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Value.able TV #5: When should you sell (Part II)?

TV Appearances | Comments (126)

Value.able TV #5: When should you sell (Part II)?

When to sell Rule #1 is: No junk policy. In the second part of Roger’s selling mini-series, he identifies Rule #2: Expensive.

While market declines alone don’t prove merit in selling shares, the broad declines do suggest a disciplined approach to shares significantly above an estimate of intrinsic value is necessary. For me, if the businesses are also of a lower quality in terms of our A1-C5 ratings, for example Asciano, Amcor, Westfield or Santos – there is an additional urgency to review.

Three weeks ago these C-rated businesses were all trading at prices significantly higher than an estimate of intrinsic value. Fast-forward to today (19 August 2011) and despite the falls, Safety Margins are are stubbornly high:

Asciano: -75 per cent
Amcor: -39 per cent
Westifeld: -46 per cent
Santos: -76 per cent

For us, it is neither here nor there whether you agree with our valuations and therefore Safety Margins. What is important for us and the portfolio we manage, is the combination of quality and value. In the absence of either trait, we would be unlikely to remain a holder of the shares.

It can be potentially permanent devastating holding shares in poor quality businesses at prices significantly above value.

Imagine you acquired shares in a business today for $2 and estimated those shares to be worth $4, rising to $4.10 the following year. Then suppose after six months the share price rises to $3.00.  What would you do?   Value.able Graduates, are expected to answer that question correctly.  Now imagine the price of those same shares has risen to $6 in the same time frame. Would your answer change?

It may be tempting to set up some hard and fast rules about when to sell. I am not as comfortable with this approach as I am with the idea that the appropriate premium above intrinsic value at which to sell depends on the future prospect for the company and therefore its intrinsic value for the future.

Your response may be that there is greater uncertainty in future valuations. If that is your view, then you should sell.

Whilst we should not try to predict the future, it is important to look through a conservative telescope. What will be the value of each company in your portfolio next year? And the following year? Understanding the business and using that understanding to help establish prospects for intrinsic value appreciation in the future is a vital component of the Value.able approach, we advocate here.

If you are yet to join the Graduate Class, order your copy of Value.able immediately at ‪http://www.rogermontgomery.com/. Once you have 1. read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).

Value.able TV #5 was recorded at Montgomery HQ on 19 August 2011.

Posted by Roger Montgomery’s A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 19 August 2011.

Visit ‪‪http://www.rogermontgomery.com/ for Roger Montgomery’s step-by-step guide to valuing the best stocks and buying them for less than they’re worth.

INVEST WITH MONTGOMERY

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.

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126 Comments

  1. Peter Ralph
    :

    Hi Roger,

    I’m a little surprised about the comments made about MCE’s cashflow…it’s an expanding business and its working capital increased from $34.216m to $52.03m during the year…..current ratio strengthened from a strong 2.0 to a stronger 2.28……it would be rare to find any company increasing sales by 84% without an increase in working capital. Margins deteriorated in the second six months but I believe this partly related to Henderson…I know of no company whose margins are not impacted while undertaking a major plant expansion and there may be teething troubles for a little while yet. Gross margin over the two years was consistent declining from 30.9% to 29.1%…..an increase in 2012 sales of 20% (directors forecast) should add $11m to the gross, most of which should flow to the bottom line…..my estimate of 2012 net profit is $42m. (this does not take in any efficiency gains from Henderson).

    Finally to those who totally disregard PE ratios, one of Ben Graham’s methods of stock selection was to focus on buying low price to earnings ratio stocks which in his view afforded him a margin of safety. Mary Buffett in ‘Buffetology’ suggests that when you project income forward you can use a PE to it to confirm value arrived at by other means.. i.e. discounted cash flow analysis. Using a net profit of $42m for MCE for 2012, a very conservative PE of 10 for a growth company and total listed shares 77.081m I arrive at a value of $5.45……my value using the Value.Able methodolgy is considerably higher. As investors we need to use all available tools and the PE is one of them.

    Peter

  2. darrin
    :

    Hello Everyone

    Can anyone assist me with what area of the annual report should I be looking at to determine whether a company has a good cashflow or not?

    Also what is a good cash flow?

    cheers

    darrin

  3. Robert Field
    :

    Hi All,

    My take on MCE’s results is that it may well be an outstanding company, but if the reason they have had no new orders in the last 6 month is essentially currency – and the high AUD is a consequence of the current global issues – and you believe our dollar is headed even higher – then it stands to reason that MCE is essentially doomed. So much for the doubling of revenue, so much for the capital raising at $8.50 to finish the plant.. the money will most likely be used just to pay the bills.. And they raised the dividend!?!? This in particular seems to me to be the hoof marks of management doing entirely the opposite of the right thing. I could go on.. But safe to say I’m extremely underwhelmed. Is buy and hold even possible in a country where mining seems to be all we have… Traders have no doubt been the winners on MCE’s $4 to $4 bell cured shaped ride since last August.. defiantly not anyone who believed intrinsic value was higher than $6 – $9..

    RobF

    • PaulS
      :

      Hi Rob,
      For what it’s worth I still feel with a fully bedded down Henderson plant running at a significantly lower operating cost than their current manufacturing cost base, this will more than offset those adverse currency movements that a lot of aussie manufacturers are struggling with at the moment. You must remember there was very little benefit derived from Henderson for this FY and we are talking about a state of the art facility that should help to drive growth and lower operating cost over the next 5 to 10 years. I agree with you concerning the dividend payout though, perhaps this was raised to appease shareholders, however a more pressing need would be to retain funds and put it to work at higher R’sOE, which this company has shown is capable of doing.
      Also, the company seems to be diversifying their product base, so the newer product offerings at this stage won’t have the same ROE of it’s prime product, which brings the overall ROE down.
      I am looking forward to Roger’s comments after his discussions with management yesterday.

      Cheers,
      PaulS.

      • Brad J
        :

        Rob,

        The only reason they haven’t booked many orders is because of the purchasing cycle. They will be announcing orders as they come through which Aaron Begly expects to start coming though over the next couple of months. I know this as I spoke to him today. He also expects a 20% increase in revenue growth over the next year and believes this to be on the conservative side.

      • Robert
        :

        Hi All,

        Cheers for that. I still think its a good business (For now), but Im going to sit on the sidelines until things get a little clearer. There has been allot of talk about cash-flow here… and my initial take on it last year was much the same as Rogers – they were in the middle of constructing a large facility – and it was to be expected.. But between then and now, there was no solid way of appraising the situation, and circumstance had it that the share price had been taken down with the market – almost back to where it started last year.

        My take on the capital raising – which seemed to be the catalyst for the downtrend – was that it was to be expected – given the half built nature of the Henderson plant – and the negative cash flow. As far as currency is concerned, I am jumping to conclusions, but It may just be justified, as the apparent evaporation of orders seems to be correlated to the rise in the AUD, which is giving other manufacturers problems. We shall see.

        I would also just like to thank Roger for bringing this company to my attention last year.. because if he hadn’t, I may not have had the opportunity to inspect it for myself. So, many thanks!

        RobF

  4. Brad
    :

    Re TRS, do you think management are a tad optimistic with a target of 400 stores in total?

    Growth forecasts may be a bit bullish.

    MCE on the other hand would appear to have a good 5 – 10 years of growth ahead of it.

    Whether your valuation is $8 or $12, the stock looks cheap at current levels

    Might be time to back up the truck ?

    NAB’s offering .9% credit cards for 12 months, might get a mega cash advance and load up ( no margin calls!)

  5. Michael
    :

    Observations on MCE result:

    – A little below forecasts, but hard to complain about 80%+ growth
    – Order book well down on prior year
    – Will likely borrow more in 2012 year to fund cash requirements
    – Korea made up over 50% of revenue in 2010, much less than this in 2011
    – Estimated revenue increase of 20% – big decline in growth rate
    – Prospects likely not as bright as many thought, but much of this would appear to be priced in

    Disclosure: I own MCE and will not be selling (I’m going down with the ship!), but am not likely to buy more.

