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Valuations basics

Estimating long-term growth and profitability

Basis of short-term and long-term estimates

The basis for the short-term estimates is the current situation in the company: the management guidance, cyclical situation, analyst’s own assessment of the competitive situation and market. However, the basis for the long-term estimates should be more the long-term growth of the sector in general.

Levelling off long-term growth

All rational company estimates are based on the fact that sales growth levels off near to the long-term GDP growth (about 3%), no matter what the business is. This means that also growth companies become “ordinary” in the long-run — even some software or mobile phones cannot grow more than 5% a year forever. Note that there is even a mathematical problem with high growth rates (higher than WACC), which makes fair value negative with high growth rates.

Profitability

Even more important for the estimates is that profitability should be levelled off to normal levels. Profitability is estimated/changed in the model with EBIT-%, but you should follow profitability with ROI-%or EVA which are much more relevant measures. In our competitive world we have to assume that sooner or later competitors will catch any company in the long run and “abnormal” profits (large positive EVA, greater ROI than 15%) will melt down.

Star companies

Of course there are companies that will not follow this rule during their next 5 years, but it is no sense that we try to “see” it in our 5+ years estimates. Those companies that have grown very rapidly and have been very profitable are for example Nokia and Microsoft. Their share prices have appreciated about 10 000% and 300 000% correspondingly. There is no sense in trying to catch that kind of stars: it is enough if we find that those companies are more than 50% undervalued, because they will grow more that 30% for the next 3 years and remain very profitable.

Seasonal variation in estimates

Some companies have quite stable turnover and operating profit between different quarters. However, other companies tend to sell each year more in certain time or make the most of the profit in certain quarters.

Consider for example a skiing centre: the most of the turnover is created in the winter, while the revenues in the summer may be close to nothing. Again, some consumer goods are sold mainly at the end of the year around Christmas.

This phenomenon is called seasonal variation and you should take it into account when you think about your estimates.

How to take seasonal variation into account in Valuatum Excel model?

There are three things that help you in this:

– Division graphs in I-divQ sheet
– Info fields in I-divQ sheet and
– Quarter graphs in O-quarter sheet

The divison graphs are most helpful things with estimating the seasonal variation and therefore there is even an own tutorial page for them. You really should learn how to use them.

Info fields in I-divQ sheet and Quarter graphs in O-quarter sheet

When you look at the Info fields in I-divQ, you can see the periodic historical values and also your estimates in the same rows. If there are considerable variation between quarters, take it into account in your estimates.

Perhaps an easier way to notice a possible variation is to look at the graphs in the O-quarter sheet. You can just change the sheet or change view: click the button in the left upper corner of I-divQ and you get two sheets to the view at the same time. When you click the button again, you will get back to the original view.

How far should I estimate in quarter level (net sales and EBIT)?

Current year

Current year has to be estimated in quarter level. In fact, there is no full-year estimate cell available.

Second estimate years

In normal case it is enough to have full-year estimates for the second year. But when year end is getting closer, you might consider making quarterly estimates also for the second year.

Quarter estimates for the following year should be made at the latest before running YearChange macro. In technical aspect you can still ignore those estimates but then the year change would cause a significant change to fair value as (new) current year growth and EBIT-% would become 0.

Third and fourth estimate years

You can always stay in full-year level when you make net sales and EBIT estimates for the third and fourth estimate years. The reason why there even is a possibility to estimate in quarter level, is mainly technical.

Quarter estimates dominate

Please, remember that if you enter both quarter and full-year estimate, the latter is ignored.

What is important in analysis to try to estimate?

Profit development one year ahead is crucial for share price

If you could estimate the results of companies one year ahead with an accuracy of about +/- 10%, then you could in many cases make a lot of money.

If you look at the shares that have appreciated 30-100% or even more last year, you will most likely find one common characteristic with them all: their sales and/or especially EBIT or EPS growth has been much bigger than investors had expected last year. In many cases, with smaller companies there were clear signs of that kind of potential to be seen, but nobody brought these things forward to wide audience. Perhaps this is because nobody really followed those small companies carefully enough. These kinds of opportunities are the ones that the analyst should try plot. And of course it is also important to find opposite cases with unexpected bad performance.

Difference to consensus is also crucial – compare you estimates with consensus

The markets price each stock according to its own expectations. The best estimate of market’s expectations is provided by the consensus estimates. Thus, if there are consensus estimates available, you should always compare your estimates to them and have clear reasons why your estimates are higher or lower than consensus. These are the most important things that you should also write to your forum comments. If you e.g. expect that the company profit (EBIT, PTP, EPS) for next quarter is clearly bigger than the consensus seems to believe – and that is not a non-recurring phenomenon but more permanent rise of performance level – then this should also mean a share price increase directly after the result announcement. Therefore you should tell this in your forum-comments and also give good reasons why you expect better performance than research providers in consensus.

