Qualiport

Earnings based valuations

Portfolio Update

At 0837 on Friday morning we officially welcomed Unilever PLC into the Qualiport. As you can see from the new Foolish Qualiport trading history area on the Web, we purchased 595 shares at 672p, costing £3,998.40. Add to that stamp duty of £19.99 and brokerage commission of £29.99 and the total cost was £4,048.38. When you buy any shares, you immediately lose a few percentage points because of the charges and the bid to offer spread on the share price. Dividing £4,048.38 by 595 Unilever shares gives us an effective all-inclusive cost base of 680p per share.

Unilever were immediately in the news, buying a Chinese soy sauce company and being featured in Alvin Hall's TV programme on BBC2. We'll review their first half results when they are released in early August.

How To Value Shares

Just as there are different types of companies in varying modes of development, there are many different ways to value a company. From the speculative bio-technology company through to the Internet start-up, then the traditional "growth share" and finally onto the "mature" multi-national, each can be valued in some way or another. It is far form a precise science, and each form of valuation will give you a different answer that needs to be interpreted in context with the company, its competitors, industry and its future prospects.

Earnings Based Valuations

The P/E

The Price to Earnings Ratio (P/E) is the most widely quoted number when investors attempt to put a value on a share. You will often see something like "Dodgy.com PLC trades at a forward P/E of 10, making it look fully valued" or "Epic! PLC has a trailing P/E of 30, which makes it look cheap in comparison with other companies in the sector." But why is Dodgy.com expensive and Epic! cheap when on face value their P/E's would suggest the opposite? The P/E is a one dimensional number and needs to be viewed in the context of growth rates, the industry, competition and many of the other valuation tools we shall look at.

The P/E is calculated as:

Share Price
-----------------
Earnings Per Share (EPS)

and EPS is calculated as:

Net Profit (after tax but before dividends)
----------------------------------------------------------
Number of Shares Outstanding

Let's take an example. Epic! PLC is an Internet start-up company, offering consumers connection to the web for free, with a 0800 access number thrown in for good measure. They make money through selling advertising space on their portal site. The company is already profitable, having signed up 2 million subscribers in their first week alone! In fiscal 1997, they made after tax profits of £1,000,000. Their number of shares in issue is 10,000,000, so their EPS is

£1,000,000
---------------- = 0.10p or 10p
10,000,000

Epic!'s current share price is 300p, so their P/E is

300p
------- = 30
10p

But what does that mean? Are Epic! incredibly cheap or wildly overvalued? It is impossible to say just by looking at the P/E on its own. What if I said that every ISP is now offering free access to the Internet, and a competitor has just begun offering to pay the consumer £10 as a lure to take business away from Epic!? Or what if I said that Epic! are forecast to grow earnings by 100% per annum over the next year? The point is that an investor needs a lot more information than the P/E number alone to attempt to put a value onto the company.

A machine that prints one £10 note per year is offered for sale. Inflation is zero. Its earnings are £10 per annum, and it has one share in issue. How much would you be prepared to pay for the machine? Clearly, if you could buy that machine for £10 (P/E = 1), you would have a bargain. On the other hand, paying £300 (P/E = 30) would be a bit rich. In this case, the P/E is equal to the number of years it takes for a buyer to recoup their initial investment. For a real company with real products operating in an inflationary environment, looking at the P/E in such a simple way is just not possible.

It is often said that in a fairly valued situation the P/E should roughly equal a company's future EPS growth rate. In the current low inflationary environment, where interest rates are low and the stock market is at historically high levels, it is now much more difficult to find great companies that pass that test. Also, perhaps investors are looking a little longer term than they did in the past and are willing to pay a higher premium for future growth. For example, a company trading at P/E of 40 but forecast with some certainty to grow at 20% per annum for the next 10 years may still offer value.

The PEG, or Fool Ratio

Meaning Price to Earnings to Growth, the PEG (or Fool Ratio as it is sometimes referred to here) is a widely used tool for evaluating a company's value. It is calculated as:

P/E
-------
EPS Growth Rate

If Epic! trades on a P/E of 30 and is forecast to grow EPS by 30% per annum over the next 2 years, its PEG will be 1. As we saw for the P/E, in a fairly valued situation it is said that a company's P/E will equal its growth rate.

