Business Valuation

“What makes a company valuable? To me, it always comes down to earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that will ever happen. But value always win out – or at least in enough cases that it’s worthwhile to believe it” (Lynch, 1989).

Of course, as investors, the most important thing is not the net income but the free cash flow. Free cash flow is the cash a company generates after spending money to maintain or expand its assets.

If there is no conflict of interests between management and shareholders, that FCF will go back to shareholders, either as dividends, share repurchases, acquisitions or via improvements in the company financial position, since:

FCF = Net Income – Capital Expenditure + Depreciation – Change in Non-Cash Working Capital – Principal Repayments + New Debt Issues

Net income and FCF are related. Each company is different and investors will have to determine the quality of the net income for each company. A good investor needs to understand perfectly each movement in the cash flow statement.

Before investing in a company, you need to see what the management team has done with each euro the company has generated. What percentage did they use to pay dividends, to buy back shares, to make acquisitions or to reduce debt/increase cash? How much is the company paying to maintain or improve its assets, such as properties or equipment and what profitability can be obtained from them? How fast can the company grow internally? Is the depreciation charge appropriate with respect to what the company has to pay to maintain and renovate its assets?

The market always ends up recognizing the ability of companies to generate cash. If market panics and the share price goes down too much with respect to what the firm can generate, investors will end up realizing that the expected annual return for them is going to be high and prices will end up adjusting upwards.

Warren Buffett has also insisted on the importance of what he calls look-through earnings, which mainly include both the retained earnings that the company uses to expand its operations, and the earnings that a company pays to its shareholders in the form of dividends, adjusted for taxes.

“The goal of each investor should be to create a portfolio that will deliver him or her the highest possible look-through earnings a decade or so from now” (Buffett, 1991).

An investor needs to think for the long term: “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes” (Buffett, 1996).

Since 1970 Berkshire Hathaway earnings figure has grown at a rate of 20.6% and the stock price over the same period has increased at a similar rate.

At the end, investors’ gains must equal businesses gains. The investor should measure the progress of their investments by evaluating the improvement in both, earnings and the widening of their “moats”.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

In order to understand this relationship between profits and multiples, we are going to take a historical example, Corticeira Amorim, and two fictitious examples.

This is not a recommendation to buy shares and we are not saying that shares are cheap or expensive at the moment. We are only showing the historical evolution of the company fundamentals and its share price from 2005 and 2015.

We decided to choose this company as an illustrative example because it operates in a very stable market. It has clear competitive advantages and there are no conflicts of interest between management and shareholders as the Amorim family has almost 85 % of the shares. The business was founded in 1872 by Antonio Alves Amorim, the great grandfather of the current CEO.

Corticeira Amorim is the world leader in cork manufacturing with a global market share of more than 35%. It is twice the size of the second largest manufacturer. The 5 or 6 largest companies in its sector control around 60% of the market and the rest of the market is supplied by around 300 or 400 small companies.

More than 50% of the cork forest is concentrated in Spain and Portugal. Algeria, Morocco, France, Tunisia and Italy are also important producers. Therefore, Corticeira benefits from its location as they have great source of supply and low transportation costs.

Annual cork production by country:

Corticeira Amorim worldwide presence:

More than 60% of its profits come from the sale of cork stoppers. It is important to notice that, as their financial statements show, the Group has been able to overcome serious threats, such as the emergence of strong substitutes – the plastic stopper and screw-cap alternatives.

In the 1990s, cork prices increased substantially due to the steep increase in demand from countries such as Australia and the United States. Cork is a limited resource so prices tripled in a short period of time. Furthermore, customers’ complaints about cork taint, caused by TCA (a powerful chemical that can cause bad flavors in wines), increased considerably and it challenged the predominance of cork stoppers.

The family decided to focus on cork, knowing that the majority of premium wine makers prefer cork and cork stoppers could be improved. Even if it could have been more profitable for them in the short term to take advantage of their distribution network to sell other products, Corticeira made the decision for the long term.

That is when Corticeira invested heavily in R&D to detect and reduce TCA in its stoppers and to do laboratory analysis to compare the benefits of cork against those of plastic. Corticeira could disclose the results of their studies and lost customers shifted back to cork again. In addition, the company launched successfully new products to compete with plastic in the lower market segment.

In 2001, aluminium screw caps also threatened the predominance of cork, but Corticeira has also been successful competing against them. According to experts, unlike plastic or aluminium, cork allows the right amount of oxygen to pass into the bottle over time and, aesthetically, wineries like cork. According to a research made by Nielsen Scanning Statistics, for the top 100 Premium Wine brands from June 2010 to June 2016, cork finished wines increased their sales by 42% compared to a 13% increase in sales for the rest.

The firm breaks down its sales by 5 business units: Cork stoppers, which represent more than 60% of their profits, raw materials (it mainly buys raw materials, stores them and sells it to the other segments), floor & wall coverings, composite cork (cork composites for different industries such as aerospace, transport or construction) and insulation cork (acoustic and thermal insulation).