In Valuatum Platform there usually are consensus estimates available for analysts, so finding consensus should not be a problem. Of course we can not have consensus for every small company as there probably isn’t consensus available. Partly this is also because we do not have access to figures of every consensus provider. However, the consensus that we have in Valuatum Platform available for analysts is going to significantly increase already in the near future so majority of the companies followed should also include some consensus estimates.

Even though profit development next year is very important to estimate roughly in the right range, it does not make much sense to try to put much energy to estimates that are more than 2 years in the future. They should of course be rational, consistent and at certain generally defined reasonable level as explained later on in own chapter, but to be honest they have very little intrinsic value. Of course they affect the DCF-based fair value, but it is not a parameter that really determines the share price as explained better below. The real pricing of the stock is normally done at the markets by the pricing multiples of current year and next year. So profit development about 2 years from this moment is most crucial, often even shorter periods. Other future years are the less meaningful the further in the future they are. Estimating about distant future is very difficult and market does not even try to do it honestly in determining the right share price level. The market does discount also the distant future and thus the market value of profitable growth companies often includes assumptions of good performance in many future years. In the same way the market value of unprofitable companies often includes assumptions of continuing bad performance in future years. This is however different thing as it is done in a very general way. What really determines current share price is the performance here and now and the performance in near future where markets have clear visibility.

 

Company performance in this quarter

As stated above the share price of a company is determined with performance in near future where markets have clear visibility. With industries in dynamic or cyclical environment the markets normally have good visibility only for current quarter results that is published in few weeks time as from that “future” they have both management guidance and lots of news flow from what has happened. It means that in most cases there is no tremendous share price effect with the next result announcement, and thus there is also no tremendous value available even though you could estimate the next quarter result with two-digit-accuracy two weeks before it is published. This can be best seen from share price graphs: a good result announcement might increase the share price by a couple of percentage points within the announcement day, but in this kind of cases the share price has normally appreciated during the past quarter normally by more than 10%-points.

So, only a fraction of the upside potential is realised with the result announcement and most of it is already in the share price. It also means that you should concentrate not on “the decimals of this quarter result” but preferably on “the trend and expected rough level of profits in current quarter and couple of quarters thereafter”. In other words the investors are not so interested if you can say a week before the result that the result will be in rage 234.9 – 235.1, as they would be if you can credibly explain why the result of the company will be on average increasing about 20% e.g. in the next three quarters. The first one is most likely already in the share price, but the latter is hardly there.

Some people might hereby protest and see it particularly important that the analyst is able to accurately forecast the result a week before the result announcement. Admittedly thereby investors might be able to earn some percentage points as I already stated above. And also these kinds of short-term predictions are much more valuable and interesting than comments right after the result about what did happen and why the result was like it was – without any new information to markets about what will happen next quarters.

To sum up: market expectations are conservative and wait status quo to remain

At this point you perhaps feel a bit confused about what is important in the analysis: Is current quarter important or not? And what is it that markets expect currently and what does it not expect?

This is how we believe the market normally behaves and what it expects:

*   Well performing companies – Markets are conservative: if the sales and profits of a company have been increased by e.g. 30% a year for already some time then market expects that the situation will stabilize and the growth will slow down soon. If you are sure that the growth will continue or even accelerate during the next year, then it is most likely a buy-case: the share price will probably appreciate during that year much more than the normal cost of equity i.e. more than about 10%. On the other hand, if positive development breaks very rapidly (as markets normally expect gradual slowdown) then the share price might come down also very quickly.
*   Ordinary and stable companies – Markets expect the status quo to continue. If you have reasons to believe that this kind of company suddenly improves (or declines) a lot then there is big upside (downside).
*   Poor companies – Markets normally expect the companies to get out of trouble very slowly. And markets normally do not believe until they see clear facts about the improvement (first positive quarter). So promises of improvement are normally not fully discounted into the share price. These cases offer always upside if you have reasons to believe to the improvement. If there is no improvement, then this kind of companies are of course always overpriced: loss-making companies are options where investors bet on improvement. If the improvement does not come then anything is too much to pay for these companies.

Note! Each standard case above must be used and viewed in the light of current valuation: if the pricing ratios like P/E are very high then of course market expects very good profit development in the future years. If P/E ratio or P/BV ratio is extraordinary low then the markets expect already quite bad performance to continue for some time. This means e.g. that “ordinary and stable” company might for some reason (very optimistic management guidance, rumours etc.) have great expectations (high pricing ratios) inside its current valuation and thereby of course continuing stable performance is a disappointment for markets and decreases share price. You can use e.g. valuation scatter to compare valuation ratios vs growth /profitability estimates of different companies.

