Building a Core China Portfolio – Part 5, The Equivalence

7 Sep

Before we move onto analysing Vtech’s balance sheet strengths and risks allow me to digress for one blog entry…

Every company has a replacement value; that is the amount it would cost to set up the company from scratch and get it to its current state of returns.

The market cap of a company is a theoretical takeover price.  The difference between the market cap and the replacement value represents the premium (or discount – a discussion for another time) that investors will pay for a company over its replacement cost. By way of an example, if the replacement cost of a company is $1bn, and the market cap of the company is $2bn, then the ratio is 2x. In other words, investors are willing to pay twice the value of the price tag to set up the company from scratch and nurture it to current state.  But why would someone be foolish enough to pay twice the price for an asset?

Put simply, investors believe that the present value of all the future returns of the company is currently worth the replacement cost of the company. Add those future returns present valued ($1bn) to the current value of $1bn, and you get a company value of $2bn, hence the 2x price/replacement cost ratio.

It should be possible to derive the same figure by finding the ratio of a company’s return (ROE) to its cost of equity.  This ratio will tell you the excess return a company will create over the cost of investing in such a return.

If one assumes that over the long-term the fundamentals of the market and prices must coincide (i.e. the arbitrage opportunity for a good buy will be removed over time), then using both these ratios together one can see whether the market is currently pricing an arbitrage situation, i.e. is the current price a good entry point. Let’s put it another way:

Over the long-term there must be equivalence between our two ratios:

[Market Cap] / [Common Equity] = ROE / [Cost of Equity]

As a one man band I am forced to make a number of simplifications when using the above principals.  Firstly, I’m sure you noticed that I substitute replacement cost with book value (i.e. common equity). Secondly, I replace a real cash return for an accounting based ROE.  In reality, a cash based return on an economic replacement cost – i.e. an economic profit version of the numbers – would yield a cleaner and more reliable set of results.

Let me digress a little more before I bring us back to VTech. These ideas are not my own. They come from a book called Cash Return on Capital Invested (CROCI), written by Pascal Costantini.  Using an economic profit adjusted model, and accounting for growth (amongst other things) Deutsche Bank currently value companies using this method, with a high degree of accuracy.

Anyway, back to VTech.  I would normally focus on the balance sheet, capital allocation and cash conversion of a company before paying too much attention to the valuation side of our work.  However, I was struck by the price/book consensus valuation on Bloomberg of 4.7x 2011e (note the company has a March year end), and 4.3x for 2012e. These numbers seemed very large to me, so I decided to investigate earlier than usual in my process, based on the equivalence of the two ratios presented above. Costantini in fact calls it The Equivalence.

In the 2010 VTech annual results, they have HK$4bn of common equity. The market cap of the company is HK$19.4bn. Dividing the Market Cap by the common equity gives a ratio of 4.85x. In other words investors are willing to pay 4.85x my approximation of the replacement cost of the company.

That’s all well and good if we assume that the company can make that residual return over its cost of equity consistently.  The data presented in my previous blog entries highlights VTech to have a sustainable ROE of around 40%. Not only is that great, but it compares favorably with both peer groups (as we’ve seen).

Nonetheless, using our two ratios, we can divide 40% by 4.85x, which means the market is assuming this company has a cost of equity of 8.25%. I’m not going to calculate a cost of equity for this company as it’s beyond the scope of our discussion. But I will stress test this level with a common sense assumption that a cost of equity below 8.25% is unlikely, so at best the company is at fair value. I note that Citi Bank’s DCF on Vtech uses a 9.1% WACC – now this company has no long term debt, so that ‘s effectively a cost of equity.

So if we just assume for a minute that VTech’s cost of equity is 9%, then the current share price is 9% overvalued. (i.e. [[40%*4bn]/9%/19.4bn]-1).

But hang on a minute… there are other plausible alternatives to this interpretation of the data…

Perhaps the book value used in the equation is below the actual replacement costs (i.e. you really need economic profit data to make The Equivalence work). Maybe  the cost of equity is either lower or expected to get lower in the future, and my common sense feel is incorrect (I’m willing to accept that!). In addition, the market might be saying that the sustainable ROE is going to increase in the coming periods. In other words all 4 parts of this equation have elements of dynamism.  The data alone does not give us the answers as to whether VTech is over, under or fairly valued. The data is agnostic.  But it gives us a prism through which to digest the company and ask relevant questions in our analysis, and to bear in mind that this might be a chink in the armor.

I am not going to write for over a week now, but in my next blog entry I will be looking at the strength of VTech’s balance sheet, capital allocation, and quality of earnings.

Stay tuned….

Zai Jian

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