LAST week, I listed down stocks with the highest returns in the last five years and tried to analyse how much of the returns came from dividends and how much from capital gains. Most of the returns, of course, came from capital gains.
Earlier this week, a friend forwarded me a paper by Eugene Fama and Kenneth French entitled 'The anatomy of value and growth stocks returns'. In that study, Fama and French broke down the average returns on value and growth portfolios into a few components. One is dividends. Two, growth in book equity. This comes primarily from earnings retention. And three, the increase in price-to-book ratio.
The report sets me thinking. Wouldn't be it be interesting if we could take a look at the 40 best-performing stocks in Singapore and try to break down their sources of returns.
And that's what I did. For the 40 companies, I tried to find out their book value per share five years ago, and compared them to the companies' latest available numbers. I also compared these companies' price-to-book ratio, their price-earnings ratio and their return on equity five years ago, to the numbers today.
Capital gains
The difference in the various measures in these companies is pretty interesting. First of all, the majority of the stocks have seen an increase in their book value per share. The average increase was 145 per cent in the last five years, with the median being 76 per cent.
For companies with no growth or even decline in their book value per share, it is due to the distribution of earnings or capital back to shareholders.
Here's what the numbers seem to suggest. The biggest source of capital gains for investors appears to be the increase in these stocks' price-to-book value. Not only has the book value of these companies increased over the past five years, investors are now also valuing the book value of these companies' assets at a more substantial premium than before.
In fact, some 70 per cent of the 40 stocks in the list were trading at a discount to their book value five years ago.
In response to my article last week, a friend noted that the question is, how do we identify these super stocks five years ago. So this simple study is perhaps confirming again what pervious studies had found, and that is: price-to-book ratio is the best predictor of the future performance of a stock. Stocks trading below their book value have a higher likelihood of seeing their share price converging to their book value.
For our 40 stocks, the average price-to-book (PTB) value was 1.1 times five years ago. The median was 0.7. Today, these stocks are trading at 3.5 times their (increased) book value. The median is 2.4 times.
Only a handful of these stocks had high PTB ratios five years ago, and are still commanding high multiples today. They include Raffles Education, Cosco, Noble Group, Singapore Exchange, Manhattan Resources, Keppel T&T, Sembcorp Marine and Parkway Holdings.
On the whole, there are sound reasons why the market is valuing these 40 stocks at a premium to their book value. The main reason is these companies have significantly raised their return on equity.
Back in 2003, the average ROEs of these stocks was 8.1 per cent, with the median being 6.8 per cent. In their last financial year, these companies' ROEs averaged 25.8 per cent. The median was 24 per cent.
Since these companies are able to generate returns of 24 per cent, which would be significantly above their cost of equity, then it stands to reason that investors would be willing to pay more than the book value of their assets.
Abnormal earnings
One way to value a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth.
This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock. Book value is the original capital invested by the company in its various assets to start up its business after taking into account depreciation.
As mentioned, if a company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value.
Five years ago, some of the companies on the list were trading below their book value probably because they were losing money. But the nature of business is such that loss-making companies will try to restructure and take measures to improve their performance. And as such, their performance will revert to the mean and their deeply depressed valuation will rebound significantly.
Meanwhile another valuation measure showed that this group of companies are trading at a lower multiple today than in 2003. That measure is price-earnings, or PE, ratio. Five years back, the average PE of the companies was some 20 times. The median was 13.2 times. Now, their average PE is just under 14 times, with a median of 9.4 times.
And based on analysts' consensus forecast, this group of stocks are trading at 11.5 times their next year's earnings.
Now back to the Fama and French study, they found that during 1964-2006, dividends contributed more to average returns on value stocks versus growth stocks, and dividends contributed more to returns on big-cap stocks versus small-cap stocks. But these patterns are special to 1964-2006. For 1927-1963, the contribution of dividends to average returns was not systematically different for big-cap and small-cap stocks, or for value and growth stocks.
