Value investing and the price earnings ratio

Because the price earnings ratio uses price as an input, it’s no help determining the value of a company. Value investing is the way to go.

Price earnings ratio, intrinsic value, net tangible assets, dividend discount model.

With so many ways to measure the quality and value of a company, you can easily become bamboozled when it comes to deciding which ones are worth adding to your share portfolio.

Rather than an over-reliance on performance indicators, like the popular price earnings ratio (P/E) used by many investors, Share Analysis favours the value investing methodology, which has been adopted and refined by the world’s most successful investor, Warren Buffett.

While the price earnings ratio – (current) share price / (historical) earnings per share – tells you what the market is prepared to pay for the current earnings per share of a company, it reveals nothing of the intrinsic value of a company, either now or in the future.

Intrinsic value

Buffett’s exceptional track record proves convincingly that intrinsic value – the sum total of the business’s worth based on earnings, dividends, equity and debt – is the key to distinguishing superior stocks from their lower quality counterparts. To Buffett, the hallmark of a superior stock is the quality of its underlying business.

Share Analysis is founded on the value investing principles practiced by Warren Buffett. Share Analysis advocates that companies capable of growing their intrinsic value are also more likely to provide increasing capital growth to an investor’s portfolio – which is what investing in the share market is all about.

While it’s never an exact science, Share Analysis arrives at an intrinsic value range by undertaking ‘fundamental’ analysis. This involves looking at a company’s financial statements over time and making an assessment of its management, markets and growth potential. A closer look at intrinsic value will show you why it’s vital to calculate when deciding which stocks to buy (or sell).

Invest in businesses, don’t trade stocks

One of the touchstones shared by value investors is the desire to understand businesses and not just treat the share market like a casino governed by share price momentum.

Governed by more short-term drivers, share prices can vary enormously over a year, whereas business fundamentals are less volatile.

Be a contrarian investor

To capitalise on market volatility, value investors have to become contrarians. Attractive opportunities are often thrown up when market sentiment negatively influences short-term price movements rather than long-term fundamentals. Remember though, a company’s valuation can also change as new information comes to light.

It’s equally important for you to understand that sooner or later, a stock’s share price will converge with its intrinsic value. That’s why alarm bells should ring when a company’s share price significantly overtakes (or lags behind) its underlying performance or intrinsic value (aka full value). As an informed investor you need to understand that the gap between share price and intrinsic value won’t last forever. So while price remains an important performance ratio, your decision to buy or sell within a value investing model should always be based on underlying quality.

Focus on the very best top stocks

Value investors seek to buy exceptional businesses when their share prices are trading at a significant discount to intrinsic value.

This strategy is more likely to grow the long-term value of your share portfolio than buying a lower quality business, with fewer opportunities for future growth, at a cheaper price. But the closer the share price gets to a stock’s intrinsic value, the greater the risk of overexposure to any single stock.

Buying shares in a poor performing business will almost guarantee you lose money over time.

QBE Insurance Group (QBE) serves to illustrate this point. In 2007, as soon as business performance started to decline, so did the company’s intrinsic value, and surprise, surprise the share price followed suit.

Share Analysis Line chart presents QBE’s share price and intrinsic value, as estimated by Share Analysis

Share Analysis Line chart plots QBE’s intrinsic value and share price.

By estimating forecast intrinsic valuations for each (profitable) stock – derived by earnings, dividends, equity and profit forecasts from consensus analysts – Share Analysis’s value investment software can help you decide whether a buy or sell decision makes sense. But given that intrinsic value calculations are only ever an estimate, it also makes sense to apply a Safety Margin to that valuation to allow for uncertainty.

Share Analysis’s patent-pending Quality Aerial View plots companies based on the quality of their balance sheet and current safety margin.

The best stocks to invest in are located in the top right corner of the Aerial View – they’re bright green.

Share Analysis’s Quality Aerial View plots ASX-listed companies based upon their Share Analysis Quality Score and Safety Margin

Intrinsic valuation models and methodology

What is the best methodology for value investors to use when calculating intrinsic value? Is it P/E, NTA, dividend discount or a discounted cash flow model?

The hallmark of successful value investing, proven by the undisputable success of Warren Buffett, is buying a company when its share price is considerably below its intrinsic value.

By ‘intrinsic value’ we mean ‘true’ value – the sum total of a business’s worth based on its earnings, dividends, equity and debt. How the business performs is after all how you as a shareholder make money.

Finding the right intrinsic value methodology

When it comes to calculating intrinsic value, what is the right methodology to use?

