"...the end of the day it is the return on the assets that underpins the share price valuation."
Thanks, davmarc for your encouraging words, but that statement of your that I’ve quoted above is only partially accurate.
But what's missing to complete your statement is some quantification of Price-to-Book Values in relation to Financial Returns.
Generically, Price-to-Book Value is proportional to Return-on-Capital (and Return on Capital is a proxy for Return on Equity, ROE)
In the trivial case of a company whose Return on Capital exactly equals its Cost of Capital, then Price-to-Book should be equal to 1.0, according the classical valuation theory.
And when business generate returns above their Cost of Capital, then the Market Value should exceed Book Value.
Conversely, when Return on Capital is less than the Cost of Capital, the Market Value should be at a discount to Book Value (which is the case for Boom).
But the question, in Boom’s case, is the current discount-to-book value steep enough? Or is it excessive?
There is a way to establish this:
That is, to artificially write down the value of PP&E – and make the corresponding adjustment to Shareholder Equity – that results in a Price-to-Equity (aka Price-to-Book) ratio of 1.0.
And to then reconcile this with the Return on Equity (derived from Current NPAT divided by Shareholder Equity, adjusted by the write-downs that were made).
If the resulting ROE exceeds the Cost of Capital, then the share price is fundamentally undervalued.
In Boom’s case, the required write-down to get parity in Price-to-Equity is a whopping $250m-odd. This would leave the PP&E carrying value at around $80m.
And the resulting ROE – based on FY14 – is 30% (recall that in the exercise PP&E was written down to the extent that got Price-to-Book Value of parity, the depreciation charge would fall by proportionally the same amount as PP&E, thereby increasing underlying profitability....)
30% is certainly a lot higher than Boom’s Cost of Capital.
[Yes, I know this is all accounting hocus pocus, but that’s what happens when companies undertake asset write-downs: ROE goes up...and of course, Price-to-Book goes up as well, maintaining the relationship between the two ratios, and this explains why share prices often do very little when write-downs are announced (unless, of course banking covenants involve Net Debt-to-Equity as key metrics, in which case it would matter, but that’s a solvency issue and not a valuation theory consideration per se).]
So, if we were to set the asset base to the point that coincides with Price-to-Book of 1.0, then that would leave Boom generating a return well above its cost of capital.
This clearly demonstrates the under-valuation of the company in a valuation theory.
Note:
Another way the exercise could have been conducted would be to write-down the asset base to the point at which the company’s ROE is equal to the Cost of Capital, and to then compare this with the resulting Price-to-Book.
Recall that when a company’s ROE equals it’s Cost of Capital, Price-to-book should be 1.0. To the extent that it isn’t will give some idea of the undervaluation.
In Boom’s case – assuming the Cost of Capital is 10% for easy maths (cost of debt is around 7.5% and cost of equity is probably 12% or 13%, so the company’s weighted Cost of Capital is around 10%, or thereabouts) – the resulting Price-to-Book value is 0.45.
Simplistically, this means the stock’s intrinsic value is double the current market value.
Point being made is that financial returns, in isolation, do not provide the full valuation picture... one needs to answer the question, “how is the stock being priced for the returns it generates (however high or low those returns may be)?”.
Regards
Camadam
(Final point: NB, while this is the way finance theory textbooks teach, in practice share prices do not behave perfectly the way the theory suggests. So while in some cases the relationship between ROE and P-to-B is not 100% correlated, in Boom’s case the discrepancy is so wide that it falls way outside the regression series of the universe of listed securities for which P-to-B is plotted against ROE, making the undervaluation case unambiguous even after allowing for statistical market inefficiencies.)
Expand
(20min delay)
