“The lack of focus on intrinsic value, but rather attempting to understand the extent of the opportunity – we are still quite unclear around this and would like further clarity as to how this is done?”
To understand the thinking behind the method we follow (which is quite simple relative to intrinsic value) you have to fully understand intrinsic value and the numbers used to calculate it. The next paragraph provides a short explanation of intrinsic value.
Intrinsic value calculations are generally based on 3 main input numbers:
- An income metric that can be projected for the company (cash flow, dividend, earnings per share, residual income etc).
- A number needed to discount the income metric, called a discount rate. The discount rate consists of a risk-free rate (generally the sovereign 10 year bond rate is used) and a risk premium (a number that is added to the risk-free rate which basically accounts for the added return you require for taking on the added risk for investing in that particular share). The risk premium is then further broken down to account for the risk of the sector the stock is in, the market environment, the quality of the management, the businesses where the company operates and other unquantifiable qualities.
- A terminal value metric (a growth rate that will continue indefinitely after a certain point in time, called a perpetuity, or a P/E multiple that the share will be able to retain indefinitely, or depending on circumstances a price at which the company will be bought out by another company).
The problem with intrinsic value lies in the discount rate and the terminal value metric. The intrinsic value is extremely sensitive to these inputs. When assessing what risk premium to add, you have to be able to quantify unquantifiable qualities and make a great number of these assumptions (with a fair amount of accuracy). The terminal value is just as important to the intrinsic value calculation and as a rule of thumb makes up between 50-80% of the total intrinsic value (depending on the numbers of years that are projected before the terminal value). The problem that we have here is that generally an intrinsic value is calculated after 5-10 years of income projections. Projecting this value that far out and assuming that it will exist into infinity is a big assumption, especially when it makes up that big part of your intrinsic value that you base your investment on today.
The method that we use is a lot more simple. We look at a fairly projectable number, namely earnings per share (EPS). EPS is more representative than dividends per share because growing companies don’t pay dividends. In a downturn, companies try to pay out dividends even when earnings are shrinking, meaning that they cannot necessarily keep on paying out those dividends indefinitely. Cash flow is also not always representative of what is happening in a company, because it might be investing cash flow for future growth. Therefore, the easiest and most reliable income metric in our opinion is EPS (the exact number that the shareholder is entitled to at the end of each year). This does not mean that we do not consider cash flow or dividends; they are just not the most important consideration initially.
Take, for example, a company that shows great earnings growth but with projected negative operating cash flow for the next couple of years. Depending on the reason for the cash flow being negative, we might choose not to invest if cash flows are negative because of the debtor book increasing faster than sales (points to risk increasing that bad debts might go up) but we might, conversely, choose to invest if management is investing heavily in making the company more efficient and technologically more advanced for the future, and these investments are expected to increase earnings in the long run. After considering earnings we look at the price of the share. We divide the price by the earnings (current and future) to get a current and future P/E ratio (usually 2 years out). If this P/E is lower than the company’s historic P/E (both relative to the share itself and to the market/sector that it operates in) the investment starts looking attractive.
We will also look at the environment in which the company is operating. If the environment is more favourable (tailwinds) than when the share was trading at a premium or even at par with its historic P/E, there is a good chance that the share should re-rate to trade at a higher P/E multiple. There is also a good chance that the earnings growth will surprise on the upside, which should bring down the forward P/E multiples even further and cause more share growth than expected. In an environment that is unfavourable (headwinds) relative to history there is a justification for the P/E multiple to be lower than its normal range. In unfavourable environments (because of what is called an anchoring bias), analysts tend not to adjust enough to new information and earnings growth tends to be even lower than what was projected. This, in turn, causes companies to de-rate on a P/E multiple. We compare the company’s earnings growth rate with the P/E in what is called an inverse price-to-earnings-growth rate (inverse PEG). The higher the inverse PEG ratio, the higher the growth should be relative to the P/E. When this ratio is favourable, we will start to do in-depth analysis into the company to look for company-specific headwinds/tailwinds in both internal and external company factors.
The key difference between our method and an intrinsic value method is that we do not try to place a specific value on a share, but rather see if the environment is more favourable (more tailwinds than headwinds) than historically, and that the company is cheaper than history, which would mean that the company should be able to grow its earnings easier than history yet you are getting it for cheaper.
Taking an example: based on Nampak valuations (around the beginning of 2015) and growth rates projected by analysts, the company looked very attractive on an earnings growth valuation. The company was slightly more expensive on a current P/E basis, but because of the strong projected growth rates, the analysts had projected it was trading on a very low 2 year forward P/E, both relative to its historic P/E, the market P/E and its sector P/E. When we looked into the environment in which it was operating, we saw that it had deteriorated significantly.
Nigeria was heading for trouble. Due to the slide in the oil price,the country was having currency problems. At that point in time, we were of the opinion that at some point the consumer will also feel the effects. Furthermore, they had just recently purchased a big canning plant and the market was in over-supply, but according to projections (made before the oil slide), the demand will outstrip supply in a few years.
In South Africa, the economy was weaker than it was in years, yet Nampak’s growth was expected to be higher than it was in years. Owing to the headwinds in the industry we determined that there was significant risk to investing in a company in this situation. A few months later the analysts started bringing down their growth assumptions. However, the big problem was that their terminal valuation calculations were too high. They now had to bring down their terminal valuation calculations, which caused the their target prices to come down significantly (because of the sensitivity to the terminal value).