Hmm. I will look more into it. I have avoided this issue by simply looking for companies that do not have much debt.
My Investment Journey
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Hmm. I will look more into it. I have avoided this issue by simply looking for companies that do not have much debt.
How does this purchase fit with your rule (intention)? It may offer adequate risk/reward through providing high reward as the insolvency discount is potentially unwound but there is no way its a low risk investment.
How does this purchase fit with your rule (intention)? It may offer adequate risk/reward through providing high reward as the insolvency discount is potentially unwound but there is no way its a low risk investment.
The problem with risky investments is that it is difficult to calculate the actual percentage of times where you will make a gain, what that gain will be, and whether that offsets the risk associated with the investment.
In poker you can take a risky play i.e. a 51% chance of winning a hand by going all in for your entire stake at the table. However, you know this is a good bet because you will win more than you will lose. You can calculate exactly how much you will win too. In poker at some stages of the hand it is correct to put all your money in even with only a 30% chance to win or even less, because the gain is going to be so great. You can calculate how much that gain will be.
The huge caveat to poker is that when you make such thin plays you do so with such a small portion of your overall bankroll (your poker networth). If you only have 10 buy ins you have a high chance of going broke. If you have 100 buy ins then your risk of going broke is exceptionally low. In the stock market if you invest 1% of your networth in something risky and you can make rough estimates of the calculations, it could be correct. However, could that 1% networth be better used elsewhere? Unlike poker, I am dealt one hand for every company listed on the ASX and get given a new price to play that hand also. Therefore, you pick the most profitable opportunities available. The only way this risky investment makes sense is if you do it with a small amount of your total portfolio and there are no better options for the use of that money and that it is going to deliver a positive expectation. It is not good enough that an investment is +EV if another investment is more +EV.
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How does this purchase fit with your rule (intention)? It may offer adequate risk/reward through providing high reward as the insolvency discount is potentially unwound but there is no way its a low risk investment.
Hi craft,
6 months ago, this would have been a risky investment, but not any more.
Despite their reported profit looking so bad for so many years, they have always generated positive cash flows from operations. Taking away goodwill write-downs, this has always been a profitable business.
I bought it now because I felt that their debt has gone down to the level where it is no longer a problem. The remaining debt will be reduced even further, quickly, being management's number 1 priority.
The key to this investment is that they continue to generate positive cash flows, which will eventually make its way to reported profit once all the write-downs and restructurings are done. There's no need for the underlying business to improve, it is simply concealed by accounting at the moment.
Their revenues, while declining, have more predictability than most business, with many customers on long term contracts.
The printing industry, has terrible economics and bleak outlook, but a better one than many mining related companies. Yet PMP is trading at a much, much cheaper price.
In summary, I think this company has finally become a safe investment after many years of serious problems. It will never be a "good" company, or a company with great growth prospects. But it deserves a much higher price, still, once the market recognises that it is no longer a risky investment. To put it in context, should they finally achieve a reported profit, and a PE of 5, I should double my money. Not a lot to ask.
But you are absolutely right, this investment is slightly outside of what I normally invest in. Opportunities like this, I certainly intend to participate in, when I see them, but I don't expect them to be a large part of my portfolio.
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Yes, investing is a lot more dynamic.
With PMP, the risk is that they will go broke. At this point, while I haven't tried to calculate the exact odds, I know they are very low. While at the current market price, any other outcome will be a good one.
Knowing whether risk is 51% or 49% is very important. But when the odds are 80%+, there's no need for exact science, been "probably right" is good enough.
Hi KTP,
Have you calculated the Altman Z Score for PMP? There is a paper with the statistics for the Z score predictability - a valuable resource when investing in businesses that have a few issues.
http://en.m.wikipedia.org/wiki/Altman_Z-score. Read the paper at the top of the References section.
Cheers
Oddson
I thought more about the capital structure of a company.