Here are some useful guidelines to help you wade through the many ways of valuing a company – drawing on certain assumptions about key financial information like profits, dividends or assets.

Generally speaking, valuation methods can be divided into either absolute or relative valuation models.

Absolute valuation models

Including dividend discount, discounted cash flow (DCF), and asset-based models, absolute valuation models search for the intrinsic value of an investment based on fundamentals (like dividends, cash flow and growth rates for a single company). By comparison, the relative valuation models are designed to compare a company with its industry peers, using ratios like the price earnings ratio (P/E).

Relative valuation models

Relative valuation models are considerably easier and faster to complete than their absolute counterparts, so many investors and analysts start their analysis with this method first.

The most popular valuation models

• Price to earnings ratio (P/E)

• Dividend yield and cash yield methods

• Net Tangible Assets (NTA)

• Dividend Discount model (DDM)

• Discounted Cash Flow model (DCF)

• Share Analysis’s intrinsic value model

First up, let’s look at the universally popular P/E model in more detail.

Price earnings ratio (P/E ratio)

Price earnings ratio is the most commonly used (and often abused) valuation tool due to its focus on company earnings, a primary driver of an investment’s value. It is usually calculated as (current) share price / (historical) earnings per share

But you can’t begin to value a company using a price earnings ratio until you know:

A. what its actual earnings are and

B. what multiple to apply to those earnings.

A price earnings valuation is more meaningfully applied to companies with an established history of consistent earnings that are indicative of the normal cash flows the business earns.

It may not be an exact science, but an earnings multiple is arrived at by rigorously assessing a company’s long term performance – the quality of its business, management’s track-record – and then comparing it to both domestic and global peers. While a relatively high price earnings ratio should reflect a company’s quality and growth potential, it may also mean that the company is overvalued. If the price earnings ratio of the stock you’re trying to value is lower than the price earnings multiple of a comparable business, it may be regarded as relatively undervalued.

Different businesses will have different growth profiles. It is not always easy to assess whether a high or low price earnings ratio reflects high or low growth prospects, or if it is a reflection of relative value. Price earnings ratios will be unhelpful in trying to evaluate companies with negative or highly volatile earnings.

The price earnings ratio does reveal what the market is prepared to pay for the current earnings per share of a company. However due to the weaknesses outlined above, many investors (and also Share Analysis) prefer to rely on absolute models to establish what a company is worth.

Dividend yield and cash yield valuation methods

Dividend yield and cash yield valuation methods can also be useful ways to value a business, but like the price earnings ratio, they’re best applied to companies with a long history of sustainable earnings and cash flow plus steady dividend payouts.

Net Tangible Assets (NTA)

A net tangible assets (NTA) per share calculation – total assets less intangible assets less total liabilities, divided by number of shares on issue – can give you an indication of value, it’s important to remember that inventories can be overstated and fixed assets can be difficult to sell. NTA also does not take into account the earning power of those assets.

Dividend Discount Model (DDM)

The dividend discount model calculates the ‘true’ value of a firm – based on the dividends the company pays its shareholders – so it should provide a reasonable value for how much shares should be worth. But while this intrinsic value model may be useful for evaluating mature blue-chip companies with quality underlying earnings per share, it’s of little help to you if the company actually doesn’t pay a dividend.

Equally important, the dividend alone won’t tell you either how affordable it was or how sustainable it is at current levels. To get a snapshot of dividend affordability, keep an eye on whether earnings per share and dividends are growing at the same rate, and check to ensure the corresponding payout ratio is equally consistent.

Discounted Cash Flow (DCF)

Where a company doesn’t pay a dividend or where the dividend pattern is irregular, a discounted cash flow model might be a more appropriate measure of value. In the absence of dividends, the discounted cash flow model uses a firm’s discounted future cash flows to value the business.

While discounted cash flow models can vary significantly, the most common two-step variation includes:

A. the free cash flows – typically forecasted for five to ten years – and

B. a terminal value calculation which incorporates all the cash flows beyond this forecasted period.

But remember, this model can’t be deployed successfully unless a company has free cash flows that are not only predictable but also positive. The easiest asset to value with a DCF model is a government bond, where the cash flows are certain. As certainty of cash flows decreases, the accuracy of a discounted cash flow model also decreases. While mature companies with a strong cash flow are relatively suited to a DCF model, small, high-growth firms can be problematic. The discounted cash flow model is often used to value resource companies, where the cash flows have a limited life due to the limited mine life.

Share Analysis’s intrinsic value model

It’s important to remember that all (valuation) methodologies should contribute to unearthing what the world’s most successful investor Warren Buffett called a company’s intrinsic value (IV).

