Valuation of companies is ultimately about cash generation, not accounting profits

This article first appeared in The Edge Malaysia Weekly, on March 13, 2023 - March 19, 2023.
Valuation of companies is ultimately about cash generation, not accounting profits
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This week, we are revisiting some basics in fundamental investing. We think it is timely, given the sea change in the macroeconomic environment. The world had, particularly in the past two decades, benefited greatly from cheap labour and cheap goods driven by globalisation, as well as cheap energy, thanks to the shale revolution — the combined result of which was years of low inflation that, in turn, drove the secular downtrend in interest rates. But this broad decline in interest rates — especially since the global financial crisis up till the Covid-19 pandemic — has ended, at least for the foreseeable future. 

Globally, inflation is at a multi-decades high and looking to be stickier than most have expected. That would, in turn, keep interest rates higher for longer (though still relatively low by historical standards). Many still expect central banks to cut interest rates, once inflation is brought back under control. It may be so, but odds are that they may not return to pre-pandemic lows for some years. This would mean the period of ultra-cheap money is over, and that has broad implications for businesses and investors alike.

Ultra-cheap money had fuelled excessive speculations in risky assets — for instance, stocks without viable business models — and rewarded companies that expanded aggressively, including those with a “growth at all costs” strategy. Cheap money also distorted the efficiency of capital allocations — lowering the hurdle rates for investments (leading to unproductive and less productive investments) and sustained many zombie companies. Zombie companies are uncompetitive but kept afloat with the infusion of borrowings and low debt servicing costs. 

When money is no longer readily available at historically low costs, risks must be repriced. In other words, investors can no longer take for granted that “stocks only go up”, a trading strategy that has worked surprisingly well for much of the past decade. We expect to see more highly indebted businesses face financial distress as the costs to service their borrowings rise. Against this backdrop, investors need to do more vigorous analyses of companies’ underlying fundamentals — especially the robustness and sustainability of cash flows — and valuations. 

What is the valuation of a company?

The intrinsic value (V) of assets is, and always will be, the sum of its discounted future cash flows (CFs). It works the same for both bonds and stocks.

For example, the annual cash flow for Treasury bills and longer-dated notes would be the coupon rate (interest rate) multiplied by the face value of the bond. Since the cash flows are pretty much guaranteed, r is equivalent to the interest rate, which is also the risk-free rate, while n is the maturity period (fixed tenure). Pretty straightforward.

The valuation for companies, on the other hand, is more complicated. For one, the future cash flows are far from certain, subject to changing market demand, competition, selling prices, costs of raw materials and other operating costs, including labour, interest rates and taxes. Because of the inherent uncertainties, we must incorporate a risk premium into the discount rate — that is, r = risk-free rate + risk premium. The higher the uncertainties, the higher should be the risk premium.

Also, unlike Treasury bills and bonds with fixed tenures, the lifespan of a business can be short (if it closes down or goes bust), indefinite or anywhere in between. Assuming a company can generate cash flows in perpetuity, the value of company can be simplified to:

You may notice, however, that most analysts talk about profits, not cash flows, and the most popular valuation metrics are P/E (price-earnings), Price/Ebitda (earnings before interest, taxes, depreciation and amortisation), Price/Sales, Price/Book value and EV/Ebitda (EV, or enterprise value = Market cap + Debt). 

So, when you hear people discuss different methods to arrive at the valuation for stocks, remember that there is ever only one definition for valuation— and, that is, the discounted cash flow. All other metrics are merely “short forms” or “shortcuts” for discounted cash flow. These metrics are widely used because they are easier to compute and understand, and can be compared across companies, sectors and markets. Critically, while these shortcut metrics are useful, they are insufficient and, sometimes, can be misused to present a false picture.

Earnings are not equivalent to cash flows

First, these metrics rely on reported profits/earnings rather than cash flows. And profits, as we well know, are presented based on accounting standards, which may not reflect the actual underlying cash flows. We have written fairly extensively on this issue in the past. For instance, interest paid on perpetual securities (perps) are not considered interest expense — thereby inflating profits. At the same time, accounting for the perps as equity also understates the company’s actual gearing. Similarly, companies can capitalise interest expense as assets in certain circumstances: for example, interests during construction of assets or when property developers borrow to purchase land for future development. Again, this would, in effect, understate expenses and inflate profits and book values.

Indeed, companies can be in total compliance with financial reporting standards but still be misleading. Case in point: A company is allowed to recognise construction revenue from in-house concessionaires based on estimated fair values of future income streams under the long-term agreements. This revenue is recorded as financial receivables/intangible assets on the balance sheet. When the concession asset commences operation, cash flows generated from the asset are recognised as sales, while the operating costs include amortisation of the financial receivables/intangible assets. Basically, companies report earnings even when there is no cash flow during the construction period, and then actual cash flows are higher than reported earnings when the asset is in operation. In short, reported earnings have little relationship to the actual cash flows. Confused yet? 

Worse, it is far easier to manipulate profits than cash flows, unless the bank statements are also falsified. For example, there have been plenty of instances, historically, in which management faked sales invoices or “pre-billings” to inflate sales, Ebitda, profits and book values — to give the impression that the company was worth more than it really was. As such, scrutinising the Cash Flow Statement — which shows the sources and applications of cash, tying the cash balance at the start and end of the financial period — can be more informative than the popular Profit and Loss Statement. 

Furthermore, most of these metrics often measure earnings against market capitalisation. For instance, the P/E ratio attributes value to the earnings — but ignores the risks of debt used to generate those earnings. This omission can have serious consequences for investors. 

