Intrinsic Value / Valuation is tricky. There are many different ways to value a business. Buffet and Graham's method is to have an adequate Margin of Safety. In other words, we want to be prudent, by giving ourselves an ample Margin of Safety so that even when we are wrong, we still make monies.
I've blogged about BAT before here.
BAT recently published its quarterly report and closed the year. To keep it simple, FYE2023 EPS and DPS is 68.2 sen and 63 sen respectively. 8 years prior, BAT EPS and DPS was 318.7 sen and 312 sen. This means that the EPS and DPS CAGR over the past 8 years are -17.5% and -18.1% per annum respectively.
Let that sink for a minute.
Every year over the past 8 years, BAT EPS and DPS shrunk around 17%-18% per annum consistently.
BAT current price is RM8.2.
- With EPS of 68 sen, its P/E is 12 times
- With DPS of 63 sen, its P/DPS is 13 times.
The question is - is the business worth 12 times current earnings (or 13 times current dividend)?
It really depends on future EPS and DPS growth rates.
This is where it gets tricky - everyone will have different views about the future growth rates.
Will it continue to shrink?
Will it stop and turn around?
Does anyone knows the future?
This is where Buffet and Graham's brilliance lies.
When nobody knows the future, they want ample Margin of Safety.
In other words, make conservative assumptions, calculate the Intrinsic Value, and wait for Price to fall below Intrinsic Value at a margin and then, only trigger the buy.
So, what conservative assumptions should we make?
I offer you 3 scenarios, to understand the mathematics of Intrinsic Value.
Scenario 1 - Aggressive - assume no shrinkage, no reduction, i.e. assume EPS and DPS has found the bottom. In my opinion, this is a very aggressive assumption over the next 10-20 years.
Scenario 2 - Ambitiously realistic? - assume the rate of shrinkage reduces by 2% per annum, i.e. eventually earnings is flat forever. This gives credit to current Management who tries to reduce the shrinkage in earnings and dividends.
Scenario 3 - Prudent - assume rate of shrinkage reduces by 2% per annum from -16% down to -6% and earnings shrink at -6% per annum flat thereafter.
What does the results look like?
I project the EPS for only 20 years for prudence.
My discounting rate is 8%. Why 8%? Because I can safely invest and earn 8% p.a. This is my required rate of return.
So, how much is BAT's Intrinsic value worth under 3 different scenarios?
In Scenario 1, if BAT's earnings remain flat at 68.2 sen forever, then, the stock is only worth RM6.70 to me.
In Scenario 2, if earnings initially shrink by 16% but improves over the years and eventually stays flat, then, it could be worth RM4.00.
In Scenario 3, if earnings keep shrinking at an ultimate rate of -6%, then, it could be worth RM3.60.
Sanity check. BAT Net Tangible Asset (NTA) is RM1.32.
Summary and Conclusion
BAT's price has crashed substantially the past decade.
It's peak price is near RM75. Today it's only RM8.2. Is this a cheap stock?
Unfortunately for BAT business, its EPS and DPS continues to shrink the past 8 years.
It's business appears to be sun-setting.
It's revenue continues to shrink.
It's hard to imagine for hard core smokers but there are less customers smoking BAT's products.
Instead, it's being persistently replaced with alternatives.
And these alternatives doesn't bring in the same level of profit margins and revenues like it did before.
The huge question mark is how long will it take the business to settle.
Nobody knows the answer to that question.
Because of that huge uncertainty, that's where Buffet's and Graham's brilliance comes in.
They insist on having an ample Margin of Safety in the valuations.
3 out of an infinite scenarios are offered here for prudence.
They indicate that the fair value is probably around RM3.50 to RM4.00 based on today's Intrinsic value.
Which means RM8.2 is still not cheap.
Final thoughts
Noone knows the future.
As retail investors ("bilis"), we can't afford to under-perform EPF returns.
EPF gives us 5.5% to 6.0% per annum long term returns for "doing nothing".
If we want to invest in stocks ourselves (instead of parking in EPF), then, we demand at least 9% per annum returns (or at the bare minimum, 7%-8% per annum returns if we DIY).
We don't lose any monies if we don't invest.
We make 5.5%-6.0% per annum long term if we park in EPF.
My illustration above showed that to earn 8% p.a. returns in a declining EPS/DPS scenario, the stock needs to be trading at around RM3.60-RM4, before I start to be interested.
In fact, I probably need another Margin of Safety, of possibly 30% buffer.
This suggests, I could probably trigger a long term buy at around RM2.50-RM3.
In short, RM8.20 is still too rich for me.
To each, his own.
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