Put val­u­a­tion into per­spec­tive

Financial Mail - Investors Monthly - - Con­tents - By Chris Pot­gi­eter, Head of Old Mu­tual Wealth Pri­vate Client Se­cu­ri­ties

N ovice in­vestors of­ten balk at the prospect of pay­ing R1000 per share or US$100 per share for an equity hold­ing, be­liev­ing the com­pany to be ‘too ex­pen­sive’. More ex­pe­ri­enced in­vestors, on the other hand, are hes­i­tant to buy a com­pany at a higher price to earn­ings ra­tio (PE ra­tio) com­pared to the mar­ket, ar­gu­ing that the com­pany must be ‘ex­pen­sive’. In both cases, the think­ing is flawed.

For novice in­vestors, price sub­sti­tutes for anal­y­sis and the price of a share is usu­ally the only de­ter­mi­nant of value. In other words, the higher the price, the more valu­able or ex­pen­sive the com­pany. At the ex­treme, this leads to ‘penny stock in­vest­ing’, based on the as­sump­tion that a low share price im­plies bar­gain ter­ri­tory.

A com­pany’s share price is sim­ply a func­tion of its mar­ket cap­i­tal­i­sa­tion di­vided by its num­ber of shares in is­sue. Two sim­i­lar com­pa­nies with sim­i­lar mar­ket val­ues, but with dif­fer­ent amounts of is­sued shares, will yield very dif­fer­ent share prices. If you are in­vest­ing R1000 by buy­ing 10 shares of R100 or one share of R1000, you are still get­ting R1000 of mar­ket value.

For more so­phis­ti­cated in­vestors, PE ra­tios or mul­ti­ples tend to in­di­cate whether a com­pany is ‘ex­pen­sive’ or a ‘bar­gain’. The think­ing is that if two com­pa­nies are sim­i­lar in size and op­er­ate in the same in­dus­try, do­ing the same thing and mak­ing sim­i­lar prof­its, then a com­pany with a low PE ra­tio must be a ‘bet­ter’ in­vest­ment than a com­pany with a high PE ra­tio. But what these in­vestors are fail­ing to un­der­stand is that a PE ra­tio is not a re­flec­tion of the past, but rather a re­flec­tion of the fu­ture. In other words, the PE ra­tio is a re­flec­tion of the fu­ture prof­its the mar­ket ex­pects the com­pany to de­liver go­ing for­ward. There­fore, the higher the ex­pected fu­ture growth rate of prof­its, the higher the price the mar­ket is will­ing to pay per unit of earn­ings and con­se­quently, the higher the PE ra­tio.

As an ex­am­ple, let’s as­sume com­pany XYZ and com­pany ABC are sim­i­larly sized com­peti­tors in the same in­dus­try and gen­er­ated the same prof­its last year. How­ever, the mar­ket ex­pects ABC to de­liver twice the prof­its of XYZ in the next year.

Their re­spec­tive PE ra­tios will de­pend on the out­look for profit growth over many years, us­ing the sim­ple ex­am­ple of one year’s ex­pec­ta­tion. Com­pany ABC will there­fore have a PE ra­tio of twice that of com­pany XYZ. This is be­cause in one year’s time, the higher PE ra­tio for com­pany ABC would have ‘un­wound’ to be the same as com­pany XYZ and in­vestors would have re­ceived the value im­plied by the higher PE ra­tio of com­pany ABC. This value would be re­turned through higher div­i­dend pay­ments, as­sum­ing no share price growth and a 100% div­i­dend pay-out ra­tio.

The point is that the share price you pay to­day is a re­flec­tion of ex­pec­ta­tions of the fu­ture, not of the past. A com­pany trad­ing at a higher PE ra­tio com­pared to its peers is ex­pected to de­liver higher prof­its than its peers in the fu­ture.

It there­fore stands to rea­son that com­pa­nies that con­sis­tently de­liver rev­enue and earn­ings growth above their peers will con­sis­tently trade at higher PE mul­ti­ples. Us­ing the ex­am­ples of com­pany XYZ and com­pany ABC, if ABC has a track record of achiev­ing con­sis­tently higher growth and has the prospects to con­tinue this into the fu­ture, then it will con­sis­tently trade at a higher PE com­pared to XYZ.

Many com­pa­nies have demon­strated an abil­ity to sus­tain earn­ings growth ahead of their peers and thus sus­tain a higher PE ra­tio over time. Nes­tle is one such ex­am­ple. The com­pany is cur­rently trad­ing on a PE mul­ti­ple of 26 com­pared to its av­er­age peer rat­ing of 22. Ten years ago, the pic­ture was pretty much the same and in our view, Nes­tle will con­tinue to re­tain its higher PE rat­ing rel­a­tive to its peers for the next 10 years. This means those in­vestors look­ing for a bar­gain based on low PE ra­tios would never in­vest in Nes­tle and would there­fore not par­tic­i­pate in the sig­nif­i­cant value this com­pany cre­ates for its share­hold­ers.

While val­u­a­tion is an im­por­tant con­sid­er­a­tion in in­vest­ing, it shouldn’t be the ‘be-all and end-all’ for deter­min­ing whether to in­vest or not. Rather than ob­sess­ing about over­pay­ing, in­vestors should give due con­sid­er­a­tion to the qual­ity and growth rates of a com­pany in or­der to place its val­u­a­tion into per­spec­tive.

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.