Valuation Update - More Info
Thursday, July 12, 2018
Posted by Mainstreet
There has been some confusion generated by our recent "refinement" to the calculation of Intrinsic Value. We would like to clarify that we are not capping the Return on Equity (ROE) for the existing equity outlook of individual stocks, we are only applying the cap of 20% for re-invested equity.
Basically, the Intrinsic Value calculation of a Company is based on a combination of:
(1) assessing the return on existing equity and future returns plus;
(2) a return based on the level of re-investment that a company makes.
For companies that have a particularly high ROE, this meant that there was an implicit assumption that because a company earned, say a 60% ROE for past investments, that it would be able to earn that same ROE for any future earnings that it re-invests.
As the Safety Margin is directly calculated from the Intrinsic Value, it appeared to us as incongruous that a safety margin should incorporate overly aggressive forecasts - albeit for a minority of stocks.
We spend a lot of time looking at our numbers and valuations. The companies that generate the most significant negative safety margin changes over time tended to be companies that had very high ROE and very low payout ratios, which then either raised payout ratios or reported new numbers with a marginally lower ROE - neither of which is a reason to see a (significantly) lower safety margin.
With our recent refinement, we are trying to ensure that companies with a very high ROE continue to look attractive, but that we don't overstate the level of safety that is published for a minority of stocks. Additionally, we also prefer not to see big changes in safety margin unless there have been big changes in underlying earnings.
The global average ROE is 11.2%* and there are a few reasons behind why we chose a 20% ROE as the maximum for reinvested earnings:
(1) to produce an ROE for re-invested equity consistently, at say, 50% a year, compounding is relatively extreme;
(2) by capping the ROE at double the global market average is still considered to be a strong performance, and;
(3) the general market consensus for a good or high ROE is between 15-20% and we are at this upper end.
We appreciate that all changes have consequences. However, we believe these changes will result in:
(1) greater stability in safety margins going forward and:
(2) the safety margin not being overstated or "inflated" for companies with a high ROE and a low payout ratio.
*Sourced from New York University Stern School of Business, 2018.
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