EPV uses a very basic equation and the calculation only involves historical data. The equation only uses 2 assumptions which is the weight average cost of capital and assume the earnings are sustainable. It does not need any prediction on the group's future earnings and cash flow. So, it's considered as a bit defensive valuation.
For more information regarding EPV, pls read the link below as explained by Jae Jun
First, we start with the calculation of Weight Average Cost of Capital (WACC) that would be used in the Earning Power Valuation computation.
Weight Average Cost of Capital
I will use a base of Cost of Equity of 10.0% which consist of risk free rate (MSG) plus risk premium and multiple it with several risk consideration before arrive at required return for equity holder.
Basic Cost of Equity, RE = 10.0%
Business Risk = 1.15
Financial Risk = 1.0
Earnings Predictability = 1.10
Adjust Return of Equity Holder, Re = 10.0% x 1.15 x 1.0 x 1.10 = 12.65%
For its business risk, since Luxchem involved in chemical trading and manufacturing which affected by commodities price and demand of their products as well as facing competition from other trading companies that may result in thinner margin. So, I rate it at a premium 1.15.
For its financial risk, the group is at net cash position with good ROE and ROIC throughout the years albeit declining profit margin. I rate it with a base of 1.0 as it's stable and has good fundamental.
For its earnings predictability, Luxchem is a local market leader in supplying UPR and also supplies nitrile for certain glove manufacturers. Their sales are stable and majority of its revenue are done locally. Thus, I rate it with a little premium at 1.10
There are many formulas to calculate Required Return of Equity Holder, Re on web. I tend to use this one as it's easier for me.
So here comes with the WACC computation
Current market capital,E = 0.83 x 260,000
Total Debt, D = RM73,243
Tax Rate = 25.9%
Bank Interest, Rd = Interest Paid / Total borrowings
= 2,376 / 73,243 = 3.24%
Total value of firm, V = E + D = RM289,043,000
WACC = (E/V)*Re + (D/V)*Rd(1-Tax rate)
= (215,800,000 / 289,043,000)*0.1265 + (73,243 / 289,043,000)*(0.0324)(1-0.259)
Earning Power Valuation
I used historical record from year 2007 to 2013 for the computation since the group only listed in 2008.
|Latest Year Revenue||('000)||524,937||Revenue for FY2013|
|Average EBIT margin||%||7.10||Past 7 years average EBIT margin|
|Operating profit, EBIT||('000)||37,289|
|Average Tax Rate||%||25.4%||Past 7 years average tax rate|
|Average EBIT After Tax||('000)||27,821|
|Average Net Capital Expenses||('000)||-463||Past 7 years capex deduct depreciation|
|Normalized EBIT||('000)||27,359||Add together|
|Cost of Capital, WACC||%||10.05%|
|Capitalized Earnings||('000)||272,225||Normalized EBIT / WACC|
|Add Excess Cash||('000)||348,466||From Q3FY2014|
|Minus Total Borrowings||('000)||271,324||From Q3FY2014|
|Minority Interests Percentage||%||-1.3%||Minority percentage for FY2013 net profit|
|EPV to common shareholders||('000)||274,878|
So, the EPV is around RM1.06 compared to yesterday closing price of RM0.83.
However, given the operating profit margin of Luxchem has been in declining trend throughout the years, I applied its latest operating profit margin of 5.44% (FY2013) in the calculation to be more conservative.
The new EPV is RM0.80 which is lower than yesterday closing price of RM0.83
Although EPV method is considered as more defensive valuation due to less assumption used, but it's better to apply a certain degree of margin of safety to the estimated value since valuation after all is just a number.
10%? 20%? 30%? It's depends on the individual risk appetite.
In addition, investors should not depend on one valuation to decide the buy or sell call.
At least for me, I quite emphasize on the growth prospect for the the companies I Invest in.
Do you think Luxchem has high growth ahead? I rest my case at least for now.