Introduction
WHILE THE PREVIOUS chapter looked at consensus broker view and the value brokers place on a company’s shares over the short term (i.e., two years or less), this chapter focuses on longer term value and the likely returns from holding a company’s shares over a ten-year period, or longer. You want to invest in companies that offer long-term returns with a sufficient margin of safety, as this helps to generate positive returns more consistently with less downside risk.
The methods that follow do not make use of broker forecasts, opting to use conservative growth assumptions instead. This allows you to produce an independent view on value and sense check broker forecasts.
Required investment return
The expected future long-term returns from a developed market, such as the UK or US, is typically around 7%. (This factors in a historic long-term real return of 5% and inflation averaging 2%.) Factoring in a +1% margin of safety, a basic return requirement of 8% offers a sensible starting point.
An upward adjustment to the basic return requirement can then be made to reflect how well a company has made a profit, paid a dividend and grown their revenues, profits and dividends. The more consistent the company’s performance, the smaller the upward adjustment made.
The consistency score (mentioned in chapter 8) is used to measure the consistency of a company’s performance. The adjusted required return is obtained by dividing the basic return of 8% by the percentage consistency score.
If a company has a perfect percentage consistency score, the required return will be the basic return of 8% (= 8% ÷ 100%). The less consistent the company, the lower the consistency score will be and the higher the required return. This is desirable as the less consistent the company is, the harder it is to forecast future performance and the larger the margin of safety required to compensate for this.
Example
XP Power has a percentage consistency score of 82% so the required return is therefore 9.8% (= 8% ÷ 82%).
A company’s sensitivity to market moves is also considered when determining the required return. The more sensitive a company’s share price is to overall changes in market price, the greater the return required to invest in the company, due to the increased uncertainty.
One measure of a company’s market sensitivity is beta, which measures the relationship between movements in the wider market and a company’s share price. If a company has a beta of 1, it indicates that the share price tends to move in line with the market. The further beta is below 1, the less sensitive the share price is to general market moves. If beta is greater than 1, the share price tends to be more volatile than the overall market.
If beta is larger than 1, the required return hurdle is obtained by multiplying the basic return requirement by beta. If beta is less than 1, the required return is equal to the basic return adjustment; if the required return hurdle is larger than the consistency adjusted return requirement, use the required return as the hurdle.
Example
XP Power has a percentage consistency score of 82% and a beta of 0.8. The adjusted return requirement is 9.8% (= 8% ÷ 82%). The required return hurdle given market volatility is 6.4% (= 8% × 0.8). This is below the adjusted return requirement, so the final return requirement is 9.8%. This is the minimum return that should be accepted for investing in XP Power.
Growth assumptions
To create a fair valuation, estimates for potential growth of sales, earnings and dividends are needed. Historic data on these three categories can be used to generate a conservative estimate of earnings, sales and dividend growth.
Using this historic data, you can also calculate the compound annual growth rate (CAGR) over five, seven and nine years. Finally, you can determine a smoothed growth rate by calculating the growth rate from the average of the oldest three years of data to the average of the newest three years.
Example
Table 12.1 shows historic earnings, dividends and sales data – XP Power.
Table 12.1 Sales, earnings and dividend data for XP Power
|
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
|
Sales (£m) |
69.3 |
67.3 |
91.8 |
103.6 |
93.9 |
101.1 |
101.1 |
109.7 |
129.8 |
166.8 |
|
Normalised EPS (£m) |
46.4 |
39.3 |
83.2 |
106.4 |
81.3 |
95.1 |
101.1 |
102.8 |
111.2 |
146 |
|
DPS (p) |
17.2 |
18.0 |
27.1 |
36.9 |
41.0 |
45.1 |
50.0 |
54.1 |
71.0 |
78.0 |
Table 12.2 shows the different compound growth rates for XP Power, which are calculated from the data in table 12.1.
Table 12.2 Compound annual growth rates (CAGRs) (%)
|
Sales |
EPS |
DPS |
|
|
9-year CAGR |
10.3 |
13.6 |
18.3 |
|
7-year CAGR |
8.9 |
8.4 |
16.3 |
|
5-year CAGR |
12.2 |
12.4 |
13.7 |
|
Smoothed CAGR |
8.6 |
11.4 |
18.4 |
From 2008 to 2017 sales have grown by 140.7% (= (166.8 ÷ 69.3) − 1), which equates to a nine-year compound annual growth rate (CAGR) of 10.3% per annum. (This is calculated using the formula (1 + 140.7%)(1/9) − 1) Similarly, from 2010 to 2017 sales grew by 81.7% (= (166.8 ÷ 91.8) − 1), which equates to a seven year CAGR of 8.9% (= (1 + 81.7%) (1/7) − 1). Sales grew by 77.6% from 2012 to 2017, which equates to 12.2% CAGR over the past five years.
From 2015 to 2017 sales averaged £135.4m (= (109.7 + 129.8 + 166.8) ÷ 3) and £76.1m (= (69.3 + 67.3 + 91.8) ÷ 3) over 2008 to 2010. The smoothed CAGR is therefore 8.6% (= (135.4 ÷ 76.1)(1/7) − 1). The earnings and dividend growth rates are calculated in a similar way.
The long-term growth rate for sales is calculated as the lowest sales growth rate based on these four measures.
