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Old world to the new

Grasping that simple truth is reassuring. It tells us that the valuation models used before the storm will continue to work, although the inputs will need to change. We’ll explain what needs to happen by walking through two examples using data from cigarettes maker Imperial Brands (IMB) and pubs operator JD Wetherspoon (JDW) both of which have seen their share price shot to pieces. At 1,290p, Imperial is down 49 per cent from its 12-month high and, at 660p, Wetherspoon is down 51 per cent.

For many well-established companies, which includes the majority of those with a London listing, three things are in the process of changing equity values. To list these is to state the obvious, but, for clarity, we need to do it:

●  Upfront profits will be wrecked. We are not sure whether that will mean total wipeout or for how long, but the wipeout period should be short.

●  Future profits growth will be from a lower base and – apart from an initial bounce – may well be at a slower pace than in recent years.

●  The notion of investing in equities has become riskier, especially in those companies with a lot of debt, so the required return to invest must be higher. In other words, the interest rates that drive values (there is always an interest rate somewhere) must be higher.

Table 1 takes these three factors and applies them, stage by stage, to the value of Imperial Brands, using data from its accounting profits over the past five years. To get our bearings, the first column, ‘Old normal’, shows the world as it was just a few weeks ago when Imperial’s share price topped £20. The figure for £2.6bn of operating profits is the weighted average of those five years, with the heaviest weighting on the most recent year. True, this is a backward-looking measure, whereas investing always looks to the future. But the average of the recent past often provides a level of profit that a company is usually capable of making. Basing value on such a figure provides an important margin of safety (well, most of the time).


Table 1: Adjusting Imperial Brands to the new world
£mOld normalNew worldNo surplus cashRaised risk premium
Operating profits2,6312,0142,0142,014
Profit after taxes1,334939939939
Taxes saved197197197197
Cost of capital800784784860
Gross value39,89230,86630,86628,118
less: debt13,66013,66013,66013,660
plus: surplus cash2,1482,14800
Installed value28,38019,35417,20614,458
per share (p)2,9932,0411,8141,525
% share price232158141118
Source: S&P Capital IQ   


At Imperial, weighted-average operating profits of £2.6bn feed through to £1.68bn of ‘Nopat’. That’s an acronym for ‘net operating profit after tax’, a contrived item extracted from the accounts. Nevertheless, it’s important since it quantifies the amount of accounting profit net of tax that would be available for all the providers of a company’s capital – both debt and equity – if the tax benefit of using debt were stripped away and all providers of capital were put on the same footing.

The merit of nopat is twofold. First, it is a marker for judging whether a group is truly profitable; that is, whether nopat exceeds the cost of capital (another estimated figure). Second, it provides the basis for estimating a group’s gross value since it is the numerator that is grossed up by the cost of capital. With its capital biased towards cheap debt, Imperial’s estimated cost of capital comes out at 4.2 per cent, which is the weighted average of equity at 8.5 per cent and debt at 2.6 per cent.

Capitalise Imperial’s £1.68bn of nopat at a rate of 4.2 per cent and that generates gross value of almost £40bn. Since we want to know what’s left over for shareholders, deduct the group’s £13.7bn debt and add on its £2.1bn of surplus cash. What remains is just over £28bn of ‘installed value’ for shareholders; ‘installed’ since it is an estimate of the annuity value of what’s already in place. That works out at almost £30 per share. If Covid-19 hadn’t come along, at their current 1,290p the shares would be stinking cheap.

Except it did. So let’s make the adjustments; the first is shown under Table 1’s column headed ‘New world’. Values in this column are driven by stripping out the most recent year’s operating profit. Instead of estimating base-level profit as the weighted average of the past five, it uses the simple average of the five while taking the most recent year as zero (Table 2 spells this out). Sure, we could have tweaked the figures differently and readers can make their own choice about a profit base (or use several); it is all part of the estimating process.


Table 2: Imperial's trading profits
£mWeighted aveSimple ave
Year -12,7750
Source: S&P Capital IQ 


Despite lower profits, taxes saved remain the same because this amount is a function of interest paid and the tax rate, which don’t change. The cost of capital shades down because lower profit means slightly less equity employed, but that’s a technicality. The result is that with ‘New world’ profits stretching into the future, Imperial would be worth 2,041p per share – still well clear of the share price.

