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Equity Valuation – Understanding What's Important

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The Goldman Sachs Group, Inc. Equity Valuation – Understanding what’s important November 2009 Helen Jewell, CFA 44-20-7552-9454 [email protected] Introduction • We are going to consider three of the most popular and effective valuation tools • Returns based analysis • Multiple Analysis • DCF • For each of them we are going to look at: • How they work • Why some work better than others, and…. • Why they are all simply different ways of looking at the same thing Goldman Sachs Global Investment Research 2 Returns Based Analysis Key Idea It’s all about the value-added Excess value Actual Return CROCI created by a versus company Required Return WACC Versus Excess value Actual Value Total EV attributed by versus Gross Cash the market Invested Value Invested If these are out of For Director’s line, the stock is Cut, but can misvalued adjust Goldman Sachs Global Investment Research 4 Why Does it Work? You invest $100m in some assets Your required return is 10% The actual The actual The actual return is 10% return is 20% return is 5% The investment The investment The investment should be worth should be worth should be worth $100m $200m $50m EV CROCI EV CROCI EV CROCI GCI WACC GCI WACC GCI WACC Value Creating Value Destroying Goldman Sachs Global Investment Research 5 Calculating CROCI Operating cash flow Non-cash items and the company’s (ignoring Working Capital) financial structure have no impact, making plus after-tax interest and comparisons more meaningful lease expense Interest and Lease x (1 – Tax Rate) CROCI = Debt-Adjusted Cash Flow Gross Cash Invested Pre-depreciation and write off value of tangible and intangible assets Gross Assets plus Operating Depreciation policies do not impact this working capital plus capitalised figure leases plus investments Goldman Sachs Global Investment Research 6 Companies are compared with the sector 1:1 line 2.0 Overvalued Line representing average valuation for the 1.5 sector Question: Why are these different? 1.0 DC score > 1 EV EV / GCI DC score < 1 0.5 Undervalued 0.0 0.5 1.0 1.5 2.0 2.5 CROCI/WACC Quartile 4 Quartile 3 Quartile 2 Quartile 1 Goldman Sachs Global Investment Research 7 Why are these different? • Capex • Valuable assets which are not revalued (eg. Intangibles) • Growth….. Goldman Sachs Global Investment Research 8 What about growth? • Absolute growth is not the driver of value • Why? • Growth isn’t always good • Returns, not growth, have historically been shown to drive valuations • Returns are more stable and consistent than growth Goldman Sachs Global Investment Research 9 Growth isn’t always good! • If management are generating lower returns than required returns, then value will be destroyed • If management are generating higher returns than required returns, then value will be added Pri ce Down Price Stable Pri ce UP Value Destroyer Value Neutral Value Adding Return < Required return Return = Required return Return > Required return h G wt o ro od G Gr ad ow B th Growth Growth High Low Low High Goldman Sachs Global Investment Research 10 Cash return spreads, not growth, drive valuation and performance Director’s Cut shows the highest correlation with market valuation over time in AEJ… …as well as in Japan 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% R^2 across sectors 2000-2008 average 2000-2008 sectors R^2 across R^2 across sectors 2000-2008 average 2000-2008 sectors R^2 across 10% 10% 0% 0% EV/EBITDA vs. Div Yield vs. PE vs. EV/GCI vs. Div Yield vs. PE vs. EV/EBITDA vs. EV/GCI vs. Next year EBITDA growth Next year DPS growth Next year EPS growth CROCI/WACC Next year DPS growth Next year EPS growth Next year EBITDA growth CROCI/WACC Source: Goldman Sachs Research estimates, Gao Hua Securities Research estimates. The market values companies on returns : The correlation between capitalization of cash invested (EV vs. GCI) and economic return spread (CROCI vs. WACC) is significantly higher than between multiples and growth Goldman Sachs Global Investment Research 11 Superior returns are more sustainable than superior growth Top-quartile returns more sustainable than growth in AEJ… …as well as in Japan 80% 90% Average years first quartile position is sustained: Average years first quartile position is sustained: CROCI: 2.4 years CROCI: 2.8 years Growth: 1.3 years 70% 80% Growth: 1.2 years op-quartile) op-quartile) 70% 60% More than 95% of companies display first About 95% of companies display first quartile quartile growth for 2 years or less. Approx. 85% growth for 2 years or less. Approx. 80% do not do not make it past 1 year make it past 1 year 60% 50% 50% 40% 40% 30% CROCI is much more sustainable, with approx. 