Tags
blind stock valuation, caning, catalyst, Fair Value, Final Destination, Jewel in the Crown, Owner-Operator, segment/divisional reporting, stock screener, TGISVP
Continued from here. Lord, you’re harsh task-masters..! Erm, thank you, sir!
Let me just post the blind stock figures again, as a reminder:
If I’m aggregating & interpreting people’s comments correctly (thanks again, guys), I calculate the following average valuation multiples:
– A 6.1 P/E ratio
– A 1.0 P/S multiple, for a business with a 27% operating profit margin
– A 3.7 Op. Profit multiple, so EBITDA multiple would obviously be lower
I have to confess I’d peg my fair valuation a lot higher than these averages. Hmm..?! Generally, I tend to find my fair valuations are lower than (or, at most, similar to) the avg. market price/capitalization (as I discovered with TGISVP). I’ve no problem with that – I’m usually looking out for the misunderstood & the outliers, anyway. So what does this all mean, do I need to look in the mirror a little harder..? My other confession – the revenue/operating profit figures are actually from a division (or segment, as you’ll see in UK reporting), rather than the entire company. Now, before you throw your hands up, I’d like to point out:
– Hopefully, you found something else of value in my last post (thks, Richard!) anyway
– Sorry, folks, it was an effective way to conceal the company’s identity!
– In my opinion, focusing in on this division OR the entire company (in light of recent performance & some specific catalysts), I’m confident the market’s significantly under-valuing this stock
– I wanted to use this blind stock valuation challenge as an intro.¹ to a potentially v lucrative stock screening strategy
Hang on, did he say stock screening..? Yes, let’s call it the Jewel in the Crown stock screener. I wouldn’t be too shocked, though – in perhaps typical Wexboy fashion, it’s tedious, cumbersome, time-consuming & decidedly manual! Oh, and you’ll never guess…yes, it involves reading hundreds & thousands of annual reports! Oh, goody…
OK, just having a little fun there – this is a stock search strategy that (I presume) NO stock screener can possibly offer. That’s potentially v exciting – could this throw up a lot of undiscovered gems? Well, yes, and no… As I’ve said before, there’s plenty of ways to find cheap stocks – but identifying a catalyst is probably the real key to better stock selection/returns. This is just as true here, but this strategy may offer a unique/better edge in identifying some dramatically undervalued stocks and/or takeover targets.
Now, there’s nothing magical about this strategy, in fact I realize I’ve used it on occasion over the years. But I’m making a much more concerted effort now to think like a corporate acquirer (and/or an owner-operator) in my valuation analyses. I recommend it! You’ll focus much more on sales, margins, cash-flows and leverage – while adjusted diluted earnings & growth rates, plus P/E & PEG ratios, will tend to matter that much less. The final destination with this approach is to home in on the sales/operating profit performance of each distinct² division/segment (and look at corporate HQ costs, capital structure & taxes separately).
Brute force is the only way to do this, unfortunately, and it can turn into a multi-year juggle of reports, notes & figures. If you want a closer look, breaking it out in Excel can really lend some clarity. And boy, this approach can deliver – what emerges from the mist can really amaze sometimes… Remember, most writedowns, ‘compliance’, interest (/capital structuring), taxes etc. happen at the corporate level. Being able to isolate out each segment can sometimes give you an incredibly different picture of the underlying attractiveness/profitability of a particular division, or the entire company. And that’s what I’m ideally looking for – the Jewel in the Crown! The consistent/high margin division that’s the backbone of the business, and could prove to be a prime acquisition target.
Home in on our blind stock division above – ignore interest, taxes etc. for a minute. It’s a stable business with a consistently high avg. 25% operating profit margin. I see no reason why a larger company wouldn’t pay a 2-3.0 Price/Sales multiple for this business – check that back against avg. market and M&A multiples. That translates to a potential GBP 15.4 to 23.1 mio price tag. To compare, the current market cap. (in round numbers) of this blind stock company is actually:
GBP 3 mio!
Yeah yeah, I know, I’m making a huge leap in perspective there from one valuation to the other, but I hope you see what I’m driving at..? [Interestingly, the company’s market cap. was within that valuation range some years back]. Run with me a little on this – have you ever wondered why larger companies often seem to pay up for small acquisitions? It’s easy, they’re not looking at the same picture as you! Let’s take a look at an example:
So, what kind of valuation do you think investors would put on this company..?!