Example
Looking at table 12.2, the long-term growth rate for sales is assumed to be 8.6%, as this is the lowest growth rate of the four measures.
The broker forecast sales for XP Power are shown in table 12.3. Broker consensus expects sales to increase by 19.3% in 2018 and by 6.9% in 2019. Thus, long-term sales growth of 8.6% looks credible relative to growth over 2019.
Table 12.3 Current and forecast broker sales for XP Power
|
2017 |
2018 (f) |
2019 (f) |
|
|
Sales (£m) |
166.8 |
199.0 |
212.8 |
(f) indicates broker forecasts, taken at December 2018.
A long-term earnings growth assumption is estimated in the same way as the sales growth estimate. However, in addition to the four compound growth measures, you can also consider a sustainable growth measure: long run book value growth. This is calculated by multiplying the average retained earnings ratio by the five-year average return on equity (ROE).
The average retained earnings ratio is 1 minus the average payout ratio, which is calculated as dividends paid out over the past five years divided by normalised earnings made over the same period.
ROE figures can be found on the Morningstar website in the balance sheet summary of the finance section. You should take the average of the past five reported years ROE. The long-term growth rate for earnings is then calculated as the lowest earnings growth rate based on the five measures.
Example
Looking at table 12.1, XP Power has earned 556.2p of EPS and paid out 298.2p of DPS over the past five years. The payout ratio is therefore 53.6% (= 298.2 ÷ 556.2), which means that the average retained earnings ratio is 46.4%.
Table 12.4 Return on equity for XP Power
|
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
|
ROE (%) |
30.1 |
25.3 |
43.8 |
41.3 |
26.6 |
27.9 |
26.0 |
23.4 |
21.9 |
25.5 |
Table 12.4 shows the return on equity (ROE) earned by XP Power over the past decade. The average return on equity over the past five years is 24.9% (= (27.9% + 26.0% + 23.4% + 21.9% + 25.5%) ÷ 5). The sustainable growth rate is therefore 11.6% (= 46.4% × 24.9%).
Looking at table 12.2 you can see that the lowest EPS growth rate of the four measures is 8.4%. This is less than the sustainable growth rate of 11.6% and the smoothed earnings CAGR of 11.4%. The long-term growth rate is therefore put at 8.4%, which is in line with sales growth of 8.6%. (Note that earnings tend to be more volatile than sales and an alternative approach is to use the lower of the smoothed earnings CAGR, the sustainable growth rate and the sales growth rate when in doubt.)
The current and broker forecast earnings are shown in table 12.5. Earnings are expected to grow by 20.6% in 2018 and 7.7% in 2019. The long-term earnings growth of 8.4% is above earnings growth in 2019, but is not too far out to consider an adjustment.
Table 12.5 Current and broker forecast earnings for XP Power
|
2017 |
2018 (f) |
2019 (f) |
|
|
Normalised EPS (p) |
146.0 |
176.0 |
189.5 |
(f) indicates broker forecasts, taken at December 2018.
The long-term growth rate for dividends is calculated as the lowest dividend growth rate based on the four compound measures. The compound growth rate may not exceed the assumed long-term earnings growth rate. If the lowest rate is negative, set the growth rate to zero or the lowest positive number, depending on your qualitative view about future performance.
Example
Looking at table 12.2, the lowest CAGR for dividends is 13.7% over five years. This is above the long-term earnings growth rate of 8.4%. The long-term dividend growth rate is therefore lowered to 8.4%.
Table 12.6 Current and broker forecast dividends for XP Power
|
2017 |
2018 (f) |
2019 (f) |
|
|
Dividend per share (p) |
78.0 |
82.5 |
87.5 |
(f) indicates broker forecasts, taken at December 2018.
The current dividends per share and the next two years of broker forecasts are shown in table 12.6. Dividends are expected to grow by 5.7% over 2018 and by 6.1% over 2019. This equates to a CAGR of 5.9% over 2018 and 2019. This is 2.5% lower than the proposed long-term dividend growth rate.
If dividends grow in line with broker expectations over the first two years and then by 8.4% over the next three years, this implies a compound growth rate of 7.9% (= ((1 + 5.9%)2 × (1 + 8.4%)8)(1/10)) per annum over the next ten years. To be prudent, the long-term dividend growth rate is set at 7.9%.
Table 12.7 Summary of long-term growth assumptions
|
Growth |
|
|
Sales (£m) |
8.6% |
|
Normalised EPS (£m) |
8.4% |
|
DPS (p) |
7.9% |
|
NAV ps (p) |
11.6% |
Table 12.7 summarises the long-term growth assumptions for XP Power. The last line shows the long run book value (or net asset value) growth, which was calculated earlier.
Earnings yield
Earnings yield is a quick way to assess the potential return on capital (i.e., equity and debt) invested in the company. It is defined as earnings before interest and tax (EBIT) divided by the enterprise value. EBIT is a measure of profit that is not dependent on tax regulations or the capital structure, as it doesn’t include interest expenses. Enterprise value (EV) equals the value of the operations of the company attributable to all providers of capital. EV is not dependent on the choice of capital structure as it incorporates all debt and equity. We therefore don’t have to consider the percentage invested in debt and equity with this measure.
