One of the most important things to recognise as an investor is that you cannot predict the future with any accuracy. That doesn’t stop thousands of people trying to do exactly that. It took me a long time to realise that trying to predict a company’s future profits and cash flows is essentially a waste of time and you shouldn’t listen to anyone who says that they can. Instead, it’s much better to try to work out what a company’s share price is implying about the future of a company and take a view as to whether that is realistic or not.
Economic and company forecasts are little more than guesswork in most cases. Yet, that doesn’t stop lots of people basing their investment decisions on them as if they are bound to happen. Having a view on a company’s future prospects is a key requirement when investing, but it should not be about trying to predict a company’s exact profitability or the valuation of its shares down to two decimal places.
A far more valuable exercise is to try to work out whether the odds are in your favour. In simple terms, if you think a company can perform better than the expectations of the future baked into its share price then you might buy its shares. If not you will sell or not buy in the first place.
The great value in doing this is to identify the mispricing of shares. You want to be able to exploit excess pessimism and avoid overexuberance.
As with many things to do with investing this is not an exact science, but something that can be a valuable part of your personal investing process before you make that all-important buy or sell decision. This article is about showing you how you can do this.
Don’t bother forecasting future profits – you don’t need to
The private investor always has two valuable pieces of information about a company that cost nothing to get hold of. They are:
- Its current share price.
- Its latest annual report.
These two bits of information give you everything that you need to get a very good feel for what the current share price is implying about the direction and size of a company’s future profits. Your job is to work out whether that is likely to be right or not and how much buffer you have to make a decision.
Earnings power value
Earnings power value (EPV) can mean a number of things. The concept was first introduced by Benjamin Graham and David Dodd in their book Security Analysis. For me, the best explanation of EPV is in Bruce Greenwald’s excellent book Value Investing: From Graham to Buffett and Beyond. He defines EPV as the value of a company if its operating or trading profits stay the same forever. In mathematical terms, it is the same as calculating the value of an annuity.
How to calculate a company’s EPV
In order to work out a company’s EPV you need to use some numbers from its latest annual report as follows:
- Take the company’s most recent annual underlying operating profits (ignoring one-off gains and losses) and add the share of profits from joint ventures and associates.
- Tax this figure at the company’s tax rate to be conservative. To work out a company’s tax rate divide its annual taxation expense by its pre-tax profits.
- You now have an estimate of owner earnings for its investors. Divide this figure by your required return (a rate of interest or discount rate) to get EPV. This is the value of the whole business if those earnings stay the same forever. This value is the estimate of the company’s enterprise value – the market value of its assets.
- Take away any debt, pension deficits, minority interest and preferred equity and add any cash balances to obtain the value of equity.
- Divide the equity value by the number of shares to give a value per share.
- Compare your value with the current share price.
The choice of interest rate used to calculate EPV is a subject of much debate and has a big impact on the calculation. The lower the interest rate, the higher the EPV will be and vice versa. I’m not going to get bogged down in an academic debate about this, but offer up some simple rules of thumb; the final choice is down to you. All I will say is that the higher the interest rate that you use, the more conservative your estimate of EPV will be.
Here are my guidelines for a choice of interest rate:
- Large and less risky companies (FTSE 350): 7-9 per cent.
- Smaller and more risky (lots of debt or volatile profits): 10-12 per cent.
- Very small and very risky: 15 per cent or more.
Once you have done this calculation, you are then in a position to get some insight into what a share price is implying about a company’s future profits. The best way to understand this is to use an example.
The EPV of Asos
Internet clothing retailer Asos (ASC) has been a very popular share in recent years. Its shares have commanded high valuations, as evidenced by measures such as a high price/earnings (PE) ratio. High PE ratios tell you that a company’s future profits are expected to be much higher, but EPV helps you understand how much of its share price is based on current profits and how much is based on the future.
From Asos’s 2018 annual report we can take the following required information.
- Operating profit of £101.9m.
- Tax rate of 19.2 per cent.
- Cash of £42.7m.
- Shares in issue of 83.63m.
I then use an interest rate of 8 per cent to calculate its EPV of 1,292p a share (I’ve also shown you the EPV using different interest rates). On Friday, 14 December Asos’s share price closed at 4,186p. The EPV is telling me that 31 per cent of Asos’s share price is explained by its latest annual trading profits, with 69 per cent based on their future growth.
Asos | £m | £m | £m | £m |
Operating profit | 101.9 | 101.9 | 101.9 | 101.9 |
Tax @ 19.2% | -19.6 | -19.6 | -19.6 | -19.6 |
After-tax operating profit | 82.3 | 82.3 | 82.3 | 82.3 |
Interest rate | 7% | 8% | 9% | 10% |
Estimated EPV | 1176 | 1029 | 915 | 823 |
Cash | 42.7 | 42.7 | 42.7 | 42.7 |
Equity Value | 1219 | 1072 | 958 | 866 |
Shares(m) | 83.63 | 83.63 | 83.63 | 83.63 |
EPV per share(p) | 1458 | 1282 | 1145 | 1036 |
Share Price 14/12/2018 | 4186 | 4186 | 4186 | 4186 |
Share price explained by current profits | 35% | 31% | 27% | 25% |
Share price explained by future growth | 65% | 69% | 73% | 75% |
Source: Company Report/my calculation
Asos has been a growing business. Therefore it is not unreasonable to expect its share price to reflect the assumption of some growth in the future. What you need to try to work out for yourself is whether that assumption of future growth is too high or too low.