    • Todd
      :

      Love that going down with the ship attitude, I also own MCE not much as a % but I’m with you I won’t be buying anymore but prepared to go down with the ship also.

      • Ivan Juresa
        :

        They make flotation devices and Henderson has just left the slips. This ship won’t sink.
        I like the story so far and in this instance have ignored my stop loss points and have averaged down three times so far but I’m still only at 10%. Paying a dividend after a capital raising was not the best use of funds or I’d have bought more

  6. Brian Aitken
    :

    MCE my IV based on a RR of 12% & also the forecasts on Commsec are 2011 – $6.15, 2012 – $7.19, 2013 – $9.31. I’m currently happy for the long term value & growth.
    Brian A

  7. Brian Aitken
    :

    My current valuation for MCE on a 12% RR is $6.15. It really was an impressive result, an 85% increase in NPAT, even though not as much as anyone was expecting. With the Henderson Plant having only been been officially opened just prior to the end of the financial year, the capital spent on the new premises has not had an opportunity to provide a return. With the forward orders of $110m & $500 in outstanding quotes, I consider that the IV will definitely grow at a good clip.
    Regards
    Brian A

  8. Scotty G
    :

    MCE Update:

    EQPS – $1.64
    Forecast EPS 2012 – $0.541 (17.5% rise on last year)
    ROE – 32.5%
    POR – 20%
    RR – 14%

    I Get $6.72 for this year going to $7.33 for next year assuming another EPS growth of 17.5% and POR increasing to 22.5% with ROE falling to 30%

    I believe Mr. Market flipped out over the lack of cash flow which is what drove prices lower today. The stock could remain unloved for a while until the HY result restores some confidence.

    Regardless I’ll be holding mine.

  9. David V
    :

    I know Mr Market was surprised and disappointed by MCE’s results today as it fell 10%. That said, there were no surprises. Cash flow was negative. This was known as they had gone to the market with a capital raising to help fund the finalisation of the Henderson plant. When you looked at the half yearly report, you could see that this was going to be the case. A lot of money has been focused on the Henderson plant and I am expecting this to return on the investmet starting in 2012 with the increased production capacity. Additionally, ROE was down, but again this was a measure of two things a) an under utilised Henderson plant and b) an increase in equity late in the year through the capital raising. The ROE increases significantly if you average in the period that they had the capital raising funds (i.e. about a quarter of the financial year). As the financial report is point in time, it makes the ROE look smaller than the actual delivery throughout the year.

    I still like MCE’s prospects and do own the stock. I just feel disappointed I already topped up my holding and can’t buy in further at this level.

    • David C
      :

      Some comments. Cashflow from operations was positive. One big change from last year is the reduction in deposits. Have a look at the comparative balance sheets. Deposits listed as a liability, i.e unearned income. Given the company is not holding any deposits as at 30/6/11 this impacts the cashflow by $35M. I seem to recall that the reason for the high level of customer deposits was the need for customers to secure supply in a competitive environment/ associated with supply constraints. Can anyone confirm this? Does the absence of deposits as at 30/6/11 reflect a reduction in product demand? I note revenue increased by $87M YOY which suggests increases in production. Need to see the cashflow reconcilation to profit which does not seem to be in the preliminary report.

  10. Dane W
    :

    Hi Roger,

    One question I have is that some of the annual report report a dividend paid out last years final and this years interim dividend (eg: Matrix). They then say that the final dividend has not been included in the annual report (again Matrix). Which figure do you use? For example MCE say they paid 3.8 Million in dividend but if you actually multiple the 8 cents paid this year buy the weighted shares you get about 5.9 million. Appreciate the book (great read!!!) and just need this answered.

  11. Kent Bermingham
    :

    How can a Company Rated as an A1 MCE have a Capital Raising in April/May 2011 of $35 MILLION being aware what the end of year financial position could have been at that time only to go ahead with it and dilute Shareholder Value by $16 MILLION.( Capital Raised at $8.50 per share and current price $4.29) a 44% dilution?
    .I am sure a number of Graduates were caught up in MCE at various stages including the Capital Raising and along with Institutional Investors are not happy Investors at the moment.
    What does it say about info from Analysts, Planners and Corporate Managers that we use to make astute Investment decisions – who can we believe?

    • Roger Montgomery
      :

      Quick thoughts only, Seek and take personal professional advice:

      Digging in a little deeper to BigAir’s financials and you might notice a few things to be cautious of – always important to read past what management tell you about revenue numbers climbing to the moon and do your own thinking.

      These are all symptoms of a fast growing business, and a business which has grown by acquisition.

      Firstly, short term funding strapped – CL > CA by 400k. This blowout and mismatch is mainly due to the $3.6m they owe on their acquisitions in the next 12 months. They have annoucned that they have bought them but havent yet paid for them. They also owe $1.375m which is in non-current liabilities – a total of $5m in payments are still to be made for past acquisitions in the foreseeable future. See note 18 to the accounts for more.

      The next 12 months are the most important, and with CL > CA, while they might be able to cover this by playing with their working capital (delaying payments etc..) clearly its not an not an ideal position to be in. What you now need to work out is if future cash flow and of course CAPEX which seems to run @ $2.5-$3.2m will provide enough free cash for them to self fund their operations and liabilities. This of course is hard to work what is actual maintenance CAPEX vs growth given the recent acquisitions and the rollout into Sunshine Coast (albeit, this wouldn’t cost that much).This is a problem with trying to analyse a business which grows quickly through acquisitions. Oh to have access to tax returns!

      That said, they will need to find some cash and while I suspect cash flows will be strong enough to see them through their “organic growth period”, just don’t expect a self funded divvy for a while!

      • Ron shamgar
        :

        Hi everyone,

        I have spoken to management of BGL and they have clarified payment liabilities and capex breakdown.

        Cash-flow is so strong for this year that all liabilities will be self funded including if they chose to a self funded divvy!

        I will write a detailed post about BGL this weekend. It is very cheap and one of the best growing companies in it’s industry.

        To be continued…

      • Andrew
        :

        Interesting post Roger, i came to the conculsion during this reporting season that these type of businesses (Vocus, BigAir etc) are not for me.

        Yeah they could be much larger in 2,3,4,5 years time but i have no idea how to comfortably analyse them. I really enjoyed and always do enjoy hearing your experienced thoughts on such topics.

        I’ll stick to my retail, finance and misc manufacturers and service providers. In fact this financial year i have called “the giant cull”. Getting my watchlist down to a core group of companys i can watch. This list has gone from 45 to 27.

  13. Craig B
    :

    This is really where the rubber hits the road for this value investing caper.

    Monodelphous hit the ball out of the park again today, and the market’s response has been to pump up their share price by 10%. Someone on this blog recently proffered another firm as possibly the best in the land (I presume they meant in terms of something you’d love to own) but MND are right up there. Look at the contribution of retained earnings to their equity. Wonderful business, obviously. But they’ve gone from overvalued to a good deal more overvalued.

    The Matrix price gets hammered by the same amount – 10% – and despite some cautious remarks in the preliminary Annual Report, the numbers suggest that at a market price of $4.80 our differences in intrinsic value calcs are irrelevant. You are compensated for a mild tempering of outlook by a very low price.

    So do you follow the herd into Monodelphous or walk into the oncoming crowd to invest in Matrix?

    Surely you have to take your chances with the latter.

  14. ZORAN
    :

    MCE , FGE

    We celebrate one and bury the other.
    What does this tell us about their IV.
    Roger always said,dont buy before you get profesional advice.

