Common Measures of Value Management

1
Common Measures of Value Management
abcd

• A Work in Progress Paper prepared by the
• Value Measurement Working Party
• 27 June 2002

2
Aims of Value Measurement Working Party

• background to SIAS paper
• SIAS survey of methods outside profession
• outline of work
• conclusions
• future work - real options analysis

3
Value Methods Survey of consultants

• 5 major consulting groups interviewed on value
  methods they used
• VBM a tool for change management and other
  services, but rigour/ precision less important
• many viewed actuaries as having potential to
  contribute but possibly too specialised
• actuaries could help with customer value
  analysis, application of real option theory
  outside finance

4
Areas for WP study

• focus on measures and ratios amenable to
  actuarial analysis - involving risk
• avoid well trodden areas accounting issues,
  earnings definition, project appraisal
• survey other professions and industries for value
  measures
• most areas for study were in securities
  investment or capital intensive industries

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Value measures and ratios

• Price/ Earnings Relative (securites)
• Price/ Sales (securities)
• Price/ Earnings to Growth rate (PEG) (securities)
• Average Revenue Per User (telecoms)
• Contract valuations in support services
• Regulatory capital valuation in utilities
• Projected EVA I (securities analysis)
• Property sector ratios
• Customer Value Management (online betting)

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Price / Sales

• popularised by OShaughnessy
  What works on Wall Street
• US evidence low P/S outperforms low P/E
• less influenced by accounting treatment than
  profits or eps, flatters early stage companies
• used little in UK, relevant only in same sector
  comparisons, same capital structure

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PEG Ratio

• Popularised by Peter Lynch, One Up on Wall
  Street
• the p/e ratio of any company thats fairly
  priced will equal its growth rate
• adjusts p/e for short run earnings growth
• issues
• what period for growth?
• what discount rate is implied?
• no distinction for dividends or risk
• are earnings correct?

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PEG versus P/E 5 year growth rate
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PEG Ratios calculated by DCF of earnings relative
to an assumed PEG ratio of 1
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Current UK PEG Ratios
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UK earnings estimates P/Es by Market Cap.

Source I/B/E/S consensus estimates, CSFB
research 17.5.02
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UK 3 year forecast eps growth rate p.a. vs Mkt
Cap

Source I/B/E/S consensus estimates, CSFB
research 17.5.02
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UK PEG ratio by Market Cap.

Source I/B/E/S consensus estimates, CSFB
research 17.5.02 2001 P/E, 02/04 growth rate
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Outcome of selected European shares recommended
in 1997 on basis of low PEG ratios
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PEG ratio recent research

• US study Easton, 2001
• Does the PEG ratio rank stocks according to the
  markets expected rate of return on equity
  capital?
• claims P/E and PEG rankings are restricted
  versions (special cases) of his model
• relates accounting and economic earnings vs cost
  of capital, and incorporates dividends
• implicit assumption of PEG that dividends are
  zero has little effect on ranking PEG is a
  reasonable first approximation to a ranking on
  expected returns

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Easton conclusions PEG bias to over-rate stocks
with

• lower capitalisation
• higher short term growth rate
• higher s.d. of past returns
• higher price to book ratio
• lower P/E

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Morrison Supermarkets Consistent Growth
PER 21.4 Tax G/R 19.9 pa Div G/R 20.9 pa

Dividend
Tax
2001 eps, share price 214p Growth Rate 1991
2001 Source FT Company Analysis/Reuters
18
Rolls Royce surprising growth rating
PER 26.7 Tax G/R -4.0 pa Div G/R 1.6 pa

Dividend
Tax
2001 eps, share price 178p Growth Rate 1991
2001 Source FT Company Analysis/Reuters
19
Consistent Organic growth retained profits
growing steadily
Tesco
PER 21.1 Div G/R 10.0 pa Profit G/R 8.9 pa
Retained G/R 4.9
Dividend
Profit
Retained
1993 to 2002 eps 12.05, share price 254.5p
Pre-tax profit -cash dividends-tax (cash) Source
FT Company Analysis/Reuters
20
Weak organic growth prospects
Electrocomponents
PER 28.7 Div G/R 17.4 pa
Dividend
1993 to 2002 eps 14.5, share price 455p Source
FT Company Analysis/Reuters
21
Weak organic growth prospects
Electrocomponents
PER 28.7 Div G/R 17.4 pa Profit G/R 6.8 pa
Dividend
Profit
1993 to 2002 eps 14.5, share price 455p Source
FT Company Analysis/Reuters
22
Weak organic growth prospects retained profits
shrink
Electrocomponents
PER 28.7 Div G/R 17.4 pa Profit G/R 6.8 pa
Retained G/R -ve
Dividend
Profit
Retained
1993 to 2002 eps 14.5, share price 455p
Pre-tax profit -cash dividends-tax (cash) Source
FT Company Analysis/Reuters
23
Morrison v Rolls Royce
Source Reuters
24
Electrocomponents 10 year share price
Source Reuters
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Real Options Analysis

• the right but not the obligation to take an
  action e.g. deferring, expanding, shrinking or
  abandoning a project at an exercise price at a
  predetermined time
• aims to capture value of flexibility (options,
  discontinuities) decision makers have in projects
• ROA maps out path of cash flows
• Copeland 2001 in Real Options claims NPV
  sytematically undervalues projects
• Potential to replace NPV as central paradigm for
  investment decisions

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Real Options Value is a function of

• value of the underlying asset
• exercise price
• time to expiration
• std dev of value of underlying risky asset
• risk free interest rate over life
• cash flows of asset over its life
• differs with existing methods (NPV,
  Black-Scholes) where series of options,
  contingent exercise, multiple uncertainties
• few studies - mainly examining companies with
  options to develop land, gold mines,
  pharmaceuticals

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Potential for ROA

• Are financial options really always a side bet,
  a secondary market transaction not affecting
  outcome?
• Unlike Black-Scholes, many underlying assets have
  divdends or cash flows
• Copeland cites 12 US UK companies using ROA
• Management of financial institutions, deferral
  options, pricing guarantees, risk
• Potential to apply techniques to some securites
  analysis and portfolio management e g. where cash
  flows material, interacting with changing capital
  structure and cost of capital

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Summary

• Need for actuaries to recognise other value
  methods
• Unfortunately potential for contribution not
  always clear
• Test US PEG model with UK data
• Progress application of ROA to financial problems