel y to be under-providing for replacement costs and therefore declaring superficial profits. While obsolete accounting standards necessitate the calculation of owner earnings for certain industries, most shareholders will find its application impractical. Not only is capital expenditure likel y to be lump y, with large expenditure in one year and little or none the next, but an expanding business will be providing for future growth by acquiring new assets unrelated to replacements. The question therefore is whether it is reasonable to deduct current capital expenditure that will increase future profits when determining current owner earnings, and over what period to average such expenditure. New real estate acquisitions, for example, are normall y for expansion. While the land component never becomes obsolete and normall y increases in value, buildings normall y have an alternate use, and when well maintained their value will increase for a period as replacement cost increases. Eventually, however, they will reach a point of economic obsolescence and be worthless. It is usuall y impossible to determine from the accounts the nature of new assets acquired and whether the expenditure was for replacements or expansion. Unless you happened to own a decent chunk of the business, I don’t suspect the chief accountant would take kindl y to you quizzing him on how the money was spent. It would seem that the onl y equitable solution is for accounting standards to require a ‘provision for replacement costs’ as discussed in Chapter 9.

Stock Valuation The business opportunity  

The business performance creates the value. The price creates the opportunity. Value can be determined in many different ways and has label...

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