Valuation Consternation

Attempting to calculate the ‘fair’ or ‘intrinsic’ value of a listed company is no easy task. For starters, one must be able to first generate accurate estimates for a range of quantitative factors, many of which are sensitive to unpredictable variables and non-specific ‘macro’ factors. Even if one could reliably calculate accurate forecast values, we must then incorporate them into a theoretical model which attempts to relate these estimates to overall value. This in itself poses its own set of problems as not only are there a wide variety of models, but each particular model can be implemented in various ways.

Given all of this, is it any wonder that we see analyst valuations vary by so much? Moreover, what hope do small retail investors have given they lack access to the same kind of resources? The good news is that you don’t need to be able to generate an exact dollar value estimate of fair value in order to gain a sense of whether a security is reasonably valued. As is best said by an old Christian prayer, it’s about learning to accept the things we cannot change, having the courage to change the things we can change, and having the wisdom to know the difference between the two. In other words, in the context of fundamental valuations, forget about those things you can’t reasonably expect to accurately know, and instead focus on aspects that are more measurable.

The first thing to acknowledge is that calculating estimates for earnings and dividends is notoriously difficult for certain companies, and much easier for others. Established firms with a steady and reliable track record offer greater certainty than start-up companies or those involved in high risk enterprises. For example, supermarket operator Woolworths is able to provide much more accurate guidance than a small minerals exploration company.

Given this, and the fact that advanced valuation modelling is difficult, time consuming and prone to error, we can instead keep things simple and focus on two of the oldest valuation methods available: Price earnings ratios and dividend yields. Of course these models are subject to the same limitations as their more advanced cousins, something that is best expressed by an old industry saying: “garbage in, garbage out”. In other words, they are only as accurate as the estimates you use in the first place. This is why I suggest focusing on the larger, more established stocks that have a demonstrated consistency in earnings and dividends. It is also why I suggest erring on the side of caution by using figures that are conservative, and even pessimistic.

Both the PE and dividend yield are rather simple calculations and most investors will be familiar with these fundamental indicators. Having said that one must be careful not to mistake their simplicity for ineffectiveness. For our purposes, I believe that a forward looking PE and yield is best. These use expected earnings and dividend values instead of historical data. If the PE is less than the market, and more importantly the industry average, it is a safe bet that it is undervalued. The exact same can be said for the dividend yield. If you are confident that dividends will not be significantly lowered, then it can give you a great idea of value.

The point is best illustrated with an example. Consider the Australian gaming company Tabcorp (TAH.ASX). Being involved in gambling, it is rather defensive in nature, enjoying reasonably reliable earnings and cash flow. Of course, followers of this stock will be quick to point out that 2008 saw a dramatic drop in both earnings and dividends, and that changes to state gaming legislation will negatively impact it in the years ahead, but I believe these can be rationalised. For starters, 2008 was impacted by the horse flu outbreak and this is something that few could have predicted. Besides, an anomalous one off event such as this is unlikely to remain a consistent factor. Indeed, the company has managed a striking return to profitability even over the course of the Global Financial Crisis (GFC).

Figure 1. Earnings History for Tabcorp.

click to enlarge

As for the negative impact we will see from the loss of poker machine licenses in Victoria, this is not a problem so long as we account for it in our estimate of earnings. Earnings per share in the year just gone was 93.3c, but it is expected to drop to just 78.1c in 2010.

Table 1. EPS and DPS forecasts for

Currently Tabcorop is trading at $6.70. Therefore we are looking at a forward PE of 8.58 (6.70/0.781). The industry average is currently 11.5, and the long term market average is around 15 - well above what Tabcorp is trading at. So even with the expected drop in earnings, the current price is representing good value. As for the dividend yield, based on expected dividends of 58.8c per share in 2010, we are looking at a yield of about 8.78% (0.588/6.70). The long term average yield of the market is only around 3-4%.

I don’t know exactly what Tabcorp’s true and accurate fair value is, nor do I need to. Given the expected earnings and dividends, the current share price represents good value. Of course as regular readers would know, I rarely put much faith in forecasts. However if you assume much more pessimistic forecasts, the ratios still appear attractive. Let’s say for the sake of argument that the actual EPS and DPS figures will be 10% lower than what is expected, does this significantly change our perceptions? If you do the maths the PE comes out at 9.5, while the yield works out at 7.9%. These are still attractive numbers and point to great value. In any case, they provide an objective justification for making a medium to longer term investment in this company.

It is important to note that these methods will never tell you what a stock is likely to do in a day or week, but over longer timeframes they are extremely powerful. Also remember to apply them to stocks with reasonably reliable earnings and dividends, and if you are like me and suspicious of forecasts, it is best to underestimate the figures.

Nonetheless, these valuation methods are easy to apply and have proven to be very reliable. At the very least they force us as investors to more objective in our appraisals.

Make the markets work for you

Andrew Page