The Qualiport invests in great companies at attractive prices
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QUALIPORT
The Qualiport -- Valuation
The Qualiport aims to buy "great companies at attractive valuations". While the "great company" part is outlined here, just how does the Qualiport define an "attractive valuation"?
Over optimistic
In the past, the Qualiport has suffered by paying too much for a company's growth prospects. This was best exemplified by the Qualiport's purchase of Dell Computer Corporation (Nasdaq: DELL) in January 1999.
This feature outlined the some of the original growth expectations for Dell, justifying its then prospective price to earnings (P/E) ratio of 75:
"Current estimates have Dell earning US$1.45 per share for the year ended January
2000. Assuming earnings growth of 30% for the next 3 years after that, followed
by 25% for the next 2 years, then 20% for the next 4 years..."
Unfortunately, Dell only generated earnings of US$1.32 per share (or $0.66 after
the subsequent stock split) for the year ended January 2000. After the slowdown
in the PC market during late 2000, earnings growth for the year ending January 2001
was 22%. And at the time of writing, growth for the year to January 2002 is expected
to be flat. As with all highly rated companies, when the growth expectations begin
to falter, the share price takes a beating. This
article rounds off the Qualiport's involvement with Dell.
As we've seen with Dell, even with the best companies, using long-term profit projections
to justify today's highly rated share price can be fraught with danger. Instead,
it usually pays ordinary investors (and that includes the Qualiport management!)
to concentrate on companies that exhibit rather more "obvious and immediate" value.
Obvious and Immediate
The value of any equity investment should be compared to the risk-free opportunities
elsewhere, for instance, those from government bonds and deposit accounts. But how
do you compare the 6% deposit rate you can get from a bank to shares on the stock
market? Enter the earnings yield.
A shareholder is a part-owner of a business and is entitled to a proportionate slice
of the annual profits, referred to as the company's
earnings per share (EPS). The earnings yield is expressed by dividing a
company's EPS; by its share price.
So, for a company with a share price of 100p and EPS of 8p, its earnings yield would
be 8%. Now, imagine that company is expected to increase its EPS by 25% next year,
to 10p, and by 20% the year after, to 12p. Which would you prefer? The bank account
that returns 6p for every £1 deposited, or the aforementioned company, which generates
you 8p now, rising to 12p in two years' time, for every £1 share bought? The company
looks the better bet, as it shows obvious and immediate value over the deposit account.
(The Qualiport has covered the earnings yield in more detail in the
Quick Fix Valuation Guide and Four
Quick Valuation Rules.)
Dividends
But remember, the company will retain and reinvest part of its earnings to generate
increased profits for the future. So shareholders won't get their hands on all of
the company's initial 8p of EPS as they would the 6p interest payment from the deposit
account. But what they should receive is a capital gain, as the company's share
price moves upwards to reflect the prospect of the greater profits.
However, perhaps an even better guide to obvious and immediate value is the dividend yield. Whilst there
can be some question marks hanging over a company's retained earnings (will they
be put to good use?), you can't really argue with the dividend element that is paid
directly to you.
So, imagine another company with a share price of 100p and having an annual dividend
payment of 7p. Then suppose this payout is expected to increase to 8p next year
and 9p the next. Again which would you prefer? The bank account that returns 6p
for every £1 deposited, or this second company, which should pay you 7p now, rising
to 9p in two years time, for every £1 share bought? Again, the company looks a better
bet, as it shows obvious and immediate value over the deposit account.
Free cash flow
However, earnings and dividends are not infallible as valuation tools. Earnings
are subject to the vagaries of an accountant's opinion, while dividend payouts are
subject to management's discretion. Indeed, relatively high and attractive dividends
may not be sustainable in the first place, as they may not be wholly funded by a
company's profits.
But fear not - there is a middle ground that nicely entwines earnings and dividends.
At the end of the day, it's cash profits that business owners require. More to the
point, it's "free" cash they require. Free cash flow is the measure by which a company
generates cash over and above what's required to sustain its current competitive
position. It funds such discretionary corporate activities as the payment of dividends,
expansionary capital expenditure and acquisitions.
So, not only does free cash flow measure cash profits, it also highlights the maximum
theoretical dividend payout for investors. More details on how the Qualiport uses
a company's free cash flow can be found
here.
Margin of Safety
What the Qualiport looks for is obvious and immediate value. Essentially, what's
required in every share purchase is a
margin of safety. In other words, buying £1 coins for 50p. We'll ensure
the free cash flow
yield is as high as possible so to limit the investment downside should
the company's progress not match our expectations. The Qualiport also tries to limit
any disappointment by investing in proven companies with predictable profits.
Remember, although the stock market may think so sometimes, no company ever offers guaranteed growth prospects. As we've experienced with Dell, the Qualiport has learnt this lesson the hard way.
Where Next?
