Sunday, August 10, 2008

The Double "Whammy" of Lower Profits and Lower Valuations

One cannot help but notice that in the current bearish climate, many companies with once sparkling results and bright futures would have their growth rudely interrupted by the arrival of high oil prices, runaway inflation and a slowdown in economic growth. Many companies which were once touted as "sure-fire" growth stories had their businesses marketed by analysts (who of course wrote equally sparkling reports) and their target prices continually raised in the raging bull market which all but ended late 2007.

Now, one also cannot help but notice that the target prices and valuations of such companies are being slashed and reduced by a margin as deep as 50-60%, with some cases even up to 70-80%. This is what I would term as the "double whammy" of lower profits and lower valuation. Together, they form a deadly cocktail mix which can cause a once high-flying company's share price to come crashing back to Earth. Ok, some may argue that it was not justifiable to trade at such valuations in the first place, but bull market baloney is common and pervasive during the final stages of any bull market; thus investors and punters will simply ignore good advice and continue playing the Greater Fool Game (to their eventual detriment).

Basically, the premise is simple: a company reports a fall in profits due to rising costs and inability to raise prices sufficiently to offset these costs. To add to their woes, staff and admin costs have also increased and put a further strain on net profits. This would of course lead to lower profits in subsequent quarters and the company may see its net profit contract by about 40-50%. The problem is that when this happens, the growth multiple assigned to a company (called the valuation metric or Price-Earnings Ratio - PER) will also correspondingly fall because of lower expectations for growth. This can be clearly seen in the cases of some China companies which had been trading at valuations of 20-25x during the bull market. In today's bear market, with falling profits and limited prospects for growth in market share and margins, analysts are valuing it at a measly 5-6x PER. Thus, the effect of these 2 events causes a severe share price devaluation due to anticipated lower profits as well as putting a screeching halt to growth expectations.

This scenario is best illustrated with an example (as shown below):-

In the simple example, Company ABC reports a 20% drop in revenues for 2008 compared to 2007. As a result of increased COGS (same COGS with lower revenues - probably due to high oil prices), they report a lower gross profit of 33%. Expenses actually increased marginally by 20% in this example but the impact is that net profit is reduced by 60% (due to the lower absolute gross profit figure). Net profit margin is slashed from 40% to just 20% as a result of rising costs. Assuming the same share capital base from 2007 to 2008, EPS is also reduced by 60%. However, the important part of this example is the valuation given to the company. For 2007 (when growth was still optimistic and everything looked rosy), the company was accorded a PER fof 20x, thus valuing it at S$1.60. When the problems kicked in and growth was shown to be stunted, the valuation accorded is reduced to a mere 5x, which values the company at just S$0.16, representing a 90% drop !

Although this example may seem rather extreme, the point I am making here is that the numbers could very well represent that of an actual company (many companies see profit drops of about 40-50% in the current economic climate); but the impact to share price would be far greater than just 40-50% and could be in the magnitude of 70-80% (as illustrated) due to lower valuations accorded. Thus, it is no surprise to see a company which once traded at S$2.52 (its peak) suddenly trading at a mere S$0.43, for a drop of about 86%. The effect can be adequately explained by the example above, though of course I am merely using hypothetical numbers.

Therefore, it is crucial for an investor to use a lower valuation metric when seeking margin of safety, and to assume that growth slows down or smoothes out over a period of time, in order to avoid such a situation. When one purchases a company with the assumption of an annual 100% growth in net profits and a valuation of 20x, one is either being unrealistic or downright foolish because a company cannot sustain such growth at such high valuations for an extended period of time.

14 comments:

patrick ho said...

very insightful indeed. what I do is not to use the PER at all. On the rare occasion that I use it,(as for Pac Andes due to its inconsistent free cash flow) will always adopt analyst consensus estimate, take between 10-20% below the forecast, and also 10-20%the PER assigned;) Thks for the article.

musicwhiz said...