    Cheers
    Zoran

  15. Brian
    :

    Hi Roger & Bloggers,
    First time blogger & 1st attempt at IV calc. Hoping someone can clarify a couple issues concerning MCE.
    1. Noticed that comments in today’s blog range IV from $6- $12, using a 10%ROR and figures from today’s Prel Financial Report I get $11.11. Is the reason for the wide range the treatment of the capital raising? If so what is the best way to calculate EPS?
    2. I have been purchasing A1 large caps at a discount to minimize short term risk but picked up some MCE today under $5 to test this strategy. Is the big drop a ‘push to bargin level’ as referred to in Chapter 11 or is there something more sinister driving prices down?

    Appreciate your views, Brian

  16. Stephen
    :

    Hello all,

    Another pleasing result from Monadelphous (MND) was posted today showing what I believe is a company going about its business very effectively.

    I’ve done my figures for the year and post them here for any comments or disagreement from my fellow bloggers.
    I have elected to use a RR of 10% in my calculations for 2011 for the following reasons:
    MND has shown consistent growth across its 3 main work areas for several years.
    EPS have grown at a good pace, this year increasing by 14 per cent. This is above the growth experienced by the company last year and demonstrates strong business activity.
    The order book going into 2012 is strengthening and I note management’s comments concerning the outlook for contract wins in 2012.
    MND’s new infrastructure division has shown enormous growth over the past 12 months and appears ready to contribute more and more to the company’s earnings going forward.
    Long term contracts with customers are stable allowing an estimate of solid future earnings to be made.
    MND has a sustainable competitive advantage through its high customer retention rate and industry reputation.
    It’s worth noting that this year’s figures show a decline in ROE from 66% in 2009, to 62% in 2010, and now to 56% this year. This may indicate that the company is starting to mature, however the emerging infrastructure division may provide enough organic growth to see that stabilise.
    Current Equity: $193,234,000
    Equity 2010: $144,286,000
    Average Equity: $168,760,000
    Eq/share: $2.206
    NPAT: $95,067,000
    Divs: $77,041,000
    POR: 81.3%
    ROE: 56.83%
    ROE used in calc 55%
    Table 11.1: 10RR:55% = 5.5 x$2.20=$12.14xPOR=$9.83
    Table 11.2: 10RR:55%=21.511x$2.20=$47.46×1- POR=$9.00

    My IV=$18.83.

    My cash flow analysis shows positive $73M however I would be grateful to know what others may have calculated for this as I’m unsure if I have this down pat yet.
    I suspect over the next few days, most of the blog will concentrate on the MCE report but as I know many of the contributors to this forum own MND, it’d be remiss of us if we didn’t evaluate this excellent company with as much attention as will be paid to the likes of MCE,VOC etc.

    Stephen

  17. Rod h
    :

    Is there any issue with MCE’s results that I’m not seeing.

    It’s dropped 10% today after the results release…
    Is there anything going on about the results or anything else that anyone knows about ?

    I note BSL lost 8 % on Friday (and I nearly bought some as a speculative 2 day trade) and I found out on Monday it’s sacking 1,000 people and which I didn’t know on Friady and it lost another 5 %

    • Andrew
      :

      In regards to Bluescope Steel, the company has been seeing declining profitability for a while. I don’t think the plant closure should be too much of a surprise in an environment where the high aussie dollar is making it hard for manufacturers and price for iron ore and coal have increased.

      One of the reasons to focus on the company and not on the share price, this could be an area you are having trouble with judging by your comments (just an observation and please take no offence to this as i was very similar at one point).

      I don’t know if there are any red flags on the MCE result but if there isn’t any, does it matter if the share price fell?

    • David
      :

      Rod,

      I suggest you look at a)the cash flow and b) the order book. Both have taken a major haircut.

      David

    • Manny
      :

      Yeah wondering myself why MCE went down 10.7%. Waiting for Roger to shed some light.

      My only two small observations were:

      1. Some of the capital raised (not sure how much) was for constructing office space i.e. used in non-core business activity (i.e not for plant, equipement etc)
      2. Somewhere in their presentation I noted them saying on the lines that competetive risks are building up for them.

      Anyway look forward to what others and Roger think

      Cheers
      Manny

    • Ray
      :

      Rod

      Two things that I have noticed are these. Although the turnover was almost double the half year figure the profit figure was down by over 5 million dollars over the first half. This suggests that there may have been some issues with bedding in the new production facility or that the increase in staff and overheads to allow for future sales push throughout the world has lowered the profit margin.

      Also they now only have an order book of $100 Million, down from $180 million on earlier reports. The quotation book is increasing nicely but they do not seem at the moment to be converting the quotes to orders.

      Therefore although the profit increase figure looks good the future looks uncertain and I believe that is the main reason for the poor performance after the release of the annual report.

  18. Todd
    :

    Roger (or anyone) can you please tell me what about the MCE results today caused it to drop on what would have been a positive day otherwise. Thanks

    • Kent Bermingham
      :

      Brad, I think the cashflow is terrible even though cah at bank has increased 13 mill, Borrowings increased $ 38 Mill and Issued Capital increases $36 Mill, Div Paid $4 Mill makes for a huge cash loss, will be interested in what has happened since Roger last talked with them?

  20. garry
    :

    hi Roger,

    after reworking the valuation for MCE today i get a 2012 valuation of $7.70 using a RR of 11%..
    Would it be fair to say that due to the recent capital raising and building of henderson that there is a substancial amount of equity that is at this stage not being utulised. And that in the future, once completed, will provide cost savings and increased production capacity that should, providing orders continue to increase, will increase ROE significantly. Am i on the right track and that the selloff on the release of the report is that institutions may not be looking beyond the lint in there navals??? ( i love that call)

    garry

    • Roger Montgomery
      :

      Hey Garry,

      I have renamed Tuesday McEday. Attended the conference call and discussed my observations with Aaron Begley. Preparing our report on them today and will be back with some insights shortly.

      • Peter M (Mully)
        :

        Hi Roger,

        I’d be interested in your comments on their cash flow which, on the face of it, doesn’t look too flash.

        In their preliminary report they state that the difference between FY2011 and FY2010 is represented by an increased working capital requirement resulting from the significant amount of deposits and advanced invoicing on projects that took place during FY2010.

        Pending further information and analysis, it looks like a timing issue to me and since I don’t expect them to go broke anytime soon, I’m inclined to give them the benefit of the doubt pending a full year’s production at the new Henderson facility and any further information, analysis and insights you may be able to offer.

        Otherwise, it still looks like a good business offering good value relative to my estimate of current and forecast values.

        Look forward to hearing more about what transpired during the conference call today.

    • Greg Mc
      :

      Certainly Henderson made a minimal contribution to FY11. The benefits of the new facility will be demonstrated in FY12, all other things remaining equal. I get the impression that they really pushed through a lot of production to work through their backlog at the higher cost Malaga plant.

    • David
      :

      Garry,

      I would suggest your RR is way too low for a business of this type. The minimum should be 12% and up from there. MCE is a 14% for me.

      David

  21. Edward
    :

    Roger,

    I cannot help but notice in recent posts that you seem to be getting hassle regarding your fund returns and the new A1 service. This hassle just amazes me.

    – Returns. The only proof of success are absolute returns over the long term. These absolute returns can be through any method– sports betting, cash, property, shares, starting a business and so on, it is all the same, just plain old allocation of capital. It is a very small percentage of the population that are able to produce annualised returns greater than 15% over the long term irrespective of what “game” they are in.
    – A1 service. Your product so feel free to package it however you wish. I hope you make plenty of cash from it. When I receive my invitation I will make my up my own mind whether I want to buy what you are selling.

    Best of luck keeping sane and please keep the blog on track – it is a very useful resource.

    Cheers

    Edward

  22. jeremy
    :

    Fellow graduates, Ive attempted an updated IV for MCE after todays results announcement, am i way off?

