Some of the dangers inherent in trying to value very cyclical businesses are neatly highlighted by two separate broker comments that recently dropped into The Value Perspective’s inbox on the same morning. Both happened to concern mining companies but really the conclusions we plan to draw from them are applicable to lots of different businesses.
Both notes shared a desire to rationalise the falls in mining companies’ share prices. When the current share price of a business moves too far away from the target price the broker firm has set, senior management can start asking questions, analysts can start getting nervous and the necessary strong conviction can start to evaporate. A note justifying the current state of affairs is often the result.
As we said, we received not one but two, the first of which – from a broker that, to be fair, has been pretty negative on mining companies for some time now – informed us the net present value (shareprice) of BHP Billion was now less than £3. Clearly we must have missed a previous note from the broker setting a £3 price target when BHP Billiton’s share price was pushing up towards £20 in the summer of 2014.
Anyway, ‘net present value’ is effectively a method of valuing a company through discounted cashflow analysis, which is not perfect because it does require an element of long-term forecasting. Still, in theory, the approach works well enough for mining companies because, as we have explained in articles such as Iron deficiency, one might reasonably expect a mine to be operational for decades.
In the greater scheme of things therefore, next year’s profits are less of a consideration for a miner and the company’s net present value should not move around too much. This in turn has led to the idea of ‘price to net present value’ where, for example, an analyst might draw attention to the fact a company is currently trading at an unusually high discount versus its net present value.
That would be fine if a business’s net present value did not move around – and, when it moves around a lot, analysts can begin to tie themselves in knots. After all, how do you set about bringing the net present value of BHP Billiton down to £3 when, as we mentioned earlier, it was more than six times that in the summer of 2014?
The answer to that question is you tinker with one of two key numbers. Either you can change the long-term price of a commodity for the rest of time to come – which is naturally going to have a huge impact on the value of any business that digs the commodity out of the ground – or you can start to play with your discount rate.
The discount rate is basically the rate you use to discount all of a business’s future cashflows in order to think of them in ‘today’s money’ terms. There are a lot of very clever and allegedly scientific ways in which you can come up with your discount rate but most people use risk in some form or another as a proxy – and that is exactly what the authors of the second broker note have done.
In relation to a different company – and using what we would suggest is a pretty circular argument – this note stated: "In light of the significantly increased commodity price volatility and resultant valuation uncertainty across the resources space, we have increased the discount rate we apply in deriving our net present values estimates, from 8% to 10%.”
Now, upping one of your key metrics by 25% is quite a reaction to valuation uncertainty and will have a huge impact on your calculations. Interestingly, the broker goes on to reassure us: “Our underlying target methodology and equal blend of net present value and P/E ratios remains unchanged.” So that is a relief – in addition to net present values, the firm uses price/earnings ratios to value businesses.
The trouble is, the increased discount rate decreases the influence of the net present value while increasing the focus on near-term earnings – and, unfortunately, near-term earnings are collapsing. In other words, the other earnings-based methodology used to value the company may now have more focus on it but it is also dropping like a stone – and that is used to justify reducing the target price.
While this sort of analysis can all sound very scientific, however, the reality is you end up chasing your tail. If the environment worsens, do you simply keep dropping your target price? In which case, at what point does confidence start to build? If you only think about businesses in this way, everything needs to have improved before you invest – by which point the share price will have already moved up.
This is a classic example of how the often highly institutionalised nature of investment and the rigid ways most sell-side participants have to think can hobble independent analysis as soon as target and actual share prices diverge too far. That in turn highlights the importance of thinking about companies in a truly independent way, which is of course what we look to do here on The Value Perspective.