Qualiport

Would you buy Unilever at 680p?

Those off-line journalists who are reading the Qualiport reports have been at it again. Yesterday, The Sunday Telegraph said "sell Unilever," and today the share price promptly fell 26p to 657p. However, this sell recommendation was different to previous ones in so far as the Qualiport still hadn't decided whether to buy Unilever. On Friday, we concluded the report by saying that we would check out Unilever's valuation using a share price of 680p. We will still use that price, but as usual, if we decide to buy Unilever for the Qualiport, we will be hoping for a market crash or a correction in the Unilever share price so we can pick them up that much cheaper. Even still, a few percentage points gained or lost at this stage will be relatively unimportant in 10 years' time, but like all investors we like to get off to a positive start.

This special Monday edition of the Qualiport was necessitated by the World Cup timetable. I had hoped to make a final buy-or-not-to-buy decision about Unilever on Friday, but the match came first. Readers will remember that last week, and particularly on Friday, we decided that Unilever was in fact a quality company and was worthy of inclusion in the Qualiport. What we need to do now is work out whether we think it to be valued so as to offer a decent return over a long period of time. As we look through just a few of the valuation techniques the Qualiport favours, be aware that this is a far from precise science. Of course, if it was, all companies would be valued at their true price, opportunities would never exist, and neither would The Motley Fool. How boring!

Earnings Per Share Model

On Friday, we decided that Unilever's true earnings per share figure for 1997 was 20.4p and that consensus forecasts of 25p and 27p for the next two years seemed a fair assumption. The City usually values companies on their short-term earnings potential, looking out, say, two years. The theory goes that any forecasts after that are pure guesswork. That short-termism, however, also sometimes provides opportunities for the canny investor who is prepared to look further into the future, especially where a company has predictable earnings.

Unilever is a huge company, with many essential day-to-day products. Their profits are relatively predictable, as are their products and markets. Smaller companies, which constantly need to innovate to keep up with the competition, are far less likely to have predictable earnings over a long period of time. Only the very best will turn into the Microsoft of tomorrow.

The following table gives a likely scenario about Unilever's long-term valuation.

  
Year   EPS  P/E*  Price  Growth  CAGR**   Divs

1997  20.4  33.3   680                    8.42
1998  25.0  27.2   680                    9.00
1999  27.0  25     675                    9.90
2000  30.2  25     756                   10.89
2001  33.9  25     847                   11.98
2002  37.9  20     759                   13.18
2003  42.5  20     850   25%     4.6%    14.49
2004  47.6  20     952                   15.94
2005  53.3  18     959                   17.54
2006  59.7  18    1074                   19.29
2007  66.9  18    1203                   21.22
2008  74.9  18    1348   98%     7.1%    23.34

Share Price             1,347.72
Total Dividends           166.78
Total 10 Year Return    1,514.50   123%  8.3%

*P/E = price to earnings ratio
**CAGR = compounded annual growth rate

Assumptions

The following assumptions are very important, and can materially affect any valuation:

EPS Growth Rate 2000-2008: 12%
Dividend Growth Rate 1999-2008: 10%
Base Year: 1998

The EPS growth rate and the P/E ratio are the numbers which could both be either pessimistic or optimistic, depending on any number of factors. As I've said previously, Unilever could just be beginning an unprecedented growth, efficiency, and profitability phase of their mature corporate life. Under Niall Fitzgerald, the company appears much more focussed on shareholder value and on return on assets than it has been in the recent past.

If you assume that Unilever will hit their forecast EPS of 25p for calendar year 1998, then according to Hemmington Scott Company REFS figures, normalised EPS will have grown from 20.6p in 1993 to 25p in 1998, for a CAGR of 3.9%. This is a far cry from my 12% earnings growth from 2000. On the other hand, Unilever's 1998 first quarter EPS at current exchange rates was up 44%, a truly astonishing growth number for such a huge and mature company. I believe the 12% average growth rate for most of the next 10 years is a fair mid-point for investors to realistically expect.

The other big assumption with this particular model is the company's P/E ratio. Over the past five years, Unilever have traded at an average P/E of between 13 and 22, with the higher number only occurring relatively recently. The EPS model expects the P/E to come back from the 1998 estimate of 27 towards 20 and then 18. This again could be either too high or too low, and may very be at the mercy of things completely out of the company's control, such as the overall level of the stock market and, more importantly, the prevailing interest rates. We make no attempt to judge either of these unknowns -- the economists are divided about which way interest rates are headed right now, let alone 5 or 10 years down the track.

Finally, I am basing all numbers based on Unilever's forecast EPS for the year ended 31/12/1998. That is a full 6 months ahead of now, and all returns are therefore assuming today's date is in fact 31/12/98. The fact that it isn't means we are effectively foregoing any returns from any investment for the next 6 months if we bought shares in the company right now.

Taking all those assumptions at face value, the above model shows that on 31/12/2008 we expect that our total return including dividends from 31/12/1998 could be 123%, for a CAGR of 8.3%. As a comparison, the current risk free 10 year bond return is about 5.84%, and the base interest rate is 7.5%.