Share Analysis’s basic intrinsic value calculation is:

(Return on equity (ROE) x equity per share) / Required Return (RR)

Share Analysis automatically calculates a Required Return (RR) specific to the type of business being valued.

The most comparable publicly available calculation model to Share Analysis’s unique formula is the Residual income valuation model.

Using intrinsic value to find the best value stocks

While it’s never an exact science, intrinsic value – the sum total of the business’s worth based on earnings, dividends, equity and debt – can only be arrived at through significant ‘fundamental’ analysis. Rather than overly relying on comparative performance indicators, like a price earnings ratio, Warren Buffett prefers to concentrate on a company’s financial statements over time and assess its management, markets and future growth potential.

Buffett uses intrinsic value to identify superior stocks through the quality of their underlying business. He believes that companies capable of growing their intrinsic value are also more likely to provide increasing capital growth to your portfolio – which is what investing in the share market is all about.

As an informed value investor, you need to understand that the gap between price and value – safety margin – won’t last forever. Buffett argues that share price and intrinsic value will at some future time start to converge, and there’s no shortage of share market history to prove that he’s right.

By estimating forecast intrinsic valuations for each (profitable) stock – derived by earnings, dividends, equity and profit forecasts from consensus analysts – Share Analysis can help you decide whether a buy or sell decision makes sense. Given that intrinsic calculations are only ever an estimate, it also makes sense to apply a Safety Margin to that valuation to allow for uncertainty.

Share Analysis estimates up to ten years of historical intrinsic valuations plus three years of forecast valuations for thousands of stocks in listed businesses. Here’s how valuations are presented in Share Analysis stock research software.

Share Analysis estimates up to ten years of historical intrinsic valuations plus three years of forecast valuations for thousands of stocks in listed businesses.

Value investments or value traps?

Quality stocks trading at a discount to intrinsic value should be good investments, but how do you know if they are ‘value traps’?

As an astute share investor you should always be on the hunt for great ‘value-plays’ or quality stocks trading at a discount to their intrinsic value. But if you don’t keep an eye on a stock’s underlying business, and where the profits are coming from, what you thought was a buying opportunity could turn out to be an accident waiting to happen.

Commonly referred to as ‘value-traps’, these are stocks that you may have bought into when they appeared to be cheap based on (low) multiples of earnings, cash flow or book value and trading at a bright green positive safety margin. However, if after an extended time period the stock never improves, there’s a strong likelihood that you’ve fallen into a value trap that needs to be dealt with before it gets any worse.

Price earnings ratio is not the only indicator

The lesson for new or misinformed share investors is that a big safety margin or low price earnings ratio (P/E) doesn’t always mean ‘cheap’. And while some stocks trade at a significant premium to their value for good reason, the opposite can also be true.

So as a litmus test of value, the price earnings ratio can be and often is highly misleading. Take for example insurers, cyclical businesses, and the materials sector, where the businesses often have high profits and consequently low price earnings ratios at the very moment when conditions are at their best.

Sadly, investors who are drawn to shares under the psychological $1 barrier often confuse affordability with value. Similarly, many investors consider ‘blue chip’ companies with a strong brand name, high profile and a long history of good performance as perennial bellwethers when they’re not.

Due to any number of factors, whether it’s poor management, deteriorating economic factors or industry-related issues, stocks that become value-traps are frequently unable to survive in the face of new competition or generate substantial and consistent profits, and often lack new products or earnings growth.

The danger of holding onto an emerging value-trap is that by the time the company’s deteriorating fortunes become obvious to the broader market, the gap between the price you bought the stock at and its value is getting wider.

Value changes with changing results

Reporting seasons can be full of surprises, so be on the lookout for stocks with disappointing results, together with negative commentary on the outlook for a business or the competitive edge it once enjoyed. The trick is to anticipate what damage reporting season will have on a stock’s value before any re-ratings occur.

Many investors will be surprised to see the discount to value they thought some companies were trading at look totally different by year’s end.

So while one sector might look attractive when compared with current earnings, weakness in commodity prices and other macro headwinds pose major risks in buying these stocks going forward.

Examples of quality insurers that have suffered from deteriorating business performance and value include: Insurance Australia Group (IAG) and QBE Insurance.

QBE Insurance (QBE)

In 2007 QBE reported earnings per share of $2.26, and by December 2012 it had fallen to $0.73. Over that same period profit has declined by more than $100 million, while debt has increased to over 25 per cent of the company’s total equity. From a peak of $31.78 in 2007, QBE’s underlying value has fallen by around 60 per cent.

