## Tuesday, 16 October 2012

### How do you value this company OPQ?

I have been looking at this company.  Its business is doing very well.  It has grown its revenues, profit before tax and earnings consistently over many  years.  Its business is growing due to its excellent products and marketing.

Its PBT margin and net profit margins have grown over the years from single digits to double digits.  It latest PBT margin and net profit margins were 17.4% and 13% respectively.  Its ROE is consistently above 30% for many quarters and the last few years.  It DPO ratio averages 70%.

Its latest trailing-twelve months earnings was \$110 million and its market capitalisation recently was \$ 3200 million.  It is projected that it will probably deliver \$130 million in this financial year with a high degree of predictability.

(A)  Calculating the value of this company today.
How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn \$110 million per year?
3.  Answer:  \$110 million / 4% = \$2750 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about \$77 million.
5.  How much deposit would you need to put in the bank to earn \$77 million at present prevailing interest rate of 4% per year?
6.  Answer:  \$77 million / 4% = \$1925 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of \$ 110 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of \$ 110 million / (4% - 2%) = \$ 5500 million.
12.  With its dividend of \$ 77 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of \$ 77 million / (4% - 2%) = \$ 3850 million.

To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of \$ 2750 million.
- the dividends stream is the equivalent to an asset of \$1925 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is \$ 5500 million.
- the dividends stream is \$ 3850 million.

This company's market capitalization was \$ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between \$1925 million (this price is supported by its dividend yield) and \$ 2750 million (supported by its earning yield).

At \$ 3200 million, its reward:risk ratio is against the investor as the current price of this company is higher than your calculated intrinsic value of \$ 2750 million.

(B)  Calculating the value of this company at the end of this financial year, using (projected earnings and dividends).
However, it is projected that this company will deliver \$ 130 million in earnings and at DPO of 70%, \$91 million in dividends.

Let's recalculate the values you will place on these earnings stream and dividend streams.

How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn \$130 million per year?
3.  Answer:  \$130 million / 4% = \$ 3250 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about \$91 million.
5.  How much deposit would you need to put in the bank to earn \$91 million at present prevailing interest rate of 4% per year?
6.  Answer:  \$91 million / 4% = \$ 2275 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of \$ 130 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of \$ 130 million / (4% - 2%) = \$ 6500 million.
12.  With its dividend of \$ 91million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of \$ 91 million / (4% - 2%) = \$ 4550 million.

To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of \$ 3250 million.
- the dividends stream is the equivalent to an asset of \$ 2275 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is \$ 6500 million.
- the dividends stream is \$ 4550 million.

This company's market capitalization was \$ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between \$ 3250 million (this price is supported by its dividend yield) and \$ 2275 million (supported by its earning yield), at the end of its financial year..

At \$ 3200 million, it is priced close to the calculated intrinsic value for the company in the end of its financial year of \$ 3250 million.  There is little margin of safety as demanded by Benjamin Graham in his teaching.  The upside reward = 50 million and the downside risk = 925 million, that is, a reward;risk ratio = 1 : 18.5.

But what if you also factored in the strong growth of this company?  What would be its intrinsic value?

Conclusion:

Since, this company is projected to grow its earnings with a high degree of predictability in the future, will you buy this company at its current price of \$ 3200 million?

Those with a short term perspective in their "investing" will realise that the current price has priced in the growth expected for this financial year.

However, for those with a longer term perspective in their investing, for example 5 years, they will realise that the earnings of this company will continue to grow consistently and predictably.  Considering the earnings growth potential, and including this factor into their calculation of intrinsic value, they may rightly be of the opinion that this company is indeed undervalued.