What period is then important for the analyst to forecast?

Above is discussed what markets normally expect from different companies. You should focus on the periods which are as close as possible (to be interesting) but so far away that the markets do not (yet) see there. So if you feel that markets do not know about next quarter, then you should focus on that. If the question is about a big company and the next quarter result announcement is quite close, then it is often the case that markets do already know a lot and there is very little room for surprises.

Thus “what markets do not see” depends slightly on situation and thus varies case by case. Naturally you do not have to try to dig something “surprising” for every company as there are perhaps no unexpected things going to happen during the next year – at least things that could be foreseen. That kind of cases should normally be in “Hold” => if there is nothing that the markets would already know by now, everything is already discounted in the current share price. Then there is no reason for you to say that the share should be “BUY” or “SELL”. Of course there is one exception: if a company is very profitable and perhaps even grows fast, then it is of course a BUY if it “only” can maintain its status quo as markets can never price this kind of companies with their intrinsic value but rather wait – very rationally – that the performance will deteriorate sooner or later.

And remember also that forecasting in itself means nothing, only your arguments within these forecasts mean something.

Where to get information about companies?

You can find information to be used in the analysis from following sources:

1) Company stock exchange releases and news releases
2) Annual reports, Company www-pages
3) Newspapers, newsletters
4) From company directly (Investor Relations)
5) Company infos, CMD, other visits to company
6) Other sources like: company sales/customer service, customers, competitors

Some information and hints for all of these:

1) Company stock exchange releases and news releases
Company stock exchange releases can be found from company www-pages and always also from stock exchange www-pages. Stock exchange is of course the best place to get these, as it is regulated and has to contain all of the releases and the releases have to be published there first. It is also practical that all the companies you follow have their releases in one place.

Some companies however, publish also news releases. These releases might contain some interesting information about their new products, received orders etc. even though the company has themselves characterized them as “not containing some essential information which might have direct stock price effect”. If they would contain such information, then they should of course be published as stock exchange releases. E.g. Nokia publishes about one press release per day but only few stock exchange releases or “company disclosures” per month.

Often companies have also a service where you have to registered as a subscriber to get all the releases that the company publishes directly to your own e-mail address. There are also third party services, which collect and distribute at least stock exchange releases. E.g. Hugin Online offers a free service where the subscribers can get releases directly to their e-mail from companies they want to follow. Notice however that the service does not seem to work for every company: We have had some problems with for example Lassila & Tikanoja and Exel, so make sure that the service works before counting on it too much. Also notice that sometimes the releases are shortened versions of the original releases. In those cases it is normally mentioned in the shortened release itself that the original version can be found at.

2) Annual reports and company www-pages
Annual reports and company www-pages offer of course a lot of such relevant information about the company that cannot be found from any releases. By browsing these sources you cannot only find information about products and services, but also about almost all other things. Even customer orientation, company values and corporate culture can somewhat be sensed by browsing this material.

3) Newspapers and newsletters
Newspapers and vast amount of different www-sites offer also valuable information for the analysts. This information might discuss the company directly or about the products, markets, technologies or competitors it operates closely with. With newspaper supply a very good and real time source for the analysts are the newsletters that are delivered directly to e-mail and are normally free as they are financed with advertisements. In Finland many financial newspapers (like Taloussanomat, Talentum) have this kind of free service.

4) From company directly (Investor Relations)
Company Investor Relation-services are dedicated to offer investors information about the company. Of course they can’t reveal anything that might have instant effect on stock price as that kind of information must be revealed to all investors simultaneously with stock exchange releases. So it is no use in asking investor relations about what kind of growth they estimate in their sales or EBIT, but you can ask them relevant background information about the published figures, products, competitors etc. Below is more about this under topic where to get information about competition.

5) Company info, CMD, other visits to company
Companies normally arrange at least some public events per year where the management tells about published result (fiscal year or interim info) or their outlook and strategy in general (CMD = capital markets day). If you have informed company Investor relations-department that you are following the company and your analysis goes to customers through Valuatum Platform and thus through brokers X, Y and Z, then you will be invited to such events. Sometimes these events are also publicly convened. Analysts can also often meet management or CFO personally with meetings scheduled on their own. Especially smaller companies are eager to meet analysts as it is their way to increase their publicity and thus also share liquidity.

6) Other sources like: company sales/customer service, customers, competitors
The best sources of objective information are of course the crucial operating activities: company sales/customer service, customers, competitors etc. If you talk with the big customers of the company and they reveal that they are not satisfied and decreasing – or that they are very satisfied and increasing – the sales from the company, then that is of course the most powerful information that you can have supporting your analysis.