Yesterday's dog, tomorrow's darling

In the first instalment of this value investing series back in issue 197/Apr 06, we noted that ‘for some, [value investing is] all about buying shares on low PERs; for others it’s about buying tangible assets for less than their book value; while still others claim that a stock like Cochlear can offer value, despite a PER of 36 and a price to tangible book value of 9’. This prompted us to ask: ‘What’s the theory that can tie up all these loose ends?’ Now, in the eighth instalment, we’re finally going to attempt to answer that question.

The short answer is that value investing isn’t about buying stocks on any particular PER or any particular price-to-book ratio, it’s just about buying stocks for less than they’re intrinsically worth, and PERs, price-to-book ratios, and all the other measures are just tools to help us find them. As we explain in this issue’s cover story, the idea is not to come up with a precise valuation for every stock on the market; we just want some signposts to point us towards a few stocks that we’re confident are priced well below their intrinsic value.

Before we can get started, though, we need to decide what overall rate of return we’re going to target from our investments. For this, history is as good a starting point as any, and it shows that, over the whole of the 20th Century, Australian shares made an average return of 7.5% per year after inflation (a figure you can find on the consumer section of the ASIC website). We don’t think it’s unreasonable to expect something similar in future.

With inflation currently trotting along at about 3% a year, and expected to carry on that way judging by government bond yields, that gives us a target of 10.5%, but we’ll round it off to 10% to keep things simple. Of course, we’ll actually be hoping to do a bit better than this, by buying undervalued stocks, but this serves as our estimate of what we can generally expect the average stock to achieve.

On this basis, all other things being equal, we’d be looking for an earnings yield from a share investment of 10% or more, and that translates (by dividing 1 by the yield) into a PER of 10 or below (as we saw in issue 202/Jun 06). Alternatively, as we saw last issue, we’d be aiming for a stock’s dividend yield plus its rate of dividend growth to add up to 10% or more. We’d then aim to check these figures off against a company’s cash flow.

Scratching a little deeper

Let’s look at one of our current outright Buy recommendations, Flight Centre (last reviewed  in issue 200/May 06 (Buy—$9.71)), as an example. Its 2004–05 earnings per share were 71.9 cents, giving it a PER of 15. At first sight that’s pretty unappealing, but if we scratch a little deeper things don’t look so bad. First of all, 2004–05 was a bit of a hiccup for Flight Centre, with net profit falling 17% mainly because the company missed the important ‘override’ commissions that it aims to get from airlines for hitting certain sales targets. If the company were to hit these targets, as it typically does, earnings would recover and the PER would come down a few notches.

Flight Centre also tends to make excellent returns on its capital and, as we saw in issue 202 , that increases the PER we’d be prepared to pay. There’s more about measuring this in the Investor’s College of issue 170/Mar 05, but a basic approach is to divide a company’s net profit by its net assets, to give a figure known as ‘return on equity’. Flight Centre scored a creditable 18% on this measure even in the disappointing 2004–05 year and, looking back over the past five years, it has averaged 23%, which is excellent.

So the PER of 15 doesn’t look so bad after all. What about the dividend yield? At 4.7%, we’d need the dividend to grow at 5.3% over the long term to get us up to our targeted return. As we saw last issue, though, while the dividend scores highly for simplicity, it’s just a number chosen by the directors and it could be that the company is capable of paying out more (or less) than it does currently.

Cash is king

We can see which is more likely by looking at the cash flow. The most useful proxy for dividends is free cash flow. This represents the cash left over after a company’s done all its investing for the future and is typically calculated as the operating cash flow less capital expenditure (see the Investor’s College of issue 171/Mar 05 for more on this).

Flight Centre’s operating cash flow was $118m in 2004–05 and net capital expenditure was $49m, so we get free cash flow of $69m, which gives a yield of 6.7% on the company’s total market capitalisation of $1,025m. But again, that’s based on a bad year’s trading. The average free cash flow for the last three reported years was $94m, which gives us a yield of 9.2%. So we only need growth of 0.8% a year from this figure to reach our 10% target.

Estimating long-term growth rates is where all the subjectivity creeps in. All sorts of factors come into play, including industry dynamics, management competency and so forth. How you see Flight Centre’s long-term growth panning out depends on how you see all these things fitting together—and this is where the margin of safety comes in.

The fact is we just can’t be sure how Flight Centre will do in future (no-one can be). But we do feel comfortable saying it has a very good chance of doing well enough to more than justify its current share price, and that we have a decent margin of safety to protect us if we’re wrong—and that’s as far as we need go.

The major problem with cash flow analysis is that cash flows can be very lumpy, not only because of operating factors, but because of large swings in the money a company is investing for the future. One way to cope with this problem is to deduct a company’s ‘depreciation’, instead of its capital expenditure, from its operating cash flow. Depreciation is the amount charged against profit each year for wear and tear on a company’s assets. So the idea is that it makes a reasonable proxy for the capital expenditure a company needs to make just to stand still.