Share Analysis Line chart plots QBE’s intrinsic value and share price (at 12 July 2013).

Share Analysis Line chart plots QBE’s intrinsic value and share price.

Insurance Australia Group (IAG)

In the case of IAG, the company’s return on equity (a strong measure of profitability), went from over 20 per cent between 2004 and 2006 to less than half that by mid 2012. But despite declining earnings, the company continued to pay a dividend. When cash dried up the company took on debt and in 2008 ROE fell to 0.14 per cent. Unsurprisingly, over the same period the company’s share price virtually halved.

Share Analysis Line chart plots IAG’s intrinsic value and share price (at 12 July 2013).

Share Analysis Line chart plots IAG’s intrinsic value and share price.

Finding emerging value traps

Let’s take a look at companies that have traded at a discount, and where future valuations are forecast to decline.

Diversified services company Monadelphous Group (MND) looks like an attractive buy. But while its intrinsic value has increased 45 per cent per annum over the past nine years, it is forecast to decrease just over 12 per cent over the next two years. So while MNDs 30 per cent discount to value looks compelling, you should be concerned that this may indeed widen based on deteriorating conditions for the sector.

Share Analysis Line chart plots MND’s intrinsic value and share price (at 12 July 2013).

Share Analysis Line chart plots MND’s intrinsic value and share price.

Then there’s taxicab payment operator, Cabcharge (CAB) which – due to the erosion of its virtual monopoly status – is forecast to see its intrinsic value (up 13.5 per cent per annum over the last nine years) decrease by around 10 per cent per annum over the next two years. Given these dynamics, the current circa 40 per cent gap between price and value is concerning.

Share Analysis Line chart plots CAB’s intrinsic value and share price (at 12 July 2013).

Share Analysis Line chart plots CAB’s intrinsic value and share price.

It would have been inconceivable five years ago to suggest that retail darling JB Hi-Fi (JBH) could be a value trap in waiting, but recent developments are concerning.

Share Analysis Line chart plots JBH’s intrinsic value and share price (at 12 July 2013).

Share Analysis Line chart plots JBH’s intrinsic value and share price.

Monadelphous, Cabcharge and JB Hi-Fi have a few things in common when you see them in Share Analysis. First, their Share Analysis Line charts are bright green – they’re all historically strong businesses, and right now are trading at positive safety margins.

On the negative side, looking at their Share Analysis Verdict we can see that the future change in value forecast is negative.

Evaluate Future Value for a look ahead

Future Value, also known as FV or Forecast change in Value, is the forecast percentage of annual growth (or decline) in value for a company. Change in Future Value estimates will change as Share Analysis’s future intrinsic value estimates change.

A business may have a great track record, and in many cases the future looks just as promising. However businesses are dynamic. Economic environments impact business models, consumer sentiment changes and businesses that fail to adapt can be left behind.

How to find value stocks in a bull market

Sometimes value opportunities do not jump out at you. Dig deep enough and you’ll find stocks to buy.

If you’re an investor that believes the market is overvalued, and you’re cashing out your investments until value reappears, consider this: unless you are buying an index fund, it actually doesn’t really matter whether we’re in a bull market or a bear market.

The stock market is made up of a vast universe of shares and within that universe there will always be some top stocks that are overvalued and some that are undervalued.

Sometimes value opportunities do not jump out at you. If you dig deep enough, and have a powerful tool like Share Analysis to do the majority of the hard work for you, there are plenty of value opportunities to be found.

Before seeking value, you must first understand what constitutes a top stock. Top stocks display similar characteristics. At Share Analysis, we believe top stocks display five essential qualities:

1. Impressive company management: they have a track record of delivering rising value for shareholders;

2. Strong return on equity (ROE): top stocks generate in excess of 20 per cent returns on their equity;

3. Low debt: companies with strong balance sheets (ie minimal debt) are generally considered lower risk;

4. Strong earnings per share (EPS) growth: earnings per share growth indicates the company is growing;

5. Positive forecast intrinsic value growth: businesses able to increase their value ultimately experience rising share prices.

Determine the best price to pay for top stocks

Once you’ve identified the very best stocks, you need to consider an appropriate price to purchase their shares.

Warren Buffett is often quoted as saying “I would rather buy a good business at a fair price, than a fair business at a good price.” Buffett’s advice is to focus on the fundamentals of the business first. Seek out businesses that are profitable (they generate return on equity in excess of at least 15 per cent), and have strong prospects for future growth

Share Analysis estimates intrinsic valuations for every business listed on the Australia Securities Exchange (ASX), plus another 2,000 of the world’s largest listed businesses on exchanges spanning North America, Asia and Europe.

