What is the value of a share of a public company?

Most investors have no idea

Valuation is as much an art as a science and investors often talk about shares trading at above or below their “intrinsic value” with no concept of what that “intrinsic value” is, yet it guides their investment decisions. The issue of value is complex and often circular, since most valuation theories use statistical measures from past trading to estimate future value - statistics like Beta, “cost of capital” using the Capital Asset Pricing Model (“CAPM”), earnings multiples, cash flow multiples, price to sales multiples, price to book multiples, etc.). Since all of these approaches are grounded in recent history , they may have little relationship to “intrinsic value” which at its heart is future oriented. An exception is banks where “book value” is a reasonable foundation for valuation and most banks are undervalued at “price to book” ratios less than 1.3 times if they reliably earn return on equity percentages of 12% or more and their accounting standards comply with IFRS. For example, Canadian Imperial Bank of Commerce (“CIBC”) (CM.TO) is today probably undervalued with a trading price of about CAD$58, a book value of CAD$51 and a return on equity of ~14%.

The most robust approaches to “intrinsic value” began with John Burr Williams theory that the value of a share is no more and no less than the present value of its future dividends in perpetuity at a discount rate satisfactory to the buyer of the share. This method was called the “dividend pricing model” and mathematically reduced itself to simple equations based on assumptions of discount rates and growth rates in the dividend stream. The so-called Dividend Discount Model is elegant in its simplicity and made popular by Myron Gordon to the extent that it (and its later derivatives) were called the “Gordon Dividend Growth Model”.

A stock paying a $1 annual dividend growing with the economy at 3% and with a cost of equity capital of 9% results in a share valuation of $16.67. Using the CIBC example, the bank pays an annual dividend of $3.32, has been growing at about 7% per year, and has a cost of equity capital of ~11%, which using the Gordon model produces a value of $3.32/(.11-.07)=CAD$80.00. If you buy the analyisis, CIBC is undervalued.

Since the future is unlikely to be monotonic, these assumptions are known to be wrong ab initio but still valid when applied to the stock market as a whole, giving rise to portfolio valuation models based on the efficient market hypthesis (EMH) that was developed by Nobel prize winners like Eugene Fama in his PhD thesis and 1970 book “Efficient Capital Markets” which concluded it was virtually impossible to outperform market averages.

Of course Fama was not the first economist to posit efficient markets - the random walk model theorized by Jules Regnault in the late 1800’s may have been the inspiration for Louis Bachelier’s PhD thesis in 1990 which he entitled “The Theory of Speculation” - but Fama, followed by Harry Markowitz, Merton Miller, Franco Modigliani and William Sharpe (all Nobel prize winners) made EMH popular and it became a mainstay of valuation approaches and portfolio theory for decades. Then along came Bob Shiller and Richard Thaler who threw the EMH approach into a cocked hat. In Shiller’s case his empirical observations found that small capitalization stocks, stocks with low price to book ratios, and stocks purchased when the Case-Shiller Cyclically Adjusted Price Earnings Ratio (CAPE) was unusually low tended to outdo market averages. Fama also found small capitalization companies and those with low price to book ratios generated returns above market averages but held on to EMH developing a so-called “three factor” variant of the CAPM. In Thaler’s case based his observations (inspired by the work of Daniel Kahneman and the late Amos Tversky) about investor behaviour that indicated investors underestimated bad news and overestimated positive trends. Many other detractors have emerged including Warren Buffett and George Soros who have made a lot of money predicting human behaviour rather than building a so-called “efficient portfolio”.

But none of the debate calls into question the basic principle that a share is worth the present value of future dividends, just whether at a given point in time the market is rational in putting a price today on that future dividend stream. Of course, many companies choose to retain free cash flow and dividend valuation models need adjustment to account for money that could have been paid as dividends but was retained - an adjustment that works if (and only if) the money retained is invested for returns at least as good as the company’s typical return on capital. The problem with valuation based on free cash flow is that the free cash flow itself is more nuanced - it needs to reflect working capital requirements which are more or less permanent uses of capital even if not fixed assets. I often see sell-side analysts publish reports implicitly based on free cash flow valuation with no mention of working capital, resulting in material valuation errors in particular for companies in the retail sector whose inventory, accounts receivables and payables comprise large portions of their balance sheets and may have more impact on valuation that operating income. Likewise, simplified valuation models don’t deal well with companies who make use of leased assets where the presence of leases distorts both income statements and balance sheets to some extent.

In more recent years, following a change in SEC regulators that permitted stock repurchases (Rule 10B-18 in 1982) many investors have concluded that stock repurchase and cancelation may be a more efficient way to “return cash to shareholders” ignoring the reality that when stock is repurchased it is giving cash to investors who are no longer shareholders having sold their shares to the issuer bid. Claimed benefits include tax efficiency (which has some merit depending on whether you hold your shares in taxable or tax-deferred accounts or what the tax laws of your jurisdiction are at any point in time), the ability to increase percentage ownership of an investee company without putting up more money directly, and a host of other arguments that appeal to the proponents of “buybacks” but don’t stand up to rigorous financial analysis. Buybacks add value to an issuer’s shares if (and only if) they are carried out at prices below “intrinsic value”.

