Calculating the intrinsic value of Diploma

I suppose this day had to come. This is what investors do when they’d really like to invest in a company but the trusted measures they use, in my case the ten year PE ratio, say it’s a bad idea; the company looks expensive.

We look for a new measure that makes the company look cheap.

But first, some caveats:

• This is the first time I’ve done this, so I might not have done it right, and if you can see a mistake I hope you’ll tell me.
• Yorkiem has been a great help as we’ve batted the model backwards and forwards deciphering it, but any mistakes are mine.
• I have a few doubts which I will not dwell on in this post as I just want to write it down. The criticism, positive and negative, will follow, soon.

You may have seen this post coming. First, the courtship of Diploma, which is the kind of company I’d like to put in the Thrifty 30, if only I could buy it cheaply enough. Second, last week’s rumination on intrinsic value offered the tantalising prospect of a method that might account for Diploma’s likely growth in a more convincing way than I can.

The method is derived from Stephen Penman’s Residual Income Model*, and pinched from a note by SG analyst Dylan Grice.

Here’s Grice’s model loaded with my data on Diploma (and here’s an Excel version to play with):

Now for the hard bit.

The model starts with the company’s book value per share in [Line 3], which is 136.1p. This is the accounting value of the assets on its balance sheet net of liabilities, i.e. net asset value or equity.

It uses the median return on equity over the last ten years (14.9%) in [Line 4] to forecast net income in [Line 1].

So, the first year of the forecast (2011) gives a net income (return) of 20.2p on 136.1p of equity (at the end of 2010) because:

136.1p x 0.149 = 20.2p.

From 2011’s net income we forecast how much will be paid to shareholders in [Line 2] using the median ten year payout ratio, which for Diploma is 0.44 times eps (44% of profit).

20.2 x 0.44 = 8.9p

Having forecast earnings for 2011 in [Line 1], and dividends in [Line 2] we can forecast the book value of Diploma in 2011. It’s the book value in 2010 plus net income, minus the dividend:

136.1 + 20.2 – 8.9 = 147.4p

And from that we can forecast the residual income in [Line 5], which is net income less the expected 10% return on equity. This is may require a little explanation:

The model rests on the notion that its not worth paying more than book value for a company unless it earns more than the annual rate of return you desire. Grice uses the analogy of a bank account:

The simplest such example would be that of a bank account containing $100, earning 5% per year interest… What’s it worth? Let’s assume my desired return is 5%. The bank account is worth only its book value of $100…. It may be liquid, stable and even growing, but since it’s not generating any value over and above my required return, it deserves no premium to book value.

Since we’re talking about shares, his model desires a higher rate of return (10%). Any ‘residual income’ over 10% earned in future will add to the value of the company now – it’s a bonus. The residual income of 6.6p per share forecast in 2011 is derived from net income forecast in [Line 1] less 10% of equity at the end of 2010 [Line 3]:

20.2 – 13.6 = 6.6p

However, income in the future isn’t as valuable as money in our hands now, so we need to reduce it by our desired return of 10% a year [Line 6] to give its present value (PV) in [Line 7].

Replicating the forecasts for subsequent periods, we have all the data to calculate Diploma’s intrinsic value. It’s the original book value per share in [Line 3] plus the sum of the residual income expressed in today’s money [Line 8] plus the continuing value (CV) of the business after our forecast period also expressed in today’s terms [Line 10].

136.1 + 38.1 + 24.5 = 198.7p

Grice follows the common practice of valuing the continuing business as a perpetuity in [Line 9] earning the same income every year, but uses a really harsh discount factor of 25% because companies generally succumb to competitive pressures in the long-term and go into decline.

It’s a rational response to the typical investor tendency to extrapolate past success into the distant future, but it seems draconian when I look at Diploma, which has been consistently profitable over the last decade and is financed for a consistently profitable future (I’m not saying forever!). The problem is if we are too optimistic about prospects in the distant future most of the businesses’ present value could be derived from the most uncertain of the three components of value, book value, residual income, and continuing value. That will be true of exceptional business, but they’re few and far between.

The calculations imply an intrinsic value of about 200p in [Line 11], which is more than the current book value of about 135p, but nowhere near the current price of about 325p (I’ve rounded the numbers because the scientific precision of the spread sheet implies a degree of accuracy that isn’t even remotely warranted!).

