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For what it's worth November 22, 2005 Most people recognise value for money when they see it, whether it's a Sydney-to-Melbourne flight for $49 or mangos for 50c each. But when faced with Telstra at $4, most investors are unsure if they are looking at a bargain or a basket case. According to Roger Montgomery, of Clime Asset Management, this is because they have no reference point when they try to put a value on shares. While shoppers can check the price of the same item at rival retail outlets, few investors
Photo: Marco Del Grande
know what Telstra is worth as a going concern. Part of the problem is that investors get distracted by the daily ebb and flow of share prices, whereas Montgomery argues that price and value are two different things. For short-term traders the price of the share is often all that matters, because they buy and sell for a quick capital return. So someone who bought Telstra for $4.02 a month ago could have sold for $4.32 two weeks ago and made a quick buck, but whether Telstra was worth $4.32 is anyone's guess. Yet for long-term investors the quality of the business is paramount, because that is what will underpin the share price and the total return they receive on their investment. That's not to say price is unimportant. As billionaire investor Warren Buffett points out, the higher the price you pay, the lower your return. When share prices fall bargain hunters pile in, because the shares look cheap relative to their recent trading history or to similar companies. Many investors use the price-to-earnings ratio (P/E) to determine whether a share is cheap relative to the market or its peers, but this still ignores "intrinsic value" and is often based on estimates of future earnings. The dangers of predicting future performance were highlighted in a recent survey by Parson Consulting, which found that only four of the top 100 ASX-listed companies met analyst earnings-per-share forecasts last financial year.
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As John Price, the developer of the Conscious Investor share analysis software, says, there is no point buying a bargain that stays a bargain. Or worse, buying a bargain that turns out to be another Enron. In order to tell the difference, investors need to be able to value the business they are investing in to make sure it can deliver the return they require. Professionals use different methods to value shares. Most brokers use the discount cash flow method, which tries to estimate future cash flow and discount it back to calculate the current value of the shares. Fund managers develop their own valuation methods, often using a mix of fundamental analysis and sophisticated computer modelling. Yet few investment professionals are prepared to reveal their complex formulae. A cynic might say it is in their interests to let investors believe that valuing shares is too tricky for mere mortals. Price and Montgomery, who both follow Buffett's investment philosophy, sell investment analysis tools, but they insist people who are prepared to invest a little time and thought can go a long way towards valuing companies themselves and making profitable investments. "I say the only question an investor needs to ask is what return do you need to get. I don't put a value on shares in terms of dollar value but in terms of returns," Price says. After all, when you finally sell an investment, the important thing is not what price you paid or whether it was overvalued or undervalued at the time, but the total return of all dividends received plus capital gains. Controversially, neither Price nor Montgomery put much stress on dividends. "We talk about total returns, dividend plus capital gains. Money is money," Price says. Buffett doesn't invest in a company unless he is confident he can make at least a 10 per cent return. Once you know what return you require and what margin of error you can live with, Price says investors need to sit back and look at the business behind the shares. He says you can go a long way by asking a few questions; the answers can be readily found on free websites. Price says investors should look for growth in earnings and sales, little or no debt and strong and consistent growth in return on equity (ROE) over the past five to 10 years. "If that hasn't been happening, you have to ask why you think it will in the future," Price says. ROE is a key measure of profitability, showing the profit made on ordinary share capital expressed as a percentage. Buffett looks for a return of at least 12 or 13 per cent, preferably more. Much less and you could invest for lower risk in other asset classes.
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While these questions are numerical, others are more subjective. Buffett prefers businesses he understands. Most Australians come into daily contact with a range of retailers, goods and services, which gives them an insight into how those businesses are going. Price says to look at what distinguishes a company from other businesses and whether it has an economic moat to protect its cash flow. For an example of an economic moat, investors need look no further than the Sydney Cross City Tunnel, where the operators negotiated a contract closing off alternative routes. Also look at a company's competition, brand name, and whether it is a market leader or has a monopoly or patents on key technologies or products. Then you should sit back and see if you can imagine the business continuing successfully in future. Only then is it time to ask what price you should pay for the company's shares. Using the method in the box below, Montgomery says investors can work out how much they should pay to achieve a specific return with a margin for error, or a level of risk, they can live with. "This approach allows you to relax. When you invest you can be confident about buying and holding because you know [the shares] are worth more," Montgomery says. Price's valuation method does take P/E ratios into account when deciding what price to pay. He compares current and past P/E levels, information that is available on some websites. "If it's been 20 but is now 15, this may be a good time to buy. Don't try to buy on dips in price but on a dip in the P/E ratio," he says. Even so, the better the business, the less important the share price valuation becomes for long-term investors. "If you paid too much for Westfield 20 years ago, so what? You would still be a multi-millionaire today," Price says.