They also found that value companies do not invest much and hence the growth in their book equity is trivial to negative. But value portfolios generate large capital gain returns as some value companies restructure, increase profitability, and move to lower-expected return groups.
The capital gains are larger in small-cap value stocks than for big-cap value stocks.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
The report sets me thinking. Wouldn't be it be interesting if we could take a look at the 40 best-performing stocks in Singapore and try to break down their sources of returns.
And that's what I did. For the 40 companies, I tried to find out their book value per share five years ago, and compared them to the companies' latest available numbers. I also compared these companies' price-to-book ratio, their price-earnings ratio and their return on equity five years ago, to the numbers today.
Capital gains
The difference in the various measures in these companies is pretty interesting. First of all, the majority of the stocks have seen an increase in their book value per share. The average increase was 145 per cent in the last five years, with the median being 76 per cent.
For companies with no growth or even decline in their book value per share, it is due to the distribution of earnings or capital back to shareholders.
Here's what the numbers seem to suggest. The biggest source of capital gains for investors appears to be the increase in these stocks' price-to-book value. Not only has the book value of these companies increased over the past five years, investors are now also valuing the book value of these companies' assets at a more substantial premium than before.
In fact, some 70 per cent of the 40 stocks in the list were trading at a discount to their book value five years ago.
In response to my article last week, a friend noted that the question is, how do we identify these super stocks five years ago. So this simple study is perhaps confirming again what pervious studies had found, and that is: price-to-book ratio is the best predictor of the future performance of a stock. Stocks trading below their book value have a higher likelihood of seeing their share price converging to their book value.
For our 40 stocks, the average price-to-book (PTB) value was 1.1 times five years ago. The median was 0.7. Today, these stocks are trading at 3.5 times their (increased) book value. The median is 2.4 times.
Only a handful of these stocks had high PTB ratios five years ago, and are still commanding high multiples today. They include Raffles Education, Cosco, Noble Group, Singapore Exchange, Manhattan Resources, Keppel T&T, Sembcorp Marine and Parkway Holdings.
On the whole, there are sound reasons why the market is valuing these 40 stocks at a premium to their book value. The main reason is these companies have significantly raised their return on equity.
Back in 2003, the average ROEs of these stocks was 8.1 per cent, with the median being 6.8 per cent. In their last financial year, these companies' ROEs averaged 25.8 per cent. The median was 24 per cent.
Since these companies are able to generate returns of 24 per cent, which would be significantly above their cost of equity, then it stands to reason that investors would be willing to pay more than the book value of their assets.
Abnormal earnings
One way to value a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth.
This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock. Book value is the original capital invested by the company in its various assets to start up its business after taking into account depreciation.
As mentioned, if a company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value.
Five years ago, some of the companies on the list were trading below their book value probably because they were losing money. But the nature of business is such that loss-making companies will try to restructure and take measures to improve their performance. And as such, their performance will revert to the mean and their deeply depressed valuation will rebound significantly.
Meanwhile another valuation measure showed that this group of companies are trading at a lower multiple today than in 2003. That measure is price-earnings, or PE, ratio. Five years back, the average PE of the companies was some 20 times. The median was 13.2 times. Now, their average PE is just under 14 times, with a median of 9.4 times.
And based on analysts' consensus forecast, this group of stocks are trading at 11.5 times their next year's earnings.
Now back to the Fama and French study, they found that during 1964-2006, dividends contributed more to average returns on value stocks versus growth stocks, and dividends contributed more to returns on big-cap stocks versus small-cap stocks. But these patterns are special to 1964-2006. For 1927-1963, the contribution of dividends to average returns was not systematically different for big-cap and small-cap stocks, or for value and growth stocks.
They also found that value companies do not invest much and hence the growth in their book equity is trivial to negative. But value portfolios generate large capital gain returns as some value companies restructure, increase profitability, and move to lower-expected return groups.
The capital gains are larger in small-cap value stocks than for big-cap value stocks.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
Published May 24, 2008
By TEH HOOI LING
SENIOR CORRESPONDENT
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