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Wednesday, May 27, 2015 - 02:16
Counter-intuitive

Recently, South African investors who are accustomed to using price/earnings ratios (P/E) as an indication of a share’s value have had to wrap their minds around higher-than-normal P/E ratios and the question of whether they are sustainable. Fairtree Capital believes some digging is needed to understand how these high P/Es came to be, and what other metrics an investor can use to find the true value of a company.

To understand high P/Es, the significant amount of local shares that foreign investors have bought in the last few years first needs to be examined.
Graph 1 shows the percentage of foreign ownership of local shares in 2006 and in 2014 and, more importantly, what happened to the P/Es of these companies as the foreigners snapped them up. For example, Mr Price went from a P/E of 9.5 to 20.2 as foreigners grew their ownership of the share from 5% to 56%. High P/E ratios did not seem to deter them.


Graph 1: Change in foreign ownership of SA Inc. shares
Source: UBS, Bloomberg

This re-rating of P/Es may be due to foreign buying, or it may be as a result of the low economic growth SA has endured, or perhaps it is a combination of both. Fairtree Capital thinks foreign investors are more cash flow orientated in their valuation techniques, and are more comfortable with higher P/E ratios for high cash-flow-generating businesses with superior growth. A discounted cash flow model (DCF) is the best methodology to value a cash flow stream, although it has the downfall of being sensitive to changes in inputs.
To understand the difference, an analysis on how a DCF would differ from a P/E ratio approach was done. Graphs 2 and 3 are used in the illustration. Assume company A (Graph 2) has a high cash conversion and grows at a fast rate. It converts 90% of its reported earnings into cash, then grows the cash flow stream by 13% per year, has an 8% terminal growth rate and a weighted average cost of capital (WACC) of 13%. The DCF value of company A is R26.20. If this value had to be converted into a one-year-forward P/E, the ratio would be a P/E of 23.


Graph 2: Company A’s DCF derived P/E for a HIGH growth, HIGH cash conversion company (free cash flow for every R1 of reported earnings)
Source: Fairtree Capital analysis

Assume company B (Graph 3) has a lower cash conversion and grows at a slower rate. It converts 60% of its reported earnings into cash, then grows the cash flow stream by 8% per year, has an 8% terminal growth rate and a WACC of 13%. The DCF value of company B is R12.01. If this value had to be converted into a one-year-forward P/E, the ratio would be a P/E of 11.


Graph 3: Company B’s DCF derived P/E for a LOW growth, LOW cash conversion company (free cash flow for every R1 of reported earnings)
Source: Fairtree Capital analysis

Not surprisingly, the two companies have very different P/Es because of their underlying characteristics, and a P/E investor would surely buy company B with a P/E of 11, but would this be the smart investment? To answer, here is the real example of Mr Price, which has grown its earnings by 24.5% per year in the last 10 years.


Graph 4: Mr Price’s earnings per share
Source: Company Reports

Mr Price has converted 93% of its earnings into cash per year in the last 10 years and is a high growth company with a high cash conversion ratio, so it is similar to company A in the above example.
If Mr Price is assumed to continue to convert its earnings into cash at the same rate as in the past, but its future earnings growth rate is reduced to 12% per year (just to be conservative), then the justified one-year-forward P/E value converted from the DCF analysis is 26. Last year, the actual forward P/E was 20.7 – a high P/E for investors’ appetite apparently, but the analysis suggests that this represented a lower price than that is justified by DCF analysis. A P/E investor would have sold the share, but the analysis suggests they should have bought more.
The value of this analysis lies in understanding how P/Es differ from DCFs.
Fairtree Capital’s view is that high cash conversion companies with high growth rates should trade at P/E ratios above the market average and companies with low cash conversion and low growth rates should trade at P/E ratios below the market average.
It is important to remember that while P/E ratio expansion played an important role in the total return in the last 10 years, earnings growth and dividends played an even greater role.


Graph 5: Mr Price’s share price progression
  Source: Bloomberg, Fairtree analysis

Mr Price generated a 37% per year return to shareholders between 2004 and 2014. These returns can be split into the following:
• Earnings growth of 24% per year
• Dividends of 3% per year
• A 10% P/E ratio re-rating per year

Importantly, the dividend and earnings stream made the greatest contributions to returns, which bodes well for holders of this share, even if the P/E ratio remains stagnant.
Fairtree Capital is of the opinion that foreign investors have influenced the valuations of certain equities to levels that correctly reflect fair value. The high P/E ratios of certain equities are likely to persist if foreign investors remain invested in SA, which will frustrate local investors who are not prepared to buy high cash generating companies at ostensibly high P/Es. Written by Stephen Brown, portfolio manager at Fairtree Capital.
 

Copyright © Insurance Times and Investments® Vol:28.5 1st May, 2015
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