The Morningstar stock report provides the latest reported values for EBIT and EBITDA (which also excludes depreciation and amortisation) as well as forecasts for the next two years. Enterprise value is not directly quoted, but the EV/EBITDA ratio is stated, which allows EV to be backed out quickly. One can then use the EBIT forecasts and current EV to gain insight into future earnings yield.
Example
Consider table 12.8, which shows EBIT, EBITDA and EV/EBITDA for XP Power.
Towards the end of December 2018, the current EV/EBITDA ratio is 11.8 and EBITDA is £38.6m. The EV is therefore £454.3m (= 11.77 × £38.6m). EBIT at the end of 2017 is £32.4m, which implies an earnings yield of 7.1% (= 32.4 ÷ 454.3). EBIT is forecast to rise to £42.8m in 2018 and £46.7m in 2019.
This means that earnings yield is expected to rise to 9.4% in 2018 and 10.3% in 2019, assuming the enterprise value remains the same. The expected earnings yield over 2019 is currently above the total return requirement of 9.8%. This suggests that, given the assumptions made, XP Power is capable of achieving the required returns.
Table 12.8 EBIT, EBITDA and EV/EBITDA for XP Power
|
2017 |
2018 (f) |
2019 (f) |
|
|
EBIT (£m) |
32.4 |
42.8 |
46.7 |
|
EBITDA (£m) |
38.6 |
49.2 |
54.1 |
|
EV/EBITDA |
11.77 |
9.2 |
8.4 |
|
Earnings yield (%) |
7.1 |
9.4 |
10.3 |
(f) indicates broker forecasts, taken at December 2018.
Asset-based fair valuation
The growth in assets can be used to assess the likely returns from an investment in a company. This valuation method is ideal for financial companies, such as banks and insurance companies, which can easily manipulate earnings and where underlying asset value is arguably more important. Companies that have large amounts of assets on their balance sheet, such as property and utility companies, may also be better valued using this method too. Conversely, companies with low amounts of physical assets, such as technology companies, should avoid using this valuation methodology as it is not suitable.
The asset-based fair valuation method typically offers a more conservative valuation than other methods described in this chapter. The steps in this asset-return-based calculation are as follows:
Step 1: Estimate the net tangible asset value per share (NAV ps) in ten years’ time
The current tangible asset value per share can be found in the Morningstar report, and is usually referred to as net tangible asset value per share (NAV ps).
To estimate the NAV ps in ten years’ time, it is assumed that assets grow in line with the long-term assumption. Therefore, it is calculated by multiplying the current asset value per share by 1 plus the asset growth rate, to the power of ten.
Example
XP Power has NAV ps of 272.7p at the end of 2017. The long-term asset value growth rate is 11.6%. NAV ps in ten years’ time is therefore going to be 817.2p (= 1.11610 × 272.7p = 2.997 × 272.7p).
Step 2: Estimate the earnings per share in ten years’ time
The earnings per share in ten years’ time is obtained by multiplying the NAV ps in ten years’ time by the average return on equity.
Example
The average return on equity was previously calculated to be 24.9%. The EPS in ten years’ time is therefore 203.5p (= 24.9% × 817.2p). A sense check against historic EPS shows that this EPS number looks plausible.
Step 3: Estimate the central price in ten years’ time
Chapter 11 showed how to calculate the average price to earnings, the average low price to earnings and the average high price to earnings ratios over the past five years. The central price in ten years’ time is calculated by multiplying the average price to earnings by the estimate of earnings in ten years’ time.
Example
Table 12.9 summarises the average PE statistics for XP Power, which were calculated in the previous chapter. The central estimate of the share price in ten years’ time is 3154.3p (= 15.5 × 203.5p).
Table 12.9 PE ratio summary statistics
|
Low |
Average low |
Average |
Average high |
High |
|
|
PE Ratio (p) |
10.2 |
12.2 |
15.5 |
18.7 |
24.8 |
Step 4: Estimate a price range for the share price in ten years’ time
The low price in ten years’ time is calculated by multiplying the average low PE ratio by the estimate of earnings in ten years’ time. The high price in ten years’ time is calculated by multiplying the average high price to earnings ratio by the estimate of earnings in ten years’ time. This provides a plausible range for the share price in ten years’ time.
Example
For XP Power, the low price in ten years’ time is 2482.7p (= 12.2 × 203.5p), and the high price in ten years’ time is 3805.5p (= 18.7 × 203.5p). Thus, we expect the price in ten years’ time to be in the range of 2482.7p and 3805.5p, provided company valuations are not at extreme levels.
Step 5: Estimate the dividends paid over the next ten years
To estimate the amount of dividends payable over the next ten years, you first need to work out the total amount of earnings that will be earned over the next ten years. To do this, assume that net asset value grows in line with our long-term assumption each year. Assuming the return on equity is in line with the average return on equity, the EPS in each year will be the average return on equity multiplied by the net asset value in that year. Using this approach, you can calculate the EPS paid out over the next ten years.
Example
The NAV ps at the end of 2017 is 272.7p and the long-term asset value growth rate is 11.6%. The NAV ps in one years’ time is 304.3p (= 1.116 × 817.2p). The following years’ net asset value is 339.6p (= 1.116 × 304.3p). Continuing with this calculation you can estimate the NAV ps over the next ten years, as shown in table 12.10.
