Telstra's income appeal

PORTFOLIO POINT: Telstra is a valuable addition to an income-based portfolio, given its stream of fully-franked dividends.

Readers may be wondering as to why various 'value’ investors derive different intrinsic values for listed company securities. One company that has widely divergent valuations is Telstra Corporation Ltd (ASX: TLS).

Today, I take a closer look at TLS and clarify why it is in my income portfolio.

Why some commentators and analysts have got TLS terribly wrong

The use of various inputs into the intrinsic valuation model will have a major effect on the derivation of its value.

The intrinsic valuation of a company assumes that all of the capital, the profit and dividends flow to one owner. When the profit is made it is either retained and reinvested, or distributed as dividends. If a dividend is franked (tax paid) then this is an important benefit to an Australian resident owner and must be considered. For instance, it is of immense value to a zero-tax Australian pension fund.

To derive the intrinsic value per share, I simply divide the intrinsic company value by the number of issued shares.

Background to intrinsic value

Most businesses have both income and growth characteristics. The derivation of the intrinsic value of a company considers both characteristics. Recognising this, the valuation approach has two components that are separated by the payout ratio. The payout ratio is important as it rewards the intrinsic value of businesses that have high normalised return on equity (NROE) and can retain and compound capital at attractive rates. Conversely, it punishes businesses that have low NROE and which retain capital at subpar rates of return.

In simple terms, the intrinsic value of a company is derived from its income value plus its growth value.

Mathematically, the components to intrinsic value are:

1. The income multiple [Equity Multiple = NROE / Required Return]

2. The growth multiple [Equity Multiple = ((NROE^2) / (Required Return^2))]

3. Payout ratio

Income component multiple is multiplied by the payout ratio
Growth component multiple is multiplied by 1 - the payout ratio
The total equity multiple is the addition of the two

(A full report on 'Demystifying Intrinsic Value – A Step by Step Analysis’ is available on Clime's website. Research provided by MyClime).

In TLS’s case, there has been little profit growth recently and market consensus suggests that growth will be in the low single digits for the next two to three years – but it is still growth.

As TLS pays out virtually all of its earnings in dividends (i.e. 100% payout), to derive its value it makes sense to focus primarily on its income value. Telstra currently has very low projected growth returns from the reinvestment of profit.

The Income Value of TLS

The income part of the intrinsic valuation suggests that if the returns generated by a company’s equity are greater than the investor’s required return, the investor will value the company at a multiple of its equity.

The valuation is dynamic as it is directly affected by the alternative market returns available in credit and bond markets. The sharp move down in the yield of Australian government bonds results in a lower risk-free rate of return and increases the value of quality income-generating securities. That is where TLS sits.

Key inputs for valuation

Consensus forecast profit for TLS in 2011/12 is $3.55 billion, and $3.65 billion in 2012/13. Dividends to be paid (director forecasts) are $3.5 billion (franked) in both years, so little is retained.

To derive the intrinsic value (IV), we must understand the inputs. So let’s consider them carefully.
1. “Normalised Returns on Equity (NROE)” refers to the earnings accruing to the owner, adjusted for tax credits distributed and divided by shareholders’ equity. The normalisation is critically important and particularly so for Telstra, as its earnings are fully paid out as franked dividends. Therefore, its return on equity of 31% (after tax) becomes 45% when the tax paid is credited to shareholders through the payment of dividends.
2. “Required Return (RR)” is the pre-tax required return for an investor based on the assessment of risk of the underlying investment asset. It is important to understand that this RR is different for an investor in a company’s debt compared to its equity. This is because an investor seeking income rather than growth may accept a lower return, because he doesn’t seek capital gain.
3. “Shareholders’ Equity (E)” is the declared equity in the company’s audited balance sheet.

