As an 'old school' conglomerate, Washington H. Soul Pattinson & Co. Ltd (ASX: SOL) shares require a few tweaks when it comes to valuation.
Therefore, knowing whether or not you are getting a 'bargain' can be difficult.
How to value shares 101
Ordinarily, when you value a company's shares you are trying to find out what they are worth. Anyone can tell you the price of shares but few people know what they are worth.
To determine a company's value, good investors focus on the cash flow of a business, forecast it into the future and discount the cash flow back to today's dollars.
That might sound a bit scary but it's surprisingly very simple.
It's the same method used by Warren Buffett, the world's greatest investor.
What makes "Soul Patts" so special?
Soul Pattinson's business model is different to most ASX-listed companies: it owns chunks of other companies, which are either listed on the share market (most of them) or private.
As most readers will know, simply owning shares of a public company does not allow you to access the cash flow of the business.
For example, if you own shares in Commonwealth Bank of Australia (ASX: CBA) you do not get a cheque every time a mortgagee has their loan repayments debited.
It's the same for Soul Patts. It receives dividends like anyone else. And unless it holds 100% of an ASX-listed company (which, by the way, would make it a private business not listed on the ASX) it does not get 'access' to the cash flow of that company.
Instead, its profit and loss statement will include something like this:
Basically, that's the 'value' of its investments going up or down. Of course, you use the "dividends received" from the companies it owns, which can be found on its cash flow statement:
But, you wouldn't be capturing all of the cash flow that is attributable to Soul Patts' shareholding in the company. For example, Soul Patts owns 25% of telco company TPG Telecom Ltd (ASX: TPM), which pays just over one-third of its profits out as dividends to its shareholders. So its "dividends received" does not take into account its entire shareholding.
You could go through each company that Soul Patts owns — it currently has around a dozen — and research, calculate and forecast their free cash flows, but that would be a pain in the you-know-what.
Instead, a quick — and dirty — way of valuing shares in Soul Patts is to take its book value, and/or use its dividends paid to shareholders to value the company as a whole.
I'm going to focus on the dividends.
Instead of focusing on the cash flow that Soul Patts earns from its investments, we use the dividends that shareholders receive from Soul Patts as a guide to its valuation.
With a twist and a wave of a magic wand we come up with the following values:
- $17, if we assume dividends grow at 4%
- $13, if we assume dividends grow at 3%
(for anyone who wants to know how easy it is to value dividend shares using this method, check out this article).
So, I suppose the next question is: How fast will its dividends grow?
I'm not sure. Nobody knows for certain.
But over the past 10 years, Soul Patts' dividends have risen by 6.2% per year. Over the past five years, they're up 3.4%.
Indeed, dividend increases have slowed for a few reasons. But I think it would be reasonable to assume yearly growth of 3.5% going forward.
That values Soul Patts' shares at $14.86, by my calculation.
Foolish Takeaway
We need to compare the value ($14.86) to the current price ($16.92). If the value is lower than the price we can say it is undervalued. Clearly, it's the opposite – Soul Patts' shares are overvalued using our model.
However, would I sell my Soul Patts shares because they are ~$2 overvalued? No way! We have only used one model.
Indeed, Soul Patts' shares are only modestly overvalued using our model, and great companies have a habit of staying richly valued for many years, anyway — and Soul Patts is certainly one of the ASX's great companies.
