Stock market Investing & Financial Services in Australia

Financial and Stock Market Investing Services in Australia - Case Studies

High Flyers

There are many high-flying companies trading today, that because of popularity, favourable press or momentum, their shares have risen in price dramatically. In some cases, investors, commentators and analysts believe that the price increases are justified because earnings have grown quickly over the period. But most people don't realise that equity has risen even more dramatically and therefore there has been a dramatic decline in their Return on Equity (ROE).

Jumping on the bandwagon of popularity could be very disappointing for investors who are currently buying shares on the back of bullish broker reports and expansion announcements.

A Possible Example

Take a look at this StockVal screen shot and you will see what we mean. This StockVal screen shot of ABC Learning reveals facts about the underlying business that are rarely decipherable from the reports produced by analysts which are heavily biased towards earnings growth and by the company's own rhetoric.

Click to Enlarge

Understanding the Numbers Presented by StockVal

Looking at the StockVal screen you will see that the lower section contains the information required to assess how the business has performed for its owners over five years. This information is presented in a way that, with a little practice, you will almost instantly be able to determine what is really going on in the company. This section also reveals management's attitude to capital allocation. That is, how much capital it reinvests, raises and pays out as dividends. When a company pays unfranked dividends for example in the same year it raises capital from shareholders, you can conclude management are not acting in the shareholder's best interests.

Together, this is extremely valuable information because it shows the performance of the business for its owners and, importantly, the business's relationship with its owners.

While our proprietary calculation of earnings for this company (see row entitled 'Net Profit inc. Abnormals less Pref Divs') has grown from $12.1 million in 2003 to a forecast $147 million in 2007 - an average rate of 87% per year (which is a major reason why the company's share price has gone from $2.39 to over $8.35 in early 2006), equity has grown at an even more staggering 133% per year. This is due to the company raising over $1.6 billion from shareholders (see row entitled 'New Ordinary Share Capital') in the four years to 2006. ABC Learning is now forecast to produce a Normalised Return on Equity (NROE) of just 9.8%, which is down from the 48% NROE it was producing in 2002 and 26.1% in 2003.

If the NROE remains at 9.8% and we adopt a required return of 15%, then the only sensible price to pay for the business is a discount to the equity in the business. By our estimates the company has $4.86 of Equity Per Ordinary Share and our estimate of value ('Investment VALUE @ Required Return') is $2.65.

For ABC Learning, you can see that the profits totaled $310.7 million for the last five years including the 2007 forecast. Of this, $137 million has been paid out in dividends to shareholders and $1.633 billion has been raised from them.

Thinking Like a Business Owner

Now imagine for a moment that you owned this business and in 2002, you injected $27.5 million (2002 'Closing Ord. Equity Ex Minorities') to get it going. In 2003 the business earned $12.1 million and paid you a dividend of $4 million. On that information alone you'd be satisfied. The business earned 26.1% on the money you invested.

But what happens if the management calls and asks you to invest another $51 million, as it did in that year? You may be tempted because the business has, so far, generated a high return on the equity you injected.

So you pay your tax on the $12.1 million dividend you received then give it back to the company plus an additional $38.9 million (total: $51 million, see 'New Ordinary Share Capital').

You have not banked any cash from this business yet. You have however injected more and paid taxes on the dividends received.

Now fast-forward to June 30, 2007 and you have still received nothing on a net basis. Yet you have paid tax on $310 million of dividends, which have been ploughed back into the business and injected an additional $1.63 billion. To rub salt into the wound, you are not receiving a 26.1% return on your equity any more. The business is now generating just 9.8%.

Your Business-Owner Return

The NROE to owners appears at the bottom of the screen and the row entitled 'Normalised IRR' shows the cash flows you as an owner of the business have received or had to inject over the period. If you owned the business outright, it would be all injections. You would have injected $1.6 billion and would own a business producing a 9.8% return on equity.

As an owner you would be asking yourself, what return am I going to get from the business for my $1.6 billion and is 9.8% satisfactory, assuming that rate can be sustained and does not improve?

How StockVal Values the Business

At the top of the screen you can see, in this instance, we adopted the 9.8% NROE the company is forecast to produce in 2007 (which may be optimistic) and a discount rate or Required Return (RR) of 15%. Obviously if equity per share of $4.86 (see 'Equity per Ordinary Share' in the 'Per Share Statistics' section of the screen) were to generate an ongoing 9.8% and we require a 15% return on our investment, the only sensible price to pay is some discount to the equity per share of $4.86.

StockVal is the only investment tool in the world that uses rational and sensible arithmetic to arrive at a true value of a company's shares – in this case it indicates a value of $2.65 – a far cry from the recent share price high of over $8.00 and the $7.50 that institutions paid in May 2006 to participate in a $600 million capital raising. At the time of writing the institutions have lost $120 million in aggregate on their purchase. StockVal investors still have their cash parked safely at the bank.

What 'The Market' Focuses On

The increase in profits from $12 million to $147 million over 5 years looks impressive and the market is indeed impressed, hence the stunning share price rise. But the true value of the business is not rising at the same rate.

The growth in profits is not a result of the original subscribed capital, but new capital subscriptions (shareholders' money) injected over the years. It is now approaching $1.7 billion. If the shareholders pump more money in, then of course the profits should rise. Its just the same as when you put more money in the bank - you will earn more interest.

StockVal: A Revelation

In this case, what was once a highly profitable small business is now a mediocre large business. There is nothing inherently wrong with this, but the share price cannot be justified on the current performance. Either performance has to improve, or the share price must eventually fall.

This example clearly demonstrates that only StockVal investors can accurately assess the economic performance of a business from an owners perspective and value the business and avoid dangerously overpriced companies.