This article is the follow-up to a previous article entitled „Time to dump your European service provider stocks?“
Over the period 2004-2010, we have seen that a number of big European stocks have been down a bit or a lot. This includes three big names in the market: Vodafone, France Telecom (Orange) and Deutsche Telekom. If these stocks have gone down over the last 7 years, does that mean that they are underpriced now?
Those who believe that the market is fully efficient will say that this question is absurd because the market is always at the right price. But firstly, there is considerable amount of evidence that the market is not fully efficient. And secondly it can be very useful to better understand what you have to believe about the future for stocks to be priced at their current level. If your beliefs are not what the market believes, then there is an opportunity to put a bet on what’s going to happen in the years to come.
How do you know whether a stock is underpriced for a start? If you have ever bought or sold stocks, we bet that in 95% of the cases you have not done any detailed analysis but relied on sentiment, gut feeling, what you read on the Internet or what your financial advisor has told you. But you should do the check yourself. This will take you a bit of time, but might avoid some costly mistakes. And in many cases, you will be surprised by the results. In all cases, you will learn something about the stocks that you contemplate buying or selling, and this is great news!
There is a fundamental problem with stocks. Unlike other familiar products that you buy on a regular basis (say petrol for your car, airplane tickets for your holidays, or simply beer for the next grill party) we as human beings are not well equipped to know what the right price for a stock should be. If Vodafone sells at 2 Euro a share, is this cheap? What about France Telecom selling at 16 Euro per share, doesn’t that look expensive? Intuition does not help when we look at individual stock prices. But this does not get better if we look at market cap: is France Telecom at 42 billion Euros cheap? Is Vodafone at 104 bn Euros expensive? Looking at total enterprise value (EV) does not help either: France Telecom is at 74 bn Euros, Vodafone at 138 bn Euros.
So we have to do a little more work. There are two broad methods to check the price of a stock: P/E ratios as well as other multiples, and ‘fair value’ using discounted cashflow models of various sorts.
P/E ratios look easy, and that’s why most people use them. But actually they are bloody complicated to use correctly, and that’s why they can be so misleading. The idea of P/E ratios is to compare the P/E of a stock with its peers at the same point in time, or with historical averages for the stock or the industry. But P/E ratios are massively distorted by gearing i.e. the way companies are financed (equity, debt), as well as accounting treatment (the way company depreciate their assets in particular). So comparison with peers can only be indicative as best. To get around these problems you should always use P/Es in combination with a couple of other ratios, in particular price to sales and price to EBITDA, taking the entity value for price rather than stock price, because Sales and EBITDA relate to the total entity (they are pre-interest expenses so don’t take the financing structure of the firm into account).
Another approach – not necessarily more complicated – is to try to figure out what the ‘fair value’ of a stock is. A stock is underpriced if there is substantial deviation between its ‘fair value’ and its current market value. Note that this does not tell you whether the stock price will increase in the future or not. Stock prices are only determined by supply and demand, and demand could remain low for many years to come. After the 2001-2003 crash investors might have good reason to hate, or a least avoid, telecom stocks. So as long as the majority of investors do not believe that the stocks are underpriced, they are unlikely to move up.
Now, the market value of a stock is easy to find: check current price on the stock market. On 31 March 2011, these were: 177 pence (2.02 Euro) for Vodafone, 15.8 Euro for France Telecom and 10.90 Euro for Deutsche Telekom.
To estimate fair value, we use a simple perpetuity valuation model that simply states that the Enterprise Value is related to NOPAT (Net Operating Profit less Adjusted Tax), the perpetuity growth rate g, the return on invested capital ROIC and the company cost of capital WACC. Note that the model assumed that profit margins, g, ROIC are constant in the future. The perpetuity formula is as follows:
EV = NOPAT x (1-g/ROIC) / (WACC-g)
Remember that the entity value is also the sum of the equity value (market cap) and (net) debt value (EV=E+D).