    Last years IV – $6.92
    New IV – $11.79

    Ive used 77 shares on issue, POR of 19%, ROE of 42.88% and ROR of 11%. All data is from comsec plus todays EPS of 46 cents and DPS of 8 cents.

    Any thoughts would be greatly appreciated

    • Darren78
      :

      Hi Jeremy,

      I got about the same with 56% ROE and 12% RR. I used 33.6m NPAT divided by beginning equity of 60m to get the ROE.

      I then have IV staying around $11 for 2012 and 2013.

      My analyst forecasts had EPS as 0.51 for 2011 and it is actually 0.46. Hard to get these things right when you can’t rely on these forecasts!

    • Craig B
      :

      Jeremy,

      I get an ROE of 26% using ending equity. I normally use starting equity but I’m thrown a bit by the capital raising.

      For 2012, and using a ROE of 30% I get $8.90 for an 11% RR.

      Despite the difficulties I have in determining an equity figure to use, at under $5, there’s clearly a Margin of Safety.

      To use one analogy from the value investing canon, if MCE was a middle aged bloke with weight issues, you could tell by looking at him. He wouldn’t need to hop on the scales.

      • paul
        :

        I got $6.49 for this year. ROE 26.5. Used this years equity figure because of the large increase in equity.

      • Lach
        :

        Jeremy,

        I get a very different figure for 2012, 77m shares, ROE 28%, RR 12 IV $7.65, looking at their report their revenue is forecast to grow at 20% and margins are under some pressure. 2012 revenue will be $224m exisiting profit margin is 18% so assuming a margin of 16% 2012 profit will be $35.9m. Another point to look at is their breakdown of enterprises, they are trying to diversify their reliance on the composite business, from 84% now to 57% in the medium term, the other business’s have poorer margins, therefore growth is likley to slow and so will value.

    • PaulS
      :

      Hi Jeremy,
      Here’s some of my inputs with some differences, as I’m trying to work out how some of the annual report figures are calculated (maybe the Value-Able gurus could confirm some of our findings):-
      1/ issued shares 77,081,507
      2/ shareholders equity 76,388,203
      3/ BV = 0.99 (shareholders equity / issued shares)
      4/ EPS = net profit 33,608m / 77,081,507 shares on issue = 0.4360 (annual report says 0.46 so my figures seem to be out here)
      5/ DPS = (div pay out of 3.75m divided by shares on issue 77,081,507 = 0.048 (annual report says 0.5c so close enough)
      6/ POR = (dps 0.048 / eps 0.4360 = 11%)
      7/ ROE = (eps 0.4360 / bv 0.99 = 44%)

      TRUE CASH FLOW FOR PERIOD I HAVE AS -19m (need to double check this)

      Using RR of 11% the same as you I get an IV for 2011 of $11.56
      Using RR of 12% I get an IV for 2011 of $8.98

      Cheers,
      PaulS..

      • PaulS
        :

        Hi Jeremy,
        A couple of corrections re: my book value which has thrown out my other calcs.
        1/ shareholders equity (including retained)126,760,000
        2/ issued shares 77,081,507
        So my new BV is 1.64 NOT “0.99” being (126,760 / 77,081)
        3/ I have EPS at 0.43c being NPAT of 33.6m / 77m shares (annual report says 0.46 so I haven’t worked out what figures their using for shares on issue.)
        4/ POR = dps 0.08 (full year including 3c interim) divided by 0.4360 eps (18%)
        5/ ROE = (eps 0.4360 / bv 1.64 = 26.58%)
        6/ 5.203 is the retain multiple i’m using from RM’s Valueable p184.
        So my new 2011 IV with an RR of 11% is $7.68.

        Cheers,
        PaulS..

    • MattB
      :

      While this doesn’t directly answer your question, I noticed several key points in the MCE report. Revenue is expected to increase by 20%. This seems low to me. Is the ROE of 42.88% sustainable?

      Dividends have increased substantially. I’d much rather they kept my money if they are even close to that ROE going forward. I’d be interested in other graduates opinion on this given MCE’s status as one of the darlings of this blog.

      • David Sinclair
        :

        MattB,

        My attitude to businesses paying dividends is fairly flexible. I want them to keep as much of their earnings as they think they can invest at a high rate of return and give the rest back to me to invest somewhere else. I don’t want them to keep all of their earnings only to end up either chasing smaller and smaller incremental returns or making dumb acquisitions.

        Looking at Matrix, the fact that they have raised capital in the last twelve months suggests that they have plenty of opportunities for further investment and should have held on to the cash rather than pay out what is, even after the recent increase, a fairly token dividend.

        David S.

    • Sean
      :

      I have quite a bit lowere than that but I use 14 % RR for mining/resource based companies. Try valuations with figures directly from the reports and you will get different figures for POR, ROE etc.

      Why use a third party with risk of miscalculations when you can get all you need directly from the reports.

      FWIW, my valuation @ 30/6/2011 comes in @ circa $8-$8.50.

    • Andrew
      :

      Hi Jeremy,

      Thought i would take a look as MCE gets mentioned a lot here.

      First of all, take my IV calculation as you want, i am not intrerested in MCE shares at all regardless of price so the below is nothing more than an arbitrary calculation based on the limited knowledge of the company i have.

      I used a required return of 13% and got a low IV of $6.23 and a high IV of $8.07 which workes out an average of $7.15.

      The average price for me on 11$ which i think is a similar RR you are using is $10.91 so you appear to be in the ball park which is the main thing, a good MOS will take care of the rest.

      From your inputs above i would say that the ROE is too high, i got 36%.

      May i suggest too always getting the information from the reports released directly from teh company (found through ASX) and do the calc’s yourself. Not only will you get to see the whole picture but you can be 100% sure of the accuracy as Comsec might work out things based on a slightly different calculation. It taks a bit longer but it is worth it.

      Hope this helps

    • Bruce D
      :

      A bit new to this but today’s ROE is 26.5 isn’t it ? And I read Comsec’s as 30.3 which is the same as today’s announcement for 2010.
      Cheers

    • david martin
      :

      Jeremy / others, I am not an accountant so Ash and other’s might have a better handle on this but as I understand it the problem with the Matrix results is its cash flow.

      In 2010 it generated NPAT of around $18.5 million but had net cash flow from operations of around $27.5 mill (before tax). In other words it received forward orders and deposit in 2010 for work that was to be completed in 2011. For accounting, the income is earned when the work is completed – not when the money is paid.

      This would have understated NPAT in 2010 and overstated cash flow relative to income.
      You only have to look at the tax position – last year tax was only $1.1 million on a cash flow from operation of over $27.5 million!

      This year the tax is $7.8 million on $9.3 million net cash from operating activities.

      In 2011 the company generated NPAT of $33.6 million but excluding tax had operating cashflow of only $9.3 million. Clearly some of the “revenue” was earned this year even though some of the cash was paid last year.

      As an exercise if I combine 2010 and 2011 and average them – the NPAT is $51 million over the 2 year period – average of say $26 million per year. Average equity is around $92 million which gives a ROE of around 30%. Current equity is around $126 million.
      Assuming their intention is to pay a dividend in future of say $.08 cent on EPS of $0.46 cents per share – POR is around 15% and valuation using RR of say 12%, current equity of $126 million, my valuation is around $7.80.

      Going forward however they have suggested revenues to rise by 20%, their forward orders are only $100 million (even though they are quoting on $500,000) and they say the market conditions have changed in terms of competitive landscape …

      I would be very interest to see how others view these results and perhaps roger, you might want to do a Valuable.TV on the numbers as I am sure many of the current bloggers own or have owned this company.