Safety Margin is the difference between a company’s intrinsic value and its share price. A positive safety margin indicates the share price is less than the value of the business and you can pick up shares for less than what the business is worth. A negative safety margin indicates the share price is higher than what the business is worth.

Buffett’s mentor, Benjamin Graham famously said that in the short run the stock market behaves like a voting machine, but over the long run it acts like a weighing machine. Market hype is not sustainable over the long term; share prices tend to converge with the intrinsic value of a business.

Find growth stocks

Finding growth stocks with Share Analysis is easy. Share Analysis estimates up to three years of intrinsic values for every listed business, then calculates the per annum growth rate, known as Forecast Change in IV.

Forecast Change in Intrinsic Value examines year-to-year changes in a company’s forecast intrinsic valuations. Companies forecast to grow display positive Forecast Change in IV growth rates.

Remove companies with excessive debt

The Net Debt / Equity ratio compares a company’s total debt to total shareholders’ equity. Companies with a significant amount of debt on their balance sheets are considered high risk.

Share Analysis recommends removing companies with a Net Debt / Equity ratio greater than 70%.

Compare safety margin with future growth rates

Whilst a company may be trading a premium to its intrinsic value this year, if impressive growth is forecast, it may turn out to be a top stock so paying a little more today could secure your position in a future growth stock.

Remove high risk or unethical sectors

At this stage some investors may choose to remove companies operating in particular sectors due to ethical reasons.

Once you’re created your shortlist of top stocks, its time to evaluateeach in further detail.

Top stocks checklist

Using our essential qualities of top stocks checklist as a guide, here’s how you can evaluate a company in Share Analysis.

1. Good management

The A1 – C5 Share Analysis Score is a proxy for good management. The only way a company can attain and maintain a good Share Analysis Score is if it is well run.

Whilst evaluating management can be quite subjective, the Share Analysis Score provides a more objective framework. You can’t argue with results!

Here’s an example of a company that has achieved Share Analysis’s highest A1 or A2 Score for 8 of the past ten years. Management of this company are doing a great job, and have the track record to prove it!

A well-run company will achieve Share Analysis's highest stock ratings

 

2. Strong return on equity (ROE)

Return on equity is ultimately the return that management are generating on the funds that you, the shareholders, have provided them with. Look for businesses that are able to consistently generate a high level of return on their equity (in excess of 15 per cent) – the blue line.

Look for businesses that are able to consistently generate a high level of return on their equity (in excess of 15%) - the blue line

 

3. Low debt

Debt can be used in a business to leverage up return on equity. In a low interest rate environment, it may well be advantageous to utilise some debt to fund a company’s operations.

On the flip side, debt (red columns) introduces a greater level of risk to the business. If profitability falls, the interest payments still have to be met. Interest rates could rise, increasing the burden on the business and the volatility of bottom line earnings. Also, in a liquidity crunch, companies may struggle to refinance their debt when it comes due which can put them in very difficult situations.

Companies may struggle to refinance their debt when it comes due which can put them in very difficult situations.

4. Earnings per share growth

Share Analysis sources forecast earnings per share figures for more than 500 ASX-listed companies and thousands of global stocks. These estimates, including the number of analysts contributing forecasts and the range of their estimates, are presented on a company’s Earnings and Dividends Evaluate screen.

Earnings per share growth

Remember, forecasts are never certain. Analyst’s estimates are determined based on the facts available at the time. If a major change happens, such as the government changing the ground rules, then earnings per share estimates and intrinsic valuations will also change.

Also remember that the further out you are forecasting the greater the level of uncertainty as to those returns being realised. Also note if a small number of analysts are covering the stock and if the range of the bullish and bearish estimates is tight, or quite varied.

5. Positive forecast intrinsic value growth

Ideally you want to invest in top stocks that are able to grow their intrinsic value. In the long run, if the value of a business is rising then the wealth of its owners will also be rising.

Whilst prices can dislocate from value for extended periods, in the long run they will usually revert.

Ideally you want to invest in top stocks that are able to grow their intrinsic value.

 

Compare your top stocks side-by-side

Share Analysis’s Compare feature allows you to evaluate 6 stocks side-by-side. Comparing businesses against each other allows you to narrow down your list to just a handful of the best stocks to buy.

With Share Analysis you can compare stocks by balance sheet quality, business performance, return on equity, dividend yield, price to earnings ratio, earnings per share growth, cash flow ratio, net debt / equity, cash interest cover, property plant and equipment / total assets, combined ratio, return on assets, net interest margin, cost to income ratio or bad debts.

