Discount deals

It has never been harder to work out how much to pay for shares. On the one hand, there is vast uncertainty for many sectors of the global economy, which brings dangers for established industries and opportunities for disruptors. On the other, low bond yields are encouraging stockpickers to demand less than they used to for taking risks.

The required returns implied by share prices are based on the market’s assessment of the present value of the future profits and cash flows companies will generate. The problem is, up to two-thirds of equity market valuation is based on long-term assumptions, which is most difficult to forecast accurately. Add to that the fact short-term earnings growth trends and dividend policies have been distorted by the impact of Covid-19 and the job of assessing fair value becomes immensely difficult.

Such uncertainty ought to worry asset markets, but central banks have kept a lid on volatility with ultra-low interest rates and asset buying programmes to buoy prices on a tide of easy money. But in 2021 the resurgence of inflation has become a significant fly in the ointment, which puts upward pressure on interest rates. It is another big factor to weigh up when wondering whether to buy expensive shares.

Successful investors must understand what the share price is telling them about estimates for a company’s short-term and long-term future; and whether good compensation is implied for the unknowns.

That’s easier said than done, of course, but three different approaches to investment can help us start to assess the discount rates on offer from a wide array of companies.

The market according to Garp

Plenty of financial commentary is dedicated to which ‘style’ of investing is in vogue and expected to outperform. This mood music is important. But a better point of departure for equity investors is to look for signs of profits heading in the right direction and share prices fairly reflecting the pace of uplift. Growth at a reasonable price (Garp) investing is something of a splice between growth and value and is a principle that underpins the philosophy of some celebrated investors.

This group included American fund manager John Neff, who is widely credited as one of the people who popularised the price/earnings growth (PEG) ratio. The PEG ratio doesn’t help get into the nuances of how long-run expectations are built into valuations, but Garp investing is a useful starting point.

Neff was focused on total returns and not paying too much for steadily growing companies. With an emphasis on quality, he used to screen out the very cheapest and most expensive stocks based on the price/earnings (PE) ratio. Then he divided this figure by a combination of the dividend yield and the forecast growth rate of earnings based on consensus estimates. Alongside checks that this growth was underpinned by rising sales and not financial engineering, this formed the basis of his stock selection.

Aping elements of Neff’s methods reveals companies that aren’t expensive relative to the profit growth being forecast. Removing some of his filters also leaves scope to flag shares that might whet the appetite of investors interested in riskier high-growth plays. 

The model used to flag companies here isn’t therefore a Neff screen, but it is loosely based on his methodology.

Shares included in the FTSE All-Share Index were given a combined ranking based on their cheapness on two versions of the PEG ratio. The first looked at a three-year forward PE multiple, divided by only forward earnings growth and expected dividends for the next three financial years (growth to end of current year and two years subsequent). The second also allowed in the denominator for the compound annual growth rate (CAGR) of earnings over the previous five years.

Other filters weren’t applied but to help guide interpretation it was calculated which shares sat between the 25th and 75th percentile of expensiveness based on forward PE ratios. Forecast growth in sales and free cash flow were viewed to help decide which companies would be worth investigating further. Recent share price momentum was also considered.

Pandemic distortions on short-term growth

Screens are always best used as a guide to which questions to ask, not as solutions in their own right and there are multiple drawbacks to using PEG ratios given the Covid-19 disruptions. As well as the longer-term PEGs, the model calculated and looked at (but didn’t rely on) PEGs over one and two years. The profit growth for many companies over these time horizons is inflated by the opening-up rebound.

Furthermore, it goes without saying that opening up forecasts depend on the worst of the pandemic and lockdowns being behind us. Setbacks would be devastating for many companies, a massive risk investors should heed if they choose to set store by these numbers. 

Even the longer-term version of PEG used in the rankings (which in the denominator split the past five years’ earnings growth rate with that of forecasts over three years to try to even things out) might easily miscalculate for the current operating environment. On the flipside, a reason not to screen out companies that are too cheap relative to forecast earnings is to avoid missing potential special situations.

The purpose here, however, is not to pick shares to buy; it is to flag interesting or widely held companies that might look reasonably priced, but require further investigation. From the top quartile of supposedly best value shares, the three here have been selected as examples to question a one-size-fits-all approach to valuation. 

With this sample established, the next stage is to look at the implied returns on offer. The principle to keep in mind is that to be deemed fair value, share prices must suggest reasonable scope for upside.

Theoretically, investors’ implied rate of return is also the cost of equity finance for the company. This figure, along with the cost of borrowing, makes up a firm’s cost of capital, an important factor in the future prospects of a business. Therefore, an estimate of what cost of equity ought to be is often part of computing the growth prospects for a company.

One of the world’s leading experts on equity valuation decides the input value for cost of equity from a share’s beta (a measure of price sensitivity to movements of the whole market) and the market risk premium (I applied the long-run equity premium for the UK from SocGen) for shares. Focusing on what companies are intrinsically worth, Professor Aswath Damodaran of Stern University New York has a series of models for companies in a variety of circumstances.

The best way to calculate whether a share is undervalued, fairly priced or ought to be cheaper differs depending on the type of business and industry.  

The bank

Barclays (BARC) ranked 27th out of FTSE All-Share companies on the blend of PEG ratios used in our model. Earnings forecasts for the current financial year predict a huge uplift on 2020, thanks to the release of pandemic-linked bad debt provisions. But the growth rate for earnings based on consensus estimates between the end of 2021 and 2023 is sobering, as it shows a 7 per cent rate of decline.

These predictions could change, but if cost of equity estimates prove accurate, any enthusiasm value investors have could be dampened. Barclays’ long-run cost of equity comes out at around 8 per cent. That figure isn’t unusually high but when you consider Barclays’ return on equity (ROE) has only averaged 2.8 per cent over the past five years, it hardly suggests the shares are undervalued.