      Regards
      David

      • Greg Mc
        :

        Good post, David. We have to remember that almost of 2011 production was from the old plant, which is more costly and requires many workers to run, as well has incurring significant transport costs measured in $100,000s per month. Henderson needs only a few blokes to run and is almost on the water. The report alluded to MCE having the highest number of employees/contactors during this period as they were pushing Malaga pretty hard as well as building and fitting out Henderson. Their cost of production should fall significantly, so while revenue may be forecast to rise by 20% (but could be quite different), their margins can improve even in a more competitive environment.

      • Dino
        :

        Progress claims 35 million as at 1/7/10. zero as at 30/6/11. Costs to produce this 35 incurred in 2011 cash received in 2010 & revenue declared in 2011. Hence the difference in profit to cash profit/operating. No material changes to payables stock or receivables.

        Mainstream investors cant see the potential in mce. Two mainstreamers on your money your call tonight “apparently much better investments than mce in the mce space/mining services”. Are they right????

      • Roger Montgomery
        :

        We have not had a material weighting in MCE. Look up the comments from recent months. I indicated here that the absence of any material contract wins, would put pressure on cash flow:

        Submitted on 2011/07/05 at 1:08am, Share Price= $7.91
        Delighted to hear you went with the more conservative option Rob. Always do your own homework and research and seek and take personal professional advice. I cannot predict short term share prices. The short and mid term outlook for Matrix will be dependent on them securing some contracts and their cash flow will be dependent on them getting a few deposits paid. We have pt a call into the company to see if we can get an answer but they may soon be in blackout so we’ll have to wait and see.

    • Ray H
      :

      Jeremy your ROE looks too high to me. I suspect you have not adjusted your starting equity for the recent capital raising. Purists may argue that the capital raised was not used to generate FY11 profit, but I would argue that it should be included. Without the capital raising the company would have had to borrow a great deal more to ensure the Henderson project continued on time. This would have raised a different alarm bell of course, but for me I prefer to include the capital raised in the FY11 ROE calculation, especially with operating cashflow so marginal this FY due to upfront payments in the prior FY.

      Using 12% RoR I have calculated an IV of $7.74 for FY11 and translating the guidance for 20% revenue growth to the bottom line I get an estimated IV of $8.45 for FY12. ROE is 30% and 28% respectively. Still a fair margin of safety, and if the operating cashflow improves significantly in the first half of FY12 then these prices will look very good IMHO.

      I am a little disappointed with dividend. With so much potential growth in the pipeline (new products etc) I would have prefered a lower or even no dividend. We can collect the franking credits years down the track when growth moderates.

      As always, DYOR.

    • Mark E
      :

      Highly likely FY12 EPS will be downgraded following this result so the commsec figures are out of date. That is the problem using a magical formula to come up with a share value, you still need confidence in the inputs ie the forward EPS forecasts

      • Roger Montgomery
        :

        There is no Magical formula. Don’t believe anyone who tells you otherwise. There are only silly formulae and sensible formulae. Even the best formulae needs a solid understanding of the business (which analysts are expected to have given their salaries) in order to estimate the inputs. remember, when Chalrie Munger was asked what made him such a successful investor he replied; “My guesses are better than yours.”

    • Kent Bermingham
      :

      I have $8.08 for next year but it appears Mr Market doesn’t agree as the price is dropping substantially as I write, cash flow is a concern, I too will be interested in Rogers comments on this stock now.

      Code MCE
      Company Name Matrix Composites & Engineering Limited
      Current Equity $Millions 126,760,166
      Current Issued Shares Millions 77081507
      Equity Per Share $1.64
      Earnings Per Share (Cents) 46.00
      Dividends Per Share (Cents) 8.00
      Payout Ratio 17.39%
      Payout Ratio Selected 17.39%
      Prior Years Equity $Millions 79900000
      ROE 34.31%
      ROE Selected 34%
      RR 13
      Table 11.1 2.640
      X EQPS $4.34
      X POR $0.75
      Table 11.2 5.389
      X EQPS $8.86
      X 1 -POR $7.32
      2010/11 $8.08
      Current Price $4.90
      MOS 65%

      Code MCE
      Current Equity $Millions 156,051,138.7
      Current Issued Shares Millions 77081507.0
      Equity Per Share $2.02
      Earnings Per Share (Cents) 55.20
      Dividends Per Share (Cents) 9.60
      Payout Ratio 17.39%
      Payout Ratio Selected 17.39%
      Prior Years Equity $Millions 126,760,166.0
      ROE 30.09%
      ROE Selected 30.09%
      RR 13
      Table 11.1 2.315
      X EQPS $4.69
      X POR $0.81
      Table 11.2 4.505
      X EQPS $9.12
      X 1 -POR $7.53
      Next Year $8.35

      Code MCE
      Current Equity $Millions 191,200,305.9
      Current Issued Shares Millions 77081507.0
      Equity Per Share $2.48
      Earnings Per Share (Cents) 66.20
      Dividends Per Share (Cents) 11.50
      Payout Ratio 17.37%
      Payout Ratio Selected 17.37%
      Prior Years Equity $Millions 156,051,138.7
      ROE 29.39%
      ROE Selected 29.39%
      RR 13
      Table 11.1 2.261
      X EQPS $5.61
      X POR $0.97
      Table 11.2 4.015
      X EQPS $9.96
      X 1 -POR $8.23
      2nd Year $9.20

      Price $4.90
      IV Current Year $8.08
      IV Next Year $8.35
      IV Year After $9.20
      Current Year
      Next Year 3%
      Year After 10%
      MOS Current Year 65%
      MOS Next Year 70%
      MOS Year After 88%
      Code MCE
      Matrix Composites & Engineering Limited

      Regards

      Kent

    • Kent Bermingham
      :

      I have $8.08 for next year but it appears Mr Market doesn’t agree as the price is dropping substantially as I write, cash flow is a concern, I too will be interested in Rogers comments on this stock now.

      Code MCE
      Company Name Matrix Composites & Engineering Limited
      Current Equity $Millions 126,760,166
      Current Issued Shares Millions 77081507
      Equity Per Share $1.64
      Earnings Per Share (Cents) 46.00
      Dividends Per Share (Cents) 8.00
      Payout Ratio 17.39%
      Payout Ratio Selected 17.39%
      Prior Years Equity $Millions 79900000
      ROE 34.31%
      ROE Selected 34%
      RR 13
      Table 11.1 2.640
      X EQPS $4.34
      X POR $0.75
      Table 11.2 5.389
      X EQPS $8.86
      X 1 -POR $7.32
      2010/11 $8.08
      Current Price $4.90
      MOS 65%

      Code MCE
      Current Equity $Millions 156,051,138.7
      Current Issued Shares Millions 77081507.0
      Equity Per Share $2.02
      Earnings Per Share (Cents) 55.20
      Dividends Per Share (Cents) 9.60
      Payout Ratio 17.39%
      Payout Ratio Selected 17.39%
      Prior Years Equity $Millions 126,760,166.0
      ROE 30.09%
      ROE Selected 30.09%
      RR 13
      Table 11.1 2.315
      X EQPS $4.69
      X POR $0.81
      Table 11.2 4.505
      X EQPS $9.12
      X 1 -POR $7.53
      Next Year $8.35

      Code MCE
      Current Equity $Millions 191,200,305.9
      Current Issued Shares Millions 77081507.0
      Equity Per Share $2.48
      Earnings Per Share (Cents) 66.20
      Dividends Per Share (Cents) 11.50
      Payout Ratio 17.37%
      Payout Ratio Selected 17.37%
      Prior Years Equity $Millions 156,051,138.7
      ROE 29.39%
      ROE Selected 29.39%
      RR 13
      Table 11.1 2.261
      X EQPS $5.61
      X POR $0.97
      Table 11.2 4.015
      X EQPS $9.96
      X 1 -POR $8.23
      2nd Year $9.20

      Price $4.90
      IV Current Year $8.08
      IV Next Year $8.35
      IV Year After $9.20
      Current Year
      Next Year 3%
      Year After 10%
      MOS Current Year 65%
      MOS Next Year 70%
      MOS Year After 88%
      Code MCE
      Matrix Composites & Engineering Limited

      Regards

      Kent

    • Kent Bermingham
      :

      Jeremy, I get about $8 for 2011, cash flow has taken a hit and institutional investors won’t be too happy right now.
      At under $5 MOS looks good but would be interested to see what Roger thinks about this company going forward now?