How do you go about doing this?
One starting point is to work out an estimate of what the steady state of profit needs to be to justify the current enterprise value. This is calculated by multiplying the enterprise value by the required interest rate.
Using 8 per cent gives a required after-tax profit of £277m, compared with the current £82.3m. Profits therefore needed to more than triple.
Asos EV | £m |
Share price(p) | 4186 |
share in issue (m) | 83.6 |
Market Capitalisation(m) | 3499 |
Take away cash | 42.7 |
EV | 3457 |
Interest rate | 8% |
Required after tax op profit | 277 |
Current after tax op profit | 82.3 |
Required growth | 236% |
Source: My calculations
How long might it take for Asos to triple its profits?
Growth rate/years | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 |
28% | 105.4 | 134.90 | 172.67 | 221.02 | 282.90 | 362.11 | 463.51 | 593.29 | 759.41 | 972.04 | |||
20% | 98.8 | 118.56 | 142.28 | 170.73 | 204.88 | 245.85 | 295.02 | 354.03 | 424.83 | 509.80 | |||
15% | 94.7 | 108.89 | 125.22 | 144.00 | 165.61 | 190.45 | 219.01 | 251.87 | 289.65 | 333.09 | |||
10% | 90.6 | 99.63 | 109.59 | 120.55 | 132.60 | 145.86 | 160.45 | 176.49 | 194.14 | 213.56 | 234.91 | 258.40 | 284.24 |
Source: My calculations
In 2018, Asos’s trading profits increased by 28 per cent. If it could continue to grow at that rate then it would take just under five years to meet that growth target. Some might think that is not too long to wait.
But what if growth rates slow down? After all, it’s not unreasonable to assume that a company cannot keep growing at 28 per cent for long. Based on the following growth rates it takes the following number of years to reach the steady state profits implied by the 4,186p share price:
- 20 per cent – between six and seven years.
- 15 per cent – nearly nine years.
- 10 per cent – nearly 13 years.
What is inescapable to conclude was that at 4,186p, Asos’s share price on 14 December 2018 was pricing in high rates of profits growth for many years into the future. The danger investors face in this type of scenario is that by owning or buying shares at this price they are already assuming these growth rates will be achieved.
But what if this doesn’t happen? The impact of Asos’s profit warning
On Monday 17 December 2018, Asos announced a massive profit warning. Its operating profit guidance came down from a consensus estimate of £121m to £55.6m. Based on lower profits and lower investment spending my estimate of its net cash balance for the year to August 2018 is £3m. Using 8 per cent as an interest rate and an unchanged tax rate and adjusting for a slight increase in the number of shares in issue, I now get an estimate of EPV per share for Asos of 673p.
Asos | £m | £m | £m | £m |
Operating profit | 55.6 | 55.6 | 55.6 | 55.6 |
Tax @ 19.2% | -10.7 | -10.7 | -10.7 | -10.7 |
After-tax operating profit | 44.9 | 44.9 | 44.9 | 44.9 |
Interest rate | 7% | 8% | 9% | 10% |
Estimated EPV | 642 | 562 | 499 | 449 |
Cash | 3 | 3 | 3 | 3 |
Equity Value | 645 | 565 | 502 | 452 |
Shares(m) | 83.9 | 83.9 | 83.9 | 83.9 |
EPV per share(p) | 769 | 673 | 599 | 539 |
Share Price 18/12/2018 | 2600 | 2600 | 2600 | 2600 |
Share price explained by current profits | 30% | 26% | 23% | 21% |
Share price explained by future growth | 70% | 74% | 77% | 79% |
Source: Company Report/My estimates
As expected, the share price fell heavily on this announcement, but actually Asos’s shares are arguably more expensive than before the profit warning. The proportion of the share price explained by future profits growth has increased from 69 per cent to 74 per cent. It needs higher growth for longer than before to explain it.
The other thing to bear in mind is that Asos’s profit margins are expected to halve from 4 per cent to 2 per cent. This doesn’t give investors much protection from another downturn in trading. So not only are Asos’s shares more expensive, they are arguably more risky too.
Using EPV to find potentially cheap shares
Companies can often trade for less than their EPV per share. More often than not, this is when investors think that their profits are expected to fall. There is usually a good reason for thinking this, such as a struggling business or a cyclical one where profits for the current cycle may have peaked.
But sometimes it can be a sign that the market has too pessimistic a view of a company’s future prospects – a situation you can find when the stock market in general had fallen a long way, such as in 2003 and 2009.
Company | Market cap (£m) | EPV ps (8%) | Price | Price % of EPV | Adj op profit | fc op profit |
Air Partner | 48 | 132.5 | 91.4 | 66% | 5.9 | 6.3 |
Babcock International | 2,588 | 692.6 | 511.8 | 74% | 584.6 | 584.4 |
Brown (N) | 283 | 192.1 | 99.6 | 38% | 90.5 | 93.8 |
Dart Group | 1,149 | 1058.7 | 772.5 | 73% | 130.6 | 200.2 |
Ramsdens Holdings | 52 | 242.2 | 170 | 70% | 6.4 | 6.6 |
Source: Company Reports/SharePad
The companies in the table above may not be the kind you would want to buy and hold forever, or at all. However, their shares are currently trading at big discounts to their EPV, while current consensus analyst forecasts are for their operating profits to grow or stay broadly the same.
Their profits may not be sustainable in the long run and of course their share prices could still fall further, but contrarian value investors might just want to have a closer look at them.
