Sunday, February 3, 2019

Investing using fundamentals – Brookfield Infrastructure

If you invest just based on fundamentals, you will take a lot of the emotions out of investing. For example, you may decide to buy shares based on the analysis but you know that these are still simplistic forecasts. As such, you also build in stop-losses just in case you have got it wrong. Many thought that nothing was as safe as GE but we know what happened. If you used a 25% stop loss from its last market peak, losses in GE could have mostly been avoided. 

I created a simple spreadsheet for each company to be analyzed. Please, understand that we use this spreadsheet only for traditional companies such as financials or consumer staples. Resource companies use a similar spreadsheet but not based on earnings but instead based on cash flow. The term ‘Net Cash Flow’ refers to cash flow minus capital spending required to maintain production at the same level. Think of depleting gold reserves that need to be replaced to maintain steady production.

This posting is about a non-typical financial corporation; it is more an asset allocation company that invests in infrastructure such as toll roads and ports. Brookfield Infrastructure Limited Partnership is one of Canada’s most successful investors in global infrastructure projects. Its numbers are in U.S. dollars.

Figure 1. Brookfield Asset Management fundamentals. DCF means discounted cash flow method. Click the image for a better quality view.

The data you must enter in the yellow fields. The rest is calculated automatically. Dividend Payout is the number of years it takes to receive enough dividend to pay for the original share purchase. The Price/Earnings ratio is the current price divided by current earnings and is calculated by the spreadsheet. The current earnings are the ones at the time of purchase (in this example 2018). You can view the number of years it takes to have the total earnings equal the share purchase price. Over time, a successful company increases its earnings and thus the earnings accumulate faster than at the current P/E rate. This number is determined from the cumulative earnings column in the lower left table of the figure.

These are simple measures to determine how profitable the future earnings and cash flow from this investment will be. In the case of Brookfield Infrastructure, you will likely collect enough dividends to cover the share purchase in about 11 years or you will accumulate enough earnings to pay for the share in about 7 years.

Earnings for the first 5 years were found on the Globe  and Mail’s website and entered in the yellow cells for 2013 to 2017. The earnings for 2018 are added up from the latest published quarter and the 3 preceding quarters (entered in the yellow cells below the 'quarter' labels.  

The annual earnings are plotted on the graph (orange dots) and a linear regression is executed to extrapolate said earnings over the next 25 years. This does not necessarily reflect reality and the data may need updating each quarter to remain relevant. No business is predictable, and earnings are affected by anything such as interest rates and other macro-economics, by the business environment and by internal corporate issues, management often being a critical element.

This is just a simple straight-line projection (guess) of the future earnings stream that is used to calculate NPV or intrinsic value and for other ways of estimating future performance. For example, earnings are projected into the future and multiplied with today’s P/E to estimate the future share price. This assumes that market valuation (P/E) does not change with time. That is not realistic. The closer the numbers are to today, the more likely the are to become real and vise versa.

The target prices for 2019 and 2020 are averaged for ‘This Year’ and then the appreciation from the current or ‘purchase’ price is calculated and expressed as the percentage of appreciation. Added to that is the dividend yield to estimate ‘Total Return’ for the near future. We all know how tentative this is, but it provides good insight in the investment’s potential. This can be compared with that of other investments. 

Next, we do the 'time value of money' calculations, using forecasted earnings, the current stock price and a projected target stock price as input. These input values create the cash flow stream for the coming 25 years. The Intrinsic Share Value or NPV of the cash flow (excluding the current stock price or purchase price) is calculated using a desired rate of return as discount rate. This is sometimes considered to represent the cost of money (e.g. the inflation rate or the interest rate). Many commercial entities use their own internal WACC or Weight Averaged Cost of Capital as discount rate and need to calculate a positive NPV, i.e. the compound rate of return is greater than their WACC over the duration of the project. We use the standard 10% discount rate and our project ‘lasts’ 25 years.

If you include the purchase price of the share as the first expense in the cash flow stream, then you can back calculate the discount rate for an NPV=0. This is called the Internal Rate of Return or IRR. In general, the higher the IRR the better the economics of an investment or project. Since these calculations include the time-value of money, IRR does not necessarily reflect your actual return on investment. The latter is simply the sum of all your proceeds (dividends plus the share price at the time of sale) minus the purchase price; this total is divided by the purchase price (and multiplied by 100). When divided by the number of years that you held the investment you get a non-compounding average annual rate of return, sometimes called the simple rate of return comparable to simple interest rate. This rate is often a lot higher than the compounding rate of interest used for example on your credit card or other consumer debt. The latter is earning interest not only on your debt principal but also on the interest you owe.

The great benefit of using an IRR to evaluate an investment is that it considers WHEN you receive or pay funds into an investment. Thus, returns received early in the life of the investment are worth more than the same returns received near the end of the investment project.  Two projects with the same return can have quite different IRRs. Afterall, if you make your profits early in the life of a project, you can use the cash flow to invest quickly into another project and thus make even more money over time (high IRR) than if you have to wait for that cash flow 20 years before you can invest it again (low IRR). Another advantage is that it is easier to rank a number of projects based on IRR. Typically, projects of similar duration and returns are more profitable when they have a high IRR.

If you are interested in the Internal Rate of Return theory, you can learn more at this link. For many investors the compounding annual rate of return that combines income and appreciation is considered more useful. We will discuss some of that with the next case history.

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