    • ken fraser
      :

      Jeremy, I`ve used average equity of $93.35m. NP of $33.6m.= ROE 36%. POR 17%. RR 14% 2011 IV = $7.82. 2012 EPS 52 cents = IV $6.50 for 2012.

    • Leigh Penney
      :

      Jeremy, that ROE looks a little high inflating your IV.

      Looking more into operating performance for FY11: FY10

      -ROA (how efficient company is at earning profit from sales/ good indicator of management performance) 5% decrease.

      -Net profit margin almost identical.

      -Inventory management :
      Inv.turnover ratio (how many times inv. is turned over annually through sales) increased by 75%
      Inv. turnover period (average inv. days held) decreased by 58%

      -Fixed Asset Turnover (how efficient company is at generating sales from fixed assets) increased by 5%.

      Although profits were under most forecasted, improvement in inventory control and operating efficiencies are evident and significant. I see the decrease in ROA attributable to the asset increase from the cap raisings, as well as significant investment in PP&E and more leverage. So whilst the market sells due to forecasted underperformance they are ignoring the fundamental trend of ratios that indicate a great performance.

    • Jonesy
      :

      Interesting although not suprising reaction to the announcement of results. Missed analyst expectations and has therefore been hammered. This is a company that has increased it’s NPAT significantly but is currently priced as if it is not going to grow from here. Some very short sighted “investors” who have just jumped ship.

    • jeremy
      :

      To everyone that has replied, thank you very much, its hugely appreciated and gives this little horticultural agronomist lots to think about.

  23. Linda Bas
    :

    Still reading your book and can’t wait till I can get rid of the rubbish and start working out values of good quality companies
    Thanks to Roger I’m feeling more confident.

  24. darrin
    :

    HI Roger

    How do I go about determining what impact Pacific Fibre will have on Vocus?

    cheers

    darrin

    • Roger Montgomery
      :

      There are a number of avenues to follow whenever you are trying to understand the competitive landscape. The first is to talk to Pacific Fibre (Mark Rushworth), then Southern Cross and Vocus…Find out from Vocus if they will take some of the additional capacity on offer, whether they think they can sell it, what will happen to prices etc… Vocus is a reseller of bandwidth, so presumably retail prices drop but so do wholesale prices as a result of the additional capacity…That makes existing contracts less attractive and new contracts more attractive.

  25. Robert
    :

    Hi Roger,

    I purchased a “collector’s edition” of value.able and read it with interest. Accordingly, could you please include me in the invitation to the new A1 investor service when it becomes available for review.

    Kind regards,

    Rob Massera

  26. Ash Little
    :

    Hi Guys,

    For those reasonably new to value.able investing go have a look at BCS’s latest balance sheet and see if you can pick if it is closer to A1 or C5.

    It makes interesting reading

    • Ash Little
      :

      If you want a second lesson have a look at PRY.

      Interest coverage of less than 1 and massive goodwill.

      Hope for the shareholders that things in the world don’t turn nasty……It could get ugly in my view

      • Ash Little
        :

        Have a look at the ROE then read note 8 in the accounts.

        to quote Darryl Kerrigan: Tell him he’s dreaming

      • Sean
        :

        Hi Ash

        Doing a megaquick valuation (they’re not worthy of going into detail), I wouldn’t touch either of these with a barge pole.

        BCS – C5 at absolute best.

        Both good illustrations and examples of looking into massive goodwill and trying to determine its’ actual value, not just it’s accounting value.

        I’m baffled as to how they ever get people to invest their hard-earned into these companies.

        Even if you don’t follow all Roger espouses, you can do very well in the long term just by cutting out all the rubbish; and isn’t there some about.

        Cheers.

      • Andrew
        :

        Indeed Sean, just like in real life its easier to find trash than it is to find gold, diamonds, platinum (insert valuable thing here).

        Why people invest their hard earned cash in these companys. Could be a mixture of reasons probably revovling around speculation. From a retail investor perspective, some guy (it seems to always be guys) at a BBQ or some other environment was probably telling everyone who will listen their hot tip and people will jump in based on his opinion. This leads to my first comment about finding trash being easier, some don’t want to put the effort in and the odds are that if you shoot blindly you will probably find a rubbish company before a quality one.

        I have started watching some Your Money, Your Call episodes and that has been an eye opener for me in regards to studying retail investor psychology. I find this area really interesting and would love to get to the bottom of it alla s to what motivates specific decisions.

        A lot seem to have very little knowledge about the actual business they ar einvested in adn are instead using most of the time the Sky Business channel (as well as others including Roger) to be a kind of de facto fund manager for them. That can’t work in the long term if even the short term.

      • Bret
        :

        Hi Ash,

        I was looking at the PRY report. Just wanted to ask what are the two ratios you use to look at Interest coverage and the goodwill.

        Thanks

        Bret

      • Ash Little
        :

        Hey Bret,

        I did not formally do ratios. I just looked at the accounts.

        Interest 88M Npat 79M

        Goodwill 3.1B Equity 2.5B

        With ROE of circa 3% the goodwill is a myth.

        you don’t need an excel spreadsheet or even a calculator to know this is bad

        Compare this to JBH

        Interest 6.2M Npat 109.6M

        Goodwill 78.6 Equity 152.3

        ROE is (humour me hear guys I am going to use ending equity) circa 70

        Goodwill is no myth here.

        Once again you don’t need an excel spreadsheet or even a calculator to know this is mich much better.

        Probably why PRY gets a C4 or C5(just guessing at this) and JBH an A3 but you don’t need the rating system to know which one is investment grade

        Hope this helps

  27. Ashley Little
    :

    i Roger,

    Next time you or one of your team are speaking to Mr Grant of DTL can you quiz him up about the big decline in Unearned Revenue for 2011.

    They has good margin expansion but the cashflow was terrible mainly due to what I mentioned above.

    Thanks In advance

    • Michael
      :

      Good question. I think with DTL they were cycling abnormally good cashflow in 2010 that was not sustainable. You can’t have $10.9m of profit and $44.9m of operating cashflow as they did in 2010 for too long, though it would be interesting to hear what the company has to say on the issue.

      • Ash Little
        :

        Yes Michael,

        I think you are right. Plus 2009 was about 20M from memorry

        Still worth asking the question though

  28. Ron shamgar
    :

    For anyone interested in ironore companies. I suggest you read carefully fortescue results commentary:

    Fortescue Metals Group has delivered a big leap in full-year profit thanks to high iron ore prices, but noted a dip in demand from China as the Asian economic superpower tightens lending in an effort to beat down inflation.

    Chief executive Nev Power said no shipments to China had been deferred but demand had cooled off recently.

    Steel mills had become “a little more short-sighted in terms of their future buying” but this had not softened iron ore prices, he said.

    The average iron ore sales price achieved by Fortescue in 2010/11, including freight costs, was $US149 ($A143.84) per dry metric tonne, up 68 per cent from the prior financial year.

    “There’s no question that the tightening of credit in China has started to moderate demand in a small way,” Mr Power said on Friday after the miner delivered a 76 per cent jump in full-year net profit to $US1.02 billion.

    “Once the inflation numbers in China are back under control, the underlying demand is very strong and that would pick straight up again.”

  29. Chris B
    :

    HI Bloggers

    I had a question for you when predicting your future IVs.

    Do you accept without question the consensu forecasting for future EPS and DPS?