Valuing Telstra Imagine Telstra has caught your eye. Management appears to be addressing its problems but the share price has fallen from $5.14 mid-year to $4 last week. So is it a bargain? Roger Montgomery, of Clime Asset Management, says you can get a rough idea by using a formula he has derived from Warren Buffett for companies that pay most or all of their earnings as dividends. All you need is Telstra's latest annual report, a calculator and some patience. The formula Return on equity (ROE)/internal rate of return (IRR) x shareholders' equity per share. Step 1 To calculate ROE, you first need to work out the company's retained earnings. To do this you subtract total dividends from net profit. Total dividends paid are found in the notes to the balance sheet ($4.1 billion), while net profit is found in the profit and loss statement ($4.4 billion). Hence 4.4 - 4.1 gives you retained earnings of 0.3. Telstra's dividends are fully franked, so to adjust for this divide dividends paid by 0.7
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(1-0.3 as the company tax rate is 30 per cent). Hence 4.1/0.7 = 5.8. Add this to retained earnings to give total earnings of 6.1. Next you need to divide total earnings by shareholders' equity at the start of the year ($15.4 billion), which is found on the balance sheet, and adjust for any additional capital raised or shares bought back. Telstra bought back almost $800 million worth of shares so, assuming capital was reduced in the middle of the year, starting capital is reduced by half $800 million to $15 billion (15.4-0.4). Hence ROE is 6.1/15 = 0.407, or 40.7 per cent. Step 2 Required return is the return you want from your investment. Buffett requires a return of at least 10 per cent. Montgomery uses a more conservative 15 per cent because this gives him a bigger margin for error. The higher the rate of return you use, the lower the intrinsic value of the company will be, and the less you will be willing to pay for it. Step 3 To calculate shareholders' equity per share, divide equity at the end of the year ($14.9 billion) by the number of shares on issue (12.4 billion) and you get a figure of 1.2, or $1.20 a share. Step 4 Putting all this together you get ROE (0.407)/IRR (0.15) x equity per share (1.2) = 3.25, or $3.25 a share. In other words, the value of Telstra for a required return of 15 per cent is $3.25, well short of last week's price of $4! However, if you use Buffett's minimum return of 10 per cent, intrinsic value increases to $4.88. To be confident of generating your required return, you would need to buy below intrinsic value.
The drawbacks of dividends When the sharemarket is volatile or the outlook uncertain, investors flock to companies that pay solid dividends. Yet dividends can hide a multitude of sins. Roger Montgomery, of Clime Asset Management, says directors use dividends as a selling point but few explain how they arrived at their dividend policy. John Price, of Conscious Investing, believes many investors feel that a known quantity of money in the hand is better than an uncertain capital gain in future. In an ideal world, companies would pay out all their earnings in dividends and still grow each year. It may amount to sacrilege for some investors, but there is a strong argument that some businesses should not pay dividends. Montgomery and Price both argue that a company with the power to produce a high return on equity is better off not paying dividends and using retained earnings to continue growing the business. Warren Buffett's investment company, Berkshire Hathaway, is a good example. It pays no dividends but shareholders have been richly rewarded nonetheless. Berkshire has produced a steady return on equity of about 25 per cent a year and its shares have grown by an annual average of 22 per cent over the past 40 years.
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This is a far better return than most investors could achieve by receiving profits as dividends and investing the money elsewhere. Price argues that shareholders with a need for short-term cash could sell a few shares and still end up better off in the long run than an investor who buys a mediocre company for regular dividend income.
Do it yourself John Butler Wood is a retired engineer who has been investing in shares for more than 40 years in a haphazard way, mostly on the recommendations of others. It wasn't until he retired and had time on his hands that he began to take a systematic approach to investment. After attending one of Roger Montgomery's ASX seminars three years ago, he began to value companies for himself. He says his method is simple but thorough. "First, I look at the financial health of a company, things such as cash flow and various financial ratios. I look for companies with a return on equity of 20 per cent, which culls out a lot of low-profitability companies. "To limit my search further, I only look at companies [with a market value of] over $100 million," Butler Wood says. This is a labour-intensive process and Butler Wood admits he spends a lot of time at the State Library of NSW during the September-November reporting season, calling up company balance sheets from the Aspect Huntley database. Then he puts the numbers through Montgomery's intrinsic valuation formula and homes in on companies with a price that is less than half their intrinsic value. One of his best purchases was Jubilee Mines, which he bought earlier this year at $4.97 when he estimated its intrinsic value at a minimum of $11.12. It is now trading at $6.50, with an 8 per cent after-tax yield. Butler Wood describes his investment approach as a work in progress. "I've never found using stockbrokers successful. I enjoy fiddling with figures and, provided I make gains, it's in my best interests to continue. It keeps me off the street," he says cheerfully.
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Copyright Š 2005. The Sydney Morning Herald.
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