Valuing the shares of Greene King (LSE:GNK)

To try and make this as easy as possible, I am going to take the shares of a business which is very easy for most people to understand. Greene King makes beer and owns and runs pubs. Its shares are on a bit of a downer at the moment and are trading at around a five year low as shown in the chart below.

So let's have a go at trying to work out whether Greene King shares are the equivalent of a half decent or very good bottle of wine on offer or something that might get poured down the kitchen sink.

Step 2: A quick glance at the share price chart

Share price charts are a great way of quickly learning about what the stock market currently thinks about a share. Rising share prices tell you that something good is happening whilst falling share prices might be telling you that the company is having a bad time of things.

We already know from the first chart above that Greene King shares are trading close to a five year low which is not a good sign. Looking at the one year share price chart shows a recent sharp fall in the share price. The share price is also below its 50 day and 200 day moving average - an often used measure of sentiment - which is also painting a very grim picture.

You now need to go and find out why this is happening. The most obvious reason is bad news about the company's trading performance or difficulties with similar companies in the pub sector. Go to the company's investor relations website or check out the News view in SharePad.

The reason for the sharp fall in the share price was a fairly poor trading statement on 8th September 2017 which said:

• Underlying sales at the Pub Company have been falling and at a faster rate than the pub market as a whole. This means the company is losing market share which is not a good sign.
• Pub Partners' profits are growing by a small amount.
• Brewing sales are falling but by less than the market. Greene King is taking market share in a falling market which is a small comfort.
• The short-term outlook is poor due to weaker consumer confidence, higher costs and increasing competition. That's a pretty worrying mix of circumstances.
• The company is still upbeat longer term and is confident it will have enough cash flow to grow the business and deliver sustainable dividends - note it did not say growing - to shareholders.

Not a lot to be cheerful about here it would seem.

Taking stock: What you already know

In a very short period of time you have learned three very important things about Greene King that will help you when you are trying to work out whether its shares are cheap or expensive.

1. It appears to be a very modest business rather than a good or very good one.
2. Current trading is poor.
3. Profits aren't expected to grow much.

Now ask yourself is this the kind of business that people should be prepared to pay a high price tag for. My guess is that most people would not be willing to.

So there are good grounds for expecting the shares to trade at fairly low or modest valuations. That's the important valuation question answered.

The second one is whether you think the stock market is right. Are Greene King shares still overvalued after their recent fall or has the market judged them too harshly and served up a potential bargain?

PE multiples

This is the most commonly used valuation yardstick as it is very easy to calculate with information that is usually quite easy to find. It is simply the share price divided by the earnings per share (EPS).

The problem for investors is what EPS number to base their valuation on. The most common ones used are:

• Historic PE based on the company's last annual year end reported EPS. Often referred to as just PE.
• Trailing twelve month (TTM) PE based on last 12 months EPS. If a company's last results were for a half year, the TTM EPS will take the recent half year figure and the second half EPS of the previous year.
• Forecast PE - based on next annual forecast EPS
• Rolling PE - This is my preferred PE measure. It looks at PE based on an estimated current year to date rather than year end EPS. This helps to better compare companies with different year ends. So for Greene King which has an April year end, its rolling EPS at the end of September 2017 will have 7 months of the last annual EPS of 69.5p (September 2016 to April 2017) and five months of this year's forecast EPS of 67.9p (May 2017 to September 2017). This gives a rolling EPS figure of 68.8p.

At a share price of 570p, Greene King trades on a rolling PE of 8.3 times. Looking forward another year it is on the same multiple. These are not high numbers and seem to reflect the company's current struggles.

Once you have this number you might want to compare it with its historic range. SharePad can calculate a rolling PE chart for you.

We can see that the company's rollling PE has been getting lower for the last three years which reflects a growing lack of enthusiasm for the shares. The company was cheaper on this measure (a lower PE) coming out of the last recession and during the technology boom of the late 1990s and early 2000s when pub shares were shunned by investors in favour of more racy technology shares.

The table above also shows that other companies in the sector - Marston's, Mitchells & Butlers and EI Group - also have low rolling PEs. In addition to low growth prospects, these companies have high levels of debt which reduces PEs to reflect their increased riskiness to investors. The higher PEs in the sector attached to JD Wetherspoon, Fuller and Revolution Bars arguably reflect their higher quality, better growth prospects and in Revolution's case a takeover bid.

So are we any wiser as to whether Greene King is cheap or expensive?

