Aug 2006

Valuation


There are three different ways of valuing a business: going concern, market comparisons and liquidation. We at Lindsell Train make use, to a greater or lesser extent, of all three.

Going concern
Going concern value determines the value of a business by the net free cash flows (most simply defined as the operating cash flow of a company plus annual depreciation and amortization minus an allowance for maintenance capital spending) expected to occur over the life of the business discounted at an appropriate rate. This is the methodology at the core of our approach to valuation at Lindsell Train. It is similar to valuing a bond. A bond has a coupon and a maturity date that determines its future cash flow. Adding the coupons and dividing the sum by an appropriate discount rate reveals the price of the bond.

For a business it is no different as we regard the sum of the annual free cash flows to be equivalent to the coupons of a bond. Some investors would claim that only dividends are the equivalent to coupons from bonds as these are the only tangible return an investor receives from an equity investment. However, reinvested free cash flows, if invested at positive rates of return, should ultimately accrue at least equivalent but, more likely, greater capital value not least because dividends are often subjected to double taxation.

The ability to correctly value a business is crucially dependant on whether the inputs to the calculation are accurate. How is it possible to determine the future free cash flows of a business with any certainty in the immediate future, let alone in 20-30 years time? We give ourselves a better chance by restricting our investments to durable business franchises whose predictability as businesses is better than the norm. Ultimately this is a judgemental assessment but we note some typical characteristics of such businesses. These companies tend to have stable market positions that have existed and should prevail for many years where barriers of entry for others seem insurmountable. They may sell products where prices hardly change from year to year and where fluctuating raw materials prices make up a small proportion of the costs. Often the customers of the company are likely to continue to buy the product because it is a daily necessity, it represents a small monetary outlay and, in addition, the customer has a strong loyalty towards the brand. Sometimes the product or service cannot be bought or sourced from anywhere else, leading to monopolistic characteristics. It is important that these businesses are not subject to financial risk, from heavy debt financing and thus have minimal balance sheet leverage and sensible and transparent management. All these factors but especially if they are combined, make the likelihood of successfully predicting future free cash flows more certain. For such businesses the free cash flows take on the characteristics of ‘coupon like certainty’ that is found in bonds.

The other variable in the going concern valuation is the discount rate. We think the most appropriate rate to discount future free cash flows is that of the longest duration government bond. Not only does this bond have a life nearest to that of equity but its pricing encompasses the dealing activities of probably the widest body of investors in the financial market. Thus the yield sends an important message to investors. The only qualification we have in using the long bond yield as a discount rate is when its nominal yield falls below 3%. As real bond yields have averaged 3% in the major western economies over long periods of time, a nominal yield of 3% implies no inflation. A yield below it implies deflation. Deflation is particularly deleterious to the real cash flows of corporations and would thus increase the risk that the ‘coupon like certainty’ of the equities we invest in could be under threat. In such an environment equities would lose any premium as a hedge against inflation and bonds may be in unusually strong demand as the certainly of the nominal coupon is much more valued in deflationary times. As a result, in Japan, the minimum discount rate we have used to discount future free cash flows was 3% even though Japan’s long-term bond yield has been below that level for the last 10 years.

Academics require discount rates to be scaled up by an equity risk premium, which in most instances is deemed to be at a constant level for all companies to account for the variability of equity free cash flows. For most of the businesses we invest in, we deem that variability to be so low as to not require such a risk premium except in the case of exceptionally low bond yields, as described above.

It is, of course, easier in practice to value a bond because of the two variables any investor is required to estimate in valuing future free cash flows that of the coupon is fixed, only the discount rate is uncertain, whereas with an equity both the quantum of future free cash flows and the discount rate have to be estimated. The one exception to this is irredeemable bonds, which have no set redemption date thus making the sum of the coupons impossible to estimate with certainly. Very few exist but conveniently most have been issued by the UK government, allowing us when allocating between fixed income and equity in the Lindsell Train Investment Trust, a fund designed to accrue absolute returns in Sterling, to more accurately compare ‘coupons’ with a similar perpetual maturity.

Rather than model free cash flow into the future based on forecasts of sales growth, margin changes and other fluctuating variables we simply estimate a real growth rate of free cash flows based on our estimate of the likely real long-term growth prospects of the business relative to the likely growth of national or international income as influenced by population and productivity changes. Growth rates tend to be in the range of 0-2% and are rarely more, but we think of this growth lasting in perpetuity rather than having some notional terminal date as some other investors might estimate. In quite a few instances we forecast no growth at all, especially where there is doubt about growth far out into the future. In this case the main assumption we make is that today’s cash flows are sustainable. Here the equity free cash flows are equivalent to the coupon of a bond, except one better, the cash flows derive from a real asset so should maintain their value in times of inflation. The free cash flows are thus equivalent to an index-linked bond.

We view long-term dividend growth as indicative of the durability of a franchise and regard accessing high yields as a bonus rather then a necessity when identifying value. We would be as comfortable investing in a durable business with a low dividend yield as we would be uncomfortable investing an unpredictable business with a high dividend yield. Often dividends provide us with a catalyst or aid for the timing of a purchase of a good business temporarily out of favour. For instance, we were particularly keen to buy shares in Unilever recently when the net dividend yield was 4%, just below the yield of an irredeemable bond and 3x that of an index-linked bond.

