Oh, and while I think about it Part 1 had some excellent Reference Material in it so I have created a new Blog Category called ‘Accounting’ so if you click on that you should be able to find it quite fast in the future.
This Second Bit covers Company Valuations in the main and I did some Blogs myself on this subject quite a while ago now and you can find those here:
There are Links at the bottom of that one to the earlier 3 parts.
(P.S. - Thanks Justin, the feedback I have had from WD Readers has been really glowing on Part 1 and I expect we will get more such applause for this bit - Pete).
I spent 27 years in the City with the aim of coming out with a specific company valuation which drove a recommendation on a company which I then used to try to sell the idea to the investment community. While I got a lot of things right, I also got a lot of things wrong, not because of a lack of knowledge about a sector or a company but because either a) I used a wrong valuation methodology or b) I used what I perceived as the right methodology, but the majority of the investment community disagreed with my methods – hence the art not a science.
There is a wide range of valuation tools, some really quite simple and some extremely complex:
- Price to sales ratio: Simply put, the multiple applied to a company’s sales in order to determine its valuation (the sales multiple). So if a company A has sales of £1m, applying a 1.0x multiple gives a valuation of £1m - simple. However, what if company B also has sales of £1m, but it generates a higher ROCE (Return On Capital Employed)? Surely Company B must be worth more because it generates a higher return? The answer is yes, the problem is how the sales multiple should change relative to the different ROCE. If the ROCE of Company B is twice the Company A ROCE then should we apply a multiple that is twice as big, i.e. 2x for Company B versus 1x for Company A?
- The answer is nobody really knows. The valuation could now get really complex because you can take a sample population of companies and plot their ROCE versus their current sales multiple. This would give you a line of regression and a correlation co-efficient which you can then formulaically apply to derive any given sales multiple to a given ROCE based on the co-efficient. The next problem is what ROCE to use? A historic one? A future one? An average of multiple years? So you have a simple valuation tool which can become very complex.
- Price earnings ratio: Often referred to as the PE or PER. This is the share price of a company, dividend by its earnings (normally expressed as EPS or earnings per share and is calculated form dividing the Net Income (NOPAT) by the average number of shares that the company had in issue in the financial year when the NOPAT was generated. A PE is probably the most often used valuation multiple with a low PE often seen as implying ‘Cheap’ and a High PE implying ‘Expensive’. However, the PE is a very static measurement and often bears no underlying reflection of the future growth or ROCE of a company. A company may have a very high PE, but this could be justified by strong future growth forecasts or by a high ROCE, i.e. a high PE does not necessarily mean a company is expensive.
- Nevertheless, it is the easiest multiple to understand and over long periods of time PE’s do correlate quite well with share price movements which are ultimately driven (even if equity markets do not understand it) by long term growth profile and ROCE generation. One would argue that a high PE reflects high earnings quality, but this should always be reflected in the ROCE of a company over a period of time. On the other hand, a low PE may suggest a company is cheap but if at the same time the ROCE is low (e.g. below the WACC) then a low PE could be fully justified because the returns being generated are below those of the capital costs.
- PEG Ratio: A company’s PE divided by future EPS growth (markets normally use the forecast EPS growth in the current forecast year or take a moving average of multiple years). In simple terms, a PEG less than 1.0x implies a company could be cheap (to varying degrees) and >1.0x expensive (to varying degrees). As with PE’s, the PEG is a useful short-term tool and easy to understand but bears no direct correlation with ROCE or cash flows.
- Dividend yield: The forecast dividend, as with earnings, represented as dividend per share or DPS, divided by the current share price. A high dividend yield may seem attractive, but it may be high because of the risk that investors attach to the actual future dividends, i.e. the risk of the dividend being cut. When a dividend yield goes above 6% this implies some market concerns about future earnings or cash flows, when it goes above 7% then the risk of a dividend cut is pretty high.
- Dividend Cover: EPS in an accounting period divided by the dividend or forecast dividend in that period. It is a measure of how much the planned dividend is covered by the future earnings being generated. A high dividend cover implies a low dividend risk, a low dividend cover implies high risk (below 1.0x is not a good position to be in).