The idea of the PEG is that allows investors to identify companies that are trading at a discount or premium to their P/E ratio. It is usually at its most useful when applied to smaller, so-called "growth shares." Bigger companies, such as those that grace the Qualiport, are usually valued off things other than their immediate growth rate, such as predictability of earnings and cash flow. When the Qualiport bought Unilever, the company traded at a trailing P/E of 33 and its long term growth rate was forecast at 12%. A PEG of 2.75 suggested the company was widely overvalued, but there is a lot more to Unilever's valuation than the PEG.

The PEG is covered quite extensively in the Fool's School article called Foolish Guide To Growth Shares. I urge you to check it out.

Earnings Growth Rate Projections

This is a technique favoured by the Qualiport. It looks at a company's potential share price over the very long term, ideally 10 years. It is only applicable to value a company over that time period if it has predictable earnings. Qualiport companies such as Marks & Spencer and Rentokil Initial are examples of reasonably mature businesses with a past record of growth, strong management and a high degree of certainty about their future growth rate. On the other hand, Epic! which operates in a fast-moving, competitive and forever changing industry, is probably less likely to have a predictable future growth rate.

In the following example, for a company called Predictable PLC, the base year is 1997 and the company is forecast to grow both EPS and dividends by 20% per annum for the next 10 years. Here's a potential valuation scenario:

   
Year    EPS   P/E   Price  Growth   CAGR   Divs

1997   10.0   30     300                    6.00
1998   12.0   25     300                    7.20
1999   14.4   25     360                    8.64
2000   17.3   25     432                   10.37
2001   20.7   25     518                   12.44
2002   24.9   20     498                   14.93
2003   29.9   20     597     99%   14.8%   17.92
2004   35.8   20     717                   21.50
2005   43.0   18     774                   25.80
2006   51.6   18     929                   30.96
2007   61.9   18    1115                   37.15
2008   74.3   18    1337     346%  16.1%   44.58
                                          231.48
Share Price              1,337.42
Total Dividends            231.48
Total 10 Year Return     1,568.90    423%  18.0%

CAGR means Compounded Annual Growth Rate. By calculating the CAGR, it allows you to compare the annual rate with other forms of investment, whether they be building society interest rates, the 10 year bond yield or other equity investment possibilities. In the case of Predictable PLC, a 10 year CAGR of 18% beats just about every other form of investment going, as presuming you've got your assumptions correct, it could present an opportunity to fill your boots.

If you set a template like this into a spreadsheet, you can play around with different valuation models. For example, what if Predictable grew at 20% for 5 years and then dropped to 10% for the next 5 years? Or, what if they traded at a P/E of 25 in 2008 but only grew at 15% per annum for the next 10 years? A little sensitivity analysis can give you a range of possible valuations and CAGRs. Ideally you want to have an idea of the low point, most likely point, and upper valuation point. I will repeat, however, that much depends on the assumptions you use, and this type of valuation is best suited to larger companies with predictable earnings. Also, as with all the valuation models and tools we will look at, it should not be used as the only method to value a company.

On Friday, we will continue to look at the different ways to value shares. Once the series is complete, it will be transported off to the Fool's School for posterity. If you have any questions, comments or thoughts, please as usual post them to our message boards.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    22/07/98


         Change       Bid
          pence        £

RTO       -0.13      4.32
EMAP       0.08     12.55
MKS       -0.06      5.27
ULVR      -0.08      6.69   


Rec'd        #     Stock       Buy      Now  % Change  £ Change

19/12/97  1565  Rentokil       2.55      4.32  69.4%      1.77
17/04/98   337  EMAP          11.85     12.55   5.9%      0.70
11/05/98   722  M & S          5.535     5.27  -4.8%     -0.27
17/07/98   595  Unilever       6.72      6.69  -0.4%     -0.03


19/12/97   1565  Rentokil  4,040.63  6,760.80  67.3%  2,720.17
17/04/98    337  EMAP      4,043.37  4,229.35   4.6%    185.98
11/05/98    722  M & S     4,052.24  3,804.94  -6.1%   -247.30
17/07/98    595  Unilever  4,048.38  3,980.55  -1.7%    -67.83


Cash                                    33.96

Total                               18,809.60 


                Day    Month    Year    History

Qualiport      -1.4%    0.5%    52.1%    55.6%
FTSE 100       -2.3%    2.7%    16.6%    19.3%
FTSE All Share -2.0%    2.5%    16.6%    19.1%