If Company A is 50% financed by debt and 50% financed by equity and Company B is 100% financed by equity and both have enterprise values of $100 (no company has any cash or preference shares etc) and both make $20 EBIT well if I was going to buy Company A I am not going to pay $100 for it. I am going to pay $50 to the shareholders and then give $50 to the bank if I want to pay off the debt. However, this is if I was buying the whole company. If I am going to buy shares in one of these companies, I would say Company B is worth more than Company A so I should be paying more for Company B than I should be for Company A if I were to be paying fair value. This is because anyone who buys Company A has to pay off the debt to get the same company as Company B and therefore Company A at fair value is worth half as much as Company B at fair value.
Further, if as a shareholder looking to buy, you might find out that management does not want to pay off Company A's debt any time soon and there will be interest on that $50 which means cashflow for Company A will be reduced somewhat (of course you can claim interest on tax, but then you only get back 30% of it).
Therefore, I am still concluding it is better to go for companies with low gearing as a general rule. Of course, it gets more complex if the company can generate a higher return than the interest rate on that debt.
If Company A is 50% financed by debt and 50% financed by equity and Company B is 100% financed by equity and both have enterprise values of $100 (no company has any cash or preference shares etc) and both make $20 EBIT well if I was going to buy Company A I am not going to pay $100 for it. I am going to pay $50 to the shareholders and then give $50 to the bank if I want to pay off the debt. However, this is if I was buying the whole company. If I am going to buy shares in one of these companies, I would say Company B is worth more than Company A so I should be paying more for Company B than I should be for Company A if I were to be paying fair value. This is because anyone who buys Company A has to pay off the debt to get the same company as Company B and therefore Company A at fair value is worth half as much as Company B at fair value.
Further, if as a shareholder looking to buy, you might find out that management does not want to pay off Company A's debt any time soon and there will be interest on that $50 which means cashflow for Company A will be reduced somewhat (of course you can claim interest on tax, but then you only get back 30% of it).
Therefore, I am still concluding it is better to go for companies with low gearing as a general rule. Of course, it gets more complex if the company can generate a higher return than the interest rate on that debt.
What about the number of shares on issue?
Higher return OR lower return - same return and the financial structure is neutral.
I noted in a previous example that the company with the debt would have less shares on issue than the company without the debt if they have the same equity per share. However, the company with debt has to pay interest. If the companies are completely equal and earning the same EBIT on their EV of $100 then the company with debt is paying interest. There net profit will not be $20 it will be $20 - the interest on their debt. Therefore, the company with debt must have shares that are worth less if they are trading at fair value. They are making less ROE, less net profit, and if the payout ratio is 100%, are paying out less.
This seems so simple to me. If all things being equal one company makes $20 and another company makes $20 less more than 0, the company that makes $20 makes more money! If all things are equal except one company makes a little less money, the company that makes a little less money should, in an efficient market, be trading at less than the company that makes that bit more money. I am failing to see what the fuss is about. In a takeover situation I might payout the same for both companies but only to pay out the debt, so the people who own the company with debt arn't getting the same amount of money as they would if the company had no debt.
Have you got excel – If so, see if this helps. The shaded cells are for variables for you to play around with.
View attachment TEMP.xlsx
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Companies may do a thing called DCFA (Discounted Cash Flow Analysis)
From Investopedia:
Investopedia
In a takeover situation you would pay the vendor (ie current owners the company) an agreed amount for the entire assets of the company.
The vendor takes the proceeds and pays out the debt - not the purchaser.
It looks like there has been a few crossed wires in this discussion. You are talking about the valuation of the equity alone (Enterprise value - debt). Others are taking about the enterprise value which takes into account the whole ownership structure and includes all of the assets. You need to know the profitability of the underlying assets.
You cannot value the equity without first valuing the entire company - the world does not exist in a vacuum! Ownership / financial structures can change rapidly.
If you want to takeover the company you have to pay for all its assets regardless of the ownership structure. If the assets are identical (regardless of debt) and earn the same return, then you would need to pay the same price. Where the money goes after it reaches the vendor is irrelevant to the purchasing decision.