    Take FGE for example:

    The current EPS is 0.452.

    The forecats EPS for 2012 is 0.489 and 2013 is 0.543.

    This implies a growth of around 8% for coming year.

    This is for a company whose EPS has grown roughly 15% for the last 2 years, and whose order book is roughly 20% up in July 11 from the previous period.

    If you accept the analyst forecast of 8%, this seems to be telling you that the order book wont transpire and we will see a decrease in the growth profile of the company.

    Additionally if you accept the forecast, the ROE will fall and have a negative impact on IV.

    On face value, adopting a 15% growth in EPS and then applying a similar POR(given comments by management that additional capital may be required to fund large contract awards), would seem reasonable, although obvioulsy less conservative that adopting forecast.

    Would be interested in other’s view on the subject.

    Cheers

    Chris B

    • Ron shamgar
      :

      Hi chris,

      In my opinion if analysts are conservative then why shouldn’t you be? It’s better to have risk to the upside.
      Also FGE may need to have cash to win larger projects but when they do they won’t need so much cash then so payout ratio is not sustainable. You should look back at mondalephous history to get a better idea of payout ratio. I believe currently it’s 85%.

      Also watch out for cost pressures and maybe a slowdown in china? Make sure their clients are big and already producing, or are gold miners.

      Cheers.

    • Craig B
      :

      Chris,

      For a 2012 valuation of FGE I’ve assumed a 20% growth rate in NPAT, which is much lower than the 30% achieved this year. I think that’s conservative enough. I wouldn’t want to deny myself a buying opportunity by being overly cautious. There’s a balance that needs to be struck I believe.

      Using a ROE of 37.5% on starting equity of $124.6M, and a 40% payout ratio (again, a little conservative), I get a 2012 value of $8.87 for a 12% RR.

      Those analyst forecasts get changed quite often as better info comes to light. I’ve noticed over time that the nearer we are to the EOF they more weight they carry, but this far out they can be way off.

      regards

    • jeff
      :

      Hi Chris,

      This is the exact situation that Roger talks about where the calculation of IV is not just mathematics! Others have said that forecasting Iv is as much art as science. In my opinion you have to take the consenus earnings with a grain of salt. (much like the opinions of economists on interest rate direction and weather forcasters more than a week in advance). Getting the projected earnings as close as possible to what actually happens is the key to accurate valuations.

      jeff

  30. Rici Rici
    :

    I think one also needs to look at the long term structural environment.

    Its interesting to note your discount to IV for Westfield. I havent looked at Westfield (holdings) but i did look briefly at Westfield Trust.

    What was disturbing for me was the low yield at NTA.
    I saw a graph the otherday of retail rent relative to tenant sales.
    Over a 15 year odd period both have gone up, but retail rent has expanded faster than retail sales.

    So why was this possible?
    My hypothesis is gross margin expansion on sales.
    If i look at DJS financials over the last 10 years, one the the main reasons they were able to increase profits (pre GFC) was the expansion in margins.

    Now this cannot go on indefinately. Mathematically its an impossibility if one extrapolates far enough into the future.

    Therefore i would be concerned that your IV estimates are potentially OVERSTATED at least for Westfield. Therefore the negative margin of safety might actually be greater than stated.

    • Rici Rici
      :

      sorry the above post should read
      its interesting to note that your negative discount to IV for Westfield.
      NOT
      ‘discount to IV’

  31. Grant Duggan
    :

    Hi Roger much appreciate the time and effort you put into this blog,and the many other areas you present your knowledge to those who follow this method of investing. Have to admit though looking at the times you post some of those blogs not sure when you actually get time to sleep. These blogs just keep getting better and thanks to the quality, i for one must say i’m addicted.

  32. Michael
    :

    Roger

    Would you please consider opening up a little of the ‘black box’ from which you draw your company quality ratings?

    For example what, broadly speaking, differentiates an A, from a B or C and what differentiates a 1 from 2, 3, down to 5? From a passing comment you made on TV, it appears that an A4 is no more ‘investment grade’ than a B3. This suggests to me that A-C measures one set of variables, while 1-5 measures another. Would you tell us more?

    A separate question you may care to answer. Can you please confirm that your intrinsic value is nothing more than a strict arithmetical calculation derived from profit (including estimates of future profits) over equity? In other words, it would not include value based on probabilities of a takeover, eg Foster’s, or value based on probabilities of new drug approvals (a drug company) or resource developments (a mining stock)?

    Thanks

    • Roger Montgomery
      :

      Hi Michael,

      Our own personal experience using the models means we will not be releasing any of our intellectual property. That may get a few people offside, but we’ll just have to live with that. Their argument might be that they can’t become a customer unless they know exactly what it’s made of. Our response is a flat, “ok then.”. Plenty of people drink coke without knowing it’s ingredients. Plenty of us drive cars without ever needing to pull them apart. I want to give those people a leg up but I’m not going to give a hand out. Much too valu.able.

    • Dan S
      :

      Michael,

      I think the trick is not to worry about x and y, but rather to think about the A1 businesses and what distinguishes them from the rest. Personally I think ROE track record (with consideration of historical gearing) and current gearing levels are important.

      Roger has said in the past that the rating measures the probability of a business “running out of cash” – i.e. not being able to service interest payments and having to raise equity or default.

      If this the case, then the will be a function of two things.

      1. Cashflow required by the business. You would expect capital intensive businesses require more cash than non capital intensive businesses. This will be pushed higher as debt and interest payments increase. This excludes cash required to fund acquisitive growth which is not a recurring item.

      2. The volatility of cashflows produced by the business. Consumer staples businesses and toll roads would expect to have rather stable cashflows. Mining, energy, life sciences and fund management businesses are likely to have volatile cashflows.

      Potentially then, this rating kind of rating might behave like a credit rating.

      Roger, would this rating define the cost of equity (Ke) you would apply? For example: A1’s:10% Ke, A2’s:10.5%, A3’s:11% etc. But the increments are fairly arbitrary.

      Roger, in consideration of prioritising sale and purchase decisions, would you use the rating system to “equalise” your margin of safety? For example something like: A2 = 0.9 A1, A3 = 0.8 A1, B1=0.7 A1…etc etc.

      • Roger Montgomery
        :

        Hi Dan,

        I am afraid you are barking up the wrong tree there. We don’t link the ratings with required returns. Separated entirely. You know what your Mum told you about double dipping! The presumption that its about running out of cash is not factually correct either. I see this a lot elsewhere, incorrect assumptions leading to support for an equally incorrect conclusions. EG: Investor #1; “Roger says you should buy stocks on a low P/E”. Investor #2, “Yeah, I heard that. How silly, doesn’t he know you should be using ROE and intrinsic value? This is the inconsistency with his approach. Investor #3, I agree, he’s really inconsistent. I thought he was on about ROE and then I heard him talking about dividend yields. My model uses ROE and intrinsic value, I think P/E’s are nonsense so click this link to my blog… And on and on it goes.

        Yet, I have never said buy stocks with low P/E’s! Its not my job to correct the factually incorrect elsewhere. Who has the time. here on the blog though, I think its important to point out what is factually incorrect but you must appreciate I am under no obligation to reveal any proprietary information. Its just too valuable.

        Those of you seeking the inputs, be mindful that anyone else posting their thoughts are just guessing. Don’t let incorrect assumptions lead you to incorrect conclusions.

      • Dan S
        :

        Hi Roger,

        Cheers for the response, to clarify these are just “thinking out aloud” ideas I thought I would share.

        We are all simply sharing ideas on this forum after all, for which I thank you for providing.

        What I was trying to say at the top, was that I think it’s a good idea to establish your own system and structure for identifying quality.

        I too believe that P/E ratios are baloney.

        Re: required return, cool, I just thought this approach might have more “common sense” merit than the CAPM, three and four factor models and every other model which tries to quantify Ke.

