Much nonsense has been written in the past two years about equity valuations. We read that we should...
Much nonsense has been written in the past two years about equity valuations. We read that we should ignore old fashioned, tried and tested measures of valuation. Instead, new measures were invented that had a lower multiple attached to them and made expensive shares look cheap.
Rather than look at earnings, assets and cash, many analysts were concentrating on sales multiples and, through the skillful use of complex discounted cashflow models, were able to create price targets that resulted in predictably laughable results. I remember a top-rated analyst set a £40 price target on a FTSE company based on a terminal value of the business, where margins were assumed to increase every year for 10 years. But the next 10 years of profits still produced a negative present value. The share price is less than £1 today.
We still consistently read or hear about EBITDA (earnings before interest, tax, depreciation and amortisation) numbers. While EBITDA is a useful performance indicator, we must never forget that all the omissions are real charges on a business and can dramatically effect shareholder value.
Analysts frequently underestimate the operational gearing in companies and while, in periods of strong economic growth, this allows them to reiterate their positive stance and upgrade profit expectations, the converse is less appealing.
We are concerned that too many companies have stretched balance sheets and poor cash generation at this time of the economic cycle, when it is very difficult to dispose of assets or to issue equity.
The inevitable conclusion from our research is that, over the next few months, we will see rights issues needed to rescue companies and management changes made in an attempt to restore investor confidence.
There will be considerable pain and many late nights required for troubled bankers. When this occurs, there will be some outstanding bargains but it is better to buy into these situations when expectations are more realistic. It is too early to buy UK equities for recovery.
This process is, of course, an inevitable part of our economic cycle. While most companies can survive with a strong economic headwind, only the good ones prosper in tough conditions. Indeed, the best companies will increase their market share and emerge in a much stronger position, with faster growth prospects. However uncomfortable it may feel, this is a useful rationalisation process and improves the allocation of capital in the long term.
For investors, this is a challenging time but it will also be full of opportunity. The stock market is semi-efficient and, in the long run, prices of all assets will tend to reflect their intrinsic worth. The key to exploiting these anomalies is in the accurate assessment of an asset's worth.
Rather than listen to analysts' price targets, read consensus forecasts or calculate EBITDA numbers, investors who can conduct rigorous, high quality research, use tried and tested measures and are prepared to back their research with aggressive portfolio action will thrive in these markets.
It is too early to buy UK equities for recovery.
Pain ahead for weaker companies.
Difficult to dispose of assets.
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