So you can now proceed as follows:
- Calculate the ratio of last year NOPAT to the cost of capital WACC. This gives you the value of the entity ‘as-is’ i.e. assuming that the financial performance (NOPAT) remains the same indefinitely in the future and with no growth (g=0)
- Subtract the value ‘as-is’ from the entity value calculated from the market cap and net debt. We call this the Future Improvement Value (FIV). The FIV can be compared to the enterprise value. It indicates how much value of the entity resides in future growth and improvement in operating performance as opposed to current performance. Growth businesses usually have FIV / EV ratios higher than 80%. On the other hand a negative FIV value indicates that the market believes that the current NOPAT level will deteriorate.
- Make your own assumptions about future growth and ROIC and use the perpetuity formula above to calculate your estimate of the Enterprise Value.
- Compare your estimate of the EV with what the current valuation of the company is (market cap + net debt).
We have done the check for you.
The first table looks at P/E, Sales and EBITDA multiples. Note that Vodafone, France Telecom and Deutsche Telekom (DT) have fairly similar turnover. EBITDA margins are also fairly close. Note however how different Profit After Tax (PAT) are. Note also how different P/Es are. DT stands out with a high P/E; but is the price high or the earnings low? Probably the latter. Looking at Sales and EBITDA multiples, it seems that the market is valuing both FT and DT in the same manner (at about 1.5 times sales and 5 times EBITDA); this seems to confirm that 2010 PAT for DT is low but the market is not terribly bothered about it. Vodafone on the other hand is valued at a much higher level that FT and DT; this seems to come from much higher PAT values than for FT (and DT). VDF’s PAT is more than double that of DT, but their P/Es are similar. All in all, Vodafone seems to manage its CAPEX (or depreciation) and tax in a much better manner than FT and DT, and this is rewarded by the market with a much higher equity value and enterprise value.
On a Sales and EBITDA multiple basis, VDF looks pricey. But it is not when looking at P/E. The market is pricing VDF at a higher multiple of EBITDA and sales because VDF’s net profit is simply better. Also the market might believe that this is more future growth in VDF with its global footprint than in the other two stocks.
For DT, this is the other way around: on a P/E basis the company looks expensive, however not on an EBITDA and Sales multiple basis. This is telling us that that P/E for DT is high because Earnings is low but the market does expect things to improve at DT and its earnings get back to the kind of level experienced by FT. So DT and FT have very comparable EBITDA and Sales multiple.
From this initial analysis, there is nothing that indicates that the three telecom stocks are particularly cheap (or expensive).
Now let us look at the value ‘as-is’ and future investment value. The value ‘as-is’ makes up 80%-90% of the enterprise value. Also the FIV is rather low, and reflects that the market does not expect major growth in the three companies or operational improvements. The market is slightly more pessimistic about DT, maybe a reflection that the company misses a growth story.
Now let us apply the perpetuity valuation model after making reasonable assumptions about future ROIC and growth (nominal term). The valuations that we get are fairly similar to the market valuations ‘as-is’ as shown in the previous table, and 10%-20% lower than the Entreprise Value. This tells use that the market is slightly more bullish than the ROIC and g assumptions that we have made in the table below, especially for VDF and FT.
All in all, the perpetuity valuation model shows estimates that are below the market estimates. The differences are not particularly significant considering the amount in uncertainties that we have in our model (our estimates for NOPAT, WACC, ROIC and g).
Our conclusion is that the three stocks are not cheap but seem to be correctly valued by the market. The pressure on the stock prices in the last 7 years has come from decreasing growth in sales in the business, as well as deteriorated EBITDA margins. The more risky of the three stocks might be DT, in case it fails to deliver on the market expectations that NOPAT and PAT should improve. Our overall recommendation on the three stocks is ‘neutral’, but we have a slight preference for France Telecom for the high dividend yield that the company returns to shareholders (9% or so, compared to 7% for Deutsche Telecom and only 5% for Vodafone). If you like bonds, you should considering buying France Telecom stocks instead.
If these three telecom stocks are to become hot again, then something rather fundamental and radical would have to happen. We call this ‘re-inventing your DNA’. We have not seen a huge amount of pressure on European telcos to re-invent their business in a ‘bold’ manner, so we believe that a major change is unlikely in the 2-3 years to come. But could Vodafone, France Telecom and Deutsche Telekom be completely different companies by 2020? Keep reading, we will come back to this issue in a future article.