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Asset duration: the most underestimated part of company valuation

Updated Thursday 28th June 2012

Terry Smith, chief executive of stockbrokers Tullett Prebon, discusses accounting standards and company valuation

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How have accounting standards changed in the 20 years since the publication of Terry's book Accounting For Growth? Terry also talks about asset duration and its importance in company valuation.

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Terry was talking to The Open University's Janette Rutterford after a recording of The Bottom Line.

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Professor Janette Rutterford (OU)

Well, Terry, it’s twenty years since you wrote your book Accounting for Growth, which exposed a whole number of scams that companies did in accounting terms to make their accounts look better.  Do you think things have changed in twenty years?

Terry Smith

Yeah, things have changed a lot in twenty years.  I mean after I wrote the book, we had the Accounting Standards Board with Sir David Tweedie and a whole raft of new accounting standards and so on.  So I mean actual accounting I think has been cleared up to a considerable degree, most of the things that I pointed out are not feasible anymore, but I think the other thing that’s happened is a couple of things.  If I could have, if I could find a way to adjudicate this bet, I would bet a large sum of money that the average investor and analyst doesn’t read the report on the accounts anymore; they rely upon management’s presentations.  And I mean I'm a chief executive of a public company, I have been for a dozen years, trust me, in presentations companies put their best foot forward, and you actually need to go and read the accounts.  I think what’s happened now is people are just not doing, you’ve got better accounts there, people are just not doing the work, almost the PR spin and presentation is what people, I guess because of their information overload, are relying on.

Professor Janette Rutterford (OU)

But what happened in the banking sector, because couldn’t you argue that there was something not in the accounts in banking?

Terry Smith

Banking’s a bit different I think.  You can't get quite the universal applicability to banking of accounting that you use for industrial and commercial companies.  I mean, I don’t know if you know but I was, before I wrote the book I was a banker for nine years, and I was the number one rated bank analyst for nearly a decade.  And the great problem with the banks is you get sound reporting within sort of Companies Act framework, but it doesn’t tell you a number of things that are very, very difficult to find in terms of off-balance sheet activity and derivative activity within those banks.  So knowing what the bank’s position is in terms of exposure to foreign exchange, interest rates, credit and so on, the credit risk that it’s taken and derivative positions, is impossible in my view; in fact it’s impossible for most of the management as well.

Professor Janette Rutterford (OU)

So the share price is just guesswork?

Terry Smith

Yes, I mean a large part of it is.  Unless you're, I mean for banks of that sort, the ones that are allowed to take investment banking risk, bear in mind it’s only in the last couple of decades since Big Bang here and the repeal of the Glass-Steagall United States that those activities have become part of banks.  Before that they were run by investment partnerships that were investment banks, Goldman Sachs were partnerships, and you'd never have been able to invest as an outsider in those.  They knew what they were doing because they all worked there.  Banks have, you’ve seen the coming together of retail banks, which by the way you can assess from the report on the accounts, they're not such complex vehicles, but once you graft on all this other stuff, how would you tell from the report on the accounts what’s going on?

Professor Janette Rutterford (OU)

So have you got any tips on how to value companies for my students?

Terry Smith

In my view, there are some big nuances within individual sectors, but it always comes down to some form of cashflow analysis; you're always trying to say what’s the sort of return in cash that the company’s getting on its capital and then trying to basically calculate a valuation on that.  I mean the commonest yardstick I use is free cashflow yield.  I calculate the company’s free cashflow, I mean they do tell you what their free cashflow is - I don’t typically use the published one because I take out the capital expenditure and have a guess at what the maintenance capex is, because if it’s growing you might penalise a growing company, and so I have a guess at what the maintenance capex is, the depreciation charge is a good start, or you can use the average for the sector.

So I calculate my own free cashflow number, and divide that basically by the market value of the company, and that tells me the free cashflow yield.  It won't be far off the earnings yield, although cash and earnings are not the same thing but, you know, over a long period of time it won't be far off that, and I have a pretty simple yardstick which is I say I reckon if you can buy a company for a free cashflow yield, that’s the same as or higher than the long bond yield, the government bond yield for a country, you're probably creating value.  Because there’s some chance that the free cashflow will rise.  There’s no chance that the government’s bond coupon will rise.

So my simple shorthand, if I was, you know, I'm not talking about doing a DCF where I say well what’s the down spike of the DCF for the investment, what’s the number of years of cashflow and what’s the terminal value, my simple one is just to take the running free cashflow yield and eyeball it against the long bond yield for the country that it’s operating in basically.

Professor Janette Rutterford (OU)

So that encourages you to buy long lived companies?

Terry Smith

It does.  I mean I think the single most underestimated thing in company valuation, there’s probably a lot of candidates for that but if I had to pick my own one it’s asset duration, and I always say to people if you had an asset that you paid 100 for and it had a cash return of 20, would that be a good investment?  And of course the answer is it’s a trick question, 20 over 100 sounds great, it’s 20%, wow, what a good return, particularly in this interest rate environment, but actually if the asset is useless after three years you’ve only got 60 back.  If it lasts for twenty years, it’s brilliant, isn’t it?  So knowing how long your company will last or can sustain itself is extremely important.

So a pharmaceutical company, you presumably think well it can only last as long as the patents, or it’s got to spend more money on new medicines.  A consumer goods company, a branded goods company like something that’s got Procter & Gamble or something that’s got Gillette and things like that, well Gillette patented the safety razor in 1908 and it’s still the leading brand.  So that one you’ve got a very long asset life.  So I think that’s the single most underestimated piece of company valuation.

Professor Janette Rutterford (OU)

I think people forget that in the old days, there were loads of new companies and they all went, you know, a lot of them went bust, and people were very aware for example of mines.  If you read the old investment textbooks, they used to tell you, remember this is going to run out of raw material, it’s going to be dead in fifteen years.

Terry Smith

Yeah, I mean by, I said there are nuances to companies, I mean you can apply cashflow to just about anything in the end in my view, but there are nuances.  I mean obviously if you're talking about a resource-based company you’ve got to have somewhere in your calculation there’s got to be something for the word depletion.  It’s going to run out, people do, you're absolutely right, they forget it.  So unless it’s going to find a new mine, but even if it does find a new mine, that’s going to be a new investment so you're going to have another down spike on your diagram there.  So yeah, people do forget those things, you're absolutely right.

Professor Janette Rutterford (OU)

Terry Smith, thank you very much.

Terry Smith

No, thank you.

(6’11”)

 

 

 

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