Which companies hold greatest market value?

By TEH HOOI LING SENIOR CORRESPONDENT

Most investors associate high- PE stocks with high-growth stocks. But as pointed out by consulting firm McKinsey in a couple of its reports, there is another, possibly more important, component which accounts for a stock's high or low earnings multiple.

That is return on capital. It makes sense. Growth requires investment, and if the investment doesn't yield an adequate return over the cost of capital, then it will not create shareholder value. That means no boost to share price and no increase in the price-earnings multiple.
So a high-PE stock could be one which is generating high growth at a return which slightly exceeds its cost of capital, or one which is chugging along slowly and steadily but earning a return on capital that far exceeds its cost of capital.

McKinsey has proposed a three-step approach to disaggregate a company's current market value into its current performance, its return premium, and the value expected from its future growth. Current performance is derived by estimating the value of a company's current earnings in perpetuity, assuming no growth.

At no growth, it is assumed that depreciation is equal to capital expenditure, and therefore net operational profit less cash taxes is equal to free cash flow for a business that does not grow. So dividing net operational profits after cash taxes by the cost of capital would give us the value of current earnings, with no growth, in perpetuity.

The premise is that companies with the highest ROICs relative to their WACCs are the greatest creators of value for shareholders

Return premium is the value a company delivers by earning superior returns on its growth capital. In order to assess how a company's return on growth capital influences its PE multiple, McKinsey recommends discounting a company's cash flow as if it grew in perpetuity at some normalised rate, such as nominal GDP growth. Through repeated analysis, McKinsey has found that the result is a good proxy for the premium a company enjoys in the capital markets because of its high returns on future growth capital.

And finally, value from growth represents how much a company delivers by growing over and above nominal GDP growth. It can be calculated as that portion of the company's current market value that is not captured in current performance or the return premium. For a company that grows more slowly than the GDP, this value will be negative.
I've decided to use this three-step approach on some Singapore-listed companies.

Three-step method

First I downloaded from Bloomberg the entire list of stocks traded on the Singapore Exchange with attributes like return on invested capital (ROIC), market capitalisation, their weighted average cost of capital (WACC), and so forth.

I then calculated the difference between the ROICs and the WACCs, and ranked them from the highest to the lowest. The premise is that companies with the highest ROICs relative to their WACCs are the greatest creators of value for shareholders.

From the top 50 companies, I randomly picked 13 and went through their latest results one by one so as to calculate their pre-tax operating margin, their asset turnover, and their ROIC (excluding and including cash held in banks). Finally, I attempted to attribute how much of the stocks' current market value is from its current performance under a no-growth scenario, how much of it is from return premium, and how much is from expected future growth. The results are pretty interesting.

The formula I used to calculate ROIC is net operating earnings before interest and amortisation charges, but after cash taxes divided by total assets, net of excess cash, and non-interest-bearing current liabilities.

Almost all the companies on the list have strong ROIC. A company can arrive at a high ROIC by either having a high profit margin, or more efficiently utilising its assets to increase sales. The former is measured by operating profit margin, and the latter by asset turnover.

As can be seen from the table, most of the companies are high-margin, low-volume businesses. The three exceptions are Hersing Corp, Apex-Pal and Olam, which are low-margin, high-volume businesses.

Meanwhile, a lot of these companies also have a lot of cash. With the exception of MobileOne and StarHub, all have more than 5 per cent of their market capitalisation represented by cash in the bank. The most extreme was C&G Industrial, which according to its June 30, 2007 balance sheet, has 557 million yuan in the bank. That's about $112.5 million, or about 40 per cent of its current market cap of $274 million.

I then tried to calculate the value for these companies based on their existing businesses under a no-growth scenario. As suggested by McKinsey, I divided net operational profits after cash taxes by the cost of capital (obtained from Bloomberg) to arrive at that number.

So companies whose existing business, under a no-growth scenario, has a higher value than their current enterprise value are presumably undervalued. Enterprise value is market cap plus debts minus cash.

From the list, you can see that C&G Industrial tops my list of companies which has the most unrecognised value.

As mentioned, it has a lot of cash - some 40 per cent of its market cap is represented by cash. On top of that, assuming it can maintain its first-half operating profit, the company may rake in $44.8 million in pre-tax profits this year. According to Bloomberg, the cost of capital for C&G - a producer of PET chips used to manufacture polyester fibre - is 10.73 per cent. Based on this, that business is worth $335 million, assuming it can maintain that performance in perpetuity.
Raising its cost of capital to 15 per cent would reduce the current business worth to $240 million. Add in the company's return premium and the stock still looks undervalued. Other stocks which appear undervalued based on the above screening include Courage Marine, Hersing, MobileOne and Micro Mechanics.

In all the above analysis, investors have to decide if they think the respective companies can maintain their current performance for their existing businesses, and that these are not top-of-the-cycle figures. Another factor to consider is the WACC, whether they think it is too low and hence not representative of the risks faced by the companies.

For example, Courage Marine is enjoying the very high dry-bulk freight rates now. Can this be sustained? Perhaps the current valuation of its business is high enough, relative to its enterprise value, to allow for the easing of freight rates going forward.

As for MobileOne, its high valuation has much to do with its relatively low WACC. Is that justified?

Meanwhile, among all the stocks I looked at, Olam has the highest imputed growth value and return premium based on its current enterprise value. The value of its existing business - under a no-growth scenario - only makes up about 19 per cent of its enterprise value today.