Why Valuation Matters!

By
Andrew Clifford,
User

Andrew co-founded Platinum in 1994 as the Deputy Chief Investment Officer, having worked alongside Kerr for several years at Bankers Trust and perfecting the craft of.. More

31 Dec 2011

With shares having lost investors money over the last five years (and even 10 years depending on the market), together with the apparent dire state of the world economy today, many investors are asking “why should they invest in the stock market?”

Especially so, when you can still receive 5% on a term deposit, and one needn’t put up with the day-to-day gyrations of the market.  The answer is that valuations of stocks are attractive and are therefore likely to give better returns than other investments.

The table below shows the earnings yield for the world’s major stock markets. For more on what these earnings yields mean to a share investor, please read the second section of this
article.

Stock Market Earnings Yields (excluding Financial Stocks)​

Region

Earnings Yield     

Price-to-Earnings Multiple

USA 6.4% 15.6x
Europe 8.4% 11.9x
Japan 7.8% 12.8x
Asia ex Japan      7.9% 12.7x

Source: Factset

By comparison with the last 20 years or so, these earnings yields are attractive. They were higher in 2008 when investor concerns were most elevated but are now similar to where the market has traded in past recessions such as in the early nineties or in Asia during the 1997-98 crisis. Going back further in history, the earnings yield offered by shares has been higher but this was associated with elevated levels of inflation and commensurately higher interest rates in general.

One might respond to this observation by pointing out that the general economic propsects have never looked this poor, and investors should be getting higher yields to compensate for the risk of owning shares today. We wouldn’t argue strongly against that point of view. However, there is a complex interplay at work involving the emerging industrial nations and the way all governments respond to the new set of challenges. We prefer to move from the general to the particular and are able to identify specific opportunities at the individual company level. Our portfolios own many strong and growing businesses trading at earnings yields that are highly attractive. BMW trades on a current earnings yield of almost 14%, Microsoft over 10%, Samsung Electronics 10%, China Mobile 9%, and Royal Dutch Shell 12%, to name just a few. Each of these businesses will face challenges in the current economic environment but our assessment is that they are well-placed to grow their businesses over the next five years or so. In addition, we have made investments in companies that are suffering as a direct result of the current environment and are trading at distressed valuations that means we are buying them well-below replacement (or book) value. Included in this category would be some of our financial holdings such as Bank of America and Allianz Insurance. On any given company we will clearly make errors, but with a portfolio of companies on starting valuations such as these, it is difficult to see how they will not provide investors with good returns over the next three to five years.

Earnings Yields, Price-Earnings Multiples, and Returns from Owning Shares

It is worth taking a moment to consider the issue of valuation and investment returns. With some investments, the return is a fairly straightforward matter. For example, a bank term deposit offering 5% pa will return to the investor 5%, providing the deposit is held for the full period (and assuming the bank doesn’t default!). A 10 year  government bond yielding 3.75% will provide that return, again assuming the bond is held for the 10 year period.

However, when it comes to shares (and property for that matter) the story is quite different. Many investors tend to think in terms of dividend yields on shares (the part of the return many of us are more comfortable thinking about as it has a similarity to an interest rate) and potential ‘capital gains’ (or losses). The problem with this thinking is that it is disconnected from what one is actually buying when one invests in a share, which is a claim on the underlying profits of a company’s business.

Consider the following simplistic example. A company has invested $50 million in the various assets of its business (plant and equipment, inventory etc) and in the current year will earn profits of $10 million. The business is growing at 10% pa so the company needs to invest an additional $5 million (i.e. 10% of the $50 million in assets) to support this growth and can distribute the remaining $5 million of the profits as dividends. There are 100 million shares on issue which are listed on the stock market and are currently trading at $1.20 giving the company a market value of $120 million.

The return from investing in this company can be looked at the following way:

Earnings yield = profits/market value = $10 million/$120 million = 8.3%.

i.e. our $1 invested in this company at the current share price is returning 8.3% in the form of our share of the underlying profits.

Usually this concept is expressed by stock market participants as the inverse i.e. the market value (or price) divided by the profits (or earnings) equals the price earnings multiple. P/E for short! In this case, the P/E of the company is:

Price/Earnings ratio (P/E) = market value/profits = $120 million/$10 million = 12 (or as it would usually be expressed, 12 times).

Part of these earnings may then be paid out as a dividend (dividend yield):

Dividend yield = dividend/market value = $5 million/$120 million = 4.2%.

So in this example, the investor is receiving an initial earnings yield of 8.3%, of which 4.2% is received this year as a dividend.

However, as the business is growing, the earnings yield and the dividend can improve each year. Suppose the business continues to grow at a steady 10% pa rate, five years down the track the profits will be $16.1 million and the dividends $8.1 million. Based on the initial purchase price today, the earnings yield and dividend yield will be 13.4% and 6.8% respectively.

Of course stock prices will move with company’s fortunes, so let’s say that new investors in the shares are still satisfied by an initial earnings yield of 8.3%, the market value will now be 12 times earnings of $16.1 million ($193 million) or $1.93 for each share. So the investor will now have made a capital gain of almost 61% cumulatively over five years (which is actually equal to 10% pa, the company’s growth rate) as well as receiving a dividend that has averaged a little over 5% pa (remember, it started initially at 4.2% and finished at 6.8%).

In this very simplistic example, the return to the investor is determined by the:
1. initial valuation,
2. subsequent performance of the business, and
3. valuation of the company at the end of the period.

Clearly the assessment of a company’s future prospects is a very significant and challenging part of the day-to-day process of investing. Not only do general economic conditions play a part, but issues such as the behaviour of competitors, technological change, government regulation, and of course management decisions, all have a bearing on the future outcomes for a company. Also understanding the future valuation that a company will attract is no simple task as often this can change quite dramatically with changes in growth rates of earnings.

However, the significance of initial valuation, which is relatively easily observed, in total return should not be underplayed. A higher valuation at the time of investment, not only reduces the initial earnings and dividend yield the investor receives, it also reduces the margin of safety. The higher the starting valuation, the greater the risk that a downward ‘re-rating’ (i.e. lower valuation) will overwhelm the company’s growth in earnings. Since 2000, Microsoft’s earnings have increased almost 250%, but its shares have fallen more than 50% as its P/E fell from over 60 times earnings at the start of the period to around 10 times earnings today!

 

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.

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