Qualiport

Using Return on Equity to value companies

On Wednesday, we looked at the theory behind return on equity (ROE). It is one of the most important weapons in any Fool's armoury, and Warren Buffett, arguably the greatest investor of all time, favours its use. In fact, in his 1997 letter to shareholders of his holding company Berkshire Hathaway he said, "If (ROE remains high) -- and if interest rates hold near recent levels -- there is no reason to think of (US) stocks as generally overvalued. On the other hand, returns on equity are not a sure thing to remain at, or even near, their present levels."

How Use ROE to Value Shares

In her excellent book Buffettology, Mary Buffett, ex daughter-in-law of Warren, goes into great detail about the valuation techniques that the Buffett uses. Somewhat contrary to his apparent dependence on discounted cash flow highlighted by Robert Hagstrom in his book The Warren Buffett Way, Mary Buffett concentrates largely on a company's ROE when determining its value.

Long-term investors, as all Fools are, should not be concerned with earnings forecasts for this year or next. The challenge for investors is to identify great companies with superb economics and wonderful long-term growth prospects and buy them at sensible prices. This is what the Qualiport is attempting to do, and the planned hold time for each of the companies in the portfolio is a minimum of 10 years. So, when valuing shares using ROE, we like to look at a company's valuation 10 years from now.

This sort of valuation is only applicable for companies that have a high degree of predictability of earnings. Looking 10 years out for Internet startup companies, or high technology concerns that have rapidly depreciating products which are obsolete in a matter of months, it is almost impossible to predict what sort of a returns they will be earning. That's not to say that you should never be invested in those types of companies, it's just that using a 10 year ROE model is probably not the most suitable. Likewise, companies that are currently going through rapid periods of growth should not be valued as if that rate of growth will be maintained for a year, let alone 10 years. One look at huge slowdown in earnings growth at big ticket retailers such as Carpetright and DFS Furniture will show investors the folly of extrapolating a 1996 growth rate of 25% forward as far as 2006. Neither of those companies have a competitive advantage, and noting the excellent returns they were achieving, competitors sprung up. By 1998 both companies have seen earnings contracting instead of growing.

Clive's Canny Carvings (CCC)

CCC is a newly floated company, starting with owner's equity, or shareholders' funds, of £1,000. From that investment the company made an after tax profit of £200, giving CCC a return on equity of 20% (£200/£1,000 = 20%). Of that £200 attributable to shareholders, CCC decides to pay out 40%, or £80, as dividends.

Summarising that:

Starting Equity £1,000
Net Profits £200 (ROE = 20%)
The £200 profit is divided into
a) £120 retained earnings, or 60% (£120/£200)
b) £80 distributed as a dividend, or 40% (£80/£200)

CCC is a very predictable business, and whilst a private company has been achieving steady profit growth over a number of years. Clive has a nice little niche business, and there is little threat of serious competition that would dent his returns. CCC is an ideal business with which to project forward a valuation based on its return on equity, taking into account its dividend payout and equity retention ratio. Here's how a 10-year projection would look...

   
Year     Equity     Profits   Dividend  Retained
    
0       1,000.00    200.00     80.00     120.00
1       1,120.00    224.00     89.60     134.40
2       1,254.40    250.88    100.35     150.53
3       1,404.93    280.99    112.39     168.59
4       1,573.52    314.70    125.88     188.82
5       1,762.34    352.47    140.99     211.48
6       1,973.82    394.76    157.91     236.86
7       2,210.68    442.14    176.85     265.28
8       2,475.96    495.19    198.08     297.12
9       2,773.08    554.62    221.85     332.77
10      3,105.85    621.17    248.47     372.70
   
Total Dividends             1,652.37

In year 0, the $120 retained earnings are added to the initial £1,000 equity to give a new starting position of £1,120. This scenario continues for the full 10 years.

In the 10 years, CCC's equity has risen from £1,000 to £3,105.85. That gives a compounding annual growth rate (CAGR) of exactly 12%. Not surprising, really, given that the company earned a steady 20% on equity throughout the 10 years and retained 60% of it -- 60% of 20% equals 12%.

To work out CAGR, you can use a scientific calculator or a spreadsheet. (I favour the latter.) Firstly, you calculate the total growth over the 10 year period. £3,105.85 / £1,000.00 = 3.106 times or as a percentage is +210.6%. You then take the 10th root (10 being the number of years) of 3.106 (3.106 ^(1/10)), which is 1.12 and represents 12% growth. (Think about it, the tenth root is the number which, when multiplied by itself ten times gives the original number, so what we are saying here is that: 1.12 x 1.12 x 1.12 x 1.12 x 1.12 x 1.12 x 1.12 x 1.12 x 1.12 x 1.12 = 3.106.