- EBITDA multiple: The PE is a static measurement of a company valuation and certainly as we showed earlier, it is not a reflection of cash flows. EBITDA is more closely aligned to cash flow and hence has been increasingly used as a valuation metric over the past decade. The rub here is that we do not use the share price as the numerator, but the EV because it considers the capital and the debt associated with the generation of the EBITDA. It is represented as an EV/EBITDA multiple. It generally behaves in the same way as a PE in terms of discount and premium relative to the perceived risk or return from investing in a company.
- Free Cash Flow Yield: FCF divided by the MC (market capitalisation) expressed as a percentage. A high FCF yield suggests that capital markets are undervaluing the cash flows, i.e. if the share price rose the FCF yield would go down. It is one of the best absolute and relative valuation metrics.
- Price to Book multiple: A company’s market capitalisation divided by its NAV. Particularly useful for companies with assets, e.g. property companies or banks but fairly meaningless for companies which are asset light.
There are many other valuation methodologies, some of which are closely correlated to share price movements over long-term time frames. For example, if a company is generating a ROCE way above its WACC that should be reflected in a high PE. However, this is not always the case but what is normally the case is that the ‘excess’ returns pertaining to the capital invested are reflected in the EV of a company. One of my favoured methods used in my past life was plotting EV/IC (Enterprise Value divided by Invested Capital) versus ROCE-WACC or ROCE/WACC. Two companies may have the same IC, but one company may have generated a 20% return, the other a 15% return. This would, or well should, be reflected in a higher multiple of EV/IC for the 20% return. This metric held the best correlation co-efficient of any metric I used.
The financial impact of acquisitions: EPS and ROCE
This is another fun topic – often seen as complex but in reality rather simple if explained properly. When making an acquisition there should be 2 central questions, which have to be aligned (in the ideal world). Is the transaction Strategically sensible? and does it generate a positive Financial outcome? – Strategic and Financial – never separate the two. We could include Operational but often it is only the acquiring company that has the data to be informed about the operational benefits (synergies).
The best way to explain the financial effects is to use an example. We will use 2 companies which are exactly the same bar one simple fact. One company has net cash on its balance sheet and one has net debt.
- Company A has net cash of 100
- Company B has net debt of 100
- Their EBIT is identical
- Their tax rate is identical
- The number of shares they have is identical
- Their share price is identical
- Their market capitalisation is identical
- Their Enterprise Values are different as company A has net cash and Company B has net debt
- The target company generates EBIT of 10 (it does not matter in this example if it is pounds, millions or pence) which at a 20% tax rate implies NOPAT of 8
- The price being paid is 100
- The pre-tax ROCE on the acquisition is 10% regardless of how it is funded (EBIT of 10 divided by cost of 100), the post-tax ROCE is 8%.
- Company A uses all its cash (just happens to be the value of the transaction)
- Company B has to issue 5 shares because of its debt position (cost of acquisition divided by Company B share price = number of shares it needs to issue so 100 ÷ 20 = 5)
The EPS effects of Company A and B are very different only because they are financed differently. So,
- Company A EPS increases by 9%
- Company B EPS is unchanged
Thus, when doing an acquisition, the EPS effect is all about how the deal is financed given that the ROCE is the same for both acquiring companies. Ideally, funding deals out of cash or lower cost debt is more beneficial to EPS than when issuing shares. The only issue though is when a company gears itself up too much (too much debt for the level of cash or EBITDA it is generating) and at times like this, issuing equity may have to form part of the funding equation.
Finally, the relationship between a PE and ROCE can be seen when doing a deal.
- The PE of the acquisition is 12.5x (Cost ÷ NOPAT or 100 ÷ 8 = 12.5x)
- The post-tax ROCE on the transaction is 8.0% (NOPAT ÷ Cost or 8 ÷ 100 = 8.0%)
- The neat trick here is that the ROCE is equal to the reciprocal of the PE or 8.0% = 1 ÷ 12.5x
A quick word on Acquisition Synergies
A company which builds an acquisition case including significant cost or revenue synergies is dangerous, in my view. Often, they never materialise, or if they do, they get reinvested and shareholders never see them. Without synergies though, many acquisitions would not stack up financially despite the strategic attractions. Here in lies the rub – most acquisitions do not achieve the expected financial outcomes. So beware the serial acquirer.