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20 lessons in 20 years – Part 12

Friday, November 16th, 2018
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Always use the appropriate valuation tool

By Michael O’Neill and Anton Tagliaferro |  06 November 2018

 

As a value manager buying companies at a reasonable price is one of the most important aspects of IML’s approach to investing. There is no single valuation method that fits all sectors and companies and there are many valuations tools to choose from.

While the commonly used PE ratio comparison is useful when comparing the valuation of companies with fairly repetitive earnings and where the corporate structure is simple (as discussed in Lesson #11 The lowest PE stocks are not always the most attractive), in this week’s lesson we discuss some other valuation tools used by IML which are more suitable to assess the long-term value of companies across other sectors on the stockmarket.

Price to net tangible asset ratio (NTA)

This ratio is most useful when comparing valuations across the listed Real Estate Investment Trust (REIT) sector – formerly known as the Listed Property Trust sector.

Using PE ratios is not that effective when assessing valuations across the REIT sector as REIT’s are structured as trusts to ensure that all rents received from the underlying properties of the REIT, net of expenses, are distributed pre-tax to REITs shareholders. Because of their structure and unlike most other industrial companies, REIT’s do not pay any tax on their income received.

Thus, one common way to compare valuations across the REIT sector is to use the Price to NTA ratio which compares the share price of the REIT to its net tangible asset value (NTA) and assess whether the share price is trading at a premium or discount to NTA. In Lesson 13 we shall discuss the REIT sector and specifically what to look for in order to properly assess REITs.

Price to NTA is also useful as a way of comparing listed investment vehicles – like QV Equities – to each other.

Discounted cash flow (DCF)/Net Present Value methodology

This valuation technique is most commonly used when valuing two sectors of the stockmarket: the Infrastructure sector and the Resources sector.

The Infrastructure sector

Infrastructure sector companies like Transurban (TCL) and Sydney Airport Holdings (SYD) operate assets for a finite life. Sydney Airport Holdings owns the licence to operate Sydney Airport in Mascot until 2097 while Transurban operates various toll roads under long-dated licences from various State Governments with these assets reverting back to government ownership at the end of the concession life (the life of the commercial arrangement).

As the cashflows from these assets are fairly long dated, predictable and of a finite life, the preferred method of valuation of companies in the infrastructure sector is to use a discounted cash flow (DCF) basis of the expected distributions payable by these entities to shareholders. This method has the added benefit of focusing on the actual cashflows that the business will produce, rather than accounting measures of earnings, which can vary considerably.

Chart 1: Transurban forecast dividends per share, compared to valuation

Source: IML and Transurban; 31 October 2018

The chart above is IML’s model of Transurban’s valuation using a DCF model to value the expected predictable and growing cashflows that Transurban’s roads should produce which will be paid to shareholders over the term of the concession life of those roads. By estimating the underlying cashflows of each road and the distributions expected to be received by shareholders, the red line tracks our valuation of Transurban.

The Resources sector

While it is not uncommon to see some in the market use PE ratios to value Resource stocks, in our opinion this is an incorrect way of assessing the value of companies in this sector.

The earnings of all Resource companies are very sensitive to the underlying price of the commodity each company produces. As commodity prices are so volatile it makes no sense to us to look at PE ratios when assessing the value of Resource companies – as when the commodity prices are high, this will lead to Resource companies having a low PE and thus they will look cheap and when commodity prices are low, the opposite is true making the PE ratios for Resource stocks fairly meaningless.

If we look at the oil price since 2005 (see chart 2 below), we can see that the oil price has been very volatile and often moves in large and unpredictable ways.

Chart 2: Crude Oil Price movements since 2005

Source: IRESS as at 30/9/2018

In our opinion using a PE to value a good quality Resource company such as Woodside Petroleum (WPL) offers little assistance to long-term investors such as ourselves who are trying to make an assessment of WPL’s long term value. This is because the company’s earnings per share and PE will vary greatly from year to year depending on what commodity price is used in the calculation.

IML believes that the net present value (NPV) technique is a more appropriate valuation tool to use for assessing the long-term value of Resource companies like Woodside. This approach uses an assumed long-term commodity price over the life of the company’s assets to come up with a long-term value for the company.

Thus, at IML we use a long-term oil price of USD55 per barrel for oil and an exchange rate of AUD/USD 75 cents when valuing all oil companies – including Woodside. Using an NPV methodology enables us to get a much more meaningful valuation for all Resource companies listed on the Australian stockmarket – because as explained earlier PE ratios only take into account the current spot commodity price and exchange rate when in reality it is the longer-term numbers that are important to assessing long-term valuation.

IML has always used an NPV methodology when assessing the value of all Resource stocks whether the commodity they produce is oil, iron ore, copper or gold.

Sum of the parts (SOTP)

A sum-of-the-parts valuation is more appropriate for companies with assets that the company owns that are not as yet earning an income. Some examples of companies in this situation are:

All these assets are extremely valuable and, as yet, they do not contribute to any of the companies’ earnings per share. This means that assessing these companies’ valuations on a PE ratio basis does not capture the value of the assets being developed.

IML uses a sum of the parts (SOTP) methodology when assessing the value of companies like those mentioned above. An estimated value of the asset not yet contributing is included in our modelling of all the above companies to arrive at our valuation.

Conclusion:

The lesson is that there are many valuation tools available to investors, so when determining a reasonable price to pay for a stock, one should always use the tool that is the most appropriate to the type of company one is assessing.

 

 

While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.