Smart Investor: goodwill and the basics of share valuation

In my previous article I introduced the basics of how to value companies. In this second part I will look at the topic of goodwill in further detail.

Goodwill or future profit

Goodwill should be viewed as future profit based on past profit. In other words you are buying the net assets of the firm for their current value and are buying a certain number of years of future profit which these assets generate. Buy too much future profit (goodwill) and you may have to wait some time to see a return on your investment.

Measurement of future profit is of course subjective, but by looking at past performance it is possible to glean an idea of what future profit may be (all discussion of ‘profit’ refers to net profit). By taking a weighted average of profit over the previous five years (an average which places slightly more emphasis on the most recent years) it is possible to make a conservative estimate of future profit. Furthermore, when analysing past profit you should look for consistency as opposed to up and down figures which could indicate that future profit may be volatile.

Time value of money

The time value of money is a subject that I will return to in future, but a profit of £100 today will not have the same relative value in 10 years time for example. Thus a discount rate must be applied to the future net profit figure in order to bring it back to present value. I normally assume a compound rate of 5% per annum; over a 10-year holding period this reduces future net profit by around 20-25%. 5% is a conservative estimate and allows for a generous level of inflation in future years.

In addition a margin of safety must be applied to any future profit figure. This is because future profit is a known unknown and you should attempt to produce a conservative estimate so as to mitigate against potential future difficulties which the firm could experience. Furthermore a margin of safety will mean you buy the shares for a lower price, the flip side being that you may miss some golden opportunities. The application of a margin of safety is simple; reduce the future profit figure by a sensible amount. Sensible to me is in the region of 20%.

The above does not take into account any increase in future profit for a very good reason; the future is always uncertain and profits can fall or rise in future. Thus I prefer to factor in zero profit growth so as to ensure that in this scenario I would still likely see a decent return over the period.

The number of years of future profit you are willing to buy will largely depend on your investment horizon. I normally assume a holding period of 10 years for shares, so start off with a multiple of 10 before discounting and applying a margin of safety. The multiple of future profit is entirely up to you; returning to a previous comment: it is the consistent application of a method of valuation which is key. In other words if you apply the same method to all FTSE 100 companies then you will still spot the ones which are undervalued.

Two examples

For example the current share price of FTSE 100 listed cruise ship operator Carnival is £27.57. Its five-year weighted average profit is around £1.65 per share and net asset value per share is around £16.60, thus you would currently be buying 6.6 years of future profit. Whether you feel this represents good value or not will depend on your investment horizon, discount rate and margin of safety.

Similarly FTSE 100 listed technology company Autonomy currently has a share price of £15.46. Its five-year weighted average profit per share is around £0.25 and net asset value per share is around £4.55, meaning over 36 years of future profit are included in the price. Again, the holding period, discount rate and margin of safety applied to future profit will determine whether this company is deemed undervalued or overvalued.

In future articles I will discuss the price to earnings ratio (P/E) in detail and indeed the P/E is a useful tool. However, it does not take into account net assets, which I think is a crucial consideration in the valuation of any company.

So in my view you should buy the net assets of a company for their current value and in addition purchase a multiple of discounted future profit less a margin of safety; future profit being derived from a weighted average of the past five years' profit. The original multiple used will depend on your investment horizon and you will be more generous the longer your horizon.

Valuing companies may seem traditional and old hat but it is a means of consistently ensuring you are paying a fair price for shares. If a company is valued by the stock market at below your valuation, this does not necessarily mean it is a diamond in the dirt; there are many other factors to consider, which I will discuss in future. However it does mean that the business in question passes the first difficult test and can be further examined under the microscope.