Find top value stocks with Share Analysis

The market can, and does, move very quickly. Opportunities do not always linger for that long. That’s where Share Analysis can give you a strategic advantage. Even when opportunities are few and far between, there will usually be something of interest, but if you haven’t got a stock research tool that sifts out all the noise, finding new opportunities may be very difficult.

Some of you may be thinking, “That’s fine for you market tragics, but I would rather spend my time sailing a boat or playing golf”.

As with any achievement in life, there will always be some time commitment involved. With Share Analysis you can drastically cut down your research time. And with the addition of new features, such as custom alerts, new opportunities are delivered to your inbox as they appear.

Share Analysis makes it easy to find opportunities, especially when the market as a whole may be looking overvalued.

With Share Analysis, identifying opportunities and monitoring the stocks in your portfolio is simple, and even fun!

Find value investments in expanding markets

Not all well-priced shares turn into valuable long term investments. Find out how to choose those that can grow in expanding markets.

You’ve found a top-quality company whose share price is offering great value-for-money. Should you jump straight in and buy?

Assuming you’ve evaluated the company in detail, reviewed its future earnings per share forecasts, are comfortable with the level of debtand confident the company won’t tap you on the shoulder in the next 12 months asking for extra cash, there’s a few more things you should do to ensure you don’t get caught out.

Using Share Analysis, look at the company’s Share Analysis Verdict and Share Analysis Line chart. Is Share Analysis’s estimate of future change in value forecast to be positive or negative?

Future Value is the key to growth investments

Future Value, also known as FV or Forecast change in Value, is the forecast percentage of annual growth (or decline) in value for a company. Change in Future Value estimates will change as Share Analysis’s future intrinsic value estimates change.

On the company’s Share Analysis Line chart, pay particular attention to the gold forecast area. What does the future value of the business look like? Is it set to continue rising or forecast to decline?

A business may have a great track record and for some companies the future looks just as promising. However businesses are dynamic. Economic environments impact business models, consumer sentiment changes and businesses that fail to adapt can be left behind.

Compare Share Analysis’s future estimates for Flight Centre (FLT) and BC Iron (BCI).

Flight Centre (FLT) share price and intrinsic value chart

BC Iron (BCI) share price and intrinsic value chart

Based on their 2013 full year financial results, both companies are rated A1. Share Analysis’s A1 – C5 Scores are based on the most recent financial reports published by the company.

Companies can release up to four financial reports per year. Interim reports capture all relevant financial and business activities that occur since the last full year report and provide investors with up-to-date information on the state of the business.

A company’s Share Analysis Score is based upon the most recent financial results. These can be interim (quarter, half or third quarter) or full year results.

Companies with a 30 June end date report their full year results in August and half-year results in February. Those companies with a 31 December year-end date report their full year results in February and half-year results in August. Some companies report outside these times. Companies in some jurisdictions provide interim reports on a quarterly basis.

Estimating future values and growth rates

Share Analysis sources consensus analyst earnings per share, dividends per share, normalised profit and total equity figures for thousands of listed companies. These figures are used to produce Share Analysis’s future intrinsic valuation estimates.

When a company releases new information, analysts covering the stock will spend time digesting the announcement. They may ring the company or arrange a meeting with its CEO and CFO to gain further insights. After undertaking further research, each analyst may update their financial model and these new estimates will be run through Share Analysis’s automated algorithims.

Does the business operate in an expanding market?

Your job as an investor is to research the markets the business operates in to see if they are expanding, stabilising or contracting.

Logically you’d prefer to invest in companies that operate in expanding markets.

It’s much easier to grow in an expanding environment, rather than fighting for market share and compromising your margins. The online space is a perfect example of an expanding market. Many internet-focused businesses are doing extremely well, whilst other markets such as retail, building and construction are suffering. So it’s important to think about the business in terms of the market it operates in and whether or not the returns it has been generating are sustainable in the future and likely to continue growing at a reasonable rate.

Owning a business whose prospects for future growth are deteriorating significantly and the estimated forecasts based on consensus numbers are less certain or the future less promising, is like a vegie garden full of weeds. No one likes to grow or nurture weeds. Think of your portfolio accordingly. Do not get emotionally attached to businesses. Be independent, remain unbiased and stay flexible.

Share Analysis’s powerful filter allows investors to narrow down the universe of stocks to only those with growth on the horizon.

Why capital raisings struggle to add investment value

Capital raisings can shore up a company’s reserves and pay down debt, but they also risk diluting shareholder value.

