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Valuation on a spectrum

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Valuation on a spectrum

Several weeks ago I posted some musings on how to estimate the cost of equity when valuing a firm via a discounted cash flow model. Of course, there was no perfect answer, but via analysis from a few different angles, we can usually come out with a reasonably good estimate.

Another key variable in this model is the expected rate of growth for the firm’s earnings. Again, there is no perfect answer, but there are several observations we can make that should assist in making a rational estimate. For the sake of this analysis, we’ll hold the cost of equity and all other assumptions constant.

If you were to pick up a standard textbook on the valuation of financial securities, the typical equation used for estimating future growth rates is the following:

Screen Shot 2016-06-08 at 8.21.53 AMThe equation itself is correct, but estimating both the return on equity and the earnings retention ratio is very difficult – even more-so several years out.

Practitioners will normally use whatever results the firm achieved in its last annual report as estimates. Often, they’ll proceed without regard for the business world’s two unfortunate realities; competition and marginally declining returns (the third is taxes, but we’ll stay on topic).

Because of this, let’s transform the problem into something that can be considered on less of a rigid basis.

It’s obvious that the higher price you pay for a stock, the higher the required growth rate is to justify the price paid.  Naturally the opposite also applies, the lower the price paid, the lower the required growth rate.

Having a high rate of growth implicit in the valuation of a stock is not necessarily a bad thing – many readers in 2015 may have raised an eyebrow at Montgomery’s investment in REA Group (ASX: REA) given its eye popping 40x price-to-earnings ratio.

But for REA, such a price was easily justified by both the likelihood of REA being able to grow (through its high value offering to home vendors) and the propensity to which it could grow to (given how small a share (circa 5 per cent) of the average vendors marketing budget that REA takes up).

Whilst we’ve historically quoted our valuation of REA at $65 a share (this may change), the valuation is actually on more of a spectrum. Across the spectrum, the valuation changes from a low case to a high case depending on the low/high rates of growth as a function of real world events.

This is easy to see – clearly REA’s valuation will be lower if its price increases on property ads are 1 per cent p.a. rather than 10 per cent p.a. The lower prices would result in lower revenue, less earnings and less money flowing back to shareholders and hence a lower valuation. A higher valuation would be justified if the 10 per cent case were achieved via similar logic.

Further, some events are more likely than others. REA has the required market power to push up prices by 10 per cent p.a. and customers (the home vendors) clearly have the propensity to pay. The exact price increase may not be 10 per cent, it may be 11 per cent but 10 per cent is certainly more likely than a 10 per cent reduction or a 1000 per cent increase.

So using this range in conjunction with an assessment of likelihood, we can get a much better idea of whether a security is trading at a cheap or an expensive price. That is, we ask ourselves what growth rate in earnings is incorporated into the market price, for how long and whether such performance is likely/unlikely given the facts. Ideally, we aim to buy companies when their prices are at the lower end of the valuation spectrum but with a high likelihood that events that justify prices towards the higher end.

An added benefit of this model is the ability to assess risk, i.e. the downside cases both in magnitude and likelihood. It would make sense for investors to spend ample time analysing the low end of the spectrum before they hit the ‘buy’ button.

Montgomery owns shares in REA Group.

Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

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.

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12 Comments

  1. Given you have quoted $65 for REA as a valuation, and it has recently passed $61 (not too far away from valuation) what would you be thinking if it did get to $65? Would you be looking to sell now or calculate a new valuation for 16/17 and then decide?

    When you talk of a spectrum of valuations, is the $65 the mid-point of scenarios? And does that mean there is a 50% chance of the valuation being higher than the $65 valuation and also a 50% chance of the valuation being below $65 depending on what transpires?

    • Scott Shuttleworth
      :

      Hi Brendan,

      Usually high/low & base cases are calculated in advance and only revised if new information surfaces.

      I wouldn’t put a specifically probability on any case – it’s too hard to determine or even guess. But generally you’d consider your base case as ‘the most likely case given the information at hand’ and the other cases being ‘possible, but less than likely (for x & y reasons)’.

  2. I think that REA certainly deserves to trade at a premium due to the high margins involved and the fact that it generates profits via listings and not sales – in the event of a severe housing downturn there’s an argument that that the business might be more profitable assuming sellers are willing to pay current fee’s. A company that doesn’t justify the current high PE would be Dominoes (DMP) which sports a market cap valuation almost on par with its US listed master franchisee (DPZ). The growth plan of going into debt to buy a German pizza chain would seem at odds with the lucrative fees that can be gained by selling franchises in Australia. Call me cynical but when ‘international merger and acquisition’ hits the pizza industry then we are pretty close to the top!

  3. Hi Roger

    Thanks for your reply and explanation.

    Based on the current performance of IPP I can understand why you valued the business at zero. The majority of the IPP Assets consist of Goodwill which on current performance appears to be greatly overvalued and could be subject to impairment if the Business does not improve., so a value of zero makes sense.

    Prior to the IPP transaction I believe the Balance Sheet carried no or very little interest bearing debt but now is saddled with $480 Million of IBD, so you had no choice but to recognize and include that debt against the valuation of REA.

    I want to make it clear that I’m not challenging your valuation of $65, but it seems to me that $480 Million of Debt plus the amount that REA had already paid for the 23% of IPP that it already owned seems like a very pricey “option” for a Business that still has a lot to prove.

    Time will tell if that “option” adds value to or destroys equity of the REA Group.

  4. Hi Scott

    I would err on the side of caution when valuing REA, but that’s not to say your historical valuation of $65 is unreasonable

    The Balance Sheet of REA has changed considerably following the recent IPROPERTY transaction. I believe the purchase was funded by $480 Million of debt and that would alter the WACC as before debt to equity ratio was much lower.

    Also, I can’t imagine REA having acquired the additional interest in IPROPERTY at a bargain price and because the Australian Assets of REA are now no longer a sizeable part of the Balance Sheet as they previously were means risk has increased

    It’s interesting to note that the overseas operations have not contributed much to the overall performance of REA to date but time will tell if that will change and for that reason caution is needed.

    Cheers – Max

    • Largely we were very conservative in our approach for incorporating IPP into REA.

      Our valuation prior to the acquisition of iProperty was $69, and after $65. We basically valued the firm at zero but still included the debt against the valuation for REA. This is a conservative approach. Further, we made no changes to WACC either (i.e. assumes the additional weighting via higher debt/equity is balanced out by a higher cost of equity).

      So with a valuation of $65, IPP becomes an option with no maturity and a strike price that’s already been paid/incorporated in the valuation. The option could be worth a lot as well, the Asia region has a property ad market is worth a similar amount to that of Australia.

  5. Scott,
    I commend you on an excellent article. Most investors would benefit from further education on the subject of valuation. I think that you have raised a very important point regarding valuation. Most people think that the valuation for an asset is a single dollar figure but in fact it is probably more useful to think of it as a probability distribution with the distribution created by the various scenarios that the analyst can create by tweaking the variables in the valuation equation & assigning likelihoods to these scenarios. This process takes a little bit of work but it provides wonderful insights into what drives the valuation.

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