Valuing Companies Part 1

Without going into enormous lengths, I thought I would talk a little this week about my process in deriving intrinsic valuations of companies I consider for investment.
Like most value-based investors, my methods draw heavily in most cases from using discounted cash-flow (DCF) analysis.  I have heard using DCF described as more art than science, where the cash flows can be accurately forecast, this is not the case, but in the case of forecasting earnings for companies, this is rarely the case.  Calculating intrinsic valuations based on blue-chip companies are generally easier than when focussing on the small end of the market.  The big 4 banks for example or ASX20 companies like Woolworths, Origin, Telstra, Brambles or AMP are quite stable and can be extrapolated forward with some confidence. Others in the ASX20 might be a little more troublesome, CSL for example has had meteoric (but slowing) growth, picking future growth and a suitable multiple is troublesome.  QBE as an insurer can be hard to assess and the miners (BHP, RIO & NCM) can be harder to predict because of commodity prices and currencies across multiple countries of operation.  These are the 20 biggest public companies in Australia and the market still misprices them regularly.  I have been a long-term bear on Telstra, though their price is much fairer now.  I have been for a good while bullish on QBE. QBE have struggled a little over the last couple of years with the strong AU$.  Putting the currency aside, it’s an outstanding business, run by able and shareholder-oriented management, trading a good measure under what I would consider their intrinsic value.  Despite this, it takes the recent announcement by QBE of an acquisition, which in terms of the size of the company is far from material and is unlikely to change EPS going forward by more than about 1% and since then, their share price has run up 10.5% (at time of writing).  Go and search globally and see how many insurance companies of comparable size and security you can find that are currently 1. Yielding over 7%, 2. Trading at a multiple of 13x or less, 3. Have doubled their EPS in the last 5 years, 4. Have a combined ratio of consistently less than 90% and 5. Provide a return on equity of 20%.  If you find such a company, I’d like to hear about it.  That said, as always, I state, despite being clearly undervalued, I maintain, far more deeply undervalued companies exist in the smaller end of the market.
DCF, coupled with consideration of underlying asset values and myriad other qualitative factors helps me arrive at my assessment of a company’s intrinsic value.  The ability to completely independently assess intrinsic values has proven critical to defending and then substantially growing my family’s assets through the recent downturn.  I will not go into too much more detail than that (I will expand a little next week).  Plus the methods I use are something of a proprietary knowledge of mine, which we will share with others through the establishment very shortly of EGP Fund No. 1.
What led me to decide to talk about valuations was my fairly recent purchase of a tiny parcel of shares in a company called Astron (Ticker code – ATR).  I have been following this company since 2007, when they sold their business in China and started to move from being an end user of mineral sands products to a mineral sands producer.  When a company completely changes its direction, the market is usually understandably cautious.  If you scour through the companies at the smaller end of the market, it is not difficult to find companies that went from being technology focussed around 2000, to becoming pharmaceutical or biotech companies after the ‘tech wreck’, that have again morphed into mining exploration companies since the mining boom started.  Astron are different.  For starters, they hold a bank balance of $166.5m in cash.  The market capitalisation of the company (at time of writing) is $160m.
Basically, when you buy $1 of ATR, you are buying $1.04 of cash.  What you get ‘for free’, are substantial Chinese business interests/contacts and a JORC resource nearly half the size of Australia’s largest Mineral Sands producer Iluka resources (ILU – a $3.94b company), or only marginally smaller than Mineral Deposits Limited (MDL – a $315m company), a Senegalese prospect at a similar stage of development, on the point of preferred placement, I concur with Dorothy of Oz, “There’s no place like home”.  ATR face challenges, it will cost about $300m to develop the Donald Mineral Sands into production, but given their good cash balance and relationships with big players such as POSCO (third largest steel manufacturer in the world), it would seem pretty likely that the project gets off the ground.  To my mind, the fact that ATR is trading up over 30% on its 12-month lows is evidence the market frequently gets it wrong (i.e. they traded at less than 2/3’s of the cash they held).
I hold only 7.5% of my family holdings in ‘speculative’ stocks – everyone needs a little excitement in their lives.  I think by ATR meeting my definition of a speculator, you get some comprehension of my idea of risk management.  By the way, if anyone has a $100,000 term deposit, I would be happy to buy it from them for $96,100, which is the virtual equivalent of buying ATR, except I don’t get substantial mineral and business potential thrown in for free. – Tony Hansen 21/02/2011.