Ideally a capital raising should deliver the classic ‘win-win’ by shoring-up capital reserves and paying down company debt while offering shareholders more shares at attractive discounts to traded prices. Unfortunately the benefits of capital raisings can be extremely one-sided. That’s why it’s important to understand that all capital raisings are not equal, and can destroy value for shareholders.

By learning how to identify an unfair capital raising, you (the shareholder) can avoid potential dilution in your shareholder value and being diddled out of your cash.

Higher share prices, lower debt – what can go wrong?

It’s not uncommon for a share price to rally following a capital raising – typically due to a quick mop-up of any perceived overhang in the market – and when it does shareholders are happy with their immediate windfall. But long-term wealth generation is a different matter, and it can sometimes take years to identify whether attempts to repair the balance sheet did add value.

A capital raising may indeed reduce company debt, but if it doesn’t result in increased earnings, the long-term value to shareholders is questionable. A capital raising may dilute earnings per share (EPS) in the hope that the future earnings impact will be positive, but this outcome is never guaranteed.

So if a capital raising has resulted in a material decline in intrinsic value, then sustainable price increases look less bankable. That’s because in the long run a company’s share price and its intrinsic value are destined to converge at some future point.

Share price rises may not last

It’s not uncommon for the share price to gravitate towards lower valuations following a capital raising. When equity increases and the company doesn’t manage to raise profits by a proportionate amount, return on equity plummets. Just look at Wesfarmers (WES) in 2008, Newcrest Mining (NCM) since 2011 and BlueScope Steel (BSL) in 2009.

Wesfarmers (WES)

In 2008 Wesfarmers added $15,941.00 million in equity to its business. That year return on equity fell to 12 per cent, from 25 per cent the previous year. By December 2008, the year of the capital raising, WES’s share price had fallen to a low of around $14.50. It had traded around $35.00 between 2004 and early 2008.

Share Analysis’s Capital History Evaluate screen shows WES’s 2008 capital raising

Share Analysis's Capital History Evaluate screen shows WES’s 2008 capital raising

Newcrest Mining (NCM)

Newcrest added more than $2 billion in 2008, and another $10 billion in 2011. Each time capital was raised, return on equity fell. Between 2007 and 2008 ROE halved, from 12 per cent to just over 6 per cent. In 2011 ROE was 11 per cent compared to 17 per cent in 2010.

Share Analysis’s Capital History Evaluate screen shows NCM’s 2008 and 2011 capital raisings

Share Analysis's Capital History Evaluate screen shows NCM’s 2008 and 2011 capital raisings

As a savvy investor, you need to ask yourself how any company could be so desperate for capital that it’s prepared to dilute existing shareholders so unashamedly?

Renounceable entitlement offers

While there are many types of capital raisings, one of the cleanest and most popular is where you (the shareholder) are offered shares at a fixed price, or rights issues, in proportion to the shares you already own. These offers, often called ‘renounceable entitlement offers’ can be sold on the market, under the code ‘ASXR’.

What makes a renounceable entitlement offer of value to you (the shareholder) is the difference between the ordinary share price and the offer price.

You’re not obliged to take up your renounceable entitlement offer, but remember loss of value is a by-product of issuing shares at a price discount. So by not participating, you’ll fail to offset the (shareholder) ‘dilution factor’ – a by-product of capital raisings that involve issuing more shares – unless the company has made other arrangements.

Share purchase plans (SPPs)

Beyond renounceable entitlements, the next most common form of capital raising is via a share purchase plan (SPP), which unlike a renounceable entitlement capital raising is not required to issue a prospectus. An SPP is an offer (at a discount) limited to a maximum $15,000 worth of shares per shareholder in a 12-month period.

While this fixed dollar amount is great for smaller shareholders, it disadvantages those with considerably larger shareholdings. However, if demand is high – as is often the case on popular SPPs – no shareholder will receive anywhere near their $15,000 worth of shares due to severe scaling back.

Placements

A third, and considerably less transparent, capital raising option is called a placement, whereby large shareholders (typically institutions) get to buy shares at a discount. However, if smaller shareholders are not given the right to participate in an SPP alongside a placement, then the value of their holding is diluted.

Don’t let capital raisings turn you from value investor to speculator

At face value, a rights issue can create opportunity to mitigate any dilution, assuming market capitalisation doesn’t change. But the trouble with speculating on this outcome is that it runs counter to what happens in most instances. It’s equally important to remember that if your goal is to capitalise on the spread between issue price and traded price, you’ve fallen from investor to speculator – and winning at this game requires fast footwork.