Let's say that CCC traded at book value in year 0 of £1,000 and at book value again in year 10 of £3,105.85. If someone were to offer to buy the business from you at book value, your total return over 10 years of your initial £1,000 investment would be £3,105.85 plus dividend income of £1,652.37 = £4,758.22. Your CAGR would be 16.9% -- a damn good return, and much better than what you'd get by sticking your money under the bed or in the building society.

[Note -- you will notice that I've ignored most taxes, including any possible capital gains tax, and any further tax an investor may have to pay on his dividend income. I'm deliberately trying to keep things simple]

If CCC were quoted on the stock exchange, it may be valued quite differently to book value. Companies are traditionally valued by the City at a multiple of earnings. Taking the thing a little further, here's some more assumptions based on the year 0 numbers:

Shares in issue 2,000
EPS 10p (£200 profit/2,000 shares)
Share price 180p
P/E 18 (180p share price/10p EPS)
Market capitalisation £3,600 (180p share price * 2,000 shares)

With profits expected to grow at 12% per annum, and the company trading at a price to earnings ratio (P/E) of 18, many investors may automatically assume the company is fully valued or even overvalued. That is because, it is often said, in a fairly valued situation, a company's P/E will equal its growth rate. There is more on this in the growth shares series in the Fool's School, where the PEG, or Fool ratio, is explained.

On a 10-year perspective, however, investors may see a slightly more favourable valuation for CCC. Let's presume over that period, CCC trades at an average P/E of 20, having hit a high of 35 in year 3 and a low of 12 in year 6. In year 10, CCC's profits are £621.17. Putting a multiple of 20 on those profits gives a market capitalisation of £12,423.40. Add to that the dividends of £1,652.37 you've received, and your CAGR based on a £3,600 starting point is an impressive 14.6%. It always makes good sense to calculate the potential high and low points of a company's valuations. With a year 10 P/E of 12, the CAGR would fall to 9.7%, and at the top end with a P/E of 35, your CAGR would increase to a whopping 20.6%. You may decide that the upside potential outweighs the downside, and buy all, or a part of, CCC.

The mix between retained earnings and dividends is a very important determinant of total returns. For example, if CCC retained 100% of its earnings, leaving them in the business to compound at the return on equity rate of 20%, over 10 years the book value would increase to £6,191.74 for a CAGR of exactly 20%. If you then whacked a P/E of 20 onto year 10 profits of £1,238.35, your £3,600 would increase to £24,766.95, for a CAGR of 21.27%. Some difference.

You will see that we are always comparing the total value of the business. Instead of buying the whole business, if you bought 2, 20 or 200 shares in the company, the percentage returns would be exactly the same. By valuing the whole business, it keeps you focussed on the essence of share ownership -- you are a part owner in a company, and not just owner of a piece of paper called a share certificate.

As I said previously, this type of profit projection works on very few companies. It is usually effective on mature, established companies, and ones that can sustain above average returns over a long period of time. These companies are few and far between.

It is worth setting up a template in a spreadsheet and playing around with some numbers. If anyone wants a copy of the simple spreadsheet I've used to create the numbers in this report, please email me and I'll be happy to send it on.

Have a great weekend, Fools. Next week we shall move onto cash-based valuations and discounted cash flow. Until then, all comments and thoughts to the message boards.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    14/08/98


         Change       Bid
          pence        £

RTO        0.21      3.63
EMAP       0.11     11.51
MKS       -0.06      4.93
ULVR       0.04      5.68   


Rec'd       #    Stock     Buy     Now     % Change  £ Change

19/12/97  1565  Rentokil  2.55     3.63      42.4%     1.08 
17/04/98   337  EMAP     11.85    11.51      -2.9%    -0.34 
11/05/98   722  M & S     5.535    4.93     -10.9%    -0.61
17/07/98   595  Unilever  6.72     5.68     -15.5%    -1.04


19/12/97  1565  Rentokil 4,040.63  5,680.95   40.6%  1,640.32 
17/04/98   337  EMAP     4,043.37  3,791.25   -4.1%   -164.50
11/05/98   722  M & S    4,052.24  3,610.00  -12.2%   -492.78
17/07/98   595  Unilever 4,048.38  3,528.35  -16.5%   -668.78


Cash                                    67.82

Total                               16,566.70 


                Day    Month    Year    History

Qualiport       2.1%   -4.1%    34.0%    37.0%
FTSE 100        1.0%   -6.5%     6.2%     8.7%
FTSE All Share  0.9%   -6.3%     6.3%     8.5%