Table 12.10 Future net asset value and earnings per share
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Year 9 |
Year 10 |
|
|
NAV ps (p) |
304.3 |
339.6 |
379.0 |
423.0 |
472.1 |
526.8 |
587.9 |
656.1 |
732.3 |
817.2 |
|
EPS (p) |
75.8 |
84.6 |
94.4 |
105.3 |
117.5 |
131.2 |
146.4 |
163.4 |
182.3 |
203.5 |
Multiplying the estimated future net asset value numbers by 24.9% (our choice of return on equity) you obtain the estimated future EPS over each of the next ten years. The estimated future EPS are shown in the second row of table 12.10. Total EPS over the next ten years is 1304.4p.
Note that the EPS numbers in the first few years look low compared to the EPS history and broker forecasts over 2018 and 2019. This suggests that this valuation method may be less applicable than others.
The percentage of earnings paid out as dividends is assumed to be in line with the average rate paid out over the last five years. The total dividends paid out over the next ten years is estimated by multiplying the total earnings earned over the next ten years multiplied by the average payout ratio.
Example
The payout ratio was previously calculated as 53.6%. The total dividends paid out over the next ten years is therefore estimated to be 699.2p (= 0.536 × 1304.4p).
Step 6: Estimate the potential return at the current share price
The overall share price in ten years’ time is the central share price in ten years’ time plus the total dividends paid out over the next ten years. The annualised expected return is the CAGR of the share price over the next ten years. If the expected return is above the required return the shares may be purchased, provided the company shares are on the buy list and the rules about portfolio allocation are followed.
Example
The overall share price in ten years’ time including the dividends paid out over the next ten years is 3853.5p (= 3154.3p + 699.2p). If the current price is 2130p, the annualised total return is expected to be 6.1% (= (3853.3 ÷ 2130)(1/10) – 1). This is below the required return of 9.8% and implies that you should wait for a better price to invest.
A more conservative estimate of the likely returns can be obtained by using an estimate of the share price in ten years’ time that is consistent with the lower end of the valuation spectrum.
Example
The conservative estimate of the share price in ten years’ time is 3181.9p (= 2482.7p + 699.2p). The annualised total return is then expected to be 4.1% (= (3181.9 ÷ 2130)(1/10) – 1). This is well below the required return of 10%, meaning you should wait for a better price before investing.
A higher, more optimistic estimate of the likely returns can be obtained by using a high estimate of the share price in ten years’ time. If the optimistic return estimate is below the required return, the shares offer poor value and should not be purchased until the price has fallen sufficiently.
Example
The optimistic estimate of the share price in ten years’ time is 4504.7p (= 3805.5p + 699.2p). The annualised total return is expected to be 7.8% (= (4504.7 ÷ 2130)(1/10) – 1). This is still well below the required return of 9.8% and implies that the shares are potentially poor value.
Step 7: Produce a sticker price for the company
The sticker price is the maximum price you should pay for the company’s shares. It is obtained by discounting the overall share price in ten years’ time including the dividends paid by the required return.
Example
The overall share price in ten years’ time, including the dividends paid out over the next ten years, is 3853.5p and the required return is 9.8%. The sticker price is therefore 1513p (= 3853.5 ÷ 1.09810), well below the current price of 2130p. Given the assumptions made, this is the price that will deliver the required return.
Earnings-based fair valuation
This methodology uses growth in earnings to estimate the potential return from investing in a company’s shares. Earnings are an effective proxy for the issues driving price, volume and costs. The performance of these variables helps determine the success of the company and the share price.
This methodology cannot be used for companies with no earnings. If earnings are very low or negative, use of the PE ratio is inappropriate. If earnings are very low but positive, the PE ratio will be so high that it is not meaningful. If earnings are negative, future earnings cannot be easily projected forward and the PE ratio is negative. Companies that tend to suffer from this problem are either highly cyclical companies, which suffer from periods of low earnings or losses at the bottom of an economic cycle, or start-up companies that are yet to make a profit. Fortunately, our screening approach will typically eliminate these types of company from consideration.
Equally, the earnings valuation method should not be used for financial companies, such as insurance, banks or property. These companies are normally valued on assets rather than earnings.
The steps in the earnings-based fair valuation calculation are as follows:
Step 1: Estimate earnings per share in ten years’ time
To estimate the EPS in ten years’ time, we assume that earnings grow in line with our long-term assumption. EPS in ten years’ time is calculated by multiplying the current EPS by 1 plus the earnings growth rate to the power of ten.
Example
XP Power has current earnings per share of 146p in 2017. The long-term earnings growth rate is 8.4%. Earnings per share in ten years’ time is therefore going to be 327.1p (= 1.08410 × 146p).
Step 2: Estimate the central price in ten years’ time
The central price in ten years’ time is calculated by multiplying the average PE by the estimate of earnings in ten years’ time.
Example
Table 12.9 summarises the average PE statistics for XP Power, which were calculated in the previous chapter. The central estimate of the share price in ten years’ time is 5070p (= 15.5 × 327.1p).
Step 3: Estimate a price range for the share price in ten years’ time
The low price in ten years’ time is calculated by multiplying the average low PE ratio by the estimate of earnings in ten years’ time. The high price in ten years’ time is calculated by multiplying the average high PE ratio by the estimate of earnings in ten years’ time. This provides a plausible range for the share price in ten years’ time.
