What’s Telstra really worth? :: Author: Alan Kohler Date: 19/02/2007 Publication: Eureka Report
PORTFOLIO POINT: Applying Warren Buffett’s principles to Telstra gives it a share price of $3.10. Its current higher price reflects speculation and investors being content with an 8% return. Telstra's interim results received strong approval from the market last week as the stock lifted to about $4.50. But analysts remain mixed on the quality of the result. Leading stockbrokers, including JP Morgan, are concerned that chief executive Sol Trujillo is spending too much money in his drive to improve performance at the troubled telco.

For long-term value investors, the question is whether Telstra is offering genuine value at current prices. The stock is trading on a price/earnings multiple of about 20 times and offering a generous gross dividend yield of 8.8.%.

Applying a benchmark valuation technique based on Warren Buffett's valuation principles should see Telstra offering a “rate of return” to investors of about 12%. In the following piece, Russell Muldoon of Clime Capital runs the numbers on Telstra based on last week's interim results.

As Muldoon reveals, Telstra is taking money from retained profits to pay for dividends; it's one of several reasons Telstra fails the Buffett test. Telstra offers a rate of return of just 8% on today's prices. The stock would have to drop back to $3.01 to get to Buffett's hurdle rate of 12%.

If you want to find out how Russell and the team from Clime Asset Management ran the numbers on Telstra through a proprietary IP system known as StockVal, here's how:

IN THIS ARTICLE we are going to look for guidance from Warren Buffett, arguably the world’s greatest investor. What we seek is his time-proven wisdom on how he would look to value businesses like Telstra that pay the majority of their earnings out as a dividend to their shareholders.

In his 1981 letter to Berkshire Hathaway’s shareholders, Buffett wrote:

“During the past year, long-term tax-exempt bond yields exceeded 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist — if all earnings are paid out and return on equity stays at 14% — such a perpetual 7% tax-exempt bond might be worth 50¢ on the dollar as this is written.”

Using the above example, let’s say you had $1 to invest and you have the choice between investing in a tax-exempt bond with an interest rate of 14%, or a listed business that has equity per share of $1 generating 14% return on equity (ROE), which distributes all of its earnings out as a dividend, and is currently trading at a market price of $1.

Let’s now say you are looking to invest in the business. If you can get a 14% (after tax) return simply by investing in the tax-exempt bond virtually risk-free, at what price should you purchase equity in the business if you are on a 50% tax bracket, to achieve a similar return?

The above cash flow analysis illustrates Warren Buffett’s wisdom. Let’s assume for a minute that you paid $1 per share (current market price) for the business, which had equity per share of $1. Your initial cash outflow is represented as –$1 in Year 0. By using its $1 of equity, the business generates return on equity (ROE) of 14%, or 14¢ in net profit after tax for the year, which it then distributes to you as a dividend (100% dividend payout ratio). Because no earnings have been retained, equity in year 2 will be unchanged at $1. The business then continues to earn ROE of 14% annually, paying all of the earnings out as a dividend.

All this is captured in the CF (cash flow) Before Tax and the CF (cash flow) After Tax rows. The CF Before Tax row shows your gross take-home earnings of 14¢ each year before your theoretical income tax rate of 50% (assuming no franking). The CF After Tax row is simply your 14¢ dividend each year less the 50% in tax, a net 7¢, which is your take-home spending money.

So while this business generated ROE of 14%, because all of the earnings where paid out to you as a dividend, your net investment return after paying taxation is 7%. If the tax-exempt bond was paying 14%, by purchasing shares at the current market price of $1, you have reduced your investment return by 50% per annum.

Valuation – a simple example

So instead of paying $1 (current market price) for the $1 of equity in this business, at what price should you purchase shares in order to generate a 14% return on your investment? Applying Warren Buffett’s wisdom:

“Such a perpetual 7% tax-exempt bond might be worth 50¢ on the dollar as this is written.”

Tax-exempt bond return	14%
After-tax business ROE	7%
Business Equity Per Share	$1
Intrinsic Valuation	= After tax ROE / Investor's required return * Equity per share
	= 7% / 14% * $1
	= 50¢ per share

The following explanation should help make more sense …

If you can get 14% in a tax-exempt bond virtually risk-free, the maximum you would pay for the equity in a business generating a ROE of 14% which pays all dividends out to you and on which you are taxed 50%, would be 50¢.

Put another way, if you get an after tax return of 7¢ for each share you own and only pay 50¢ for the $1 of equity in this business, your return will be 14% (7¢ divided by 50¢).