Dividing intrinsic value by price gives the intrinsic value to price (IVP) ratio in [Line 13], which at just over 0.6 suggests Diploma shares are expensive. The intrinsic value is just over 60% of the market value.

There are huge assumptions in a model like this, which Grice acknowledges. The words of Benjamin Graham written in The Intelligent Investor, and repeated in Penman’s textbook* are haunting me as I type:

The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favoured issue. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather justify, practically any value on wishes,however high, for a really outstanding issue.

I suppose Graham was talking about the discounted cash flow model, a cousin of the residual income model but although, for better or worse, Grice’s very conservative assumptions have kept the Thrifty 30 out of Diploma, it’s easy to see how with a tweak, here, and another there, I could make it give me the result I want. As I said, I’m going to criticise, and perhaps experiment with the model in a future blog. For now, I’m happy just to have got it out there.

BTW, John Kingham, UK Value Investor, extrapolated future earnings from historic ROE to value Mears.

* See: Financial Statement Analysis and Security Valuation, a heavyweight textbook that is very well written. One day I’ll work my way through it from beginning to end.

Some notes that may help, if you plan to do this at home:

• The model for Diploma diverges from Grice’s in [Line 4] Grice gradually reduces the ROE of the business to the industry average over the forecast period to account for likely competitive pressures but Diploma’s ROE is actually lower than the median for the Industrial Supplies sector. That may be because Diploma is much less indebted than some of its peers, or it may be a fantastic sector! I don’t think it’s because Diploma is a bad company, so I’ve assumed its ROE remains at the same level as its historic median over the forecast period.
• To establish the median ROE for the Industrial Supplies sector I exported the ten-year data series for each individual company in the Industrial Suppliers sector from Sharelockholmes, calculated the medians and averaged them (see the second tab of the Excel sheet).
• To establish the payout ratio I exported Diploma’s ten-year earnings per share and dividend per share record to calculate its median payout ratio (dps/eps – see the third tab of my Excel sheet).
• Here’s Grice’s worksheet for Akzo Nobel, unadulterated (click for a larger version):

Targeting Diploma

I was already apprehensive about Diploma’s price when I profiled the company last week.

One day later, before I’d had a chance to check my theory that it’s a hidden champion against its financial record, Diploma published a trading statement reporting strongly increasing sales and profits in the half year closing at the end of this month.

The price, which was 264p (valuing the company at 24 times ten-year earnings), is now 318p, valuing Diploma at 28 times ten-year earnings.

Rather exasperatingly that would make what looked like a very good company even more difficult to add to the Thrifty 30 portfolio.

The events prompted a debate in the comments section about:

1. The usefulness of average earnings for valuing a growth company
2. The maximum multiple of earnings a value investor should pay.

If Diploma keeps growing over the next five years as fast as it has over the last five, it’s obviously going to make a lot more profit, so using past averages as a guide is a waste of time. Using last years earnings figure, the plain old historic PE might be a better guide. Unfortunately it’s also pretty high, at 17.

Let’s call it 20 to keep the arithmetic simple. The case against paying twenty times earnings, assuming earnings stay constant in future, is you can only expect a 5% annual return on your investment in a typical year (i.e. you only get 1/20 of your investment back in profit). There are surely more lucrative investments to be made.

Of course we already know Diploma’s revenues in the first half of this year are 16% higher. I could assume the company grows it’s earnings, say 10% a year for the next five years. Then at the end of its financial year in 2015 its earnings will be 61% higher. The price now is only 12 times Diploma’s ‘forecast’ earnings in five years time, and that’s approaching bargain territory. At least it promises a return of more like 8%.

The problem is, the company is only a bargain if events unfurl as expected (and let’s face it I made the 10% growth figure up – it’s roughly the growth rate of the last five). I’d rather invest in a company that promises these returns now, even if business isn’t better than it was in the past.

But this is not the end for Diploma and I. The company publishes its annual reports for the last five years and I’ve requested the previous five. Judging by the ones I’ve got it looks like a highly profitable, conservatively financed company, and the consistency of its stats, albeit over a fairly short period, suggests it could be a hidden champion.

In other words its competitive advantage may last, which makes continued growth more likely.