Not really. Its current business performance and growth prospects suggests that its low PE ratio is not unreasonable. It is not the cheapest share in the sector and who's to say that the PE ratio could not fall?

SharePad calculates a number of statistics for a portfolio or a sector. The average rolling PE weighted by market capitalisation is 9 times. We could use this to get a crude estimate of Greene King's valuation upside if it traded on a sector average multiple.

If we use SharePad's target price indicator using the current rolling EPS and sector average rolling PE it tells us that there is not much upside in the shares.

Dividend yield

This expresses the company's dividend per share as a percentage of its share price. It measures the income yield from owning a share.

Income investors like high dividend yields but if they are too high they can be a warning sign for investors that the dividend may not be safe and could be cut. In today's markets, a yield of 6% or more is entering the danger zone and at the very least can be a sign that future dividend growth might be quite weak.

This is what seems to be happening at Greene King. Dividends have been increasing steadily in the recent past but future growth according to analyst forecasts is expected to be very weak.

Last year, shareholders received 33.2p per share in dividends. This gives the share a dividend yield of 5.8% at a share price of 570p. That looks quite tempting compared with the tiny interest rates currently being offered on savings accounts and government bonds but you have to ask yourself whether that is a sign that the shares are cheap.

If you look at the table below, it is calculating the dividend yields you might be receiving at the current share price based on City analysts' dividend per share forecasts. Greene King's yield is not growing which is not a good sign. A high yield without much prospect of dividend growth can often be a very disappointing investment - especially if the dividend ends up being cut. Note the comment in the recent trading statement which mentioned 'sustainable' rather than growing dividends.

Shares with large dividends can be valued by estimating the future stream of dividends and discounting them to give a value per share in today's money (or a present value). You can do this quickly in Sharepad.

Price to net asset value (P/NAV)

This is a useful valuation tool for companies with lots of assets. Many pub companies own the freehold properties they trade from which can give them similar characteristics to property companies. If you can buy a company for close to or below its net asset value (the value of its assets less total liabilities) then you may have come across a bargain.

For a pub company, it is best to focus on tangible net asset value which ignores intangible assets such as goodwill (the amount paid above NAV when buying another company).

Greene King is not shouting 'bargain' but other companies such as Mitchells & Butlers or EI Group can be bought for less than their NTAV per share.

When you come across companies like this you have to ask yourself why the stock market is valuing the shares for less than the value of its net tangible assets. The shares could have been overlooked and represent genuine bargains but it could be that savvy investors don't believe that the value of the pubs on the balance sheet are realistic.

So how do you go about trying to work out if the asset values are realistic and not overstated. As an outsider you are never going to know for sure but there are a couple of checks you can do:

1. Look at the ROCE of the business. A ROCE of less than 8% in the current interest rate environment might suggest that the company's assets can't make enough money to pay their way - they are overvalued.
2. Check for losses on disposals of pubs. Losses occur when assets are sold for less than their NAV. Losses on disposals are a sign that asset values on those assets have been too high and this might be the case - but not necessarily so - for the ones remaining. One place to look is under 'Profit on disposals' in the Net cash from operations section of the cash flow statement. Losses on disposal will have been deducted from operating profit. However as they are an accounting loss rather than a cash loss they are added back to operating profit on the cash flow statement.

Mitchells and Butlers has a low ROCE which might make you think that its asset values need to be checked further.

However, the company's recent trading statement highlighted that the pubs it had sold this year had been just above their NAV:

"During the year we have disposed of 79 sites which did not fit into our long-term estate plan, 73 of which were sold as a package which completed in July with the remainder sold individually. The proceeds from disposals total GBP46m which is marginally above the net book value of the properties"

Sum-of-the-parts (SOP)

This approach is used a lot by professional investors in order to get a more detailed and accurate valuation of a company. An EV is calculated for each separate business and various adjustments are made to get a value per share.

SOP is often referred to as a 'break up' valuation which estimates what a company would be worth if it was bought and its businesses were sold off separately.

These valuations can be quite involved and are best suited to someone who has some degree of industry knowledge. As with any absolute valuation it is only as good or credible as the assumptions behind it. A good SOP can take a lot of work.

The first thing I've done here is to adjust the most recent trading profits by allocating central costs of £20.4m to each division based on their proportion of turnover. I've then valued each division by applying an EV/EBIT multiple from a recent or ongoing takeover transaction in the appropriate sector to get an estimate of market value.

On this basis, I can value Greene King shares at 735p each and therefore raise the question whether its shares might be undervalued.