Join our community of smart investors
OPINION

Putting a figure on value

Putting a figure on value
March 17, 2016
Putting a figure on value

In the past two weeks we have established that, for the purposes of valuing all securities, what matters is the cash that's generated for the owners of securities; that, without cash disbursements, there will be no value. For the owners of ordinary shares - our chief interest - the game is especially tricky because shareholders are in a peculiar position. They are only entitled to the residual claims on a company's cash, their securities are effectively irredeemable and, meanwhile, cash is being invested on their behalf by the company's managers. So valuing ordinary shares requires a bigger toolkit that in its most sophisticated form - though not necessarily its most accurate - requires many forecasts about a company's progress. What follows is a simplified version of that toolkit. It sidesteps most of the forecasting not least because in investing it usually pays to be approximately right rather than to be precisely wrong.

The foundation that underpins our valuation model comes from conventional finance theory. Its shorthand title is 'M&M' theory - the Ms in question being Nobel Prize-winning economists Franco Modigliani and Merton Miller. The bit of their theory that interests us is the idea that a company is simply the sum of all its projects - both those in place and producing revenues, plus the ones that could be created given the company's resources and its expertise. So, formally the value of a company equals the value of assets in place (what's often label 'installed' value) plus the value of growth (or 'franchise' value).

Now to put that theory into practice. As we said last week when explaining where free cash comes from, our guinea pig is instruments maker Renishaw (RSW), which, as it turns out, is not the ideal specimen. The fact that Renishaw is debt-free - good in many ways - means it sidesteps some of the value-creation process that the model highlights. Still, onwards.

This explanation will be most effective for those who follow it with the accompanying spreadsheet -

- open on their computer. Basically, all that needs to be done is to fill in the yellow cells - the brown-coloured data for those reading the magazine version - and the spreadsheet does the rest.

 

Step 1:

Because a company's value is independent of the sources of its capital - that's basic M&M theory, too - we need first to calculate the free cash that would have been available to holders of debt and equity were they treated equally for tax purposes. So Step 1 in effect adds back the taxes that have been saved by the tax deductibility of interest payments. In a later stage of the valuation process, the residual value of equity will be isolated.

For now, we need five years' worth of data for revenues, operating profits and so on. The question is whether to use forecasts or historic figures. My preference is to use - or at least to start with - historic figures. That's because we are trying to estimate an annual rate of free cash generation that a company can sustain. Yet free cash, almost by its very nature, is volatile - look at the way it has bounced around in the past five years at Renishaw. So forecasting it is especially tricky. Better to start with an average of the recent past and ask whether that is likely to be a fair proxy for the future. Besides, we don't have to concern ourselves with the company's growth at this stage anyway. That will come later.

The only complex figure in Step 1 is the change in working capital. Quite often, companies isolate this nicely in their cash flow statement - Renishaw does. If they don't, then the amount is the sum of the change in inventories, debtors and trade creditors, where an increase in inventories and debtors sucks cash out of the business and an increase in creditors releases it.

 

RenishawRSW
Step 1:  The basic numbers
year ending June (£m)20112012201320142015Average
Revenues288.8331.9346.9355.5494.7363.5
Operating profit81.785.477.769.0142.591.3
plus: Depreciation18.620.021.123.028.122.1
minus: Capital spending-27.8-41.1-39.8-51.4-62.6-44.5
+/- Change in working cap-26.4-20.4-2.1-19.7-20.8-17.9
minus: Tax paid-16.0-17.0-15.0-9.1-21.8-15.8
Taxes saved by debt shield0.0
Free cash30.126.841.911.765.435.2

 

Step 2:

This starts with more background numbers - for total tax charged and the amount of deferred tax within that. We are interested in the likely cash flows in and out of the company, so tax paid is more important than tax charged as the latter will include deferred tax. In the steady state, nil growth company from which installed value is derived, deferred tax allowances will fall away as capital spending will do no more than replace existing fixed assets. Within the spreadsheet, enter deferred tax charged as a minus amount and deferred tax reversed as a plus. The spreadsheet will do the rest.

A mixture of facts and guesses are needed to complete the other cells. Most of the facts - share price etc - are straightforward. For the balance sheet data, use the latest available figures. This might sound odd since it means we are juxtaposing average cash profits against the latest capital employed. But it's logical to the extent that it answers the question: how might this company perform in a typical year starting from now?