As a stock market investor you need to value the assets of the company in their entirety as if there was a neutral ownership structure. Once you have calculated the enterprise valuation you then subtract the debt from this valuation to ascertain what you would pay for the equity portion of the current ownership structure.
Please note that different valuation techniques may take into consideration the risk levels of the debt and factor this into any net present value of the enterprise.
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Bah! Thanks, V. I've been trying to write something similar but you said it perfectly. My brain has been fried the last week or so. Too many reports.
The only thing I would add is that the purchaser will often acquire the debt and then make a decision about the capital structure post the acquisition.
Good presentation of the underlying numbers in the calculation, by the way. Should help for those more numerically inclined in their learning.
Yup. Acquisitions can get messy - but they always need to be based on the underlying value of the assets to make sense.McLovin said:
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Yup. Acquisitions can get messy - but they always need to be based on the underlying value of the assets to make sense.
Absolutely. Which is why debt/equity is such a rubbery number. Full of accounting quirks and omissions. As Einstein said "not all that counts can be counted and not all that can be counted counts".
You really need to understand the nature of the business. Which is I guess gives you the underlying value of the assets.
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I haven't, but what an excellent suggestion.
The score, like all statistical scores have some drawbacks when used against a specific scenario, but nevertheless, this exercise was very helpful. Here's a quick overview of Altman Z score for others reading:
3.0+ : Safe
2.7-3.0 : Warning
1.8-2.7 : chance of bankruptcy in the next 2 years
<1.8 : severely distressed.
And here are the numbers for the last few years for PMP.
I seem to have been right in my assessment that the company is a much safer investment than before. In fact, even safer than before things imploded in 2008. It is also interesting to note, that while there is some correlation between Alt Z and share price, there's a much stronger correlation between reported profit and share price.
Taking it one step further, I am even more interested in what Alt Z would be next year. While I expect underlying profit next year to be stronger that this year, I will assume that:
- underlying profit is the same as this year.
- no dividends paid, debt reduced with profit.
- remaining goodwill written off.
This would give a 2014 score of 2.2728. Not completely safe, but consistently improving with a profitable, underlying business.
Should the business improve EBIT from 34.2 to 45, score becomes 2.3825.
Another funny quirk of the score is that it takes market cap into consideration. Assuming share price for PMP doubles, score becomes 2.6632, making this almost completely safe from statistical standpoint.
Overall, I think the ratio shows the same results as my analysis, but also shows that statistically, this is still somewhat riskier than my "minimum risk" rule.
Hi KTP,
Interesting analysis. A couple of points:
1. As you have pointed out the Z Score uses the Market Value of Equity in the calculation, I personally think the Private Business version of the Altman Z Score which uses the Book Value of Equity instead of Market Value of Equity is more suitable for some listed companies to remove the effect of market volatility/illiquidity on the results (i.e. ignore the market!). Note Altman did research into proving his Private Business (and Foreign Markets) version of the Altman Z Score and provides the results in the paper. Revisiting your calculations by applying the Private Business version of the Altman Z score might be an interesting exercise.
2. For me the paper took some digesting, but I came to the conclusion that the Z score is a useful tool for certain turnaround situations and it is interesting to see his checks 30+ years later to see how effective the original formula has been. IMO, selecting an appropriate Z score formula, careful selection of cut-off and trending the Z score over time can provide insight into a possible turnaround (note I found on the web a business academic recommending it as a management KPI tool).
Cheers
Oddson
From memory a lot of the Z sore factors have Total Assets as the denominator. Increasing Z scores based on improving profitability would have to be a lot more robust then an increasing score due to the company writing off good will and implementing asset sales and lease backs.
OCF less a reasonable estimate for maintenance capex was negative this year. Reported FCF was massaged by the asset sale and lease back. Debt reduction was solely as a result of the assets sales.
I’m not saying with enough detailed analysis that a case for an adequate risk/reward investment doesn’t exist – I haven’t done the work.
Just saying this is no sure turn around bet – It’s a HIGH risk play. If that’s going to be your game you should recognise it in your rules and consider your risk management accordingly.
