Understanding value is key to dodging the landmines

Understanding value is key to dodging the landmines

Reporting season is in full swing and the very large share price reactions following a large proportion of company announcements suggests that the results are surprising and unanticipated. It also might suggest that analyst valuations – those relied upon for the final buy or sell recommendations – might be filled with optimistic inputs or inappropriately formulated. Given the large number of financial types that read this blog, and the number of investors in the banks, it’s worth revisiting the valuation formula.

In assessing the value of a company, the market tends to focus almost exclusively on the outlook for earnings growth. Indeed during reporting season the market obsesses over it. While obviously important, other variables are equally relevant in determining whether a company and its business represent a good investment.

The value of a share of a business is derived from the future potential cash payments receivable by shareholders. Such a valuation uses 4 variables. First, the level of earnings – technically, the valuation requires an estimate of the earnings generated over the next year.

1.  Sustainable earnings growth

2.  The sustainable marginal return on capital

3.  The cost of capital – this is the annual return required by an investor for a given investment

Given the extended period of very low interest rates and the corrupting influence this has on investors’ sense of risk, I will focus on the third point, the marginal return on capital.

To deliver earnings growth, a company needs to invest, and more often than not, reinvest. This investment might be in new production capacity, or funds for incremental working capital. It might also be capital for acquisitions. As is the case for an individual, the best kind of investment is the type that requires the lowest upfront outlay and therefore produces the highest return. Any rational investor would, for example, prefer a $10 investment that generates $5 a year of return than a $100 investment that also returns $5 a year. The same applies to a company.

Like us, a company has a finite amount of capital. It can either reinvest for growth or it can return surplus capital to shareholders in the form of dividends or share buy-backs.

The higher the return on capital achieved on growth projects, the lower the amount of capital required to be retained to fund a given rate of earnings growth.

A lower amount of capital required to fund growth leaves a greater amount of capital available to be returned to shareholders.

The very best businesses, by definition, grow earnings every year, without requiring an additional dollar of capital. While Unitab was separately listed, it produced exactly this kind of outcome.

The ability to repeat the reinvestment in growth at a high rate of return is what defines an exceptional company due to the impact of compounding returns.

While not wanting to get bogged down in a finance theory lesson, a little mathematics is necessary. Below is the standard formula for valuing a company using the 4 variables.

If we assume a 10 per cent annual return is required by shareholders, we can calculate combinations of earnings growth and marginal return on capital that generate the same valuation. For example, the value of 5 per cent per year growth at a 50 per cent marginal return is that same as 6 per cent growth at a 21.4 per cent return and 7 per cent growth at a 15.2 per cent return.

The importance of the marginal return on valuation highlights why it is important to understand the source of a company’s future growth. Historical returns provide a guide, but not an answer. Organic earnings growth is generally higher return than earnings growth from acquisitions. This is because the net investment for acquisitions includes a payment for the value the previous owners generated above the value of the investment they made in the business themselves. This reflects a payment for goodwill, which reduces the marginal return on capital for the acquirer. Acquisition growth also tends to be higher risk because the vendor is more informed.

Looking at Amcor as an example. The acquisition of Alcan in 2009 delivered strong earnings growth at a very high marginal return on capital through cost reductions. However with the majority of the benefits from that acquisition having been realised, and organic growth in the packaging industry remaining weak, future growth needs to be driven by acquisitions of small competitors. The company targets a 25 per cent pre-tax return on acquisitions, but this is likely to represent a lower marginal rate of return than the company has generated over the last five years. While Amcor has remained disciplined in walking away from deals if the returns don’t meet its minimum requirements, rising asset prices invariably mean there are fewer available opportunities. This negatively impacts both the growth and marginal return outlook for the company relative to its recent history.

Another example is the impact of APRA’s decision to increase mortgage risk weightings for the major banks. Effectively, the major banks will be required to hold 55 per cent more equity on mortgages from July 2016, diluting the return on equity for mortgages by 36 per cent. Estimates of the dilution to bank ROEs resulting from increased capital requirements ranges from 1.5 to 2 percentage points, reducing both the earnings base as well as the future return on new mortgages written.

Therefore if the banks do not reprice products to increase profits, their stock values should not only fall due to the dilution of Earnings Per Share from the capital raisings, but their Price Earnings ratios should also fall due to lower marginal return generation in future periods. If they raise prices to compensate for the increase in equity capital, then their competitive position will be negatively impacted relative to other lenders in the market.

Whichever way you look at it, an understanding of value will enable you see opportunities and avoid the landmines.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.