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Equity Valuation – Understanding what’s important

Core Content

Equity valuation involves understanding the relationship between a company's actual returns and the market's valuation of it. The document outlines three primary valuation methods: Returns Based Analysis, Multiple Analysis, and Discounted Cash Flow (DCF) Analysis, and explains that while they differ in approach, they all fundamentally assess the same core concept: the relationship between returns and value.

Main Valuation Tools

1. Returns Based Analysis

• Key Concept: The market values companies based on their Cash Return on Cash Invested (CROCI) compared to the Weighted Average Cost of Capital (WACC).
• CROCI vs. WACC: If a company's CROCI is higher than WACC, it is creating value; if lower, it is destroying value.
• Director's Cut Methodology: This is a framework that compares the company's Total Enterprise Value (EV) to Gross Cash Invested (GCI). It shows how much the market is willing to pay for a company based on its returns.
• Premium/Discount: Companies with sustained top-quartile CROCI are ascribed a premium, while those with bottom-quartile CROCI trade at a discount. The premium or discount depends on the duration of the performance.
• Sustained Laggards: These companies tend to revert to an asset-based valuation, trading at a floor. The floor is around 0.34x sector relative EV/GCI in AEJ and 0.27x in Japan.
• Growth vs. Returns: While growth is often emphasized, returns are more stable and historically more important in driving valuation. A company with high growth but low returns may not add value.
• Alpha Generation: Backtesting shows that the Director's Cut methodology generates consistent alpha in both AEJ and Japan.

2. Multiple Analysis

• Multiples and Market Moves: Using multiples directly can lead to price targets that follow market trends, so they should be used as a sanity check.

• Target Multiples: The expected multiple for a company should be based on the industry average at the end of its competitive advantage period.

• Fundamental P/E and P/B: These multiples are based on Return on Equity (ROE), Cost of Equity (COE), and Growth. The formulas for P/E and P/B are:

  • P/E = (ROE - g) / (ROE × (COE - g))
  • P/BV = (ROE - g) / (ROE × (COE - g))

• Sensitivity Analysis: The methodology is sensitive to changes in accounting inputs, WACC, and terminal growth. A higher ROE or lower WACC increases the P/E and P/BV.

3. Discounted Cash Flow (DCF) Analysis

• DCF Framework: DCF is a fundamental valuation technique, but it requires careful construction.

• Forecast Period: Should reflect the company's competitive advantage period. The terminal value must be based on a sustainable cash flow.

• Terminal Value Calculation: Two main methods are used:

  • Gordon Growth Model: Assumes perpetual growth at a constant rate.
  • Multiples Approach: Uses the industry average at the end of the competitive period.

• DCF and Returns: DCF is essentially a way of valuing a company based on the difference between actual returns and required returns. The formula for EV is:

  • EV = DACF / WACC (assuming no growth)
  • EV = GCI + (DACF - GCI × WACC) / WACC (including growth)

Key Insights

• Returns Drive Valuation: The market's valuation is more closely tied to a company's returns than to its growth.
• CROCI and WACC: The ratio of CROCI to WACC is a key indicator of whether a company is creating or destroying value.
• Sustainability Matters: Sustained superior returns are more valuable than short-term performance. The market assigns a premium based on the length of time a company maintains high returns.
• DCF and Returns Based Analysis: DCF is mathematically equivalent to returns based analysis. The core idea is that the enterprise value is determined by the company's ability to generate returns above the cost of capital.
• Alpha Generation: The methodology can generate alpha by selecting top and bottom 20% of stocks based on CROCI and rebalancing monthly.

Methodology Considerations

• Forecasting Accuracy: The accuracy of the valuation depends on the quality of the inputs. Errors in forecasting working capital, operating leverage, and revenue can distort results.
• Working Capital Calculation: Using the Cash Conversion Cycle provides a more detailed and accurate analysis of working capital than simple percentage-based methods.
• Industry Concentration: More consolidated sectors tend to have higher average cash returns and are more stable.
• Provisions and Depreciation: These can distort ROIC but not CROCI, as CROCI is a cash-based measure.
• Time Horizon: The methodology is sensitive to the time horizon used for forecasting. A 1-year horizon is generally best, but a 3-year horizon may be better during market peaks.

Conclusion

All valuation methods ultimately reflect the same underlying principle: the relationship between a company's returns and the market's valuation. The Director's Cut methodology, based on CROCI and WACC, is particularly effective in identifying value creation and destruction. It is also useful in generating price targets and alpha through strategic stock selection. The key is to be consistent and understand the limitations of each approach.