Telstra (ASX:TLS) has done well for its shareholders over the past several years. From a low of $2.60 in March 2011, TLS shares have risen to above $5.00, providing capital growth of around 90% as well as healthy, fully franked dividends along the way. This is well above the returns delivered by the broader market during that period.
More recently, the capital growth rate has eased back to “market” rates. For the last 12 months, TLS shares have added around 16%. This is still a very satisfactory result in absolute terms, but no better than the broader market which has also delivered 16% capital growth.
While the recent history of TLS returns is interesting, investors are naturally much more concerned with the future. The critical issue is: having delivered excellent returns for investors recently, is TLS poised to deliver further growth into the next few years?
Before we get into the analysis, it is worth making the point that as a general rule, assets that have delivered very good returns in recent periods tend to offer less attractive prospects going forward. The reason for this is that very good returns often come about as part of a process where prices move from being cheap to being fair value, or expensive. When prices become expensive, the balance of probability tilts against investors, and a move back towards underlying fair value becomes more likely than continued gains.
Of course there are exceptions. Some companies have the ability to steadily increase earnings year after year, and this drives their underlying intrinsic value higher. If intrinsic value rises indefinitely there is nothing to stop share prices rising indefinitely. Companies that have this character can deliver an exceptional investment experience – and are rightly prized by investors.
For TLS then, a useful question to consider is whether it has the ability to grow intrinsic value at a rate that can sustain returns into the future. If it doesn’t, then greater attention needs to be paid to the current intrinsic value, and what it would mean if the share price were to move closer to that intrinsic value.
A good starting point for growth in per-share intrinsic value is growth in earnings per share, and for an established business like TLS, history should tell us something about the future. A business that has not delivered earnings per share growth in the past may change its spots and do better in years to come, but these tend to be the exceptions rather than the norm.
When we look at the data for TLS, the historical picture is fairly stark. Over the past 10 years, TLS has delivered nearly flat EPS, averaging around 30 cents per share. FY13 was a bit better than average, with EPS hitting 32 cents, but this is no more than the result achieved in 2004. On a 10 year view, TLS EPS growth has effectively been nil.
This is an important point. It means that unless the future looks very different to the past, TLS is unlikely to deliver material growth in intrinsic value going forward. While the future is inherently unpredictable, it is worth noting that TLS is the dominant player in the Australian market, and technological change presents opportunities for nimble competitors to cherry-pick attractive market opportunities. In short, it seems difficult to mount a persuasive case for strong future growth for TLS.
This brings us to valuation. If TLS is unable to grow intrinsic value over time, then a comparison of current intrinsic value with share price should give us a sense of the potential future returns.
Estimating intrinsic value is as much an art as a science, but there are a few facts that are relevant. Firstly, over the last 10 years the TLS share price has fluctuated in a range between about $3.00 and $5.00 per share. The current share price is at the top of this range, and given that EPS has not grown in this period, it seems reasonable to expect that share price reversion back to the mean may be more likely than continued growth going forward.
Similarly, our estimate of intrinsic value for TLS sits well below the current share price. It must be stressed that this is only an estimate, but the conclusion is clear enough – there is more room for lower prices than higher prices going forward.
The timing of any reunion between price and value of course is impossible to predict. However, it is worth noting the role played by interest rates in current share price dynamics. With rates at record lows, it is natural that investors should favour stocks with the ability to pay a reliable dividend, and as long as rates remain low we should expect stocks like TLS to be viewed fondly.
When the market starts to anticipate increasing interest rates however, there is the potential for a significant reassessment of merits. We don’t know what the timing of that move might be, but from record lows it is clear that rates will rise at some point, and when you are convinced a party is likely to end badly, sometimes you can avoid a lot of stress by having a quiet night in.