Example
For XP Power, the low price in ten years’ time is 3990.6p (= 12.2 × 327.1p), and the high price in ten years’ time is 6116.8p (= 18.7 × 327.1p). Thus, the price in ten years’ time is expected to be in the range of 3990.6p to 6116.8p, provided company valuations are not at extreme levels.
Step 4: Estimate the dividends paid over the next ten years
To estimate the amount of dividends payable over the next ten years you need to work out the total amount of earnings that will be earned over this period. The EPS in a year can be obtained by multiplying EPS in the previous year by 1 plus the long-term earnings growth assumption. This allows you to calculate EPS over the next ten years and sum them together to obtain the expected total EPS earned over the next ten years.
Example
The current EPS is 146p per share and the long-term earnings growth rate is 8.4%. The earnings per share in one years’ time is 158.3p (= 1.084 × 146p). The following years’ earnings per share is 171.6p (= 1.084 × 158.3p). Continuing with this calculation you can estimate the EPS over the next ten years, as shown in table 12.11.
Table 12.11 Future earnings per share
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Year 9 |
Year 10 |
|
|
EPS (p) |
158.3 |
171.6 |
186.0 |
201.6 |
218.5 |
236.9 |
256.8 |
278.3 |
301.7 |
327.1 |
The total dividends paid out over the next ten years is estimated by multiplying the total earnings over the period by the average payout ratio.
Example
From table 12.11, total earnings are estimated to be 2336.7p per share over the next ten years. The payout ratio was previously calculated as 53.6%. The total dividends paid out over the next ten years is therefore estimated to be 1252.5p (= 0.536 × 2336.7p).
Step 5: Estimate the potential return at the current share price
The share price in ten years’ time including the dividends paid out is the central share price plus the sum of the dividends paid out over the next ten years. The annualised expected return is the CAGR of the share price over the next ten years. If the expected return is above the required return, the shares may be purchased.
Example
The central estimate of the share price in ten years’ time is 5070p. The overall share price in ten years’ time including the dividends paid out is 6322.5p (= 5070p + 1252.5p). If the current price of XP Power is 2130p, the annualised total return is expected to be 11.5% (= (6322.5 ÷ 2130)(1/10) − 1). This is above the required return of 9.8% and implies that the shares are cheap enough to invest in.
A more conservative estimate of the likely returns can be obtained by using a low estimate of the share price in ten years’ time. If this is above the required return, the shares are attractively priced and likely to offer excellent value.
Example
The conservative estimate of the share price in ten years’ time is 3990.6p. A conservative share price in ten years’ time, including the dividends paid out over the next ten years is 5243.1p (= 3990.6p + 1252.5p). If the current price of XP Power is 2130p, the annualised total return is then expected to be 9.4% (= (5243.1 ÷ 2130)(1/10) − 1). This is below the required return of 9.8%, which implies that there may not be enough margin of safety when valuations are based on earnings.
A more optimistic estimate of the likely returns can be obtained by using a high estimate of the share price in ten years’ time. If the optimistic return estimate is below the required return the shares are likely to offer poor value.
Example
The optimistic estimate of the share price in ten years’ time is 6116.8p. The overall share price in ten years’ time including the dividends paid out over the next ten years is 7369.3p (= 6116.8p + 1252.5p). If the current price of XP Power is 2130p, the annualised total return is expected to be 13.2% (= (7369.3 ÷ 2130)(1/10) − 1). This is well above the required return of 13.2% and implies that the shares have good upside. Returns are expected to range between 9.4% and 13.2%.
Step 6: Produce a sticker price for the company
The sticker price is the maximum price we currently want to pay for the company’s shares. It is obtained by discounting the expected overall share price in ten years’ time including the dividends paid by the required return.
Example
The overall share price in ten years’ time, including the dividends paid is 6322.5p and the required return is 9.8%. The sticker price is therefore 2482.4p (= 6322.5p ÷ 1.09810). Given the assumptions made, this is the highest price that will deliver the required return. This suggests the current price of 2130p provides a 14.2% (= (2482.4 – 2130) ÷ 2482.4) margin of safety.
Sales-based fair valuation
This method uses growth in sales to estimate the potential return from investing in a company’s shares. Sales can be a more reliable indicator of growth as figures are harder to manipulate than earnings.
This sales-based method can be used to double check that a company’s growth has not become overvalued. Equally, it is useful for evaluating recovery situations. For example, if a company begins to suffer losses and, as a result, has no earnings (and no meaningful PE ratio) to assess likely returns, the sales figures can be used instead as these tend to be more stable than earnings. The ratio is less appropriate for service companies like banks or insurers that don’t really have sales.
The steps in the sales-based fair valuation are as follows:
Step 1: Estimate sales per share in ten years’ time
SPS is calculated by dividing total sales by the total number of shares outstanding. Assuming sales growth is in line with the long-term growth assumption, SPS in ten years’ time is calculated by multiplying the latest SPS by 1 plus the sales growth rate to the power of 10.
Example
In 2017, XP Power reported an SPS of 860.3p. The long-term sales growth rate is 8.6%. SPS in ten years’ time is therefore expected to be 1963.1p (= 1.08610 × 860.3p).
Step 2: Estimate the central price in ten years’ time
The previous chapter showed how to calculate the average price to sales ratio as well as the average low and average high price to sales ratios over the past five years. The central price in ten years’ time is calculated by multiplying the average price to sales by the estimate of sales in ten years’ time.
