The
Ins and Outs of Company Valuation
And
A G Barr
Two readers of this blog have asked how the model used here for
valuing a company's share price works. What follows
might not be to the taste of all readers.
The chess grandmaster, Aron Nimzowitsch, titled his
book on chess theory and practice My System. Most experienced investors
probably regard their methodology in the same light.
So it is with the Joyful Investor. The
inspiration for 'my system' is Buffettology (Simon & Schuster, 1997),
authored by Mary Buffett and David Clark. Mary Buffett is Warren Buffett's former
daughter-in-law and David Clark is an old friend of the Buffett family. Whether
they describe Warren Buffett's method as they claim or not, their system
is convincing. For a brief and incomplete outline of the method used to select
stocks prior to the valuation model, see http://thejoyfulinvestor.blogspot.co.uk/2013_02_17_archive.html
and http://thejoyfulinvestor.blogspot.co.uk/2013_06_30_archive.html
Once a company has passed the initial hurdles, the valuation process
commences. The aim of the model is to use three different approaches to find,
in a fuzzy way, a company's intrinsic value. The three sub models project earnings per share, 1 based on
historical data; 2 based on equity per share and the return on projected
retained earnings using historical data; and 3 based on projections for
equity per share and return on equity using historical data. The formulae
are included below at the end of this section.
As this is an earnings-based model, it is incomplete for businesses,
such as banking, property and insurance, that require a balance sheet approach.
While it is impossible, in the space available, to explain in detail
all the ins and outs of the methodology, in summary it works as follows:
1. Projecting earnings
per share (eps) based on historical data V1 = (eps X (1+g1)n
X PER)/ (1+d)n).
i.
Preferably,
the last three years and the first three years of a 10-year earnings record are
averaged and provide an historical base for the company's compound growth rate(g1).
ii.
Eps are
adjusted only for discontinued and/or new operations and truly extraordinary
gains and losses.
iii.
Management
guidance, depending on past reliability, recent trends in eps, broker forecasts
and a review of external factors (competition, regulators, overall market) are taken into account.
iv.
The
projection is limited to 5 years (n). Presently 2013-2017 or
2014-2018 depending on the company's year end.
v.
The 5-year
projected eps is multiplied by the average valuation that the stock market has
put on the company's earnings per share (Price Earnings Ratio -PER) in the past. The PER of competitor companies
is taken into account.
vi.
The
resulting future share price is discounted at a rate (d)
that includes the cost of the company's debt, the company's operating risks and
a margin of safety. The share's dividend yield is
deducted from the discount rate. See http://thejoyfulinvestor.blogspot.co.uk/2013_06_30_archive.html
for a further discussion of the discount rate.
2. Projected earnings per share based on equity
per share and the return on projected retained earnings using historical data V2 = (eqps X (1 + (ROE%/100
X RET%/100)n) + eqps X PER)/(1+d)n)
i.
The
latest equity per share (eqps) is used as a
base. As eqps is multiplied by the historic return
on equity (ROE), it is immaterial whether
assets are held at market value or cost or are tangible or intangible. Where
equity is negative, one uses return on capital employed (debt + equity).
ii.
Here return
on equity focuses on the return on new equity, for the most part retained
earnings. The return on new equity per share is calculated by taking,
preferably, the last 10 years eps and deducting the dividends per share paid in
this period. The difference between the latest 3-year average eps and the first
3-year average eps provides the added return from the new use of capital
derived from retained earnings and other sources.
iii.
Going
forward, retained earnings per share (RET)
are based on the historical record of retaining earnings and management policy,
where this is stated.
iv.
Steps iv,
v and vi above are repeated.
3. Projected earnings per share based on
projections for equity per share (eqps) and
return on equity using historical data (V3
= (eqps X (1 + g2)n X ROE% X PER)/ (1 + d)n)
i.
The same
figure for eqps is used as in 2.i above.
ii.
The
projected annual compound growth rate (g2)
in equity per share is based on historical data, preferably, for the last 10
years.
iii.
The
growth in eqps takes into consideration items that
do not normally pass through the income statement. This includes charges/gains
on defined benefit pension plans, share issues/buybacks, asset sales and
certain tax items.
iv.
Recent
historical data is used to arrive at the projected
return on equity. This takes into account the variation, where significant,
between the historical ROE and the ROE on new equity.
v.
Steps iv,
v and vi of 1 above are repeated.
As with any model, there is the risk of 'garbage in, garbage out'. The following are some checks on the model.
a.
The model also
produces valuations for 10 years forward. By comparing these values with the
5-year projection, odd results can be detected.
b.
It is easy
to apply a sensitivity analysis to key assumptions - growth being the
most significant.
c.
A
significant change in the debt to equity ratio can
distort results, and this may require adjustments to the data.
d.
Results
that are quite out of line with the present share price need reviewing.
e.
Further
valuations are based on the lowest PER reported in
recent times and on the eps divided by the 10-year yield on corporate bonds of
the same creditworthiness as the company. These provide both low and high range
valuations.
The wise investor will use the valuation of a company produced by a
financial model with a great deal of caution. It is
a useful indicator, nothing more, and ignores:
1.
A change in management that can dramatically alter the
expectations for a company.
2.
The chance of a takeover, a major disinvestment or
acquisition.
3.
