QUALIPORT
How To Value Companies Set For Recovery

By Maynard Paton (TMFMayn)
January 31, 2002

Rochester, Kent – Plenty of listed companies are experiencing profit troubles at present. However, many will survive, recover and eventually prosper. But with their profits somewhat deflated at the moment, earnings-based valuations can sometimes appear quite rich. So how do you value a company whose forthcoming profits are bleak, but where a longer-term recovery looks on the cards?

Renishaw

Let's use Qualiport watch list company Renishaw (LSE RSW) as an example. Last week's interim results from the specialist engineer highlighted a sharp fall in sales and profits:

Six months to              2001           2000
31st December        
Turnover (£)             51,210         60,206
Operating Profit (£)      3,988         12,495
Pre-tax profit (£)        5,276         13,913
Earnings (£)              4,202         10,425
Earnings per share (p)      5.8           14.3
Dividend per share (p)     5.08           4.84

After sales to the US and Japan plunged 25%, Renishaw reported group turnover slumping 15%. And including £1.3m of costs associated with redundancies, half-year profits fell nearly 70%.

Although Renishaw reported (FRS17 adjusted) earnings per share (EPS) of 33.3p during the twelve months to June 2001, the group's current financial year will probably see an EPS figure of around 17p.

So here's the problem: At the present 418p share price (equating to a market value of £300m), Renishaw is valued at 25 times this year's earnings. But with profits halving in 2002, that rating looks very expensive. The market is certainly pricing in some sort of recovery at Renishaw. And rightly so...

Fine record

Renishaw has a long, fine business record and is run by very experienced management. The company has seen many economic peaks and troughs before. In addition, the company stated last week:

"We have continued to invest in research and development, with expenditure, including associated engineering expenses, of £9.3m during the period, up 7% on the £8.7m for the comparative period last year... This, coupled with a recovery by our customers in industries such as semi-conductor, telecoms, engineering and aerospace, gives your Board every confidence in returning to its historic performance levels in the longer term."

Not only that, but Renishaw also sits on £30m cash pile which will help cushion any further downturn.

So just how much of a recovery at Renishaw is priced in?

Recovery pricing

There are three parts to a company's 'recovery value equation':

* The timescale and extent of the recovery;

* The post-recovery share price rating, and;

* Accumulated dividends.

To judge the timing of a company's recovery, it's best to use history as a guide. For instance, following the early nineties recession, it took four years for Renishaw's profits to fully recover:

Year to 30th June         1991    1992    1993    1994    1995 
Turnover (£m)             45.7    44.0    48.0    50.9    66.7
Operating Profit (£m)      8.3     6.7     4.9     7.2    11.8
Earnings per share (p)    10.8     8.8     6.9     8.1    13.4
Dividend per share (p)     4.0     4.4     4.4     4.7     5.3

Will Renishaw take four years to fully recover this time around? That's debatable, but one thing is for sure: going on past form, Renishaw is unlikely to be firing on all cylinders the year after next.

Rating

Whatever valuation tool you prefer, judging a company's future stock market rating is never easy. But again, clues can be found from history.

During the relatively bleak years of 1992, 1993 and 1994, the Renishaw share price hovered between 194p and 253p. Using the EPS figures in the above table, it appears investors were prepared to pay P/E multiples of at least 20 for Renishaw's then recovery prospects.

Turning to the past four years, during which time earnings growth has been robust, investors have (on average) still paid P/Es of around the 20 level:

Year to 30th June         1998    1999    2000    2001 
Earnings per share (p)    22.0    25.5    28.9    33.3
Dividend per share (p)    10.0    11.4    13.2    15.1
Average share price (p)    417     436     607     579
Average P/E               19.0    17.1    21.0    17.4

And dividends? Well, Renishaw did not reduce its dividend during the previous downturn. And although profits have fallen heavily of late, last week's results did highlight an improvement to the interim payout. Given the cash pile too, it's fair to expect Renishaw to at least maintain its 2001 15.1p payout during the present slump.

Putting it all together

From those findings, here are some conservative assumptions for Renishaw:

* It takes four years for Renishaw's profits to fully recover and equal the record 33.3p EPS level set in 2001;

* After the recovery, Renishaw shares then sit on a P/E of 17.5, and;

* Dividends of 60p are accumulated over that time (i.e. the payout level remains static).

In 2005 then, you could expect a Renishaw share price of 583p (33.3p * 17.5). Combined with the 60p of dividends, that would give a total prospective investment of 643p four years out. At today's share price of 418p, the assumptions equate to a compound investment return of 11.3%. To get a 15% return over four years, an entry price of 368p is required.

So even though Renishaw's forward P/E ratio looks quite rich at the moment, the stock market isn't actually pricing in an outlandish longer-term recovery.

Of course, you can modify the recovery assumptions to produce a range of different scenarios. For instance, if it took Renishaw five years to make a full recovery, during which time 80p was paid out via dividends, an entry price of 330p is needed for a prospective 15% annual investment return.

Summary

Although P/E ratios were used in this example, similar calculations can be developed using any shorthand valuation tool. But it's not your valuation preference that is important for 'recovery investing'; it's making sure you're looking at the right type of company in the first place.

You can't invest in any old business and hope it comes through a sticky patch. When looking many years into the future, you have to ensure the company's products, finances and management all have the qualities to make a recovery as near a certainty as possible.

More: Renishaw For the Watch List | Invest In Experienced Management