Other points to note:

■ Calculating equity employed

The deferred tax reserve and the pension fund deficit are basically book-keeping items that shunt capital away from shareholders' equity. For the purpose of getting a feel for a company's real return on equity, it is best to shunt them back

■ Gross cost of debt

Two ways to guesstimate this figure. First, see to what extent the notes to the accounts give a decent feel for the cost of debt. Usually, the more debt that is fixed rate, the more helpful the notes will be. Second, calculate interest paid against average debt for the latest year (ie, the mid point between the opening and closing figure). Apply whichever figure looks more sensible.

Tax rate

■ Unless there is good reason not to, use the standard rate of UK corporation tax, which is 20 per cent, but set to fall to 18 per cent by 2020

■ Cost of equity

Basically, this cost is the return that an investor wants from holding shares in a particular company. There are technical ways to estimate this, but it's usually better that this should be a subjective, though realistic, figure. For Bearbull, the cost is usually 8.5 per cent because that's a proxy for the long-term annual return from holding shares in UK companies. Remember that the higher the target return, the less value there will be; an observation that underlines the basic truth that investors who want high returns must be sure they are paying low prices.

 

Step 2:  The background numbers & workings
year ending20112012201320142015Latest
Tax charged16.317.015.010.722.9
Deferred tax-0.34.10.9-1.6-1.1
Tax paid16.017.015.09.121.8
Net operating profits65.768.462.659.9120.875.5
Share price (p)1,775Gross interest paid0.0
Shares in issue (m)72.79Equity472.1
Market value of equity (£m)1,292Gross debt0.0
Book equity406.2Capital employed472.1
Deferred tax reserve17.3Equity/capital1.00
Pension fund deficit48.6Debt/capital0.00
Gross cost of debt (£m)0.0Cost of equity (%)8.5
Tax rate (%)20.0Net cost of debt (%)0.0
Gross cash (£m)33.4WACC (%)8.5

 

Step 3

Input the data in Steps 1 and 2 and Step 3 will look after itself. No extra data is needed, just reflection on whether the inputs have been sensible enough to produce a sensible output

Step 3:  Installed value£m
Free cash annuity . . .35.2
Raised by cost of capital . . .8.5
Equals gross value . . .414.1
Minus gross debt . . . 0.0
Plus spare cash . . .28.4
Equals Installed Value443
Installed Value per share (p)608

 

Step 4

Just two pieces of guesswork are needed, but let's explain what's happening in what is the most complex step of all. We are trying to answer the question: what's today's figure for the value that the company might create in the future, given its strengths. The question needs to be asked, but there is no point in pretending that the answer is anything more than food for thought.

Step 4 assumes that value will be created when a company's future capital spending is grossed up by the return on that outlay. Future cap-ex is proxied by the average capital spending in excess of depreciation and excess returns are proxied by return on equity. Then value created fades as the company's excess returns fade to the cost of capital.

That's an awful lot happening in some fairly simple workings, but the maths is logical to the extent that £1 spent on expansion projects will be more valuable than £1 of free cash, so long as the return on excess cap-ex is higher than the cost of equity. Therefore, the wider the gap between excess returns and cost of capital and the more that is spent on new projects, the more that franchise value will be created.

 

Step 4: Value of the growth potential
Growth orientated cap-ex (£m)22.4
Return on excess cap-ex (%)16.0
Fade rate of excess returns (% pa)6.00%
Growth in excess cap-ex (% pa)3.00%
Perish rate3.18%
Value of growth potential (£m)620
per share value (p)852

 

Step 5

Self explanatory. It’s where installed value is added to the growth potential (franchise value) and we get the answer whether the shares are cheap or not. Don’t be fooled. The final line is more neat gimmick than serious assessment. After all, the whole process is to get investment thoughts moving rather than providing formulaic answers.

Step 5: Intrinsic value – installed + growth 
Installed value (£m)443
Growth potential (£m)620
Installed plus growth potential (£m)1,062
Value per share (p)1,460
Value/share price (%)82
Are the shares cheap?no

Keep this spreadsheet handy, we will discuss it further next week. Meanwhile, make a copy of it, clean out the data, substitute data for other companies, play around with the numbers and keep asking yourself whether value is created, where it's coming from and whether it's sustainable.

For further reading, try Valuation: Measuring and Managing the Value of Companies, McKinsey & Co (John Wiley & Sons), the sixth edition has just been published. Also, The Quest for Value, G Bennett Stewart, (Harper Collins) and Principles of Corporate Finance, Brealey & Myers, (McGraw-Hill) - the last of which is a must-have for serious investors.