By deducting depreciation from operating cash flow, you therefore get a figure for a company’s cash flow before, rather than after, investment for the future. As a result, it’s comparable to earnings rather than the dividend and, as we discussed in issue 202, we shouldn’t then add growth to estimate our total return.

For Flight Centre, depreciation is given in note 3 to the 2004–05 accounts as $33m, so our alternative cash flow figure comes out at $85m, which is a yield of 8.3%. Over the past three years, though, it averages out at $113m, which gives a yield of 11%. That’s a bit above our targeted rate of return and, as with earnings, we’d actually settle for a bit less because of the company’s high return on equity.

It’s all a far cry from issue 85/Aug 01 (Sell—$26.91), when we recommended selling Flight Centre (after holding it all the way up from issue 3/Apr 98 (Speculative Buy—$3.00)). When we made that Sell recommendation, Flight Centre was priced at a PER of 51, a dividend yield of 1.0% and a free cash flow yield of 1.9% based on the average free cash flow for the preceding three years.

As we said at the time: ‘What worries us now, and has worried us for the past 18 months, is that there is very little margin for error. Everyone expected it to do wonderfully, which of course it has. We think that if that ever changes, the share price could stall.’ Well that did change and the share price has done more than stall—right down to the point where we think it’s back in bargain territory.

Full circle

Another stock that has come full circle on us is Leighton Holdings. In issue 151/May 04 (Buy—$7.83), we upgraded the stock to an outright Buy after its price had been savaged by news of cost blow-outs at two of its projects. At that point, the stock was on a PER of 15, a dividend yield of 5.6%, and a three-year average free cash flow yield of 9.5%. And all this for a company that had averaged a return on equity of 20% over the previous three years. We explained in the review why we thought the problems could be overcome, and we felt, in any case, that we were being given a huge margin of safety in case there were more skeletons in the closet.

As it happens, the closet was empty and the market celebrated by sending the stock into the stratosphere. In issue 195/Mar 06 (Sell—$17.70), it finally became too much for us and, with a PER of 24, a dividend yield of 2.8% and a three-year average free cash flow yield of 2.9%, we gave in. The margin of safety had disappeared and this is an industry where you certainly need one. Of course the margin of safety is even less now as the stock has kept going up, to $18.66 at the last count, but that doesn’t bother us in the slightest. We’re not trying to be invested in every stock that goes up—we’re just trying to find a few that offer compelling odds.

Two that might get away from us are the Australian Stock Exchange and SFE Corporation, which we recommended selling in issue 196/Mar 06 (Sell—$33.85 (ASX) and Sell—$17.10 (SFE)). Really fast-growing companies always present a conundrum, because their growth rates seem to be greater than your target rate of return, meaning that any free cash flow at all will make them infinitely valuable. We touched on this problem back in issue 198/Apr 06 and explained that you can’t predict long-term growth for a company greater than your target rate, else that rate of growth (plus the yield) should become your target rate.

The practical answer is that you need to remember that you chose your target rate of return for a reason—it’s what you might reasonably expect stocks to deliver over the long term, including a dividend yield. So the most long-term growth you can conservatively expect from any stock is a little less than your targeted rate of return—but the difference between 2% less and 4% less will double your valuation of a stock.

Volatile valuation

This is no doubt a large part of the reason why value investors are so wary of highly priced fast-growing companies. With more of the valuation coming from the relatively uncertain growth element and less coming from the cash a company is making in the here and now, the valuation can be very volatile. This makes it very hard to get enough margin of safety.

At the current prices of the two stocks, the merged ASX/SFE offers a pro forma free cash flow yield of about 4%, allowing for some cost savings, so we’d need long-term growth of 6% to justify the price. That might seem trivial for stocks that are currently growing at rates of 20–30% a year, but things can turn sour for financial markets very quickly.

Everyone loves SFE now, but only a few years ago it was firmly in the doghouse, with markets subdued and investors fretting about the potential demise of the government bond market. On 5 March 2003, when the company announced its 2002 results, the stock offered a free cash flow yield of 11%. Now that’s a margin of safety.

It’s these risks that make the difference between these stocks and Cochlear, whose extravagant valuation we mentioned in the introduction (and which also involves a free cash flow yield of somewhat less than that of ASX/SFE) and which we’re still happy to rate a Hold.

It’s not so much that we expect more growth from Cochlear over the long term (although we do), but rather that the growth is more predictable (some of the reasons for this are given in our most recent review of the stock in issue 199/May 06 (Hold—$53.25) ).

So while neither Cochlear nor ASX/SFE offer much margin of safety, with Cochlear we’re prepared to settle for less because it’s harder to see what might upset the apple cart. For ASX/SFE, however, the spectre of a major market downturn will always loom large. When that happens, as sooner or later it must, we’ll be ready with our pencils sharpened to see if the stock might represent a bargain.

Disclosure: Staff members, including the author James Carlisle, own shares in Flight Centre.