How to value shares for the future

Responding to a question about valuation technique, our companies analyst explains why a little judgement can improve your returns.  

First of all, an apology. I am going to explain something I have been putting off explaining for years because it is technical. The concepts are straightforward, but together they may make a boring article. I will do my best not to be boring, but sorry if I am, and sorry for putting this off for so long.

Just to recap for newer readers, the Decision Engine is a scoring and ranking system. Each company is scored according to five criteria, the maximum total score is 10, and the highest scoring shares are, in theory, the best long-term investments. You can see exactly how this works by clicking any of the shares in the ranked table at the end of this article.

Valuation conundrum

One of the five criteria is the enterprise's valuation. I need to explain why the multiples I quote are not always consistent with the scores the Decision Engine gives for valuation.

A reader has rumbled me. This is an excerpt from his very thoughtful email: 

"In April you gave Science (LSE:SAG)a 1.4 for 14 x adjusted profit (ap), in May you gave Next (LSE:NXT)a 1.2 for 16 x ap, in July you gave Bodycote (LSE:BOY) a 0.7 for 15 x ap, and this month you gave Trifast (LSE:TRI)a 0.6 for 15 x ap. Can you provide a quick explanation as I'm slightly confused how the scoring seems to have changed?"

Of course, I replied with a quick explanation, but I also made a note to provide a fuller one to all readers. If one person has noticed the discrepancy, others probably have too but are too polite or trusting to say (don't be!)

I have linked the names of the companies my correspondent mentions so you can see he is right. Next was valued by the market at 16 times adjusted profit and the Decision Engine gave it a score of 1.2, yet Trifast, which is slightly cheaper in terms of its adjusted profit (15 times) scored only 0.6. Since we are trying to find good companies and not pay much, low valuations should score more highly. What is going on? 

Subterfuge!

The answer is a bit of subterfuge on my part, with the best of intentions. 

The multiple I quote is the firm's enterprise value divided by adjusted profit in the most recently concluded financial year. It is a close cousin of the venerable price/earnings (PE) ratio. The price earnings ratio is usually calculated on a per-share basis, but the resulting ratio would be exactly the same if it used market capitalisation (the market value of all the shares added together) and total earnings (profit after tax) instead of earnings per share. 

The enterprise multiple is different because market capitalisation is only one component of enterprise value. I am valuing the company as an acquirer might, adding the company's debt to its market capitalisation (or subtracting any cash we might be able to extract). Included in debt are other financial obligations, the pension deficit and roughly capitalised lease obligations. 

By including debt in the price we are valuing the business as though we must pay the debt off, so, because a company that has no debt pays no interest, the profit figure we divide into enterprise value excludes interest. Debt and interest skew the price earnings ratio, and this calculation puts companies on an equal footing however they are financed. I deduct tax at the standard UK corporation tax to get, in all its glory, adjusted profit before interest but after tax.

The technical differences between the PE ratio and the enterprise multiple does not cause the discrepancy noted by my correspondent, I am just being thorough. If it helps, forget the last three paragraphs, and think of the multiple as a PE ratio. Other things being equal, low PE's are good, high PE's are bad. The Decision Engine's score is inconsistent with the multiples quoted because it uses a different version of the enterprise multiple, to the one I quote!

Before I explain this variant, let me defend my use of the standard form of the enterprise multiple / PE ratio described above. It is like a common currency. Everybody knows it and understands it. I do not need to write an article like this every time I use it. I did believe that Next was better value on a standard multiple of 16 than Trifast on a multiple of 15. I just think that multiple is a very blunt instrument, and I have found a way of sharpening it ever so slightly.

Taking the long-term view (as usual)

To the best of my knowledge nobody uses my variant multiple, although I am sure there will be other investors doing something similar. The trouble with the simple PE ratio or enterprise multiple I have described is that it judges the company by a single year and that year may have been unusually good or unusually bad.

I prefer to judge a company by what it would have earned if the current year were a typical year. To work that out I usually average return on capital over a number of years, good and bad, that are probably representative of how the company will perform in the future. The number of years varies depending on the company and how it has performed in the past.  

Return, in this instance, is just another word for adjusted profit before interest but after tax, so, to find out how much the company would have earned if the latest year were a typical year, we just have to multiply the return on capital (the percentage of capital invested in operations it earns in profit in a typical year) by the amount of capital the company needed to fund its operations in the most recent financial year. 

To normalise the enterprise multiple, we just need to divide the normalised result, profit, into the company's enterprise value (that is normalised profit into the price of the equity and debt).

An average will only work for the kind of stable companies I focus on, but sometimes extraordinary circumstances require extraordinary measures and then I improvise. 

Next is a case in point. It has a tremendously profitable past, but its present is slightly less profitable. Next is an extraordinarily well managed business, but I am cautious about its prospects because it is an Internet retailer now, and the Internet is so much more competitive. So, I am not normalising Next's multiple. I am assuming the slightly lower level of profitability it is achieving today is more representative of what it might achieve in the future.

Trifast is the opposite case. Trifast's return on capital is at an historic high, and I doubt it will persist. So I am using a 9 year average to calculate its multiple. That does not include the years of the financial crisis, because I think Trifast has improved, but it still penalises Trifast quite heavily compared to its current earnings multiple, which was 15 when I wrote the article. I cannot remember what the normalised multiple was when I wrote up Trifast, but I am sure it was over 20. That’s why Trifast scored lower than Next, which had a multiple of 16.

It is a hopelessly unscientific method, I know, but although I try to be as systematic as possible, this is one of many areas of investment where I believe a little judgement can improve our returns.  

So there you are Fred, and anybody else who has got this far, it was a very good question. I hope you like the answer. My scores are not derived from the quoted multiples. They are derived from Heath-Robinson shenanigans that sound better if you call it normalisation.

Now you've taken the medicine, here's the sugar...

Scores on the doors

Since the last update I have reviewed Dart Group (LSE:DTG), Games Workshop (LSE:GAW), Cohort (LSE:CHRT) and Castings (LSE:CGS). They all came out shining...

Proof of the pudding

By the way, I invented the Decision Engine over four years ago to help me run the Share Sleuth portfolio for Money Observer Magazine as well as to invest my own pension. On 9 September, the Share Sleuth portfolio celebrated its tenth anniversary, and, although the Decision Engine is younger, it is an increasingly important factor in the portfolio's returns.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.