How to value insurance companies

Given that insurance is a game of probabilities and pricing, their analysis requires a unique set of evaluation criteria.

Insurance stocks are difficult beasts to value because much of their business model is wired to complex actuarial calculations.

Accurately forecasting future growth rates is also tricky, because fortunes of insurance companies is based on the unknowable frequency of natural (and man-made) disasters – plus the probability of claims against a myriad types of cover.

Even within the sector – which includes life insurance companies, personal injury, car and CTP insurance to name a few – the key drivers of individual stocks can vary dramatically.

Life insurers can sufferer from surges in claims and an increase in consumers cancelling policies. A lack of natural weather events, and strong results from a continued rise in premiums, will benefit general insurers.

How do investors value insurance companies?

Given that insurance is a game of probabilities and pricing, their analysis requires a unique set of evaluation criteria, beginning with an understanding of the term Net Earned Premium (NEP).

The NEP is simply the Gross Earned Premium (GEP) – revenue earned from the insurance policies written during a financial year – minus any reinsurance costs. Its designed to protect insurers against abnormally large risk. Reinsurance costs can and do vary depending on management’s appetite for risk.

When it comes to valuing insurance businesses, popular valuation models like the price earnings (P/E) ratio and evaluating dividend yields aren’t helpful.

Measuring cost efficiency of insurance companies

Uncovering the percentage of the net earned premium (NEP) paid out in the process of acquiring, writing and servicing insurance payments – the expense ratio (aka the underwriting expense) – provides a meaningful window into how efficiently management is running their insurance business.

Within today’s highly competitive industry dynamics, it’s crucial that insurers keep costs down. The lower the costs, the more insurers can attract new customers without compromising their profitability.

Measuring loss

Costs and expenses aside, it’s equally important for insurers to measure the losses resulting from the risks they take.

The loss ratio helps to unearth the insurer’s skill as a disciplined underwriter and reveals the insurer’s success at correctly balancing price with risk to deliver profitability over time.

One-off ‘fat tail’ events can distort an otherwise good loss ratio, so it’s important to look for a longer-term pattern. A consistently high loss ratio – calculated as net claims expense divided by NEP – would suggest that an insurer is under-pricing its insurance.

Calculate an insurer’s Combined Ratio

Arrived at by adding expense and loss ratios together, a combined ratio below 100 per cent means an insurer is operating at an ‘underwriting profit’ – before returns from investing customers’ premiums are added.

A ratio less than 100 per cent (below 95 per cent is regarded as outstanding) means the insurance stock is less dependent on investment income to compensate for any (underwriting) losses.

Using Share Analysis stock market software, its easy to compare the Combined Ratios of Australia’s largest insurance businesses.

Using Share Analysis stock market software, its easy to compare the Combined Ratios of Australia’s largest insurance businesses.

 

Insurance margin

Insurance margin relates to the transactional gains that insurers’ make on the cash they acquire in premiums (aka the float) that are invested – in cash or other asset classes – during the period between the premium being paid and a claim being made.

The ‘insurance profit’ is calculated by adding the return from investing the insurer’s float to the underwriting result. Once you know what the insurance profit is you can divide it by the Net Earned Premium (NEP) to arrive at the insurance margin. The higher the insurance margin, the better.

To make sure the insurance margin is legitimate, check if its being propped up by returns from investing their float. If yes, you need to ask whether the insurer is in the right business.

Minimum capital

The Australian Prudential Regulation Authority (APRA) requires Australian insurance businesses to hold minimum amounts of capital. This safeguard ensures they can continue operating and fulfill their obligations to policyholders, even when confronted with unexpected losses.

Whilst its desirable for insurers to have a capital adequacy multiple well in excess of the minimum amount stipulated by the regulators, companies with a capital adequacy multiple set too high will be missing out on higher returns from deploying those funds in its insurance operations.

Price to book ratio

As a valuation method, the price to book ratio is more suitable than the traditional price earnings ratio because of the unpredictable nature of financial results produced by insurance businesses.

A price-to-book ratio is essentially the value you would see if the business was liquidated and liabilities paid out. A ratio of 1 indicates shareholders can only expect a return of book value. A ratio above 1 indicates the extent to which shareholders are potentially exposed to market risk.

Calculated by dividing the current closing price of the stock by the latest quarter’s book value per share, the price-to-book ratio can be viewed in direct correlation with a bank’s return on equity (ROE).

As a rule of thumb, analysts would want to see a price-to-book ratio of one or less, if they thought an insurer was going to produce a return on equity of 10 per cent or less over time. By comparison, return on equity in excess of 12 per cent could justify a price to book multiple of more than one.