Buffett's yardstick values T3 at $2.80 ::

Date: 21/10/2006
Publication: Sydney Morning Herald

Assessing shares like a hardhead starts with simple arithmetic, writes Simon Hoyle.

TELSTRA has an intrinsic value of $2.80 a share, and if Warren Buffett were an Australian he wouldn't touch the telco if its shares were selling for any more than that.

Buffett has made his reputation and rather a lot of money by following the simple principle of buying great businesses at a good price.

This Buffett hypothetical comes from StockVal, a service launched last week by Clime Asset Management - a listed investment company that uses the valuation methodology pioneered by the legendary American investor to manage its own portfolios.

The "intrinsic" value of a company's shares is the figure you reach when you determine the value of the company's business and divide the figure by the number of shares on issue. It is often a very different figure from the market price of a company's shares. According to StockVal, Telstra is a case in point.

Following Buffett's rules means would-be investors in T3 must only answer two questions: is Telstra a great business, and what's a good price for its shares? Everything else, especially the $20 million ad campaign and all the hype surrounding the sale, is irrelevant.

According to the valuation methodology Buffett uses, the Government's upcoming sale of its Telstra shares represents good value only if the total amount investors pay is less than $2.80 a share.

But the final price is yet to be set. Investors will pay $2 upfront with the balance to be announced by November 20 and paid in May. (On Friday, Telstra shares were at $3.63.)

StockVal's call on Telstra is not the only one to raise eyebrows - it assesses ABC Learning Centres, for example, as having a value of $3 a share. ABC is now trading above $6.

But Clime's managing director, Roger Montgomery, says StockVal has a sound track record.

"When we were recommended Repco at $3 by three brokers, with $3.40 targets, StockVal said it was worth 90c," he says. "Twelve months later Repco was at 90c."

Successful investing isn't only about avoiding losers, it also requires knowing the difference between price and value. Montgomery says price is what you pay, and value what you get for your money.

Trouble starts when you pay too much for what you're buying - when the price paid for an asset is greater than its value.

Although many people claim to perform intrinsic valuations of companies, there's "only one right way" to do it, and not everyone does it correctly, Montgomery says.

"The idea of all intelligent investing is that you want to buy assets for less than they are worth," he says. "Intrinsic valuation is an estimate of that worth. What price do I have to pay to make sure I get an attractive return on my investment? There are a lot of online tools for doing it and there are books about it, yet I have not found any that are mathematically correct.

"There's only one right way. It's based on the equity in the business, the return on equity that can be generated sustainably by the business, the proportion of the return on equity retained or paid out as a dividend, and the discount rate or required rate of return of the investor."

As an example, Montgomery suggests assuming the after-tax rate of return on a government bond is 10 per cent. Also assume that a particular company is generating a 10 per cent return on equity.

"If we assume you're on the highest tax rate, and there's no franking credits on the dividend, and the company pays all of its earnings out as a dividend, then that business is worth no more than 50c in the dollar," he says.

That's because if you invest, say $10, in the business, the 10 per cent return on that investment will be $1 (that is, a 10 per cent return on equity). But you receive the dollar as a dividend, and you pay tax on it.

"You pay tax at [close enough to] 50 per cent, so that gives you 50c after tax," Montgomery says. "You have now got a 5 per cent return after tax.

"The 10 per cent [after tax] you get from the bond is twice what you get from the company. So the company is worth only half of every dollar invested in it, whereas the bond is worth a dollar."

Most companies do not pay out all of their earnings as dividends, so any valuation method has to factor in the effect of retained earnings on the company's ability to maintain its return on equity. Dividends are often wholly or partly franked, so that affects the investor's after-tax return, and the valuation method has to take this into account, too.

"If T3 is attractive, it's because of the structure of the offer," Montgomery says. "That's a consideration that's different from buying the business. I think the piece of paper itself may be attractive, but that's not what StockVal does. StockVal focuses on the business."

Whether you accept a valuation for Telstra shares of $2.80, as suggested by StockVal, or think the shares are worth more, you still have to work out if Telstra is worth investing in.

In a research note published on October 10, Fat Prophets analyst Greg Canavan says "the T3 offer represents a fundamentally good deal for both long-term and short-term investors".

"In the short term, investors are entitled to a hefty yield, while over the long term, share price appreciation should result if [Telstra chief executive officer] Mr [Sol] Trujillo and his team pull off the company's ambitious transformation plan," he says.

"This optimistic view is subject to two main risks - regulatory and operational. On the regulatory front the risks are well known.

"So, if you accept the regulatory risk, the next hurdle to achieving solid returns from T3 becomes operational risk. By this we refer to the risk that the company's ambitious transformation plan, currently under way, might not work out as expected.

"Weighing up all of these factors, we believe T3 represents a good deal for investors. Given the huge amount of negative sentiment surrounding the whole T3 saga, we take the view that the Government had to price the offer very favourably. Our contrarian instincts tell us this will be a handsome deal."

It may be, however, that the views of all the experts are falling on deaf ears, or that retail investors have reached their own conclusions already.

A survey conducted by the research group Brandmanagement suggests T3 is not attractive to the vast majority of retail investors.

According to the survey, almost three quarters of more than 1336 respondents are simply not interested in T3 at all.

Only 12 per cent of respondents say they won't invest because they do not have the money, so most have made a conscious call on Telstra specifically.

About three-quarters of respondents participated in T2 and are still annoyed that their shares are worth less than they paid for them, which has a strong influence on their view of T3.

The survey finds a growing belief among investors that T3 does not represent good value at prices above $3 a share.

Eighty-two per cent of respondents say there's little likelihood of T3 providing a capital gain and 72 per cent believe Telstra is not a great company, saying it is poorly managed and too risky.

It seems the main reason investors do want to invest in T3 is less to do with the quality of its business and its management than to do with its brand name.

Eighty-eight per cent of respondents "agree strongly" that Telstra being "a well-known Australian company" is the main reason they'd invest.

The share buyer's checklist

Five wrong reasons to buy shares

1. Friends/family members/workmates (etc) say it's a good idea.

2. The prospectus/product disclosure statement/research note looks good and has lots of impressive charts in it - but you haven't read it and/or don't understand it.

3. You've received an offer from someone you do not know (especially if they're based offshore).

4. Your sole source of information is an advertisement on TV, in a newspaper, on the radio or online.

5. Everyone else is doing it so you don't want to miss out.

Five right reasons to buy shares

1. You understand very well the business you're buying and believe it has good prospects.

2. You can buy the shares for less than they're truly worth.

3. It's appropriate to your investment goals and your tolerance for investment risk.

4. The shares you intend to buy fit in well with other investments you already own.

5. You've received advice or guidance from an expert whose livelihood does not depend on convincing you to transact.

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