Example
Table 12.12 summarises the average PSR statistics for XP Power which were calculated in the previous chapter. The central estimate of the share price in ten years’ time is 5398.5p (= 2.75 × 1963.1p).
Table 12.12 Price to sales ratio summary statistics for XP Power
|
Low |
Average low |
Average |
Average high |
High |
|
|
Price to sales ratio (PSR) |
1.8 |
2.2 |
2.75 |
3.3 |
4.2 |
Step 3: Estimate a price range for the share price in ten years’ time
The low price in ten years’ time is calculated by multiplying the average low price to sales ratio by the estimate of sales in ten years’ time. Similarly, the high price in ten years’ time is calculated by multiplying the average high price to sales ratio by the estimate of sales in ten years’ time. This provides a plausible range for the share price in ten years’ time.
Example
For XP Power, the low price in ten years’ time is 4318.8p (= 2.2 × 1963.1p), and the high price is 6478.2p (= 3.3 × 1963.1p). Thus, we expect the price in ten years’ time to be in the range of 4318.8p to 6478.2p, provided company valuations are not at extreme levels.
Step 4: Estimate the dividends paid over the next ten years
To estimate the amount of dividends payable over the next ten years you need to work out the total amount of earnings that will be earned over the period. To do this, assume that sales grow in line with the long-term assumption.
Example
The SPS in 2017 is 860.3p per share and the long-term sales growth rate is 8.6%. The SPS in one year’s time is 934.3p (= 1.086 × 860.3p). The following year’s SPS is 1014.6p (= 1.086 × 934.3p). Continuing with this calculation you can estimate the SPS over the next ten years, as shown in the top row of numbers in table 12.13.
Table 12.13 Future sales per share and earnings per share
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Year 9 |
Year 10 |
|
|
SPS (p) |
934.3 |
1014.6 |
1101.9 |
1196.7 |
1299.6 |
1411.3 |
1532.7 |
1664.5 |
1807.7 |
1963.1 |
|
EPS (p) |
165.4 |
179.6 |
195.0 |
211.8 |
230.0 |
249.8 |
271.3 |
294.6 |
320.0 |
347.5 |
The profit margin is the proportion of sales converted into earnings. The average profit margin is defined as the average price to sales ratio divided by the average price to earnings ratio.
Example
From table 12.12, the average PSR for XP Power is 2.75 and, from table 12.9, its average PE ratio is 15.5. Thus, the average profit margin is 17.7% (= 2.75 ÷ 15.5).
Assuming the profit margin is in line with the average, the EPS in a particular year will be the average profit margin multiplied by the SPS in that year. You can calculate the EPS over the next ten years and sum them together to obtain the expected total EPS earned over the next ten years.
Example
Multiplying the estimated future SPS numbers by 17.7% (the average profit margin) you obtain the estimated future EPS over each of the next ten years. The estimated future EPS are shown in the second row of table 12.13, from which total earnings over the next ten years can be estimated to be 2465p per share.
The total dividends paid out over the next ten years is estimated by multiplying the total earnings over the period by the average payout ratio.
Example
The average payout ratio for XP Power is 53.6%. Thus, the total dividends paid out over the next ten years is estimated to be 1321.2p (= 0.536 × 2465p).
Step 5: Estimate the potential return at the current share price
The overall share price in ten years’ time, including the dividends paid out, is the central share price plus the total dividends paid out over ten years. The annualised expected return is the CAGR of the share price over the next ten years. If the central expected return is above the required return the shares may be purchased.
Example
The central estimate of the share price in ten years’ time is 5398.5p. The overall share price in ten years’ time including the dividends paid out over the next ten years is 6719.7p (= 5398.5p + 1321.2p). If the current price of XP Power is 2130p, the annualised total return is expected to be 12.2% (= (6719.7 ÷ 2130)(1/10) − 1). This is above the required return of 9.8% and means that an investment in XP Power is likely to yield more than the required return.
A more conservative estimate of the likely returns can be obtained by using a low estimate of the share price in ten years’ time. If the conservative return estimate is above the required return, the shares are attractively priced and are likely to offer good value.
Example
The low estimate of the share price in ten years’ time is 4318.8p. A conservative share price in ten years’ time, including the dividends paid out over the next ten years, is 5640p (= 4318.8p + 1321.2p). If the current price is 2130p, the annualised total return is then expected to be 10.2% (= (5640 ÷ 2130)(1/10) − 1).
A more optimistic estimate of the likely returns can be obtained by using a high estimate of the share price in ten years’ time. If the optimistic return estimate is below the required return, the shares are expensive and should not be purchased until the share price has fallen sufficiently.
Example
The optimistic estimate of the share price in ten years’ time is 6478.2p. The overall share price in ten years’ time, including the dividends paid out over the next ten years, is 7799.4p (= 6478.2p + 1321.2p). If the current price is 2130p, the annualised total return is expected to be 13.9% (= (7799.4 ÷ 2130)(1/10) – 1). This is above the required return of 9.8%, which suggests the shares have plenty of upside. Based on sales, the shares are expected to return between 10.2% and 13.9%.
Step 6: Produce a sticker price for the company.
The sticker price is the maximum price you should pay for the company’s shares. It is obtained by discounting the overall share price in ten years’ time including the dividends paid by the required return.