Other Valuation Methods

As I said, there are other valuation methods that can be used to help determine a company's fair value. I will not go into the methodology too much in this report, suffice to say that we will do so in the very near future.

Return on equity is a vital number in the armoury of the equity analyst, notwithstanding the many different interpretations and calculations you can have on what should be a rather simple concept. In the earlier Unilever reports, you will have seen that I calculated Unilever's trailing ROE at 10.4%, yet I have decided on the following assumptions:

Return On Equity: 14% for 3 years, then 16% for the next 3 years, and 18% for the next 4 years.

A model I have used gives a CAGR of 5.0% after 5 years, and CAGR of 8.0% after 10 years, dividends included.

The final valuation method I have used when assessing Unilever's prospects is discounted cash flow (DCF). Again, I won't go into detail apart from saying that I've assumed a discount factor (risk free) of 9%. The model, which it must be remembered can be relatively flattering, values Unilever at a discount to its current intrinsic value of 31.2%.

Valuation Summary

We have various valuation models amid some wide ranging assumptions. A company like Unilever is open to such valuation techniques because of its size and quality of earnings.

I always like to have some sort of high and low point expectations regarding a company's valuation. Using the 10-year earnings per share model, we can plug in a couple of high and low assumptions to look at potential 10 year annualised returns.

If EPS growth = 8% per annum and 2008 P/E = 14 and dividend growth = 8%, the 2008 CAGR = 2.9%.

If EPS growth = 10% per annum and 2008 P/E = 15 and dividend growth = 10%, the 2008 CAGR = 5.1%.

If EPS growth = 12% per annum and 2008 P/E = 18 and dividend growth = 10%, the 2008 CAGR = 8.3%. These are the assumptions used in the above model, and I believe are the most likely.

If EPS growth = 14% per annum and 2008 P/E = 20 and dividend growth = 10%, the 2008 CAGR = 11.0%.

If EPS growth = 14% per annum and 2008 P/E = 22 and dividend growth = 12%, the 2008 CAGR = 12.0%.

That gives a big range of potential returns, from a low point of 2.9% per annum to a high point of 12.0% per annum, with a most likely return of 8.3% per annum. The other most likely valuations techniques using the ROE and DCF methods give a CAGR of 8.0% after 10 years, and a discount to intrinsic value of 31.2%. These need to be compared with the risk free rate of return, which is 5.84%. The Unilever returns, whilst not risk free, are relatively stable and predictable.

The Decision

This is a very difficult call. Part of me wants a part-ownership in Unilever right now, because I get the feeling that they are just showing the signs of being a company that is in the process of turning themselves into a lean, focussed and large growth company.

The spread of total returns, however, make it difficult for me to buy them at 680p. Over the years, the share market has returned around 12% per annum, and using the most likely scenario above, that would imply the share price falling to 488p before buying shares in Unilever and seeing them match the long term returns of the market. As of writing, that level seems unlikely, although at beginning of 1997 (only 18 months ago) the share price was as low as 338p.

My investing style is to be very much aware of the buy point, as that very much determines the long term returns of an investment. There are many other styles of investing, including the "buy quality companies and hold them regardless of the entry point." The theory goes that you can't predict the future P/E of any company, or its long term growth rate. If, however, you make sure you buy obviously great companies, you can at least be guaranteed of market beating returns. If and when the market tanks, you want to have your money invested in great companies, and this should help cut your losses.

I've always said valuation and stock analysis is open to much debate, as are investing styles. I personally cannot buy Unilever at 680p, or even the 657p they closed at today. The co-manager of the portfolio, Dave Berger, has a different view and opinion. I've just spent the past 45 minutes on the phone discussing the merits, valuation and possibilities of Unilever, and we still can't come to an agreement. So, what we've decided to do is for Dave to give his views about whether Unilever are a Qualiport buy or not. This will happen on Wednesday's update. Then, on Friday we'll make our final decision, where my two headed coin could be brought into action.

We are aware that we are dragging this decision out yet more. But a couple of extra days or weeks is a short time to wait when you're talking about making a 10 year investment. In the meantime, we encourage Fools to help us out by giving their opinion on the Qualiport message board. Are you a valuation Fool, or a buy quality regardless Fool? Could you buy them at 680p?

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    26/06/98


          Change     Bid
          pence       £

RTO        0.08      4.35
EMAP      -0.34     12.08
MKS        0.03      5.46         


Rec'd       #    Stock     Buy     Now  % Change  £ Change

19/12/97  1565  Rentokil  2.55    4.35    70.6%    1.80 
17/04/98   337  EMAP     11.85   12.08     1.9%    0.23 
11/05/98   722  M & S     5.535   5.46    -1.4%   -0.075


19/12/97  1565  Rentokil  4,040.63  6,807.75  68.5%  2,767.12 
17/04/98   337  EMAP      4,043.37  4,070.96   0.7%     27.59
11/05/98   722  M & S     4,052.24  3,942.12  -2.7%   -110.12

Cash                             33.96

Total                        14,854.79 


                Day    Month    Year    History

Qualiport       0.2%   -0.5%    52.7%    56.1%
FTSE 100        0.3%    0.1%    14.4%    17.1%
FTSE All Share  0.2%   -1.4%    14.6%    17.0%