The last four units have shown stable results over the period. Focusing on cork stoppers, which is the most important segment, we can see how segment sales have increased from €240M in 2005 (selling around 2,900 million cork stoppers for an average price of 8.3 pence) to €393M in 2015 (selling around 4,200 million cork stoppers for an average price of 9.4 pence).

Volumes have increased, and although prices have increased only slightly, the company has been able to increase its EBIT (earnings before interest and tax) margin from 6.3% to 12.5%, thanks to improvements in efficiency. Therefore, its total EBIT has increased from €26.8M to €75.7M.

Over the period, it has generated more than €350M in free cash flow and it has spent around 42% of that money to reduce debt by around €150M, around 45% in dividends and around 13% in acquisitions. As the debt has been reduced substantially, the company can now distribute most of its profits among its shareholders via dividends as it did in 2015.

It is very interesting to observe the evolution of the share price in the period. In 2005, an investor could buy shares in Corticeira Amorim for a price of €1.48, equivalent to 12.5 times the annual earnings of the company for that year. In 2015, the share price was €5.90, equivalent to 14.3 times the annual earnings of Corticeira for the year.

As we can see, the share appreciation has been due to good results, there has not been a bubble. If you add up dividends to the share appreciation (without taking into account taxes investors pay when they receive dividends), the annual return over the 10 year period has been 14.6%.

It is interesting to notice the volatility in the share price in the short term. After 7 years, in 2012, although the company was making twice as much money and it had already repaid around half of its debt, the share price was lower than in 2005, trading at just 6.1 times its earnings. Some good investors realised this. How could they be sure that the price was going to adjust upwards to its intrinsic value? For that price, the estimated annual return (dividends + future price appreciation) investors could obtain from their investment was too high and investors would rush to buy shares as soon as they saw this investment opportunity. For instance, only in dividends, the company paid in 4 years as much as what an investor had to pay in 2012 to buy the shares.

If you had invested in Corticeira in 2005, in 2012 your annual return would have been close to 0%. You would have been right in your investment thesis, but you would have had to calm your nerves because other companies that you knew were bad investments were performing better. Even your friends would have, from time to time, reminded you how low the share price was. They would also have reminded you how bad the chart pattern looked…

However, at the end value always wins out, the share price went from €1.42 to €5.9 in just 3 years. That is why Alvaro de Guzmán quoted: “Value investing is about looking dumb most of the time and suddenly being right”.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

In order to understand this relationship between profits and multiples, we are going to take a historical example, Corticeira Amorim, and two fictitious examples.

We also wanted to show how both, a stable company and a growth company can be attractive for a value investor:

FICTICIA STABLE S.A.

Let’s imagine that we research a company with a very good position in its market, which has shown stable profits for the last years and decades. We see that the company has an acceptable level of debt, it has always converted its profits into free cash flow an due to its lack of growth opportunities, it has always paid all its profits in dividends.

If we pay for €10 a company which generates €1 per year (P/E ratio of 10), our expected annual return (without considering taxes), expecting a P/E ratio of 10 in 10 years, will be 10%.

Even if our price falls by 50%, we are going to be happy knowing that we keep on receiving that €1 dividend per year. Investors would soon realise that the annual expected return with a P/E of 5 would be around 23% and the price will go back up.

FICTICIA GROWTH S.A.

Now imagine a company which uses all its profits to invest in new assets, so it does not pay out any dividends. We see that it has historically grown at an average rate of 20%. We understand how much it can obtain per euro invested and determine that the market has not changed at all so it can still grow at the same annual rate for the next 10 years.

If we buy for €23,8 a company that generates €1 per year (P/E ratio of 23.8) and grows at an annual rate of 20%, expecting a P/E ratio of 10 in 10 years (P/E of 10 as a margin of safety), our expected annual return will also be 10%.

Therefore, when an investor buys a company selling at a high multiple, the expected return can be good if the company delivers that expected growth in the long term.

However, investors could not obtain good returns from their investment if they pay too much for those good future results. For instance, if an investor pays more than €23.8, her expected annual return will be lower than 10%, even when company results are good.

Consider a company which sells at a P/E ratio of 30 because its growth rate in the past has been impressive and the outlook looks good. If the company keeps on growing at a very high rate, the returns for the investor will be good. On the other hand, if the fundamentals of the company deteriorate, the investor can lose a lot of money on that investment. First, there will be a rating downgrade and the P/E ratio will go down, and so will the stock price. Then, if the company earnings decrease, the stock price will go down even further.

That is why a company which sells at a P/E ratio of 30 can be cheap if you know the company extremely well and its growth is going to be positive. Conversely, a company selling at a P/E ratio of 5 can be very expensive if you know that in some years the company will earn a quarter of what it now earns.