Investors often look to invest in companies where their share prices are trading below their intrinsic value. But what does one mean by ‘intrinsic value’? As an example, we recently took a look at Grafton Group’s potential intrinsic value from an asset viewpoint. Grafton Group, of course, is the Irish-based but London-listed distributor of building materials and DIY products.
At the end of June 2022, Grafton’s shareholders’ funds amounted to £1,756 million, made up of goodwill (a premium over asset value on acquisitions), fixed assets, working capital, net cash and some long-term liabilities (principally deferred tax). With a total of 235 million shares in issue, this gives us an asset value of £7.47 per share, 3% above the current share price for Grafton.
In capital intensive industries, the value of a company starts with the replacement value of its assets.
If you had £1,756 million to place into risk-free bank deposits or government bonds today in the UK (Grafton’s share price is quoted in sterling), you could probably get 2.0% on bank deposits – generating an income of £35 million. Or you could invest in Grafton, which in 2021 generated net income of £222 million off its balance sheet value of £1,756 million, for a 13% yield. In other words, a 6x uplift in earnings from the same asset base.
Clearly, there is an element of risk in Grafton – bank deposits are guaranteed, while Grafton is subject to competition and has cyclical earnings. Nonetheless – an initial 13% earnings yield is excellent compensation for this risk. Arguably, it is too high: Grafton is debt-free, well-run, and has lots of room to grow.
What yield, then, would represent fair compensation for risk? If it is 10%, the value you put on Grafton’s assets should be €2.2 billion – a share price of €9.50 (26% above current levels). At, say, 8%, the assets should be valued at €2.8 billion – a share price of €11.81 (58% above current levels).
Looked at this way, we can see why starting with a company’s assets is a good, clear way to approach valuation. Moreover, you don’t need near-term earnings certainty to be able to judge a company’s intrinsic value! There may be fluctuations in earnings in the short-term – but this matters less to long-term investors.
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