Table 1 is a simplified example of two companies, one with debt and one without, making exactly the same sales and margins (let us assume zero depreciation and tax, for simplicity’s sake). Company A reports net profit (in this case, the same as cash flow) of $30. Company B reports net profit of $20, after deducting $10 interest expense on its $100 borrowings. If one were to assess both companies based on the commonly used metrics of Price/Sales, P/E and ROE (return on equity), Company B would appear to have more attractive valuations. Hence a better investment. Is it, though?

Let us say economic conditions take a turn for the worse and sales drop by 50% (from $100 to $50) while margins contract to 20% (from 40%) as a result of lower utilisation (see Table 2).

Company A will break even (zero profit), but Company B will now be loss-making, losing $10. Company B will not have cash to pay its interest expense of $10. Of course, in real life, this company can probably borrow — or dispose of some assets — to service its debts, at least in the short term. The point is that Company B’s more attractive valuations come with higher risks, which are not immediately evident and, therefore, not properly accounted for, simply by looking at the P&L Statement. When companies have to borrow to service debts, the situation will, often, spiral rapidly out of control.

Debts are often neglected in company analysis and valuations

And herein lies the importance of the ability to analyse risks, to determine for yourself the risk-rewards you want and can afford to take. Remember, companies do not go bust because they make less profit — they go bankrupt when they cannot meet their commitments, primary of which is the failure to service and repay debts. Therefore, analysis of companies needs to be more vigorous and encompass cash flows, not just profits. 

Useful valuation metrics include EV/FCF (free cash flow), interest expense cover, net debt/FCF, net gearing, inventory turnover (reality check on sales and inventories and probability of stock obsolescence) and receivables turnover (reality check on sales and possible bad debts). Look out for companies that report consistent profits but also a substantial rise in gearing, which would indicate negative FCF. This is usually the case when companies report increasing sales but where receivables and/or inventories rise even faster. 

Let us consider another simplified, hypothetical scenario for Company C. Revenue consistently grows by 10% annually while operating profit margin is stable at 10%. But it struggles to collect cash from customers. If the company’s receivables grow at a much faster rate than revenue, it will suffer net cash outflows, which have to be funded with increasing debt (or cash calls). Table 3 shows how it can continue to report steady profits for many years — even as the company is being crushed by mounting debt and interest expenses. Investors who are fixated on earnings would not realise the looming issue until it is too late.

Companies that pay dividends in excess of cash flow from operations may also warrant a red flag. This is the danger when management interests are not always aligned with that of shareholders. The fact is that management remuneration/incentives are usually based on profitability and share price gains, which encourages short-termism and risk-taking, including using leverage to boost earnings. Anecdotal evidence shows that high dividends/share buybacks tend to lead to higher share prices.

Indeed, sometimes not all shareholders’ interests align either. Some are short term, preferring dividends/share buybacks while longer-term-minded investors would prefer companies conserve cash for future opportunities and/or pay down their debts. 

To be clear, companies necessarily reinvest for the future, funded with internally generated funds and/or borrowings and equity cash calls. Borrowing to invest in productive assets that will generate future cash flows is perfectly fine — as long as the increased risks that come with it are understood and properly taken into consideration. 

Finally, we present a hypothetical scenario with Company D and Company E in Table 4. Both companies start (time, t) in the exact financial position, with $100 debt and $50 market cap, giving an EV of $150. Over the next three years, Company D uses all of its earnings to pay down borrowings while Company E pays out all of its earnings as dividends. Assume EV remains the same over the entire period.

If one were to compare the P/E and Price/Ebitda ratios, then the share price for Company D should fall, since valuations are higher than those of Company E, which also pays dividends and has a higher ROE to boot. Is Company E really the better investment? Not necessarily. Company D, by paying off its debts, would be better positioned to withstand any unexpected economic and financial shocks — thereby making it the safer investment. Also, it would be better able to capitalise on future opportunities — for example, mergers and acquisitions, relative to its competitors (Company E), thanks to its now stronger balance sheet. 

In conclusion, there will always exist a trade-off between risks and rewards — and it is important to analyse both aspects in tandem. There is nothing wrong if you choose to go for the higher returns, provided you also understand the risks and can stomach the potential losses. Some investors are risk takers, others are more risk-averse, but the smartest investors make informed decisions.

The Global Portfolio gained 0.7% for the week ended March 8. The biggest gainer was Velesto Energy Bhd, whose share price rebounded by 21.2% (in US dollar terms), following the sharp selloff in the previous week. Other gainers were Grab Holdings Ltd (+1.9%) and iShares 20+ Year Treasury Bond ETF (+1.4%). Chinese stocks were the big losers last week, with Alibaba Group Holding Ltd (-6.7%), Tencent Holdings Ltd (-5.2%) and Global X China Electric Vehicle and Battery ETF (-4.6%) finishing sharply lower. Total portfolio returns since inception now stand at 24.4%, trailing the MSCI World Net Return Index’s 41.4% returns over the same period.

Meanwhile, the Malaysian Portfolio was up 3.2%, bolstered by gains from Velesto Energy (+23.1%) and RCE Capital Bhd (+2.8%). Mega First Corp Bhd Bhd (-2.2%) and CCK Consolidated Holdings Bhd (-0.7%) were the two losing stocks. Total portfolio returns now stand at 159.5% since inception — outperforming the benchmark FBM KLCI, which is down 20.5% over the same period, by a long, long way. 

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views  to influence readers to buy/sell stocks. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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