The SEC is taking a hard look at share repurchase regulations since there is room for substantial abuse in volatile markets where company managers have an informational advantage over retail investors and the SEC is concerned about insider trading violations. This is a serious issue since investors who sell into a buyback may be disadvantaged in favor of those who remain invested, or the reverse, and the sponsors of the buybacks (company management) are better informed than ordinary investors on the possible risks and benefits. A fundamental tenet of securities regulation is that all investors receive equal treatment and buybacks (other than substantial issuer bids supported by prospectus level disclosure) do not meet this standard. Normal course issuer bids (NCIB’s) popular in Canada are particularly troublesome since the approval provides management with freedom to trade or not trade for an extended period of time, issuers make their repurchases without notice beyond the original application for approval, and by the time retail investors are informed of the number of shares repurchased and at what price they will often have missed the window to create a synthetic dividend to rebalance their holdings to be in the same position they would enjoy had the same funds been used to pay a dividend. The term of art often used to describe retail investors by management of public companies is offensive and I will not repeat it other than to say it is analagous to “prey” and the clamor of many retail investors for stock buybacks is evidence they do not understand the impact such buybacks may have on the price or value of their holdings despite their closely held belief they will universally benefit.

Valuation is the key. For energy names, many sell-side analysts, advisors and investors like to use a multiple of cash flow to value an energy stock, typically 4 x EBITDA. Let’s unpack that valuation a bit.

Consider an oil company with a capital efficiency of $25,000 - that is, adding 1 barrel of oil per day of production costs $25,000. Assume an oil price of $80 and an all operating cost of $20 a barrel with a royalty rate of 15%, a 10-year reserve life, a 30% decline rate and an asset retirement obligation at the end of well life of $100,000. I have used 100 barrels a day from a single well for this example. The costs and decline rate would be typical in the Cardium basin.

By inspection, you can see a rule of thumb multiple of 4 x EBITDA is more or less the same as a discounted cash flow (DCF) value at a 9% discount rate. The 4 x EBITDA multiple is a reasonable way to estimate in gross terms the approximate intrinsic value of an oil producer, but it is far from precise. A lot turns on the capital efficiency and the decline rate and the life of the reserves. Be wary of comparing companies simply on the basis of EBITDA multiples and spend some time looking at the type curves for the reservoir to arrive at a representative decline rate and the company’s experience with capital costs in that local area.

If you can’t value the shares you own, you have no idea whether a stock buyback helps or harms your investment or is better or worse than a dividend. Buybacks at greater than intrinsic value destroy value and valuation is more complex than an EBITDA multiple applied to today’s results or next year’s forecast which may be as reliable as a weather forecast for next July.

Long lived reserves with low or no decline rates are more valuable, for example, like MEG Energy (MEG.TO) with a 30 year plus life and no decline (although there is maintenance capital to consider). I think of MEG’s cash flows as warranting a multiple of 8 x EBITDA if you must use a multiple for convenience, but I suggest a valuation of MEG should be even more nuanced and detailed. Conventional multiples will undervalue MEG’s enterprise value (EV) most of the time but not necessarily its share price which is also affected by the effective cost of its debt which shifts with foreign exchange rates and interest rates. While I think MEG warrants a higher multiple than conventional oil, MEG is particularly subject to swings in the WCS/WTI discount which has been very volatile, and to rising interests rates and falling Canadian/US exchange rates owing to its high US$ denominated debt balance as pointed out above. Elimination of 100% of MEG’s debt would fix that problem but management is determined to use as much as half of MEG’s free cash flow to repurchase stock, exposing shareholders to the risks (or benefits) I have described.

MEG’s case was for illustration only. Commodity price differs by product and producer. Light sweet crude, syncrude and condensate command higher prices than Western Canadian Select so the product mix is important. Natural gas is a different kettle of fish altogether.

If you are serious about energy investing, ignore the conventional wisdom, avoid the fads like buybacks versus dividends, and do your homework. Spend your time building a portfolio that will provide you with regular cash income in the form of dividends based on debt free companies with low costs and you can look forward to years of profits. Get excited about short term trends and mezmerized by higher stock prices (which are not your friend unless you plan to sell at that moment) and you will have good days and bad days and overall are likely to have bad experience.

I own 102,000 shares of Birchcliff Energy (BIR.TO) which I started adding in early 2020 at less than $1.00 a share. Today that stock is $11 and Birchcliff plans an $0.80 per share dividend beginning in 2023. For the next several years, I expect my dividend income from Birchcliff of $81,600 a year to be a contributor to my day to day expenses and cannot imagine wanting to sell the shares. I also own shares of Peyto (PEY.TO), Cardinal (CJ.TO) Whitecap (WCP.TO) Bonterra (BNE.TO and Spartan Delta (SDE.TO) which I expect to become long term sources of dividend income and on which my costs are a fraction of today’s prices. I don’t have to get exercised about whether management can eke out a slightly better result for me through stock buybacks or dividend tweaks and frankly don’t care that much.

The key to building a portfolio like mine is homework. Either make an effort to understand the company’s economics or hire someone who can, and don’t get led around by the nose by a financial advisor whose motivation is a trade.