30% of 30% companies that ever returned a top quartile CROCI, holding the CROCI is much more sustainable, with more than 35% of position for longer than 3 consecutive years companies that ever returned a top quartile CROCI, holding the 20% position for 3 consecutive years and longer 20% 10% 10% Percentage of companies (at least one inyear the t Percentage of companies (atinyear of least one Percentage companies the t 0% 0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Number of consecutive years in first quartile Number of consecutive years in first quartile First quartile CROCI First quartile Growth First quartile CROCI First quartile Growth Source: Company data, Goldman Sachs Research estimates, Gao Hua Securities Research estimates. And understanding the sustainability of returns is critical for valuation…… Goldman Sachs Global Investment Research 12 Taking the methodology one step further – understanding the behaviour of Q1 and Q4 CROCI companies • Companies who have Q1 CROCI and who can sustain this level of CROCI will be ascribed a premium by the market (they may appear to be overvalued but they are not). The size of the premium depends on how long they will stay as a Q1 CROCI stock • Companies who move into Q1 CROCI but for who the market does not believe this to be sustainable will not re-rate (they may appear to be undervalued but they are not) • Companies which are Q4 have a floor valuation and so trade at a premium to the line. The size of the premium depends on whether they are a sustained loser or not Goldman Sachs Global Investment Research 13 The adjusted Director’s Cut methodology – looking at the duration of value addition/destruction Sustainable leaders: Valuation premium increases over time, up to c.10% premium Unsustainable leaders: Trade at a c.10% valuation EV/GCI EV/GCI Unsustained disadvantage: discount Trade at a c.20% premium Sustained Quartile 4 Quartile 1 disadvantage: Trade at a c.5% CROCI/WACC premium Source: Goldman Sachs Research estimates Goldman Sachs Global Investment Research 14 Industry Leaders: Sustained advantage greater than four years is reflected in the valuation premium Average premium/(discount) ascribed to stocks sustaining top-quartile CROCI for 1-6 years 20% Similar to our analysis in Europe, we find 15% that 4 years of return sustainability is the key. There is a valuation premium for 39 24 companies sustaining top-quartile CROCI for 4 years or more and a valuation CROCI/WACC 10% discount for companies sustaining top 56 quartile CROCI for 3 years or less 5% 0% 1 2 3 4 5 6 82 -5% -10% 141 Number of companies -15% 260 Valuation Premium/Discount to sector avg vs. avg EV/GCI to sector Premium/Discount Valuation -20% Number of consecutive years in first quartile Source: Goldman Sachs Research. Goldman Sachs Global Investment Research 15 Industry Laggards: Sustained disadvantage leads to a lower valuation premium, which disappears after 4 years Average premium/(discount) ascribed to stocks sustaining bottom-quartile CROCI for 1-6 years 25% 20% 504 209 WHY? Number of companies CROCI/WACC 15% 10% 101 5% 56 0% 30 1 2 3 4 5 6 -5% 15 -10% Valuation Premium/Discount to sector avg EV/GCI vs. EV/GCI to avg sector Valuation Premium/Discount -15% Number of consecutive years in fourth quartile Source: Goldman Sachs Research. Goldman Sachs Global Investment Research 16 Sustained laggards tend to revert to an asset- based valuation Continuous fourth-quartile CROCI companies find a floor at about 0.34X sector relative EV/GCI in AEJ… …and 0.27X in Japan 0.60x 0.60x 0.55x 0.55x 0.50x 0.50x 0.45x 0.45x 0.40x 0.40x 0.35x Sector Relative EV/GCI Sector Relative 0.35x Sector EV/GCI Sector Relative 0.30x 0.30x 0.25x 0.25x 0.20x 0.20x 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 9 Number of years in fourth quartile Number of years in fourth quartile Source: Goldman Sachs Research. While CROCI may trend towards zero (or negative), enterprise values are unlikely to converge towards zero due to potential for sale or break-up, hence sustained laggards find a floor Goldman Sachs Global Investment Research 17 Sustainable returns…..GS SUSTAIN GS SUSTAIN identifies companies which stand out for their superior performance in each of the drivers of corporate performance: • Return on capital Identified by looking at CROCI quartile • Industry positioning Identified in collaboration with teams Using our ESG Management quality with respect to ESG issues • framework GS SUSTAIN focus list performance YTD Goldman Sachs Global Investment Research 18 Backtesting shows consistent alpha generated 75% The Director’s Cut basic methodology generated 47% long/short performance in Asia on average (2000-200 60% 45% 30% 15% 0% 2000 Source: Goldman Sachs Research.
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