The conservative in me just doesn’t want to pay growth company prices for growth companies. Instead, I’m going to make Diploma the first member of a new list, a watch list of potential hidden champions that will remind me to:

1. Consider them for the portfolio, should their prices drop (Diploma’s price fell below 100p during the credit crunch, when its one year historic PE was just 6).
2. Learn more about their businesses, because basing your case on the strength of the business requires considerable confidence.

Next time I run my hidden champions stock screen I’ll cap it at 25 times average ten-year earnings. If companies are so popular they cost more than that, I can only assume they’re not well hidden!

BTW, I’ve changed the format of the summary table (top) whilst retaining a traffic light system. Diploma gets a red light on market risk, because it’s pricey. But statistically speaking it looks like a great company. Consistently high returns on equity suggest low business risk, and financially it’s a fortress.

Diploma makes its own case

And it looks like a good one

Diploma (DPLM) operates in three technical niches, with sales roughly evenly divided between them, and between Europe and North America:

1. Life Sciences: For example, the supply of blood testing instruments and consumables used in hospital laboratories, usually under long-term service contracts.
2. Seals: For example, the supply of seals used in the repair of hydraulic cylinders found in construction equipment, dump trucks, bin lorries and forklifts.
3. Controls: For example, wiring and fasteners used in the defence, aerospace, motorsport, energy and industrial markets.

It’s sixth in my table of hidden champions which seeks out potentially great companies at reasonable prices. To rank as a hidden champion a company must have been highly profitable over the course of the last decade without using excessive leverage, and still have a market valuation I can at least imagine paying.

The numbers on my screen are enticing. Diploma has consistently good returns on equity (averaging 16%), without being highly leveraged (68% of its assets are funded by equity), although it’s on the pricey side (24 times average earnings over the last ten years). The earnings figure used in that valuation is extremely conservative though. Diploma’s F_Score is a thumping eight out of nine, implying 2010 was a very good year, at least in comparison to 2009.

The hidden champions strategy is inspired by the book, Hidden Champions of the 21st Century by Hermann Simon, which analyses the mainly German exporters that have driven globalisation (I’ll review the book when I’ve read the final two chapters).

By dint of their expertise in niche markets, which they’ve extended around the world, these companies have earned abnormally high profits for decades.

Actually, I’m going to let Diploma flesh out its credentials, because the strategies listed on its website could have been lifted directly from the hidden champions book.

1. Resilience: Because Diploma sells a lot of consumables, for example the reagents used in its medical testing equipment, and service contracts as opposed to new equipment, recessions have less of an impact on sales. Its products, like seals, are used to repair equipment so demand is fairly continuous, and because Diploma is technically specialised it isn’t easy for customers to switch to low cost alternatives (I don’t know whether that’s because there aren’t any, or because it would be expensive to switch).
2. High margins: Packaging products with services, like service contracts, or assembly, is a favourite hidden champion strategy because customers are prepared to pay extra for convenience and are less able to compare prices with competitors. That’s not to say hidden champions are price gougers, the customer must still think it’s getting good value.
3. Strong management: Training and retaining staff also features strongly in Simon’s book. Staff turnover is lower at hidden champions with Hans Riegel, ceo of Haribo, the sweet manufacture taking the long-service award. He’s been running the company for 63 years. Diploma identifies 60 senior managers who have an average tenure of ten years.
4. Soft diversification funded by its own resources: Diploma calls soft diversification ‘value enhancing acquisitions’, but I’ve stuck with Simon’s nomenclature here, which is easier on the eye. Because hidden champions operate in narrowly defined niches their growth prospects are limited unless they diversify. Some expand geographically; others set up or acquire businesses in related niches. Some do both, like Diploma. The trick seems to be to operate the new businesses fairly autonomously – as mini hidden champions.

Diploma has pretty much laid out the investment case. The only questions are do I believe it, and are the shares cheap enough?

Haribo aside, Diploma, like most hidden champions, does not supply a consumer product. Its products are almost invisible to us, forming a small part of a plane we might fly in, or the crane that is erecting a neighbouring office building.

And since my knowledge of controls, seals and life science equipment is minimal I can’t easily validate Diploma’s business model beyond noting its similarities to the successful hidden champion strategy.

But I can check the figures. You’d expect a company with strong management operating in niche markets and expanding using its own finances to have been consistently profitable and relatively unindebted in recent years. That’s what I’m going to double-check next.