Valuing Telstra

Valuing Telstra
Imagine Telstra has caught your eye. Management appears to be addressing its problems but the share price has fallen from $5.14 mid-year to $4 last week. So is it a bargain? Roger Montgomery, of Clime Asset Management, says you can get a rough idea by using a formula he has derived from Warren Buffett for companies that pay most or all of their earnings as dividends. All you need is Telstra's latest annual report, a calculator and some patience.

The formula Return on equity (ROE)/internal rate of return (IRR) x shareholders' equity per share.

Step 1 To calculate ROE, you first need to work out the company's retained earnings. To do this you subtract total dividends from net profit.

Total dividends paid are found in the notes to the balance sheet ($4.1 billion), while net profit is found in the profit and loss statement ($4.4 billion). Hence 4.4 - 4.1 gives you retained earnings of 0.3. Telstra's dividends are fully franked, so to adjust for this divide dividends paid by 0.7 (1-0.3 as the company tax rate is 30 per cent). Hence 4.1/0.7 = 5.8. Add this to retained earnings to give total earnings of 6.1.

Next you need to divide total earnings by shareholders' equity at the start of the year ($15.4 billion), which is found on the balance sheet, and adjust for any additional capital raised or shares bought back. Telstra bought back almost $800 million worth of shares so, assuming capital was reduced in the middle of the year, starting capital is reduced by half $800 million to $15 billion (15.4-0.4). Hence ROE is 6.1/15 = 0.407, or 40.7 per cent.

Step 2 Required return is the return you want from your investment. Buffett requires a return of at least 10 per cent. Montgomery uses a more conservative 15 per cent because this gives him a bigger margin for error. The higher the rate of return you use, the lower the intrinsic value of the company will be, and the less you will be willing to pay for it.

Step 3 To calculate shareholders' equity per share, divide equity at the end of the year ($14.9 billion) by the number of shares on issue (12.4 billion) and you get a figure of 1.2, or $1.20 a share.

Step 4 Putting all this together you get ROE (0.407)/IRR (0.15) x equity per share (1.2) = 3.25, or $3.25 a share. In other words, the value of Telstra for a required return of 15 per cent is $3.25, well short of last week's price of $4!

However, if you use Buffett's minimum return of 10 per cent, intrinsic value increases to $4.88.

To be confident of generating your required return, you would need to buy below intrinsic value.

The drawbacks of dividends
When the sharemarket is volatile or the outlook uncertain, investors flock to companies that pay solid dividends. Yet dividends can hide a multitude of sins.

Roger Montgomery, of Clime Asset Management, says directors use dividends as a selling point but few explain how they arrived at their dividend policy. John Price, of Conscious Investing, believes many investors feel that a known quantity of money in the hand is better than an uncertain capital gain in future.

In an ideal world, companies would pay out all their earnings in dividends and still grow each year. It may amount to sacrilege for some investors, but there is a strong argument that some businesses should not pay dividends.

Montgomery and Price both argue that a company with the power to produce a high return on equity is better off not paying dividends and using retained earnings to continue growing the business.

Warren Buffett's investment company, Berkshire Hathaway, is a good example. It pays no dividends but shareholders have been richly rewarded nonetheless.

Berkshire has produced a steady return on equity of about 25 per cent a year and its shares have grown by an annual average of 22 per cent over the past 40 years.

This is a far better return than most investors could achieve by receiving profits as dividends and investing the money elsewhere.

Price argues that shareholders with a need for short-term cash could sell a few shares and still end up better off in the long run than an investor who buys a mediocre company for regular dividend income.

Do it yourself
John Butler Wood is a retired engineer who has been investing in shares for more than 40 years in a haphazard way, mostly on the recommendations of others.

It wasn't until he retired and had time on his hands that he began to take a systematic approach to investment.

After attending one of Roger Montgomery's ASX seminars three years ago, he began to value companies for himself.

He says his method is simple but thorough.

"First, I look at the financial health of a company, things such as cash flow and various financial ratios. I look for companies with a return on equity of 20 per cent, which culls out a lot of low-profitability companies.

"To limit my search further, I only look at companies [with a market value of] over $100 million," Butler Wood says.

This is a labour-intensive process and Butler Wood admits he spends a lot of time at the State Library of NSW during the September-November reporting season, calling up company balance sheets from the Aspect Huntley database.

Then he puts the numbers through Montgomery's intrinsic valuation formula and homes in on companies with a price that is less than half their intrinsic value.

One of his best purchases was Jubilee Mines, which he bought earlier this year at $4.97 when he estimated its intrinsic value at a minimum of $11.12. It is now trading at $6.50, with an 8 per cent after-tax yield.

Butler Wood describes his investment approach as a work in progress.

"I've never found using stockbrokers successful. I enjoy fiddling with figures and, provided I make gains, it's in my best interests to continue. It keeps me off the street," he says cheerfully.