"I wonder if you have any EV sort of estimates as I find it very useful when you have an objective range on what you think is a fair value for a business to buy. I thought I should ask just in case you are feeling generous to share your estimates of a fair value for GUD."
What the appropriate valuation multiples to apply to different businesses is the essence of investing. By its very nature, it is a subjective exercise, being part science; part art.
Essentially, the way I come to a view of the sort of valuation multiples that I am happy to pay for a company is to benchmark it to the prevailing multiples at which the broader market trades over time, and making adjustments - up or down - for differences in what I call financial pedigree, starting with:
1. underlying organic earnings growth rates,
2. volatility of historical financial performance, and
3. ROE
Looking at these metrics for the overall market, its underlying earnings growth rate is around 7%pa (ranging between zero and 15%, depending on the nature of the economic/business cycle - i.e., recession or upwsing) and the "average" company ROE is somewhere between 10% and 12%.
Therefore, if I was looking at a company that had similar financial traits (underlying earnings growth at the same level of variability, plus similar ROE) to those of the overall market, then it stands to reason that stock is likely to be priced at similar multiples to the market.
And my sense is that, over time, the average EV/EBITDA multiple for the market has been somewhere between 7 and 8 times, and the average P/E multiple has been between 13 and 15 times. (Currently, both of these valuation metrics for the market are somewhat elevated compared to history, but that's a debate for another time.)
So, let's deal just with EV/EBITDA (it is my preferred valuation approach because it, unlike P/E's at current record low interest rates), captures differences in capital structures between companies.
A company that has an ongoing ability to, grow its earnings - with a reasonably stable financial track record - at around 8%pa, generating a 10% ROE in the process, should, logically, be valued at an EV/EBITDA multiple between 7 and 8 times.
Consider some variations from this benchmark:
Company A:
Underlying organic earnings growth (OEG) = 10%pa over time (ranging from 8% to 12%) ROE = 15%
This would be a superior quality investment proposition to the overall market; therefore the EV/EBITDA multiple I would apply for such a business would be, maybe, 9x
Company B: (represents very good, fast-growing businesses, such as BRG, TME)
OEG = 15%pa
ROE = 15% => EV/EBITDA ~ 10x to 11x
Company C: (exceptional businesses: fast-growing at high ROE, such as CSL, RHC)
OEG = >15%pa
ROE = 20% => EV/EBITDA ~ 13x to 14x
Company D: (market-type growth rates, but at high ROE, such as ARB, ASX, DLX, IFL)
OEG = 7-8%pa
ROE = >20% => EV/EBITDA ~ 10x to 12x
Company E: (mature, and ex-growth, but still generating high ROE)
OEG = <5pa
ROE = ~20% => EV/EBITDA ~ 8x to 9x
Company F: (mature, and ex-growth, but low ROE)
OEG = <5pa
ROE = ~10% => EV/EBITDA ~ 6x to 7x
Company F: (companies undergoing secular decline, and ROE)
OEG = <5pa
ROE = ~10% => EV/EBITDA ~ 5x to 6x
In relation to GUD - which I see as a company that is able to grow its Revenues organically by around 4%-5% pa and its earnings by 7%pa, and which generates very high (>25%) ROE - that makes it somewhat akin to Company D.
So, around 11x EV/EBITDA is what I have been happy to pay when acquiring GUD shares.
With the subsequent run-up in the share price, the stock is currently trading at around 12.5x which, to me, is a bit "meh" in terms of valuation appeal.
Of course, the above are all very simplistic examples, but - as I said- this is not an exact science. As such, this exercise is intended to be indicative, rather than prescriptive.
No two companies are exactly alike, therefore it is difficult to pigeon-hole all stocks into nice, discrete and neatly-quantifiable categories.
There are other other factors that enter into the mix, such as market cap (large cap companies tend to attract premia of at least one or two valuation multiple points above small caps), management quality, incentivisation and alignment with shareholders, regulatory and legislative framework, competitive landscape and industry structure, quality of financial results, etc.
Also, to a greater or lesser degree, in determining what are "appropriate" valuation multiples, I try to think about companies in terms of the following three qualitative buckets:
1. Business Model
- Degree of customer concentration
- "Lumpiness" of Revenue
- Supplier dependency
- Scalability
- Obsolescence threats
- Brand value and resonance
- Capital intensity
2. Management Track Record and Integrity
- Relevant skills and experience
- Alignment with interests of shareholders
- Track record of shareholder value creation (or avoidance of value destruction)
- Stewardship of shareholder capital
3. Integrity of Financial Reporting
- Timing of Revenue recognition
- Treatment of operating expenses
- Depreciation policy conservatism (or otherwise)
- Capitalisation of funding costs
- Providing for taxation
- Off-balance sheet liabilities
- Related party arrangements
(20min delay)