Example
The overall share price in ten years’ time, including the dividends paid out over the next ten years, is 6719.7p and the required return is 9.8%. The sticker price is therefore 2638.3p (= 6719.7p ÷ 1.09810). Given the assumptions made, this is the highest price that will deliver the desired required return. The current price of 2130p is well below the sticker price of 2638.3p and currently offers a margin of safety of 19.3% (= (2638.3 − 2130) ÷ 2638.3).
Quick and easy dividend-based fair valuation
This valuation method can be used to place a value on large income or value companies that consistently pay out a dividend every year. It cannot be used to value companies that do not pay a dividend or young companies that irregularly pay a dividend, which typically rules out growth companies.
The simple approach outlined here produces a fair value price but does not provide an estimate of the likely return over the next ten years. However, it benefits from being a quick way to estimate the sticker price.
The steps in the dividend-based fair valuation calculation are as follows:
Step 1: Calculate the excess return over dividend growth required
The excess return required over the dividend growth is calculated by subtracting the long-term growth rate from the required return.
Example
The required return for XP Power is 9.8% and the long-term dividend growth rate is 7.9%. The excess return required over the dividend growth is therefore 1.9% (= 9.8% – 7.9%).
Step 2: Estimate the central price
The central price is determined by dividing the current dividend by the excess return required over the dividend growth.
Example
The 2017 dividend for XP Power is 78p. The central price is therefore 4105.3p (= 78p ÷ 1.9%). This is well above the current price of 2130p and suggests there is a 72.5% (= (4105.3 – 2130) ÷ 4105.3) margin of safety.
Step 3: Determine the fair value price range
The price range is determined by varying the dividend growth rate. The lower end of the price range is calculated by reducing the long-term dividend growth rate by 25% and repeating the calculations in steps 1 and 2. Similarly, the upper price range is determined by raising the long-term dividend growth rate by 25%; if this growth rate is above the required return, simply use the central projection as the upper bound.
Example
The lower dividend growth rate is 5.9% (= 0.75 × 7.9%) and the upper growth range is 9.9% (= 1.25 × 7.9%). The lower end of the price range is 2000p (= 78p ÷ (9.8% – 5.9%)) and the upper end of the price range is set at the central price of 4105.3p. Thus, the fair value price range is 2000p to 4105.3p. The current share price is 2130p, which suggests there is more upside than downside.
Dividend-based fair valuation
This valuation method can be used to place a value on large income or value companies that consistently pay out a dividend every year. It cannot be used to value companies that irregularly pay a dividend or do not pay a dividend. Unlike the quick and easy version, this approach produces likely return ranges as well as a sticker price.
The steps in the dividend-based fair valuation calculation are as follows:
Step 1: Determine the historic dividend yield range
The dividend yield for a company is the DPS divided by the share price. The dividend-based share price range is obtained by looking at the share price the company traded at during a given year. The highest and lowest dividend yield is calculated by dividing the share price by the share price low/high in the same accounting year.
The average high/low dividend yield is calculated by averaging the high or low dividend yields achieved over the past five years. An overall average dividend yield is obtained by averaging the high and low average dividend yields.
Example
Table 12.14 shows the historic DPS paid out each accounting year and the share price range for XP Power. This information is used to calculate the highest and lowest dividend yield attained each year. For example, in 2017 the highest dividend yield was 4.5% (= 78 ÷ 1725) and the lowest dividend yield was 2.2% (= 78 ÷ 3626.4).
Table 12.14 Historic dividend yield ranges for XP Power
|
2013 |
2014 |
2015 |
2016 |
2017 |
Average |
|
|
High Price (p) |
1630.0 |
1798.0 |
1750.0 |
1845.1 |
3626.4 |
|
|
Low Price (p) |
972.3 |
1340.0 |
1375.0 |
1396.8 |
1725.0 |
|
|
DPS (p) |
45.1 |
50.0 |
54.1 |
71.0 |
78.0 |
|
|
Dividend yield – high (%) |
4.6 |
3.7 |
3.9 |
5.1 |
4.5 |
4.4 |
|
Dividend yield – low (%) |
2.8 |
2.8 |
3.1 |
3.8 |
2.2 |
2.9 |
The high dividend yields averaged 4.4%, while the low dividend yields averaged 2.9%. The overall average dividend yield is 3.7% (= (4.4% + 2.9%) ÷ 2).
Step 2: Estimate the dividend per share paid out in year ten
To estimate the DPS in ten years’ time, it is assumed that dividends grow in line with the long-term dividend growth assumption. The DPS in ten years’ time is calculated by multiplying the current DPS by 1 plus the dividend growth rate to the power of 10.
Example
The current dividend per share is 78p and the long-term dividend growth rate is 7.9%. The dividend in ten years’ time is therefore estimated to be 166.8p (= 78p × 1.07910).
Step 3: Estimate the central price in ten years’ time
The central price in ten years’ time is calculated by dividing the DPS in ten years’ time by the average dividend yield.
Example
The average dividend yield over the past five years was 3.7%. The central price for XP Power is therefore 4508.1p (= 166.8p ÷ 0.037).
Step 4: Estimate a price range for the share price in ten years’ time
The low/high price in ten years’ time is calculated by dividing the DPS in ten years’ time by the average high/low dividend yield. This provides a plausible range for the share price in ten years’ time.
