The UK’s riskiest big companies
Posted on February 19, 2009 by Richard Beddard
Filed Under Companies, Investing |
Three risks, and three risky companies
Since the point of investing in companies is to buy a share that will return us more money in the future, the risk investors face is that they might get less money back. The problem, as bankers, around the world have discovered is, we’re not very good at measuring risk.
In a note published in 27 January, James Montier, looked beyond standard statistical measures of risk to identify what could go wrong with an investment in a company. Then he measured the risks.
The first and third should be familiar to readers of this blog, and the second, business risk, is significant today as companies face prolonged recession.
1. Paying too much
Montier calls this valuation risk. If you pay a high price for a company based on expectations of future profits then you risk disappointment if those profits don’t materialise.
Borrowing a rule from Benjamin Graham he suggests 16 times average earnings is a benchmark for valuation risk. Any more than that would imply a return of less than 6% if profits in the future are similar to those in the past, an insufficient reward for the risk of investing in the stock market.
Since the UK market average is 11 times average earnings – a historical low, valuation risk, the risk of paying too much for shares, is also low.
2. Business risk
This is the risk a company’s profits might be permanently lower in future, either because of bad management, or because of a change in the economics of its business1.
Because the immediate outlook for company profits often drives share prices, temporary declines in profit are an opportunity to buy good companies at cheap prices. The trick is, to avoid companies facing a permanent decline in profitability, where the value represented by a low price earnings ratio might prove illusory.
Montier measures business risk by dividing a company’s latest profit figure (earnings per share) by its ten-year average. If a company looks cheap based on its latest earnings, but not on its ten-year average then its value is more likely to be illusory2.
Worryingly, 54% of big UK companies are in this position, which may explain why prices on the UK stockmarket are so low, investors are expecting a big fall in earnings.
3. Financial risk
This is the risk that a company might go bust and it’s best avoided by checking the company’s balance sheet. Montier uses Altman’s Z score3, a combination of balance sheet ratios, to measure financial risk, and a score of 1.8 or less, he says, is a good indication of future problems.
About 23% of big British companies have Z scores below 1.81.
Presumably, companies with long-term price earnings ratios above 16, current earnings greater than two times average earnings and Z scores below 1.81 are the riskiest of all.
The good news is, only three of forty-odd big company stocks that have the full trinity of risks are British. They are:
Ten American companies make the list, including Coca-Cola Enterprises and News Corp. Most of the rest are Japanese.
Correction: This blog originally said Coca-Cola is on the list of risky companies. Just to be absolutely clear that’s Coca-Cola Enterprises and not The Coca-Cola Company. What’s the difference? See the Coca-Cola Enterprises FAQ.
Footnotes:
- Newspapers may be a good example now.
- I don’t think this measure encompasses all business risk, although it may help.
- I use Piotroski’s F_Score, which I think captures elements of business risk and financial risk.
Comments
4 Responses to “The UK’s riskiest big companies”
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Richard,
Great post and thanks for putting a link on OldSchoolValue. I have a major issue with the Z score approach. In brief, its a crutch. It makes you dependent - I would rather do my own analysis and be forced to think about risks; granted, it is difficult, but if I rely on the Z score I will never develop the mental muscles to do the heavy lifting. The danger of using the Z score was imbeded in your post - I don’t know what Coca Cola’s Z score i, but even if its low, I don’t see it going out of business anytime soon.
Cheers,
AJ
Second, any formula is
Hi AJ,
Thanks for your comment.
Actually I’ve just realised I’ve made a humungous cock-up. It’s Coca-Cola Enterprises, not The Coca-Cola Company (KO not CCE).
Coca-Cola Enterprises has a Z Score of 1.3, a 10 year PE ratio of 24 and earnings risk of 3.0.
I haven’t used the Z Score myself, preferring Piotroski’s F_Score. I must admit to using it as a crutch i.e. if I’m in doubt I almost always go with the numbers (and avoid companies with low F_Scores).
Hi Richard,
Glad to see it wasn’t KO after all, but I think it proves my point … I read your article about the F score and here’s the part I liked best:
“One of the things I like about the F_Score is it is a good entry point for investigation of the company’s financial statements. So some interpretation is possible.”
If you use the tests as a template for checking a company, I don’t see that as a bad thing at all. I only fear that by using a shortcut I will eventually have a crutch. It is very difficult to regulate behavior and familiarity breeds contempt or carelessness. Then you get burned …
Cheers!
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