The key inputs for TLS based on 2012 forecast consensus earnings are as follows:

• Shareholders’ equity is $11.6 billion (90 cents per share)
• Forecast reported profit is $3.5 billion (29 cents in earnings per share)
• NROE is $4.96 billion because the $3.5 billion of dividends is fully-franked to owners and includes a $1.46 billion tax credit. The 29 cents earnings becomes 41 cents per share normalised. 41c/90c is a NROE of 45%.
• The RR for Telstra as an income security or bond is between 10% (low) and 12% (high).

Intrinsic Value at 10% is 45/10 X 90 equals $4.05
Intrinsic Value at 12% is 45/12 X 90 equals $3.38

Midpoint valuation for an income investor is $3.72 and at this value, a pre-tax yield of 11% is generated assuming earnings and dividends are maintained.

Conclusion

The above analysis shows why it is important to understand the inputs into intrinsic valuation. In Telstra’s case, any failure to normalise the returns to the owners by ignoring franking credits is a serious flaw in determining the valuation. Such a mistake has led to erroneous valuations and assessments of the value of TLS as a company that produces a steady stream of franked income to its owners.

More importantly, the required return (RR) of an investment is always stated on a pre-tax basis because different investors have different tax rates. Noteworthy is that the burgeoning “pension phase” investor in SMSF pays no tax and franking is rebated in cash.

From an income perspective, TLS fits nicely into my income portfolio and this is reinforced when you note that the current yields on Australian government bonds are historically low, with three-year bonds at 2.7% and five-year bonds at 2.8%.

Thus, at the current market price of TLS ($3.64), a pension fund over three years would receive about 93 cents more income cash flow than it would receive from a three-year bond. The market is rightly reassessing the value of Telstra and suggesting that this difference is too high.

TLS to a three-year bond

• Assume $3.64 outlay
• TLS $1.23 cash in (pre tax) compared to 29.5 cents (pre tax) cash in from the bond

The Portfolio

-Hybrids/Pseudo Debt Securities
Company	ASX	Market Price ($)	Margin over BBSW (%)	Running Yield (%)	Franking (%)	Total Return (%)
ANZ Note	ANZHA	100.91	2.75	6.44	0	0.04
Multiplex SITES	MXUPA	78	3.90	9.81	0	1.96
Australand ASSETS	AAZPB	93.43	4.80	9.15	0	1.55
Macquarie Group Floating Rate Note	MBLHB	67.10	1.70	8.12	0	0.15
NAB Floating Rate Note	NABHA	72.90	1.25	6.86	0	-1.06
Seven Group TELYS4	SVWPA	83.50	4.75	10.16	100	-0.69
Woolworths Notes II	WOWHC	103.90	3.25	6.74	0	0.70
Ramsay Health Care CARES	RHCPA	101.72	4.85	8.43	100	-0.03

-High-Yielding Equities
Company	ASX	Market Price ($)	Dividend ($)	GUDY (%)	Franking (%)	Total Return (%)
Telstra Corp	TLS	3.64	0.28	10.99	100	3.7
Ardent Leisure Group	AAD	1.34	0.12	8.96	0	8.06
Commonwealth Bank	CBA	51.90	3.29	9.06	100	0.46
Westpac Banking Corp	WBC	22.90	1.56	9.73	100	1.01
			Average	8.70	Weighted	1.32
			Yield		Portfolio Return

*Total return is inclusive of distributions accrued on SVWPA & WOWHC securities, having gone ex-interest over the past fortnight.
*Weighted portfolio return is rounded up to nearest two decimal places.

Clime offers individually managed account services to sophisticated investors with an emphasis on highly profitable and high-yielding businesses that pay 100% franked dividends to investors. Click here if you are interested in an income generation portfolio or free trial to MyClime, our online stock valuation & research platform.

Please note: Model portfolios only provide general information and does not take into account the investment objectives, financial situation and advisory needs of any particular person nor does the information provided constitute investment or personal advice. Under no circumstances should investments be based solely on the information herein as they are of a general nature.