In the first post of this thread I wrote about
the uncharacteristically large discount the SFX SP has to its theoretical value (for an ASX listed stock of this nature) given the stage of production, and other financial characteristics of KMS/SFX.In the second post (excluding the short correction post)
I provided a summary of what was shared during Bruce Griffins 31st October Zoom update, with the aim of making it clear what development risks were behind us and what development risks lie ahead. I concluded by once again suggesting that the SFX SP discount is unwarranted and that this is in part due management's lack of willingness to tie together the implications of the exceptional development achievements to a share price proposition and call to action for investors.
In an earlier post I made a similar claim that management consistently brushed over an emphasis on investor value proposition. I stated that I didn't expect management to turn into salesman who are unreasonably making unachievabe claims and hyping the share price beyond what is reasonable, but rather just hoped they would focus more on emphasising more some of the undeniable value propositions outlined in the various SFX research analyst reports. This really is something that Bruce Griffin almost masterfully manages to exclude from his presentations, and seemingly (based on the unenthusiastic on market buying) from his backroom communications too.
In this post I would like to focus on how a stock price is decided on by market participants in the aim of highlighting how the SFX SP diverges from the value proposition.
Relevant to discussion is the notion of:
1) Market capitalisation (market share price multiplied by shares on issue)
2) Net Present Value
3) Net Asset Value
4) Net asset value per share.
It is fair to say that most investors don't actually work out their own valuation of a company's shares, this would require a very complex set of spreadsheets and calculations et alone insight into the company and anlalytical knowledge which most of us don't have. Rather, we rely on a research reports to suggest what the shares are worth. However, even understanding how the research report has determined the company's valuation range is often too much of an ask, and what it ultimately comes down to is what the research report shows as the price target on the first page.
Let's take a look at a simple scenario example to understand how valuations are determined by a market and how then a market price comes to some sort of equilibrium.
Scenario 1 - Gold producing company announces shut down of operations.
In early January a gold company makes an announcement that its only income producing asset will be shut down at the end of March and that all company operations will be concluded by the end of June. The closure of operations is due to the ore body being exhausted.
The mining operation up until this point was producing earnings of $25mil per quarter (before interest, tax, depreciation and amortisation). The remaining life of the orebody was known to be coming to an end, however the exact remaining mine life was unknown prior to this point, there was a market consensus that it would likely be 1 to 4 more quarters. The directors announced that they should receive $20mil of net cashflow from the current quarters operations (above the existing cash bal of $120mil).
Prior to the announcement the share price was trading at $1.40. The company had 100 million shares on issue, with no other shares, options or rights. The market capitalisation was $140 million dollars ($1.40 x 100,000,000 shares).
The company has $120mil of cash in the bank, it has a forecast net tax liability of $10mil for the year, and an expected shutdown and rehabilitation cost of $20mil. Plant value is to be written off and there is no expectation of being able to sell any of the plant. The directors have announced that they will make a capital return of 100% of remaining cash once operations have been shut down and all liabilities paid.
To work out what the shares should trade at one would first look at what the existing and forecast assets less forecast liabilities will be at the close of operations. Then various discounts or premiums can be factored into the valuation depending on various factors.
Asset value = $120mil (current cash at bank) + $20mil (forecast free cashflow from current quarter operations) - $10mil (tax liability) - $20mil (shutdown and rehab costs) = $110mil.
The theoretical asset value per share is therefore $1.10 per share ($110mil / 100mil shares)
The reason the shares were trading at $1.40 prior to the definitive announcement is because the market must have been factoring in additional asset value. This additional value was probably attributed to potential additional revenue past this current quarter of operations, or because the market was not factoring in certain costs such as a tax liability or shutdown costs, or a combination of these factors. Following the release of the announcement one would expect the shares to drop to a price of between $1.00 and $1.10 per share.
Why would it not trade at exactly $1.10?
1) there will be a lag of 6 months before the expected payout
2) the forecast $20mil of current quarter sales has not yet been achieved and may come in short (or may exceed expectations)
3) the actual shutdown costs may vary from forecast.