Sure, it’s got GBP 18 mio in revenues, but considering interest coverage & net income, I’d expect the market cap. to be probably marked down severely. Far lower perhaps than the value an acquirer might pay for Div 1 – how about GBP 12 mio, anybody? If management snagged an offer like that, and distributed proceeds or (even better) sold up/liquidated the rest of the company also, I think investors would enjoy a v healthy return multiplication on investment.
Selling the entire company to an acquirer can offer surprising upside also. Larger companies find it easier to offer paper (making it easier to pay up), they’ve more available cash and/or cheaper funding, and they can be more flexible/aggressive on taxes. Of course, the best part is that they can immediately eliminate pretty much all of the central costs – who needs two sets of accounting/auditing/listing fees, more managers at HQ, directors etc.? And any costs retained are likely to be more than offset by other low hanging fruit, like divisional cost savings/synergies.
This works best with smaller companies, of course – a lot of them find it hard to grow their way sufficiently out of the minimum fixed cost base a listed company demands. [They don’t like to highlight this when they IPO…or the new compensation packages they awarded themselves to recognize their new exalted status as public company directors!]. Volatile divisional results can sometimes produce the same set-up – the attraction of a consistent/growing division can be drowned out by the noise of another wildly erratic division.
Best of all, the Jewel in the Crown strategy works in reverse too: What if you keep the jewels, and get rid of the duds? Let’s not be too optimistic here…just picture the company above manages to get Div 2 back to break-even (or sells it for a nominal sum, or better):
This is a relatively mild example, but the elimination of a loss-making division can easily produce a step-change in valuation…
Of course, all this might be expecting a bit too much from most management teams! So this kind of upside, or value realization, may never happen… But I don’t believe this presents as big a risk as you might think – it amazes me how many companies have none of this potential upside priced in!
Or the company manages to sell/turn-around a loss-making division – but that’s often accompanied by one last write-down, a complete lack of transparency or comparability, and is generally compounded by poor communication from management. That may offer an extra window of opportunity to buy at a much unchanged price, even though underlying profitability might have been significantly transformed at that point. Throw in a catalyst or two, of course, and you can really stack the odds in your favour.
So, start scouring those annual reports, find a few gems, pay a perfectly reasonable price, and get a potentially lucrative option thrown in for free..!
¹ And as an intro. to the actual company/stock itself, of course… Forthcoming post, I promise, folks!
² I don’t mean by geography. That’s mildly useful in terms of risk exposure, but personally I’ve never found much use for this type of segmentation from a valuation perspective.
Wexboy 
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It’s a division?! Is the “operating profit” after overhead allocation or before? And does overhead allocation include D&A allocation?
There’s a giant american company that also has stable 25% operating margins and is selling at a multiple of 3x operating profit.. Based on your2x P/S multiple, it’s an 8-bagger waiting to happen..
This is fun. And if it turns out that you’ve discovered a new, reliable valuation method — Price to Gross Margin or something similar, then hats off to you!
Well, note any allocation process (as I’ve learned!) is art, not science, so differences/changes in allocation methodology are not unusual. But broadly speaking any cost (or share of a cost) that can be identified with a specific division/segment should be allocated to properly determine each segment result (i.e. operating profit).
Some companies now also display an interest allocation – which is v useful, but still pretty rare.
After all divisional/segmental allocation, all that should be left as a separate item is ‘Unallocated Central and Corporate Expenses’, and then, of course, possible write-downs, interest, tax, minorities & the like.
What I find really interesting about this approach is that it can lead you to relatively safe stocks that are potentially trading at a colossal under-valuation. Realistically, most stocks you find like that are suffering from financial distress, and are often simply a risky bet on their survival…
I agree with you about the sifting process: go through them all, A-Z, and one is going to find some colossal mis-pricing.
This P/S multiple approach, however, feels like I’m partying hard like its1999, valuing internet stocks via Price-to-Click.
I want to become a believer, so I’m looking forward to the big reveal.
But using a Price/Sales multiple as a valuation tool (as long as it relates back to the operating profit margins) is v well-established, and certainly just as good/probably better than a P/E multiple. It’s only pie in the sky if you pick bad companies with bad margins, and extrapolate a high P/S ratio based on what margins should be….
Thanks – remember, the big reveal is just a (very) small-cap, so not for everybody, but it certainly caught my attention..!