Fundamental to our approach is our belief that the investment in companies should involve the same logical techniques and disciplines, whether those companies are listed, unlisted or private. It appears to us that there is a great temptation for many investors to believe that listed companies are somehow different from unlisted ones. Consequently they think that valuation techniques should somehow be different and less disciplined in the listed market. In particular there is a blind belief price earnings ratios is the basis for valuing companies.
To demonstrate MyClime’s proven methodology of investing and illustrate that a logical approach to investing has little to do with the popularly used price earnings ratios, let’s work through the following example.
Imagine that you are a wealthy individual with a substantial amount of available investment capital at your disposal. You are interested in purchasing a private business and you are considering two competing opportunities from business vendors.
The first owner offers you his business (Company A) that has revenue of $5M, a profit of $200,000 after tax (which he states is maintainable next year), no debt and has capital or equity employed of $1M. The owner excitedly tells you he has never taken a dividend and has reinvested all the profits back into the business. Last year he paid himself a $50,000 salary and this was fully expensed. At this point you may have doubts as to whether the expenses or overheads are properly stated. You may surmise that the $1M of equity that generates a return of just 20% is reasonable but if the owner’s salary was higher, the return would be lower. Intuitively you may conclude that there is a lot of capital used to generate the return and the return has required a significant reinvestment of profit. You may be enticed by the high level of capital as you may feel that you can always liquidate the company and get some money back. However, you should surmise that the business does not deserve goodwill and that its value is approximate to its capital.
The second owner offers you his business (Company B) that has revenue of $5M, a profit of $200,000 after tax (which he states is maintainable next year), no debt and has capital or equity employed of $500,000. He openly tells you that he paid himself a $100,000 salary last year (fully expensed) and the business paid a dividend of $100,000 in each of the last two years. Intuitively you should be attracted to this business. Further, you should try and convince the owner to sell his business immediately to you for its capital of $500,000. Of course the owner will not do so because both he and you intuitively know that the business deserves goodwill. In other words the business must be worth much more than its $500,000 of capital backing. The question is, how much more is the business worth?
Let’s say that both businesses are offered to you but at different prices. Company A is offered to you for $1.6M and Company B is offered to you for $1.8M. You have a trusted advisor and they point out to you:
- Company A is offered at a discounted PER to that of Company B.
- The PER of Company A is 8 times earnings whilst Company B is offered at 9 times earnings.
The advisor therefore suggests Company A is cheaper relative to Company B, but is it?
In reality the price of Company A & B could be cheap, fair or expensive as the PER provides no information about a company’s value.
At this point you have to look at the two businesses and investigate their recent history to determine their relative merits. We know that Company A is capital hungry. The owner has not taken a dividend and has reinvested all its free cash flow. The return on the capital was at 20% last year and possibly overstated. When you look at Company B you see a dividend of $100,000 has been paid in each of the last two years, the company is not capital hungry and the return on the capital employed was 40% last year.
Clearly, there will be a price at which Company B is no longer an attractive investment. However, the derivation of this price or value has nothing to do with the offered price of Company A. The relative price earnings ratio of company A to company B is of no relevance. Thus, the first decision you should make is to cease negotiating with the vendor of Company A as the real return being generated on its capital is not adequate and it is being offered to you at a price that approximates its value.
As for Company B, you should continue to negotiate whilst carrying out further reviews of the business to confirm it’s financial performance. The stated return on equity is very attractive, but is the return sustainable? Is the business understandable (i.e. how does it make money) and can it continue to grow? Is the business able to employ its retained earnings at attractive rates? What you need to determine is whether Company B is an attractive company, and if so you should negotiate to purchase it below your assessment of its value.
If you, as an investor required a return of 15% we would suggest that Company B has a value of around 4.9 times its equity (i.e. $2.44M). We would also suggest that you seek to buy it at a considerably lower price than this and given the offered price is $1.8M you may well decide to purchase it.
The inputs for a fair valuation would be:
| Company A | Company B | |
|---|---|---|
| Equity | $1.0M | $0.5M |
| NPAT | $0.2M | $0.2M |
| Return on Equity | 20% | 40% |
| Distributed | $0% | 20% |
| Reinvested | 20% | 20% |
| required Return | 15% | 15% |
| Equity Multiple | 1.78 | 4.89 |
The above approach is what Clime Asset Management, our asset management division does when it invests its client’s capital in the equity market. It should also be what you do when you utilise MyClime to discover attractive investments for your portfolio.
It is interesting to note that:
- there are approximately 2,200 listed companies on the Australian Securities Exchange ASX);
- the majority of listed companies do not make a profit;
- less than 500 listed companies have made a profit in each of the last five years; and
- less than 100 listed companies have achieved a return on equity of over 25% in each of the last five years.
From an investment perspective the numbers of companies that are listed on the ASX which have the characteristics of Company B are limited. There are many more Company A type companies and far too many other companies which are destroyers of capital and impossible to value.
Whilst new attractive companies can emerge through a new listing, transformation or inflexion points; these are very limited. Further, the purchasing of companies based on bland price earnings ratios, charts, moving averages or overseas market moves etc. are not sensible, logical, rational nor realistic investment approaches. In the main, they are alternatives to a genuine intellectual thought process which are consistently justified by the dogmas of custom.
