In fact – being the pedant I am – I also use a third way to estimate value, a simplified synthesis of the income statement and the cash flow account, which I explained back in 2016 in a three-part mini-series on how to value companies (starting with 'Cash and value', 11 March 2016). The logic there was that the more ways we play around with value, the more likely we are to strike the spark that lights a real insight into a company’s merits. True, such moments don’t come along often, but that’s in the nature of investment analysis where the yield on effort is small but potentially lucrative.
Thus, as I indicated last week, I have crunched numbers on five stocks that showed promise as high-yield candidates in an earlier trawl through the components of the FTSE All-Share index. Of the five, I want to focus on publisher Bloomsbury Publishing (BMY) and structural steel engineer Severfield (SFR), adding in tiles retailer Topps Tiles (TPT), which I highlighted last month ('The top and Topps', 12 October).
The table indicates what a chancey game it is to value companies. Compared with their share prices, the values for Bloomsbury and Topps Tiles are all over the place. Meanwhile, the guesstimates for Severfield are close together but – miserably – are all short of its share price.
|Cash conversion (%)*||98||73||62|
|*Productivity in relation to base 100 four years ago; cash conversion, average of past five years|
Roughly speaking – very roughly – in the pecking order of company valuations, cash flow outranks an income statement valuation. That’s for the fairly obvious reason that a cash profit is more useful than an accounting one. That looks good for Bloomsbury, where the cash flow value is 13 per cent higher than its share price, while the income statement variation is 22 per cent below it.
It’s doubly good because – in theory anyway – a cash flow valuation comes in two parts. The first – and more important – part is an annuity valuation of the cash that can be generated from the company’s infrastructure and contracts already in place. Second – and much more vague – is the value that might be created given the goodwill that a company has built up. So it’s an ethereal ‘what if’ figure, but I try to ground it by basing it on a company’s average capital spending in excess of depreciation and amortisation. The underlying logic to this ‘franchise’ value is that its quantity will depend on how much excess capital spending a company does and the likely return on that outlay, for which I use a company’s estimated return on equity. Factor in assumptions about likely growth in capital spending and the rate at which excess returns may fade to the cost of capital and we have a complex piece of maths and a very provisional estimate.
However – getting back to Bloomsbury – it barely does any capital spending in excess of depreciation; not surprising, perhaps, seeing that it’s a publisher. The effect is that its free cash flow is high in relation to accounting profits, thus pushing up the value based on cash flow. That point is underlined by the very high rate of converting accounting profits into cash that Bloomsbury achieves; not that any of the three is a slouch in that regard.
Meanwhile, Severfield’s valuation is limited by the fact that four and five years ago it was making pre-tax losses and only nominal trading profits. Assume that the average of the past three years is more typical than the weighted average of the past five, which I use as the basis for valuations, and you have a business whose income account value matches its share price and whose cash flow value slightly exceeds it. The question is whether using the three-year average is sensible for a company that operates in a cyclical industry and is quite possibly at the top of its cycle. Maybe we’ll know more later this month when Severfield announces its first-half results for 2018-19.
Yet of the three shown here, shares in Topps Tiles perhaps look the best bet because the group’s bosses can reduce the rate of capital spending, which seems to be slowing anyway, and still preserve value thanks to the high return on equity that the group achieves. True, that’s more a working hypothesis than a firm opinion, but it’s one that I might want to work on before Topps announces full-year results at the end of the month, if only because there will almost certainly be a final dividend that alone will generate a 3.6 per cent yield. That’s not to be scoffed at if the shares really are worth buying. We’ll draw this to a conclusion next week.