Qualiport

[ July 10, 2000 ]

Quick Fix Valuation Guide

By Bruce Jackson (TMFGoogly)

Who wants to spend hours and hours trying to calculate the value of a company, especially when you know the answer is invariably going to be wrong? Not many investors, I'm guessing. Yet you should definitely be aware of a company's value before considering investing in it.

So...

1. Why bother trying to value a company if the answer is going to be wrong?
   
2. How do you get a quick fix on a company's value?

Valuation is very subjective, because there's many variables involved. They include, each with a varying degree of importance:

• past growth record;
  
• future company and industry growth prospects;
  
• past and future competitive environment;
  
• current and future interest rates;
  
• current and future market sentiment.

As you can see, some of these factors are completely outside a company's control. For example, the UK base interest rate at the moment is 6%. What's it going to be in 5 years' time? That's anyone's guess.

Future Growth Prospects

The factor that usually most affects a company's valuation is its future growth prospects. Stop and think about that for a minute. It makes absolutely perfect sense. When you buy a used car, you don't care about its past performance, although that does have some bearing on your investment decision. Instead, you are concentrating on its future prospects. How reliable is that car going to be in the future, and how many miles are you going to get out of it? Those are the main factors that will determine the price you pay for the car.

The same goes for buying companies. As an investor, you place most emphasis on the company's future growth prospects. The past is some guide to the future, but only that. Yet, like the purchase of a used car, the future is impossible to predict, hence so is a precise valuation of a company.

Marks & Spencer

For example, let's rewind to 1995. As an investor, you are considering buying shares in the UK's biggest retailing group, a company called Marks & Spencer (LSE: MKS). Knowing a bit about the company, because you're a regular shopper, you reckon you're in a reasonable enough position to have a stab at projecting a future growth rate. You go for 10% per annum, which takes into account their past record and strong brand name, but more importantly their future prospects -- factors like continued domestic expansion and the exciting prospect of international expansion.

At the time, it must have all sounded very feasible. Here was the bluest of blue chip companies, with what you would have thought were semi-predictable future earnings. You realise that the earnings of a company vary from year to year, but overall an average 10% per annum growth rate must have sounded feasible.

Here's the actual normalised earnings per share (EPS) "growth" record of Marks & Spencer over the past 5 years

    1996   1997   1998   1999   2000

EPS +7.8%  +9.9%  +1.6% -43.1% -14.8%

Uh oh! I guess we thought wrong. Big time. As we all now know, history turned out to be very different. The moral of the story -- accurate valuation of any company is nigh on impossible.

The P/E Ratio

I keep coming back to the good old price to earnings ratio, or the P/E, when looking for an excellent company valuation starting point. Here at the Qualiport, we believe in buying good companies cheaply. That we've mostly failed to achieve that simple-sounding goal is entirely my fault, as I've made far too many investment mistakes, paying over the odds for most of our current holdings. That's something we're working on rectifying for future Qualiport investments.

Back to the P/E. It is only the starting point, because the future growth prospects of a company will still almost always determine its valuation. For example, which of the following companies would you invest in?

              P/E    Future Growth Rate

Company A      10           8%
Company B      40          20%

Obviously you'd require more information before taking the plunge, not least how long the future growth rate holds. If it was 10 years and with a high degree of certainty, I daresay Company B would be the better investment. However, unfortunately life isn't that simple.

Earnings Yield -- The Quick Fix

The inverse of the P/E is the E/P, otherwise known as the earnings yield. It is easiest calculated as 1 divided by the P/E -- the result is exactly the same as E/P. A P/E of 10 translates to an earnings yield of 10% (1 / 10 = 0.10 = 10%), and that can be compared to other forms of investment. For example, with base interest rates currently standing at 6%, by comparison a 10% earnings yield sounds attractive.

With Company A in the above example, as the company grows the earnings yield of 10% will expand by 8% per annum. Given those facts, you're far better off investing in that company than putting your money in the bank account.

So, for the quick valuation fix, take the current earnings yield as a starting point, estimate a future growth rate for the company, and then compare that to base interest rates.

But, beware of the Marks & Spencer syndrome. By far the most important part of the equation is the future growth rate, and unfortunately that's still the hardest part to predict. To compensate for that uncertainty, here's one final piece of advice -- the lower the P/E starting point the better. In conclusion I repeat the following.

Here at the Qualiport, we believe in buying good companies cheaply.

Your Turn

Please post all questions and feedback to the Qualiport discussion board, in the Resources section below. Also, Maynard's excellent articles on Independent Insurance have provided some interesting and thought-provoking responses on the discussion board.

Where Next?

• How To Value Shares is a 12 part in-depth series, encapsulating earnings based valuations, discounted cash flow valuations, and much more.
• The Motley Fool UK Investment Workbook, 228 pages of off-line reading including chapters on valuing shares and perfecting your portfolio.
• Don't try this at home! The Qualiport once owned M&S.