Hi Patrick Ho,

Hmm problem with analysts is that they tend to go by sector analysis and using a basket of companies for comparison. Nothing wrong with that of course, but each company may have its own unique competitive advantages which cannot be reasonably quantified. Hence, I think a holistic view of a company is a better gauge of whether it has sustainable growth.

Regardless, everyone has their own method and you should definitely stick to whatever you are comfortable with. :)

Regards,
Musicwhiz

Anonymous said...

Hi Musicwhiz,

I am looking for a book on how to read/interpret a company's "balance sheet" & "profit & loss statement". Do you happen to know any good "introductory" book ? [ My background: I am an Engineering and have studied a subject called "accountancy" many years back. I am also a beginner in stock investing. ] Thanks in advance !

Augustine said...

interesting article that highlights the problems of relative valuation.

I believe that's why most analyst and investors have switched over to using DCF valuation whenever possible.

But then again, there will always be a problem with whichever valuation tool one uses. Hence it's always prudent to keep your assumptions conservative

Cheng said...

Hi MW,

I learnt something new today! :D

Thanks for your article.

Regards,
Cheng

musicwhiz said...

Hi Anonymous,

Well I usually recommend "Value Investing for Dummies" as a good introductory book for those who are clueless about accounting. It gives a very layman explanation and is suitable for those wanting to get a basic understanding of the 3 statements.

Regards,
Musicwhiz

musicwhiz said...

Hi Augustine,

Yep, analysts can change their valuation metrics on a whim, and no one questions their sudden switching from DCF to PER and back again to DCF when it suits them.

Recall that for Boustead's valuations, Phillips first used PER and then switched to DCF when it suited them to lower their target price. Later on, DBSV used PER again, so it gets confusing for a retail investor. I do agree we should keep all assumptions very conservative, in order to maintain margin of safety.

Cheers,
Musicwhiz

musicwhiz said...

Hi Cheng,

No problem, thanks for visiting !

Regards,
Musicwhiz

Augustine said...

Hi Musicwhiz,

I haven't tracked the inconsistencies of analyst when it comes to their valuation.

I do know that DCF, PER, EVA etc are decided mainly by choice of the analyst or dictated by the reported earnings of the company.

It would be interesting to track the inconsistent change in valuation methods by these analyst in Singapore.

musicwhiz said...

Hi Augustine,

Yep, it certainly would. I think you'd be amazed how quickly analysts change their minds about a company, and they can slash target prices by as much as 60-70%, which makes you wonder about the original forecast eh ?

Regards,
Musicwhiz

Xtrocious said...

I guess there is no one "right" valuation methodology...

As the saying goes, there is more than one way to skin a cat :p

The P/E method is usually used because it is easy to relate to and offers a simple way of comparing between companies...

Cashflows-related valuations are a bit more complicated and they also depend on how certain are the company's cashflows and uses of cash...

In an ideal situation, different valuation methodologies should yield the same target price but then again, we are not living in a perfect world :(

Personally, I always take these analysts' estimates with a pinch of salt (but sometimes may be a case of sodium overdose where certain houses are concerned)...hahah

Ricky said...

Always enjoy reading your posts. Had the dubious distinction of buying the worst of the China stocks, suffering a loss of 90% of about 2k.Thankfully, i only bought 1 lot as i didn't have much capital to begin with. But it was a painful lesson for a beginning investor like me.

musicwhiz said...

Hi xtrocious,

I agree there is more than one method. PER is the "roughest" method and has been criticized for over-simplication. Therefore, I use a combination of other qualities in a company plus other numbers to determine my BUY decision. Of course, one can use a variety of methods but the ultimate question would be which method is the most suitable ? That's the grey area in my opinion.

Regards,
Musicwhiz

musicwhiz said...

Hi Ricky,

Sorry to hear that. Yes it's a lesson to learn and I've been through it too.

Take care and be cautious when investing in a bear market !

Regards,
Musicwhiz