With stock markets volatile, do the processes for capturing company value need to change? Nick Fitzpatrick finds out.
Investors were struggling with the question of Facebook’s true value when the company floated in May. Its share price settled at $38 (€30.6) on the first day of the initial public offering – not far off the target price. But for some people, Facebook’s expected value had always been too steep for the largely untested social media sector.
The question of valuations does not begin and end with Facebook. The volatility of stock markets has made some investment professionals think harder about the best way to value company shares across other industries.
When company share prices bounce around more because of decisions in Brussels than because of fundamentals, and in an era when equities are looked at as risky whether prices are high or low, some are asking if the processes used for capturing company values need to change.
A time-honoured starting point for valuations is the price/ earnings (P/E) ratio. This has come under scrutiny in some quarters.
Typically, the company with the highest P/E ratio is expected to have the highest earnings.
To put it another way, if a eurozone company’s P/E ratio is 13 times earnings, it is interpreted that investors are willing to pay €13 per €1 of earnings.
It just so happens that 13 times is the historical average P/E for European equities and anything below that would normally be considered cheap. The historical average for US equities is 15 times. US P/E ratios have recently been in the low teens. But is it still right in today’s climate of fear to consider these stocks as cheap?
For Franz Wenzel, head of investment strategy at Axa Investment Managers, the long-term average P/E ratio should be revised downwards to factor in the considerable uncertainties that people feel about economic growth and corporate prospects.
“Keeping the old long-term anchor at 15 times would require more growth to be happening in the US and globally. But these days we are in unchartered waters where growth is concerned.”
Add a few other game-changing factors to the difficult growth environment (volatile earnings, the end of declining interest rates and yields) and investors should then demand higher risk premia and lower P/E ratios, says Wenzel. He believes the long-term equilibrium range for US equities is now best considered somewhere between 13 times and 15 times, with 15 times being the upper limit and no longer the average.
Yet despite the precarious economic and financial situation, US corporates continue to have high levels of profitability. Wenzel concedes that this is an anomaly. “The micro element I am struggling with is US corporate profits, which are still by and large elevated by historical standards.”
But Wenzel thinks this is to do with restructuring, which has happened at a rapid pace in the US, and it may continue to support profits for some time.
“Profits may have remained elevated due to continued restructuring [and] if weakness prevails, we could see another round of restructuring too.”
To put it another way, increased earnings, thanks to economic growth, is not what is powering profits but redundancies, downsizing and efficiencies, and these are finite.
As a fundamental investor, Simon Edelsten, manager of the Artemis Global Select Fund at Artemis, a UK independent fund manager, generally uses earnings to measure the value of a company before making a judgement about its risk.
But he also says that, at a time when markets are volatile yet the balance sheets of most businesses are pretty stable, balance sheets provide a more stable way of valuing a company. Consequently, investors should use balance sheets to supplement other analysis, such as cash flow.
Edelsten is another investment professional who thinks investors may need to reconsider their approach to valuations. A key point for him is that a standard valuation method – the capital asset-pricing model – has shortcomings due to its reliance on beta, or share price volatility relative to the market.
An example of a failure of this model was seen in the banking crisis. Prior to the crisis, the banks had higher share prices, theoretically meaning they were less risky compared with other companies. Consequently, they had a lower relative volatility, and therefore lower beta.
“A few years ago, when banks produced consistent earnings, their beta was low and the markets thought they were low risk,” says Edelsten.
“How wrong could they be! By 2009, all these betas had become very high and told risk-averse investors to sell. So beta does not always help investors do the sensible – or most profitable – thing at the right time.”
The earnings of a house builder will move rapidly from profit to loss as house building declines. Yet assets on the balance sheet, like land, may still remain steady in value, meaning the company’s book value has hardly really changed.
“Similarly, many investors prefer to focus on the book value of banks today rather than their earnings because book values are more stable, as long as regulators are clear what capital reserves they require,” says Edelsten. “We believe that balanced views between the two types of valuation – book value and cash flow – and how these change over the business cycle gives the most robust framework for long-term investors.”
Thinking about valuation methods is also happening around transaction activity in the non-listed market. David Mitchell, head of valuations at accountancy firm BDO, highlights the commonly used discounted cash flow method. This method uses estimated forecast cash flows that a company is expecting to generate and applies an appropriate discount rate to arrive at a company’s value.
“When using the discounted cash flow method, using government bonds as the relevant risk-free rate needs to be carefully considered, especially at a time when even Germany is on negative watch by the ratings agencies. Could it be more appropriate to use, say, an IBM corporate bond? This is a question that has not been answered.”
He adds: “We are not talking about a new way of doing things, but a new way of thinking.”
But the fact that people still see bonds as being somehow less risky than equities even though, as Edelsten points out, small signs of inflation could dramatically hit capital values, shows that it might not be easy to change how people think.
©2012 funds europe