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The two numbers needed to value shares

When it boils right down, just two bits of data are needed to value almost any asset you care to mention and especially Investors’ Chronicle’s stock in trade, listed securities. If that makes the process sound simple, think how much easier it becomes if one of the figures is so subjective it can be almost any number you like. That leaves just the other number grounded in fact and in need of some analysis.

Still, that’s how it is. Even the most sophisticated valuation exercise that could ever boggle your mind will reduce down to two essentials – the numerator and denominator of a fraction. Divide the numerator by the denominator and there it is – out springs a valuation. The denominator is the ‘easy’ number to obtain. Note the inverted commas, however. They indicate that easy does not mean any number that just happens to meet your requirements.

Let’s link the discussion to reality by reminding ourselves what a denominator does in the valuation process. It drives value in effect by answering the question: if I start with £x, which is the numerator, then how much value might I end up with? I can produce any valuation I want if I choose a silly denominator.

In the exercise that produces per-share valuations for DIY retailer Topps Tiles (TPT) shown in Table 1, the denominator is 8.5, which, hopefully, is a sensible number. Actually, for the values shown in the column headed ‘Operating profit’, the denominator is a bit more subtle, but we need not worry about that. Instead, focus on the column for free cash flow valuation and, in particular, the £11.0m, which is the retailer’s weighted average cash flow for the past five years adjusted by removing the effects of one very odd year. Think of that £11m as an annuity. So what would I pay if I wanted it to provide an 8.5 per cent return on my investment? Answer – £129m or 66p per share.

Table 1: Subjective value
Topps Tiles (year to end Sept)
£mOperating profitFree cash flow
2021-13.922.1
20208.744.4
201919.914.1
201824.216.9
201726.75.0
Weighted average (£m) 
Unadjusted6.724.6
Adjusted11.311.0
Denominator (%)see text8.5
Value per share (p)  
Unadjusted30149
Adjusted7966
Share price6262
Source: FactSet, Investors' Chronicle

Why 8.5? Because, in percentage terms, I reckon that, on average, 8.5 is what I should make each year given the asset class – mostly UK equities – in which the Bearbull Income Fund is investing. Sure, there will be a wide variation around that average, but, roughly speaking, that’s the number it will come down to. Give or take, it is the total return produced by UK equities over the very long haul and I don’t imagine the income fund will stray far from it; though, over its 22 years, its average annual return is 9.9 per cent.

It does not matter whether that 8.5 per cent return is supplied exclusively by income received, by capital gains or any combination of the two. That said, the greater the confidence the investment will easily hit that target, the greater the inclination to pay more thus, actually, lowering the target return.

This, if you like, is the paradox of value – that the more we expect value in the future to materialise, the more we are willing to surrender value in the present by paying higher prices and the less likely it becomes that the sought-after returns will actually be achieved. Thus it makes all the more sense to ground the denominator in reality and to mess with it as little as possible.

If the other figure in the fraction – the top line, the numerator – is the more difficult that’s because it is supposed to be an estimate of a real amount of money; it is, after all, the annuity that’s going to be paid. Ideally, it should be found in a company’s future performance since it can never be paid from past profits (they have gone), only from future ones.

However, for the purposes of modelling value, estimating the future can be hit and miss. So it is often better to get an idea of the profit a company may be capable of producing on average and, for that, it is okay to turn to the recent past. Thus Table 1 takes the past five years operating profit and free cash flow for Topps Tiles and shows their weighted average where the most recent year gets the heaviest weighting in a sum-of-the-years calculation and the most distant year the lightest.

For Topps, even this produces some odd weighted averages. The effects of Covid-19 hammered the group’s operating profit in 2019-20 and, especially, 2020-21. But it brought big benefits to cash-flow generation in 2019-20 as Topps’ bosses devoted much effort to cash preservation. As a result, the weighted average operating profit is just £6.7m, surely an untypically bad indicator of the group’s profit-generating capacity. Weighted average cash flow shows the opposite effect and, at £24.6m, exaggerates the group’s ability.

One response is to say “okay, we’ll live with that because the future will produce some odds years too”. True, but it hardly helps get a handle on what needs to be a reliable figure for underlying value; one that can be usefully juxtaposed to the volatile take on value that is the manic way the stock market goes about things.

