One of the first things any investor looks at when valuing a company is its profitability. If you know what a firm is making now, and what it should make in the future, you can work out how much you'd be willing to pay for those earnings today. But what profit figure do you use? This year's profits could be unusually high due to one-off cost-cutting, or because the economic cycle is peaking. And trying to predict what will happen in five years' time is a mug's game.
Enter the concept of 'sustainable profits' a level of profitability that can be maintained through thick and thin. This can be traced back to legendary value investor Benjamin Graham, who reckoned that if you can buy a firm more cheaply than its sustainable profits imply that it's worth, you'll have a 'margin of safety' and a good chance of decent returns.
Estimating sustainable profits
1. Find the base operating profit: Look at the company's business environment and profit history. Is it in a cyclical industry, such as construction or engineering? If so, are the profits at a cyclical peak or trough? For cyclicals, it's probably conservative to take an average of the last five years' operating profits as your basis for sustainable profits.
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2. Calculate the adjusted operating profit: Subtract one-off profits, such as money raised from selling buildings or other assets, and add back any one-off costs, such as redundancies.
3. Calculate the sustainable gross cash flow: Now add back the charges for depreciation and amortisation. This gives you an estimate of sustainable gross cash flow the amount of money that's actually coming in to the business.
4. Calculate the sustainable cash operating profit: This is the toughest part estimating how much to subtract from gross cash flow to account for the capital expenditures needed to maintain and replace assets (the money the company needs to spend to stay in business). The depreciation charge is supposed to reflect this. But it's often based on costs that are out of date. As we are aiming to be conservative, adding 10%-20% to the depreciation charge probably gives us a better estimate of what the firm needs (an exception may be IT firms, where costs tend to fall). We now have a cash-based sustainable operating profit estimate.
5. Adjust for tax: The final adjustment is to tax this operating profit estimate at a sustainable long-term tax rate. For British firms, we can generally use the current rate of corporation tax of 28%. The end result is an estimate of sustainable profits that can be paid out to the debt and equity investors.
Using sustainable profits in valuation
If we believe that a company can earn a certain level of profits forever (essentially) then with a bit of simple maths, we can value the company on that basis. Just divide the sustainable profit figure by the required rate of return. This figure is the cause of much debate among investment professionals, but you can decide for yourself what would be reasonable.
For example, if a company had sustainable profits of £10m and the investor wanted a return of 10%, then the value of the firm would be £100m (£10m/10%). In other words, assuming your profit estimate is correct, this is what you'd be willing to pay for the firm today, to get a 10% annual return. You can then compare this with the current enterprise value of the firm (the market capitalisation minus net cash, or plus net debt), to see how your estimated value compares with the market's view.
Is Home Retail Group a buy?
Let's take an example. Home Retail Group (LSE: HOME), owner of the Argos and Homebase retail chains, has few friends among City analysts none rates it a 'buy' and is exposed to fears over consumer spending. Is it a good investment?
HRG made operating profits of £287.7m for the year to February 2010, compared to £398m made in 2008. There are no major one-off costs or profits to account for. So we add back depreciation and amortisation costs of £130.1m to get gross cash flow of £417.8m. Take away estimated capital spending costs of £150m (£130.1m plus around 15%) to get cash operating profit of £267.8m. We tax this at HRG's current high tax charge of 31%. This gives an estimate of sustainable profits of £184.8m. If we need a 10% return, this values the firm at £1,848m. Add the £414m of net cash on HRG's balance sheet, and you get an overall value of equity of £2,262m or 259p per share. If we use 8% as a required return (in line with many professional investors) then our valuation would increase to 312p.
At the time of writing, the share price is 203p. That makes the enterprise value of HRG £1,286m (£1,700m less £414m of cash). Using a 10% return, this implies that the market believes HRG's sustainable profits are £128.6m, which would equate to operating profits of £186m, compared with current City estimates of more than £250m in 2011. That's pretty pessimistic. Throw in the dividend yield of 7.1% and the large chunk of shares owned by the chief executive, and HRG looks tempting.
Phil Oakley worked as an investment analyst for banks and asset managers for 13 years. He is now a freelance journalist.
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