Given banks still operate with greater restrictions post-Lehman and that net interest income is inhibited by low central bank target rates, it seems unlikely their ROE will rise significantly. If the ratio of a bank’s return on equity to its cost of equity is below one, then the ratio of its share price to net asset value (NAV) should also be below one for the shares to be considered reasonable value.

Consensus estimates for Barclays’ ROE in FactSet fall some way short of 8 per cent in each of the next few years. The model Damodaran recommends for financial services looks at earnings growth rates, dividend payout ratios and ROE trends to compute a figure. A lot of choice is left up to the person inputting data, but conservative treatment of growth rates reinforces the impression that 8 per cent ROE is unrealistic.

Another important input in Damodaran’s models is the dividend per share (DPS). For banks, that figure was suppressed in the pandemic and before, thanks to having to prioritise capital reserve requirements after the global financial crisis. So, although payout predictions work from a very low base, these could cause investors to assume there may be reason the share price could rerate higher if income prospects improve.

It seems reasonable to focus on ROE getting better before assuming any dividend growth could be maintained.

The oil major

Dividends are an important component of total returns and therefore of valuation. Many models are derived from dividend discount methods, which work out the discount rate that must be applied to future dividends, so that the sum of them equals the current share price.

The most famous of these is the Gordon growth model, named after the late American economist Myron Gordon. This assumes a constant growth rate in the economy and for dividends, so it has its drawbacks.

While economic growth rates can be smoothed out and are valid inputs, the real world fact that dividends can be axed or that payout policies may change means the base assumption of the Gordon model is unreliable. An alternative is to focus on free cash flow (FCF) returns to equity, which accounts for debt and capital expenditure. Again, these can change, but for valuing a company with high capital expenditure requirements and interest costs it seems appropriate.

Oil companies are tricky due to their historic commitment to paying dividends and fall into the category of high debt and capex. When Royal Dutch Shell (RDSB) cut its dividend in the pandemic it was a watershed moment and although payouts will remain a hugely important part of energy companies’ returns, this is an industry in transition.

The world is facing up to a need to decarbonise, which means energy behemoths must adapt or die, a conundrum that suggests capex will have to be prioritised over dividends. Therefore, a constant dividend growth model seems inappropriate for valuation. Fortunately, Damodaran offers a model on his website that reconciles the dividend discount and FCF to equity valuation approaches.

Using a beta-led estimate, Shell’s cost of equity comes out at around 10 per cent, which demonstrates the shares should offer investors a fat incentive to back the company. But making good on such a promise is more difficult. Considering that debt finance will probably become more expensive with upward pressure on interest rates and that fossil fuel producers are increasingly charged a climate risk premium by environmental, social and governance (ESG)-conscious investors, then Shell’s cost of capital is set to remain high. This is likely to drag on its earnings potential.

Again, the Damodaran model used gives plenty of scope to make your own assumptions, which means there is room for conjecture. Still, there are some noteworthy observations to be made when a pessimistic approach is taken. For example, one might decide that the old payout ratio was unsustainable and make a conservative forecast or that the terminal growth rate assumed for earnings must be lower to account for a decline in demand for fossil fuels. 

If such allowances are made in the valuation model then the output can show that, far from being cheap, if investors require 10 per cent annualised returns, Shell is expensive. 

The growth industry player

Dividend-paying companies in industries with good growth prospects are easier to value using the simpler Gordon growth model. Its core assumption that the present value of future dividends should equal a fair share price neatly enables calculation of the required rate of return from a share price, dividend per share and forecast dividend growth rate.  

Using this method to value payments business PayPoint (PAY), it still looks attractive. Dividends were affected by the pandemic and have since recovered somewhat, but for a sensible long-term growth rate it is best to use the 5 per cent uplift forecast between the end of the current and the next financial year.

Applying that to today’s share price and last year’s dividend per share isn’t strictly correct but gives a rough estimate of just under 10 per cent for the cost of equity.

For a payments business, the threats include competition, disruption and careful consideration of the post-pandemic retail environment. Still, the payments industry has secular tailwinds rather than headwinds, so to have the idiosyncratic risks an operator faces reflected in the price makes taking on those risks more acceptable for investors prepared to do more groundwork on the company.

Market premiums and rewarding uncertainty

Realising that some shares are cheap for a reason is a simple concept to grasp. Knowing that some companies can be poor value even if they are priced cheaply relative to the growth they promise takes things a step further. It’s also important given the dearth of quality currently available at a reasonable price on the UK market, despite its apparent cheapness.

The equity risk premium (ERP) implied for UK shares was above its long-run average of 5.6 per cent when Société Générale (SocGen) last carried out its regular valuation analysis at the end of July, with the implied return for shares 6 per cent above the yield on 10-year gilts. Since then, government bonds have become pricier, pushing down yields further.

Comparing some of the cheaper individual companies to a cheap market, it must be tempting for value investors to rub their hands at the possibilities for reratings. That said, the SocGen team who compute the risk premium acknowledges that roughly two-thirds of the implied return from equities is based on estimated long-run growth rates.

Investors must keep that in mind, especially as the world faces some paradigm shifts over the next few years: how the rise of China will affect western asset markets; a fundamental rethink of taxation and government spending; and most importantly of all, the changes needed to become environmentally sustainable.  

The part of valuation models that has always been assumed may need to be assessed as more volatile and certainly not constant as it has been. For individual shares, the question must be not only, “does this company offer me an attractive price for profit growth?”, but also “what are the reasons it has to?” and ultimately, “is that a good deal to overcome those risks and make good on the promise of the return”?