Sudden changes in
the marketplace.
4.
Environmental, governance and political disasters.
5.
Big bumps in the stock market.
6.
The consequences of large-scale cluster buying or selling
of the company's shares by its directors.
And it is
a salutary reminder that for every buyer of a stock
who believes it is undervalued, there is a seller who believes it is overvalued
at that same price.
The formula for the model is:
V = ( V1+V2+V3)/3
Where:
V1 = ((eps X (1+g1)n)
X PER/ (1+d)n
V2 = (eqps X (1 + (ROE%/100 X RET%/100)n)
+ eqps) X PER)/(1+d)n
V3 = (eqps X (1 + g2)n
X ROE% X PER)/ (1 + d)n
V = Value per share
eps = current earnings per share
g1 = annual compound growth in earnings per share%/100
g2 = annual compound growth rate in equity per share%/100
n = number of years
PER = average Price Earnings Ratio
d = discount rate%/100
eqps = current equity per share
ROE% = Return on Equity percent
RET% = Retained Earnings as a percent of earnings per share
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A G Barr PLC
Image
courtesy Wikipedia
A G Barr,
the Scottish based soft drinks company, has a consistently good record of
revenue and profit growth in the UK. Originally in the carbonated drinks
market, with its lead brand Irn-Bru (formerly Iron Brew), the company
now generates 22% of its revenue from still drinks and water. It acquired the water
brand Strathmore in 2006 and the still drinks brand Rubicon in 2008. In 2012,
it began marketing Rockstar, an American competitor to Red Bull, in the UK as
franchisee. It has also launched a range of ice creams under the Rubicon label.
The company is completing a new canning plant in Milton Keynes, which will
double its canning capacity.
In its 2013 Annual Report the CEO explained,
Our consumer
base is growing in number, location and diversity. We aim to build long term
relationships with all our consumers through our brands by appealing to both
traditional and new tastes as well as by bringing exciting innovation to the
market. We believe people want choice and we aim to build brands and develop
innovation which meets this need.
In 2012, A G Barr announced an agreed merger
with its larger British competitor, Britvic. After a long delay caused
by the Competition Commission, Britvic renounced the agreement. Given
the very high indebtedness and spotty trading record of Britvic, A G
Barr's shareholders seem to be the main beneficiaries of the failed merger.
A G Barr shares (in red) have been an outstanding
investment compared to the FTSE 250 (in orange) these past 5 years:
Image courtesy Investors Chronicle, click to
enlarge
Over the last decade, A G Barr has grown at a fast clip:
1. Earnings per share have increased every year except 2013,
cumulatively averaging 13% per annum.
2. Equity per share has increased by 12% per annum and dividends
by 10% per annum cumulatively.
3. Return on Equity is an historical 21% which is equalled by the
return on retained earnings, at 22%.
4. Net margins, a healthy 11% in 2008, are now an even healthier
14.7%.
And the company is financially in good health. Consider:
1. Net debt is 19% of equity, and this is historically high only
because of the 2008 purchase of Rubicon, the funding of the new canning plant
and a 9-million pound special dividend paid in 2012. Net debt could be paid off
with one year's post tax profits.
2. Operating cash flow for the period 2009-2013, once capital
expenditure is deducted, covered the dividend payment 1.5 times. Once the
dividend was paid, A G Barr was still left with 23 million pounds these last 5
years for acquisitions and the special dividend.
3. The defined benefit pension fund, now closed to new entrants,
is in deficit to 3 million pounds. This is just 0.5% of the company's market
value of 632 million pounds.
The Barr family still controls 15% of the company's shares. One Barr, formerly
Chairman, is on the Board and another is Company Secretary. Between April and
June, there have been 2 director sales of shares at 546p and 503p worth 2
million pounds. And 2 director purchases at 543p and 536p worth 0.5 million
pounds. Judged by their purchases, the weight of director opinion is not
favourable, but might have been related to the end of the merger between Barr
and Britvic.
With its fine trading record, A G Barr commands a prospective price earnings ratio
of 21 and a prospective yield of 2% at its present price of 544p. My model
values A G Barr at 526p. This is based on a continuation of historical
growth rates for earnings and equity, as well as maintaining the current return
on equity and dividend payout. It uses the average PER of 20 and a dividend
payout of 52% of EPS. All for the years 2014-18.
The discount rate of 11.8% used for the model includes 3.8% for investment grade corporate bonds
(from SLXX), 3% for operating risk and 5% as a margin of safety.
The prudent investor will note:
1. The failed attempt at the merger with Britvic by the first
management team not to be led by a Barr could be followed by another grand
scheme that will not prove, necessarily, to be beneficial for shareholders.
2. While the stalling in earnings growth in 2013 can be
attributed to the cost, both in pounds and management time, of the failed
Britvic merger, it nevertheless breaks a long-term growth record held by the
company.
3. The franchise arrangement with Rockstar is a departure from
the company's practice of only promoting its own brands. Franchise arrangements
can end in tears.
4. Competition from Coca Cola has knocked Irn-Bru off its
perch as the favourite carbonated drink in Scotland.
5. Accounts receivable have
been lengthening. They have increased from 57 days in 2009 to 63 days in
2012 to 72 days in 2013. The company explains that the 2013 increase was due to
prepayments to be recovered and the earlier year-end closing date.
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