We suspect that investors systematically undervalue durable franchises because they fail to fully account for the value of the perpetual nature of such free cash flows. As an example we looked at the market’s value of Cadbury’s 10 years ago. With the benefit of hindsight we know free cash flows have increased at an annualised rate of 10.2% since 1996. Discounting those earnings at the then long bond yield of 8.4% in 1996 and assuming no further growth beyond 2005, the warranted value just about equated to the market’s value. But we know today that Cadbury has good prospects for growth in 2006 and beyond yet the markets in 1996 failed to take account of such a scenario. Turning to today’s value, if we assume Cadbury’s is able to grow its real free cash flow by 2% over the next 10 years and 1% in perpetuity thereafter, using a discount rate of 4.4% we arrive at an assumed value of £8.20 per share well above the current £5.50. Interestingly of that £8.20, £2.24 is attributable to the next 10 years free cash flows while the remainder, the vast bulk, to the perpetual cash flows thereafter, illustrating the importance of the distant cash flows to this estimate of intrinsic value.

Market Comparisons
The greater the doubt in predicting the future free cash flows of a business the more reliance we place on other valuation methodologies especially comparative market valuations such as comparing the multiple of one security’s earnings versus another. Just as important as comparing present day valuations, is comparing valuations in the past as this reveals the historical tolerance investors have for the ranges of comparative value. Price to earnings is the most common multiple though there are a plethora of others including price to sales, price to EBITDA and so on. For all the discounted cash flows we compute we like to compare such multiples to rationalise or validate what we have derived independently.

We favour comparing market capitalisations or enterprise values in relation to sales rather than profits for businesses in the same industry on the assumption that in an open and free market economy the profit earned by such companies should/could be similar. Arguably the sales of a business are less manipulable than profits and they fluctuate less from one period to the next, providing a more stable indicator of true long-term business value. We take particular note of what the whole or significant proportions of businesses are valued at in transactions where businessmen are buying or selling. Not only should they, as practitioners in their respective industries, have a better, more experienced and informed insight on value than outsiders but also such decisions tend to be made on a time horizon longer than most portfolio investment decisions but more akin to ours.

As an example we are interested to note that in the last two years there have been two important transactions in the consumer healthcare industry. The recent purchase of Pfizer’s consumer healthcare business took place at 4.3x sales and last year’s purchase of Boots’ business by Reckitt Benckiser at 3.7x sales. These multiples of sales are significantly higher than the values of consumer branded franchise business quoted in the market, suggesting that the businessmen who engaged in these transactions place a far higher value on the security and predictability of such earnings. Of course businessmen may be paying the wrong price but we think it more likely that the market systematically undervalues the compounding effect of long-term stable or growing free cash flows as already mentioned above. Witness the purchase of Adam’s confectionary by Cadbury’s for 2x sales or the purchase of Kanebo cosmetics by Kao Corporation of Japan for a similar multiple. Both businesses were bought funded entirely by debt, which by our reckoning will be repaid over approximately 6 years, yet the businesses will benefit from such cash flows in perpetuity.

Liquidation
Liquidation value is the cash value generated after selling all assets net of all liabilities. A true liquidation value ignores any future earnings potential as the presumption is that the business will no longer be viable. However our use of liquidation values does not necessarily assume that the business will be actually sold. Instead we assume that investors will arbitrage the difference between the market’s value and the net value of the assets. For our approach, it is important to be sure that the future free cash flows of the company will, at least, be positive, so should enhance rather than harm balance sheet value. This methodology equates to that described in Ben Graham’s well known book ‘The Intelligent Investor’, Harper Business Essentials, 1973. He describes companies that trade at a 50% discount to the net effective cash in the balance sheet as ‘net-net’ stocks and characterised them as some of the best investment opportunities he could find. The 50% discount was his preferred requirement for the margin of safety necessary should the determination of the net effective cash value be different from that originally estimated. ‘Net-net’ opportunities have been few and far between since the 1950’s in western markets. However we uncovered many such cases in Japan in 2002-2003 and a few since.

Today, as a derivation of this methodology, we hold and buy businesses on the basis that their liquidation value represents a significant minority if not the majority of the company’s market capitalisation. Some investors employ a liquidation value based on net assets rather than net effective cash. Such a methodology has to be treated with caution as, in our experience, balance sheet values of real assets are often overstated especially in the (unlikely) event of liquidation of the business. The values of other non-cash financial assets are more certain but should be discounted to allow for unfavourable market volatility. In this way a company, with typically as much as 40-70% of its market capitalisation accounted for by effective cash or discounted non-cash financial assets, has such a store of value that it provides an important margin of safety backing such an investment. The implied value of the remainder of the business may be so small that the risk of investing, even in less predictable businesses, is much reduced. For instance, recently, we invested in Mabuchi Motor, a Japanese manufacturer of micro-motors used in toys, electronic products and automobiles, at a price when effective cash amounted to 66% of market capitalisation. The remainder, the operating business, was thus valued at just 0.7x sales, 8% free cash flow yield on current low margins and 15% free cash flow yield on average margins over the last 14 years.

Another derivation of liquidation value is that used by private equity investors. Having estimated the liquidation value of a company’s assets a private equity investor might value a business dependant of the borrowing capacity of those assets and the scale of the subsequent cash flows from the business. Such values are dependant on both stable long-term borrowing costs and, more crucially, dependable cash flows. To some extent the examples above of Kao Corporation’s purchase of Kanebo Cosmetics in Japan and Cadbury’s of Adams confectionary in the USA have such private equity characteristics. Both were funded totally with borrowings, but crucially with the security of a much larger corporate balance sheet, at interest rates at a significant discount to assumed free cash flow yields at acquisition, which were then expected to grow materially in the years immediately following, allowing for a progressive retirement of debt. Many pure private equity transactions do not have the support of the parent as in the cases above and thus leverage to equity is huge resulting in an outsized risk /reward profile.

LTL 000-039-3 22 August 2006