Initially if the market considers the forecasts to be reasonable then I would imagine that the shares would trade at around $1.00 per share giving a buyer the upside between $1.00 and $1.10 if everything pans out according to forecasts.
So why would it be anomalous if it were to trade trade at $0.60 (my intention in this example is not to equate this very short term concrete example proportionally with SFX, however I will use these principles and apply them to the current SFX scenario in a following post)?
On the surface there appears to be no reason for the shares to trade at 60c which would be a large discount to the theoretical valuation of $1.10 and so being able to buy stock at $0.60 when it appears that it will be worth $1.10 in less than 6 months (and with very few risks to the $1.10) is unrealistic as buyers would compete with each other for the available shares up for sale. In a perfect market the buying and selling would find an equilibrium point which accurately reflects the existing risks and costs (time costs) to the $1.10. So maybe we could expect the shares to trade at $0.98 - $1.02.
As the above listed uncertainty and time factors get taken off the table then the share price will get closer and closer to the theoretical value of $1.10 (assuming that the eventuating net assets end up being $110mil). On the last day of trading prior to the $1.10 capital return then you cold expect the shares to trade at $1.09 - $1.095 because some investors would be willing to make a cent or half cent profit for a short wait to receive a guaranteed $1.10, the question is would there be sellers at $1.09 or $1.095? maybe not, but its also quite possible that there would be some sellers as the discount to the alternate form of payment s not very big and so getting the money in two days instead of 30 days may be attractive to some.
So what has this got to do with valuations for SFX or other shares on the market. Well the valuation always comes down to asset value which translates into shareholder value (Net tangible assets divided by shares on issue). Often however a large portion of the theoretical net present value per share is not attributed to current assets (such as cash at bank or property assets) but rather is attributed will future earnings (either capital in nature due to asset appreciation and or sale or of a revenue nature (cashflow).
What this means is that in order for an asset (current or future in nature) to have a net present value (worth to an investor), and have that value appreciated by the market, that asset doesn't need to take the form of a near term dividend or capital return. It just requires that there will be future revenue streams or capital growth within the business. Those earnings streams can be quantified using a commonly agreed formula and a net present value can be determined.
A revenue stream generated over an extended period has a present value or net present value (PV or NPV), in other words it has a worth in today's terms depending on the duration, initial investment cost and discount rate applied. This means that a 20 year revenue stream has a net present day(NPV) value. The most significant determinants of the NPV is the discount rate applied to future earnings, upfront costs required to be invested to generate those earnings and the duration of time in years to those earnings.
The discount rate is essentially a compounding interest rate that is used to discount a future income streams at a desired annual rate of return. An 8% discount rate in an NPV calculation
is essentially tells the investor how much to pay for an income stream if they wishes to receive an 8% annual compounded return on that money.
In other words, $100,000 of revenue cashflow due in 10 years time must be discounted by 8% per annum to tell the investor how much he should pay for that future revenue in order to receive a net return of 8% per annum over the waiting period of those 10 years.
An investor who wants 8% compound annual return can justify paying $92,592 today for $100,000 they will receive in 1 years time
An investor who wants 8% compound annual return can justify paying $46,320 today for $100,000 they will receive in 10 years time.
An investor who wants 8% compound annual return can justify paying $21,454 today for $100,000 they will receive in 20 years time.
An investor who wants 8% compound annual return can justify paying $9,937 today for $100,000 they will receive in 30 years time.
An investor who wants 8% compound annual return can justify paying $5,798 today for $100,000 they will receive in 37 years time
An NPV calculation where there are yearly earnings over a number of years (as is the case in an ongoing business) takes the NPV of each year's earnings and totals them together to get a cumulative NPV.
So using the above examples of $100,000 in years 1, 10, 20, 30 and 37 the net present value of that $500,000 income stream would be (92,592 + 46,320 + 21,454 + 9,937 + 5,798) = $176,101
In the next post I'll look at why this chart which shows the NPV of dividends from KMS to SFX is such a good calculation to use in order to start determining what the theoretical value of an SFX share is and what sort of discount or premium is warranted given the risks to those earnings.
(20min delay)