Note Buffett’s words “might be worth”. Due to inflation’s erosion of the equity and the higher risk nature of a business over a bond, an investor would need to pay less, and perhaps, significantly less than 50¢ to be sure of a bargain.

Valuation – a real world example

On February 15 this year, Telstra announced its half-yearly results. Net profit after tax was $1.704 billion, down 20% from the same period last year. Detailed in the same report was a payment of a 14¢ per share dividend made to existing shareholders and a declaration that another 14¢ will be paid to investors over the next six months.

This represents a total of 28¢ per share in dividends for each investor or a total of $3.484 billion in dividends to be paid for the 12,443.1 billion shares on issue. Now, if institutional analysts are forecasting a total net profit for the 2007 calendar year of $3.147 billion, by paying out $3.484 billion as a dividend, this means Telstra is paying out its entire profits and then some. Telstra is revealing its bond-like characteristics.

Leaving aside the attractiveness or otherwise of the business and using his 1981 metrics, how might Warren Buffett value Australia’s leading provider of telecommunications and information products and services, Telstra Corporation Limited, a business that has a current dividend payout ratio of over 100%?

Step 1: Determine performance as measured by return on equity (ROE)

First, he might look at the performance characteristics of the business over a review period of not less then the past three years.

As the above chart shows, Telstra has been a very consistent performer as measured by return on equity (ROE), the most important financial ratio. Our forecast for 2007 shows this trend is likely to continue for this year, albeit down slightly from the previous year.

From the last annual report in 2006, Telstra generated ROE of 38.8% for its shareholders, which was only 2.4% less then the 40.2% ROE produced in 2005. In 2007, using the financial data released in the half-yearly report and analysts forecasts, ROE is forecast to be about 36.9%, which is only slightly below the average ROE over the last four years (2003–06) of 38% — an impressive number by any measure (ignoring capitalised expenses).

Impressive performance aside, however, what becomes clear from the fundamentals is that Telstra is not profitably reinvesting profits so cannot earn high rates of ROE on incremental capital, nor growing profits — the hallmark of a great business. In 2006 and using our forecasted 2007 financial data (as can been seen below), Telstra is actually distributing its entire earnings (net profit after tax) and also a large proportion of its previously retained profits to its shareholders as a dividend, giving it bond-like characteristics. In actual fact, over the last five years, Telstra has a negative reinvestment balance.

Step 2: Calculate the equity per share (EQPS)

You now need to determine the amount of equity (on a per share basis) being used to produce the 36.9% ROE. This can be quickly determined by taking the closing ordinary equity and dividing this by the number of ordinary shares outstanding.

As a potential investor in Telstra, what annual rate of return are you seeking? There are many variables that should be considered, such as debt levels (gearing). For this example we are going to assume that an investor looking to purchase shares in Telstra is seeking a 12% before-tax annual return on their investment.

Step 4: Valuation

You now have all the necessary inputs to value an asset like Telstra that pays out all of its earnings as dividends.

Intrinsic Valuation	= ROE / RR * EQPS (see footnote)
	= 36.9% / 12% * 98¢
	= $3.01 per share

Should Telstra continue to pay all of its earnings out as a fully franked dividend and should the business performance remain consistent around 36.9% ROE, then an investor who requires a 12% return should pay a maximum of $3.01 per share.

Think about it this way: if the business uses 98¢ in equity to produce ROE of 36.9%, which is 100% distributed to you as a dividend, and you require a 12% return on your investment, you can afford to pay a shade over three times for that 98¢ equity, or $3.01.

The market is therefore expecting much higher rates of return on equity in the future from this business, is speculating about “corporate activity” or is happier with a return of about 8% (36.9% / 8.0% * 98¢) = $4.52 — the current market price.

Given the current price and all the risks associated with being a partial owner in a business and the uncertain future of what will transpire now Telstra is privatised, the safety of cash might seem much more appealing to Warren Buffett.

PS: Remember, this is a valuation based on Telstra operating in its current form. The valuation could change dramatically if Telstra is broken up, owned by a media baron or it changes its profit distribution policy.

Clime Asset Management’s intrinsic valuation for Telstra and other businesses, can be calculated using StockVal, an online, intrinsic value calculator and tracker that enables investors to separate a business’s estimated worth from the daily gyrations of their shares.

Footnote: Please note that the formula detailed in this note only works for assets that pay out all earnings as an income stream. It does not work for assets that retain and compound earnings.