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TMFNigel always finds his stomach churning when the Qualiport states something along these lines. In this case, it's my stab at valuing PizzaExpress (LSE: PIZ).
I wrote: "So what's my stab at a future growth rate, given I'm bullish on PizzaExpress? In previous features, Bruce has commented on at least 15% plus per annum growth. I'm not that optimistic. I'm going for 12.5% growth over the next few years. So 12.5% earnings per share growth for the next six years gives earnings per share of 67.7p in 2005. On a fairly reasonable prospective earnings multiple of 20, that gives a prospective share price of 1354p five years out."
Nigel retorts: "Now why do you believe that 12.5% is the right figure to forecast 6 years ahead? It is simply a figure plucked from the thin air! I just don't see how these sorts of calculations can ever be accurate..."
Back to basics
Okay. Let's get back to basics. There are two parts to every long-term investment decision. There's the business part and the valuation part.
Before the Qualiport ever looks at valuation, first and foremost we always consider the underlying business. We're on the lookout for businesses that have a proven record of growth and a superior financial operating history. An exceptional past performance from a business lends some credence to the fact that the company must have some inherent strength and some "predictability" surrounding its operation. And with those two factors, our faith looking over the horizon is given extra weight.
Granted, past performance is no true guide to the future, but let's put it another way. If a company doesn't have a superior track record, then what's going to trigger an above-average corporate future? Bruce and myself just aren't clever enough to spot a humdrum business that can turn itself into a wonderful business. We're looking for the easy option. We're looking for businesses that have a great history because we only then have one question to consider -- "Can the history continue?"
Take PizzaExpress. The restaurant industry is a very crowded sector. Yet PizzaExpress has consistently generated operating margins and returns on equity both in excess of 20% for many years. You only have to look at some of the difficulties experienced by several other players in the sector: City Centre Restaurants (LSE: CTC), Oriental Restaurants (LSE: ORR) and Belgo (LSE: BGO) for example, to realise that PizzaExpress is an exceptional business. The PizzaExpress history, showing how the company has coped with many other restaurant themes, fads and fashions over thirty years, gives us more confidence when trying to forecast its future.
Growth Rates
Given that we've decided PizzaExpress has a superior operating history and a business we feel comfortable to own, the second part of the investment equation is the valuation. A definite value "anchor" has to be established to benchmark the current share price. Valuation counts. It's no good buying a company at any old random price.
With PizzaExpress, there is visible growth in the years ahead. The company has the capacity to nearly double its UK restaurant estate over the next five or six years in addition to its international expansion plans. With a record of successfully operating in the competitive restaurant sector, plus obvious future potential, I think the chances that PizzaExpress will have materially higher profits in five years time are pretty high.
With that in mind, trying to roughly judge PizzaExpress' future performance to set today's valuation benchmark isn't a meaningless exercise.
What if...
The extrapolations referred to at the top of this feature are rough estimates, never a gospel "this will happen" type prediction. They are basically "what if" scenarios. Here's how I see this valuation methodology.
At the moment, brokers forecast 15% earnings growth for PizzaExpress in this current financial year and 18% earnings growth the year after. Instead, let's take a conservative approach to the future growth at PizzaExpress. What if PizzaExpress expanded at 12.5% annually over the next five years? How does that compare to today's share price expectations?
With a few calculations, I can arrive at a rough expectation of the PizzaExpress share price some years down the line. So, using the earlier example, the expected 1354p share price can then be compared to today's price. We're aiming for a 15% annual investment return.
Say PizzaExpress shares are 900p. Our admittedly crude extrapolations would suggest that an investment in PizzaExpress at 900p wouldn't generate a sufficient investment return (only 8.5%) over the five-year period should our calculations prove correct. Instead, say the current PizzaExpress share price was 500p. Then we could anticipate a substantial annual return of 22%.
(In fact, because of the nature of the PizzaExpress business, I've subsequently restated these growth projections using an alternative method. In this feature, I've estimated the financial performance of PizzaExpress five years hence using information supplied by the company that describes the financial profile of a typical new restaurant. After a bit of simple number-crunching, I concluded that a 660p entry price would give the Qualiport an anticipated 15% annual investment return.)
It is this expected investment return that is key to the whole valuation process. By its very nature, it represents a margin of safety, a feature that is mandatory in any investment decision.
The greater the anticipated investment return using conservative growth projections, the smaller the investment downside becomes should our projections prove optimistic. On the flip side, the more conservative our projections, the greater the investment upside will be should PizzaExpress exceed our expectations.
But remember, you can only realistically attempt these projections on a business that has the history and potential to merit them. PizzaExpress has the history and potential.
The Art of Valuation
Valuation is an art, not an exact science. For the long-term investor, it's a mixture of simple and conservative projections and "gut feel".
It's a bit like judging a person's height. I don't need a tape measure to determine exactly whether a person is a giant or a dwarf. Similarly, I don't need exact earnings projections or discounted cash flows to decide if a company is precisely under or overvalued. I know from playing around with undemanding growth assumptions that PizzaExpress are definitely overvalued at 900p and definitely undervalued at 600p. But exactly where within the 600p to 900p band PizzaExpress suddenly moves from being undervalued to become fairly valued and then to become overvalued is far more subjective.
From these calculations, I've decided that the level where definite under valuation ends and various degrees of fair value start is at 660p. It's arbitrary and I could be wrong. But the fact that the PizzaExpress share price constantly hovers just out of reach of my clear-cut undervaluation mark probably lends some support to the calculations.
In summary
Some would say that trying to predict any company's long-term earnings is futile. In most cases, they're right. Some businesses operate in ever-changing industries that lead to uncertainty. Other businesses plainly don't have any sort of record that inspires predictability to their future.
But there are a handful of businesses that have a proven and consistent past record and have visible future prospects. It's not unreasonable to expect these businesses to carry on their superior operating record. Common sense would suggest that there is more chance of a group of proven companies outperforming in the future, with their apparent inherent strengths, than any random selection. It's these proven companies that the Qualiport looks for in a long-term hold. But we're not going to buy them at any price.
Bruce and myself are no experts at forecasting the exact future. You know the mistakes. But with the right business in the right industry with the right prospects, conservative growth assumptions can be applied and a valuation benchmark set. Given our lack of foresight, what's more important to us is not whether our growth rates prove to be exactly correct, it's whether an acceptable margin of safety exists should the unexpected occur.
To quote a phrase from Warren Buffett: when it comes to valuation, we would rather be "vaguely right than precisely wrong". Applying unspectacular growth assumptions to great businesses and then purchasing them only with a suitable margin of safety will lead the Qualiport to be "vaguely right" more often than not.
Related Links
• The Value of Pizza
• Less is More
• Margin of Safety