Saturday, July 07, 2018
Posted by Mainstreet
One of the areas that has caught our attention is the valuation of companies with high Return on Equity (ROE) and low payout ratios.
ROE is a measure of a company’s efficiency in generating profits for shareholders with their level of equity. Our current use of ROE is calculated from Net Income of the company divided by its Equity value. With changes in accounting standards over recent years, we recognise that the current ROE can sometimes be artificially high through activities that reduce Equity. Such actions can include, but not limited to, write-downs, share buybacks and leveraging through debt.
For example, a write-down or share buyback will reduce the level of Equity with Net Income remaining (relatively) constant, leading to an increased ROE as the denominator reduces.
The valuation method that Skaffold uses rewards high ROE companies that re-invest capital. In order to better align the valuation with the returns available, we have decided to cap the return assumed for re-invested capital at 20%. We believe this will more accurately reflect the investment opportunities available to companies and introduce a more conservative safety margin.
This update is aimed to be available in the upcoming week across all the stocks that are covered.
EDIT - Below is more detailed explanation of valuation update
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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