Next, we strip out the group’s surplus cash. That’s estimated on the logic that a company only needs the cash necessary to sustain day-to-day business, so the rest is surplus and belongs to shareholders. For Imperial, the most recent amount is over £2bn. Post Covid-19, however, the assumption is that all of it will have been exhausted. True, for many it won’t be that bad. But, since we are being cautious, it’s sensible to erase the lot and see what’s left. For Imperial, that’s plenty – value of 1,814p per share is still 140 per cent of the share price.

Last, but important, we need to factor in the extra risk of holding equities in the new world. To do that, we raise the so-called ‘equity risk premium’. Granted, we could have accounted for all the adjustments we have made just by raising the risk premium since, in theory, it bundles up all the risks that come with holding equities – the unknown ones as well as those known. And the final stage is to account for what we can’t know, including lower growth, via the risk premium.

There are formal ways to estimate the premium, but we’re not bothering with those here. Bearbull starts with a high risk premium, which feeds through to a cost of equity of 8.5 per cent. How much further should it go? That’s another way of asking, what return do I want to persuade me to put my capital into equities?

In Table 1, the result is shown by raising Imperial’s cost of equity to 10 per cent. That feeds through to an overall cost of capital up from 4.2 per cent to 4.6 per cent. It’s enough to cut the value down to 1,525p per share, although that’s still more than Imperial’s depressed share price.

Naturally, however, there is more than one way to skin the cat. Estimating values based on smoothed accounting profits is fine since it points to stable underlying figures. The alternative is to extract value from a group’s cash-flow statement. The merit of this approach is that it can coax out value that may be created in the future. It does this by focusing on capital spending in excess of what’s needed to maintain the infrastructure already in place. The result is a more volatile estimate of value, but it may be more useful because it rewards companies that are likely to grow profitably.

As with the accounting model, the cash-flow version starts with the weighted average of the past five years; in this case, the average is of free cash flow (the cash left over for shareholders after all dues are paid). That amount is simply capitalised at the cost of equity, much as we did earlier.

The clever, but tentative, bit is to estimate how much of a group’s capital spending (capex) is for new projects and how much value they will create. The incremental capex is simply a group’s capital spending in excess of its charge for depreciation and amortisation. The value created is based on a complex formula that rewards companies for generating a high return on equity (RoE) and for growing capex quickly. It also penalises those where RoE is low, where RoE is likely to decline and growth in capex is likely to slow.

True, such an exercise is glorified guesswork, but it’s often instructive. For JD Wetherspoon, the results are shown in Table 3. In the ‘Old normal’ average free cash flow of 62.4p generates 735p per share of installed value. Meanwhile, average incremental capex of 14.8p yields 560p of so-called ‘franchise value’ (‘franchise’ because the extra value owes its creation to the group’s strengths). Chiefly, this stems from Wetherspoon’s high RoE. True, that guesstimate places too much importance on the inestimable future. Even so – and for what it’s worth – it puts total value at 1,294p per share, twice the share price.


Table 3: Wetherspoon's cash-flow value
pence per shareOld normalNew worldRaised risk premium
Free cash from assets in place (p) 62.456.256.2
Cost of equity (%)8.508.5010.00
Incremental cap-ex (p)
Return on incremental cap-ex (%)14.814.812.0
Fade rate (% pa)6.0%6.0%6.0%
Growth rate incremental cap-ex (%)2.0%2.0%2.0%
Installed value (p) 735661562
Franchise value (p)56025468
Total value (p)1,294914630
Source: S&P Capital IQ   


In the ‘New world’, free cash flow is estimated in the same way as the accounting model – it is the simple average of the past five years with the most recent year restated to zero. As a result, installed value drops 10 per cent to 661p per share. Since lower profits imply less incremental capex, there is a big hit to franchise value. But that also means the new-world value shows a realistic balance between value being created by what’s already up and running and what could be put in place. And total value of 914p per share is still well clear of the share price.

Raise the risk premium to 10 per cent and installed value falls to 562p per share. Also, by implication, lower profit means a lower RoE, which hammers franchise value since this figure is very sensitive to changes in its variables. The result is total value that’s close to Wetherspoon’s share price.

But that’s okay. This whole exercise is designed to give us a formula to adjust to the world that is to come; to change our thinking, but in a simple and sensible way. While the outlook remains wild, that's all we can expect.