Goldlion Property Thought Exercise: The Science Vs Art Of Valuation by SG Value Investor, The Value Edge
In our previous post, we briefly mentioned our difficulties in valuing Goldlion Holdings Limited (HKG:0533)’s property division.
There are 2 common ways of valuing properties; the first would be an asset-based approach and the second would be based on earnings power. The ideal way of using the asset approach would be to value all properties based on their land areas multiplied by their price per unit area. Due to the relative opacity of the Chinese property market and the large amount of properties which Goldlion Holdings Limited (HKG:0533) possesses, this is simply not feasible for us. The other more simplistic way would be to apply a discount to its book value. The discount factor is meant to accommodate any possible shocks to the market; it is often an arbitrary value and of course, the steeper the discount the more conservative the valuation.
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The second method of earnings power valuation discounts all future cash flows (which are based on rent) to a present value. This is the approach which we have chosen in our analysis. Once again, the risks of using an inappropriate cash flow or discount rate persists.
Under a true, pure concept of value, both methods should converge to give the same figure and it does not matter which method one uses. In the real world, this almost never happens but we should still see some convergence. For example, from our previous post “We think that 6% is adequate compensation for the risk of property investment and based on an FCF of HKD83.5m, the property division would be valued at HKD1391.67m.” This is equivalent to a 37% discount of its book value from an asset perspective which also cements our conservative estimates. Based on the science of valuation, everything seems in order.
The art of valuation comes in making sense of the numbers; it is the primary mechanism that decides on the FCF figure of HKD83.5m. It is also the one which causes us to ask questions for the purpose of check and balance. In this case, the question would invariably be “Is this FCF an accurate number moving forward?” and this unfortunately, opens a mental can of worms.
To answer this, we need to roughly gauge a long term rental yield. We can see that rental yield has been declining steadily since 2009 to its current 8.20%. Considering that one-third of its properties are in Hong Kong (with the remaining in China) which has lower rental yields of around 4-5%, an 8.20% rental yield seems a stretch as a long-term sustainable figure. In this regard, a HKD83.5m figure would therefore be too high. There are 2 possible outcomes of this conclusion; one, the book value of properties is understated or two, rent would have to decline. The second outcome seems more likely given that the book values are revalued annually.
Whatever rent and FCF you may determine, the next step would be to decide on a suitable FCF yield/cost of ‘equity’ and since properties are usually less risky than equity, we honestly think that 6% is adequate compensation. However, given that the FCF yield on US 30Y Treasury bonds is 3.48%, we cannot rationally say that an FCF yield of 3.51% is adequate compensation for the risk of property investment. This gives rise to a contradiction – how can we expect an increase in FCF yield from its current 3.51% and expect a depression in rental yields at the same time? After all, free cash flow is always a derivative of revenue (rent). Another corollary is that FCF yield should always be lower than rental yield. How do we resolve this impasse? The only conclusion we can make is that costs of running the division are inefficiently high.
Another way to ascertain this is to compare this with the average dividend yields of REITS. As REITS pay almost all of their cash inflow as dividends, their dividend yield will be a good proxy for FCF yield. A dividend yield of 3.51% for a REIT is very low indeed as most will have yields upwards of 5% (or at the very least in the high 4 region). Therefore, this reinforces are our conclusion that the division is inefficient.
How does this change our valuation? Surely between 2 entities of different cost margins but with everything else identical, the more efficient one should command a higher price?
To account for its inefficiency, we need to further discount our valuation by subtracting the present value of expected cash costs. We derive this by taking Segment Results – Fair value gains – Segment’s Share of Unallocated Cost + Depreciation. Surprisingly, cash cost has declined steadily from HKD151.94m in 2009 to HKD110.28m, perhaps indicating the scalability of the division. By assuming a similar 6% cost of equity but a 1% growth rate, we have a present value of HKD1575.43m. I arrived at a negative valuation by subtracting this value from our original valuation of HKD1391.67m, but I realise this is wrong as we would be double counting the costs.
Nevertheless, this inefficiency matters in determining the appropriate long term FCF for valuation. Let’s say we think that 6.5% is the true long term rental yield, this will give us revenues of HKD142.62m which corresponds to a FCF of HKD39.72m, based on 2013 figures. This corresponds to a value of HKD662.0m using a 6% cost of equity. Alternatively, we can also subtract the present value of costs from the current book value which will give a similar figure. This is only about 30% of its current book value and is akin to trading at 0.3 P/B in the context of a property developer. Could it really be worth so little? It seems to go against all intuition and unfortunately, I have no answer for this.
To summarise, I tend to think of property value as a function of rent. This equation changes when we deal with equity-owned property where we have to consider the costs factors as well. This brings another dimension to the valuation of property developers, hitherto the norm has been to base valuation only on the value of properties owned, omitting the costs of operations.