Example
The average high and low dividend yield are 4.4% and 2.9%, respectively. The low price is therefore 3790.9p (= 166.8p ÷ 0.044) and the high price is 5751.7p (= 166.8p ÷ 0.029).
Step 5: Estimate the dividends paid over the next ten years
The amount of dividends per share (DPS) paid out each year can be estimated using the current dividend and the estimate of long-term dividend growth. The estimate of DPS in one year’s time is the current dividend multiplied by 1 plus the growth rate. The DPS in two years’ time is the estimate of DPS in year one multiplied by 1 plus the growth rate. This approach can be extended to estimate the DPS paid out over the next ten years.
Example
The current dividend of XP Power is 78p and long-term dividend growth is 7.9%. The dividend paid out in the following year is therefore 84.2p (= 78p × 1.079) and in year two is 90.8p (= 84.2p × 1.079). The dividends paid out over the following years are similarly calculated and shown in table 12.15. The total dividends paid out over the next ten years is 1213.4p.
Table 12.15 Future dividends per share
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Year 9 |
Year 10 |
|
|
DPS (p) |
84.2 |
90.8 |
98.0 |
105.7 |
114.1 |
123.1 |
132.8 |
143.3 |
154.6 |
166.8 |
Step 6: Estimate the potential return at the current share price
The overall share price in ten years’ time including the dividends paid out is the central share price plus the total dividends paid out over ten years. The annualised expected return is the CAGR of the share price over the next ten years. If the central expected return is above the required return, the shares may be purchased.
Example
The central share price in ten years’ time is 4508.1p and the total dividends paid out is 1213.4p. The overall share price is therefore 5721.5p (= 4508.1p + 1213.4p). The current share price is 2130p and the estimated CAGR is therefore 10.4% (= (5721.5 ÷ 2130)(1/10) − 1). This is above the required return of 9.8%.
A more conservative estimate of the likely returns can be obtained by using the share price low.
Example
The low share price in ten years’ time is 3790.9p and the total dividends paid out is 1213.4p. The overall low share price is therefore 5004.3p (= 3790.9p + 1213.4p). Thus the CAGR is 8.9% (= (5004.3 ÷ 2130)(1/10) − 1).
A more optimistic estimate of the likely returns can be obtained by using a higher share price in ten years’ time.
Example
The high share price in ten years’ time is 5751.7p and the total dividends paid out is 1213.4p. The overall high share price is therefore 6965.1p (= 5751.7p + 1213.4p). Thus, the CAGR is 12.6% (= (6965.1 ÷ 2130)(1/10) − 1) and returns are expected to range between 8.9% and 12.6%. This again suggests there is more upside than downside when compared against the required return of 9.8%.
Step 7: Produce a sticker price for the company.
The sticker price is obtained by discounting the overall share price in ten years’ time by the required annual return.
Example
The overall share price in ten years’ time is 5721.5p and the required annual return is 9.8%. The sticker price is therefore 2246.4p (= 5721.5p ÷ 1.09810). Thus, the current share price of 2130p has a 5.2% (= (2246.4 – 2130) ÷ 2246.4) margin of safety.
Overall fair valuation
The different valuation methods based on assets, earnings, sales and dividends produce different estimates for the expected investment return and sticker price. You will generally want to see at least two of the methods indicating that the current share price offers value.
For companies where the valuation methods are equally applicable you will need to combine the valuation methods to produce an overall fair valuation, which gives a composite expected long-term return and a sticker price.
One option is to take an average of the valuation methods that are applicable to a company. Alternatively, a more pragmatic approach is to select the valuation method that has the closest sticker price to the current share price.
Example
Table 12.16 summarises the estimated long-term returns from investing in XP Power and the sticker price under each valuation method.
Table 12.16 Estimated long-term returns
|
Expected return (%) |
Sticker |
|||
|
Valuation method |
Low |
Average |
High |
Price (p) |
|
Earnings yield |
- |
7.1 |
- |
- |
|
Asset |
4.1 |
6.1 |
7.8 |
1513.0 |
|
Earnings |
9.4 |
11.5 |
13.2 |
2482.4 |
|
Sales |
10.2 |
12.2 |
13.9 |
2638.3 |
|
Dividends |
8.9 |
10.4 |
12.6 |
2246.4 |
|
Overall |
8.9 |
10.4 |
12.6 |
2246.4 |
The asset valuation method suggests that XP Power is expensive. However, this approach generates low earnings projections relative to recent history, and is not as credible as other methods for XP Power. In addition, XP Power is not an asset-heavy company, making this method less relevant.
The earnings, sales and dividend methods all indicate that an investment in XP Power at a share price of 2130p will likely deliver the required return of 9.8%; the average returns are all above 9.8% and the share price is less than the proposed sticker prices. The earnings and dividend methods have estimated lower bound returns that are below the required return, which suggest that weak valuations risk the required return not being achieved over the long term.
The dividend valuation method produces a fair valuation method that is closest to the current share price. It suggests that an investment in XP Power will offer a return of between 8.9% and 12.6%, with an expected return of 10.4%.
Summary
This chapter has shown you how to work out the required return for a company and how to value its shares using a variety of different approaches. These methods help you to assess the possible returns that might be generated from an investment in company shares at their current price. Using this knowledge, you can then make an informed decision about whether it is currently worthwhile investing in companies on the buy list.