        Re: my last point, in my opinion higher quality businesses are likely to trade at narrower margins of safety.

        Re: your rating system, in the past you have said:

        “Businesses that achieve Roger’s A1 or A2 MQR have the lowest probability of a ‘liquidity event’. His A1s are less likely to raise capital, borrow more money, default on debt repayments of breach debt covenants.”

        I was just trying to paraphrase the above concept as the proability of a business “running out of cash”.

        I was doing this because “liquidity event” is also used in my office to describe something else – i.e. when a private investor wishes to sell all or part of their business for cash, generally via an IPO or sale transaction. If you google “liquidity event” you will get this definition in the results and in wikipedia.

        Cheers,

        Dan

    • Andrew
      :

      Hi Michael,

      I can’t speak for Roger (not involved in any regard with him other than a contribtor to his blog) and i also support Roger in his protection of his methods.

      Your second question though, whilst i am sure i use a different valuation formula and techniques than Roger, i think we both share the same outlook that we are valuing the business and not a trade. There for i think it would be innappropriate to allow speculation of a takeover to impact the valuation of that business as at the end of the day has nothing to do with the underlying business and most companys overpay.

      Buying a share because a company might get a higher offer as part of a take over is a speculation play, it has little to do with the udnerlying business. i would also add that even if it does get taken over, i am sure there would be better opportunities around elsewhere with less risk for a satisfactory return when held over the long term.

  33. Ron shamgar
    :

    Roger, good episode. What about naming your next episode:

    When should you sell – part III – How about to take some profits! ;-)

  34. Dino
    :

    Hey Rog,

    what did you think of mineral resources results?

    I was quite impressed. I have an iv of about $16 year end 2012 &Future IV growth beyond 2012 rising.

    They seem leveraged to the china story but have other plays eg the massive crushing contract they won not long ago.

    However they are difficult one to assess – An iron ore business in a crowded iron ore market???? Or a very solid mining services???

    • Ron shamgar
      :

      Dino,
      your IV seems a bit optimistic to me. I’m getting closer to current prices and only in 2013 I’m getting anywhere around $15.
      You do need to ask yourself whether you feel confident forecasting commodity prices 2 years ahead, when in their nature, commodity prices are extremely volatile?
      I prefer large discounts to current IV just to be safe. MIN is a good business but there are other contractors who are even better. It would have to be around $8 for me to get excited.
      Cheers.

    • Manny
      :

      I think their focus is more on mining services going fwd and I think it is a great stock. It is a great stock that gives you exposure to both. It just seems to be stuck in the $10.70 – $13 range for some reason.

      My IV is $15.5 for FY ending June 2012 (Very similar to yours, What RR did u use?)

      Manny

    • Christopher
      :

      Hi Dino,

      I am also very impressed by MIN, although we must remember that underlying profit was within expectations (approximately $1m below consensus).

      Most brokers use DCF models to ‘value’ companies, and this gets a price target of about $16 for this year (e.g. Austock). I think their IV is around $14, although I am aware that I am in the minority on that one. Personally I might be happy to buy at these levels if we weren’t surrounded by other bargains at the moment.

      As for their corporate structure, we have to remember that MIN is made up of individual businesses. You have to treat each one separately when considering both IV and quality, as each has their own risk factors and earnings drivers. For example, earnings from the iron ore at Carina can only be grown so much without being granted further port allocations.

  36. Mark
    :

    I’ve completed my first “back of the envelope” type valuation and just wanted to check I’m on the right path.

    I came up a current valuation of $14.76 for TRS

    My ROE number was 37.5%
    Equity Per Share was $2.03
    Pay out all dividends number was $7.61
    No dividends paid out was $21.91
    Valuation based on 50% pay out ratio.

    Thanks in advance for any feedback.

    • Roger Montgomery
      :

      We’d need to know why you think the ROE and the Payout ratios are individually and in aggregate sustainable. The combination implies 18% earnings growth. Or earnings per share growth depending on your inputs.

    • Ron shamgar
      :

      Mark,
      I’m getting around $9. So it seems ur roe is too high. I’m getting about 30%.
      the other issues are rising debt and shrinking margins. They had some flood issues but the business doesnt feel right. Have you visited a store lately?

      • Mark
        :

        OK, well I may have read the book but I’m obviously mis-interpratating a few things. I was trying to replicate the example used on pages 188-190 taking the data provided from the TRS annual report. I guess one thing I got wrong is the data in the report is reporting what has already happened where I guess I should be trying to do an estimate for the future? My ROE was based on an average of 30% for 2011 and 45% for 2010. Would appreciate a break down of how you reach $8-9 valuation. I’d like to know if my math is wrong or the numbers I used as inputs. Cheers.

      • ron shamgar
        :

        fy11 eps 62c and div 31c if you use that you should get around 30% ROE and your other figures seem about right. have a look at changes in debt, margins and also cash flow statement. cheers.

      • Peter N
        :

        Hi Mark,

        There have been some posts in “why are we excited” on TRS which I have repeated below:

        1. Posted by Peter N on August 18, 2011 at 6:52 pm
        Just completed my IV for Reject Shop ( TRS ) using 12% RR and forecasts from broker of 50% pay out ( on basis that cash will be required for working capital, store roll out and debt reduction ) and profit of $22.4m 2012 and $29.4m in 2013

        2011

        Equity per share $2.04
        EPS .62 cents
        POR 50%
        ROE 31%
        IV $7.85

        2012

        Equity per share $2.47
        EPS .86 cents
        POR 50%
        ROE 38%
        IV $13.45

        2013

        Equity per share $3.04
        EPS $1.12
        POR 50%
        ROE 41%
        IV $18.39
        any comments would be appreciated as these are my first attempts and learning!
        Reply
        o
        Posted by Ron shamgar on August 20, 2011 at 1:07 am
        Hi Peter, 2011 looks ok but the other IVs are way too optimistic. you are talking about some serious eps growth. What makes you think they can turn it around so easily?
        Reply

        Posted by Peter N on August 21, 2011 at 1:26 pm
        Your comment is awaiting moderation.
        Hi Ron,
        The EPS in my calcs were extracted from a Bell Potter piece of reserarch that was published after the 2011 results. They argue that putting the flood disruption behind them, opening of new stores and the effeciences to be optained from the Brisbane wharehoues will allow TRS to return to good EPS growth.
        Since doing my calcs other research that I have read indicates more sedate EPS going forward of :

        2012 .85 and .72

        2013 1.05 and .88

        Maybe I redo my calcs usiing a consesus EPS

        Prior to the 2011 result TRS had a good history of EPS growth:

        2007 35%

        2008 35%

        2009 14%

        2010 23%

        Thanks for your comments which helps a great deal in my learning.
        regards,
        Peter
        Reply

      • PaulS
        :

        Hi there Mark,
        I have an IV at around $8.00, so here’s my inputs for 2011. Hope this helps.

        I have true cash flow at end of 2011 period of $792,000.00 which includes an increase in current debt from 14m to 39m and dividends paid of 13.2m. New store rollout was maintained despite the flooding within the TRS distribution centre in Ipswich, they needed to borrow funds to do this. The floods obviously reduced the level of stock the company had to distribute to their stores, so no stock to sell means less profit, on top of the increase in debt needed to fund the new stores. There is an insurance claim of $15million plus pending.

        2011 IV inputs:
        RR = 10%
        BV (book value) – 2.034 (current equity 53,050,000 / shares on issue 26,071,170)
        EPS – 0.62 (netprofit of $16,171,000.00 / shares on issue 26,071,170)
        DPS – 0.51 (div payout $13,277,000 / shares on issue 26,071,170)
        POR – 82.25 (being dps divided by eps)
        ROE – 0.30 (0.62 eps / 2.034 bv)
        IV (2011) – $7.71

        Cheers,
        PaulS

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