A quick-and-easy solution is to count as zero the offending year in each method – the £13.9m operating loss in 2020-21 and the £44m cash inflow in 2019-20 (see table). Do this and the valuation numerators become very similar. Proceeding down different routes, they produce values that are sensibly close together – 79p per share by grossing up operating profit, 66p via the cash-flow method – and, happily, both indicate the shares are on the cheap side.

So let’s recall the purpose of this exercise; first, to throw some light on the thought processes that go into share valuation and, second, to find a new holding or two for the Bearbull fund. One new holding, however, is a must since the fund needs to invest the cash raised from December’s takeover of drinks distributor Stock Spirits.

Topps Tiles would fill the gap. It has been in the fund before and was only sold in mid-2020 because the Covid-19 response forced the suspension of its dividend. The payout has been revived, dividend cover looks comfortable (see Table 2) and an update from management earlier this month indicated trading in the final quarter of 2021 was decent. Sales volumes were 21 per cent up on two years ago – the most recent period of ‘normal’ trading – while cost pressures and supply-chain blockages produced the stiffest headwinds.

Table 2: Take your pick
 Price (p)% 5-yr highCh on 6 mths (%)Est'd value (p)Value/price52-week betaPrice volatility (%)Mkt Cap (£m)PE ratio*Div yield (%)*Pay-out ratio (%)*Profit margin (%)†Return on cap (%)†
Tate & Lyle71587-36500.90.6223,42117.63.35710.514.0
Topps Tiles6258-9see textna0.14412210.54.8506.223.3
Devro21286-22401.10.34636012.24.45316.916.0
Severfield6972-12640.90.1182139.34.5427.011.1
Royal Dutch Shell1,75362311,7501.01.531138,47110.03.7375.56.7
Johnson Matthey1,86448-392,7001.41.1373,7668.94.0364.313.9
Kingfisher32684-133551.10.8356,7469.13.7346.39.1
*Based on forecast earnings & dividend; † average of past 5 years; Price volatility - 30-day average annualised. Source: FactSet

So shares in Topps would most likely do a job, but the same could be said of sausage-skin maker Devro (DVO) – see last week’s Bearbull – structural-steel engineer Severfield (SFR) and probably DIY retailer Kingfisher (KGF), which occupies a similar commercial space as Topps, though on a far bigger scale.

Arguably the most reliable of these is Severfield, the UK’s biggest structural steel supplier whose current flagship project is the steel for the glamorous Merseyside stadium that will be the new home for Everton FC. Capturing that contract was a big factor behind the 30 per cent leap in the group’s order book to £393m in the first half of 2021-22. Even that elevated figure is still only equivalent to just over one year’s worth of revenue, which may be why Severfield seems to avoid the cash-flow difficulties that can undermine engineering contractors.

Yet its business is far from risk-free. Almost by definition its activities are linked to the construction cycle, which stalls late in the economic cycle, long after consumer sentiment has turned down. Severfield has been through this. For 18 months from late 2007 to early 2009 its share price lost 75 per cent as the effects of the global financial crisis hit. Worse followed, largely of its own making, in 2011 to 2013 as overbidding for contracts led to losses, especially on the Leadenhall Tower project in the City. That mess meant another 75 per cent off the share price and a rescue rights issue. Next time round, better internal discipline may mean it won’t be nearly so bad, but there will be a next time even if it’s still some way off. So do I want to buy shares that already look up with events and which have little in the way of upwards momentum?

Yet among those income-fund candidates in Table 2, only shares in Shell (RDSB) have momentum. Implicitly that’s because the market still hopes Shell will split itself into, as it were, Good Energy and Bad Oil. Just as likely is the prospect that Shell’s bosses will waste the diminishing cash flows from what would have been Bad Oil on overhyped projects in Good Energy. I’ll watch this one further.

Meanwhile, I might have liked to be brave and chosen metals chemistry specialist Johnson Matthey (JMAT), as discussed last week. But there seems no sign yet that sentiment has turned in its favour. I might yet buy Matthey shares as I make further changes to the income fund in the coming weeks, especially as the table shows they are the cheapest of the bunch. For now, though, a holding in Devro – 7,000 shares at 211.5p each – will absorb the fund’s spare cash and let’s hope the sausage-skin maker can bring home some bacon.