Low valuation and requirement of dialogues from the viewpoint of cost of capital
In FY2018, Seikitokyu’s ROE is estimated to be 10.2% and adjusted ROE 12.2%. These are higher than the average ROE of TOPIX. On the other hand, Seikitokyu’s PBR is 0.8x which means its market capitalisation is less than liquidating value. Please note the valuation is as of the end of March 2019.
Seikitokyu’s PBR in 5 years
（Source：QUICK ASTRA MANAGER）
“Residual income valuation” is a method of evaluation that calculates shareholders’ value using ROE, cost of equity (r) and growth (g) etc.
（please find the bottom of this page for further explanation）
Based on the theoretical PBR above, higher ROE or growth increases PBR and higher cost of equity decreases PBR. ROE minus cost of equity is also called “equity spread”. If the equity spread is bigger than 0, theoretical PBR is more than 1x.
Followings are our consideration according to the “Residual income valuation” above why Seikitokyu’s PBR is lower than 1x.
- High cost of equity
- As long as Seikitokyu adopts the current policy to accumulate equity-capital, it is inevitable to cause decline of ROE in the future. Such prospect has already been discounted and the valuation became low in advance.
- Seikitokyu has been subjected to an on-site inspection by the Japan Fair Trade Commission (hereinafter referred to as “JFTC”) 5 times since 2015. Such repetition of antitrust violation may cause the uncertainty and increase the cost of equity (Link).
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Negative growth
- The demand for asphalt paving is solid as an industry-wide trend. It is fair to say the growth in the future is not high but not negative.
From the consideration above, we conclude one of the reasons for the low valuation is concern of the market that the equity spread may become even smaller than the current level.
From the viewpoint of Enterprise Value (hereinafter referred to as “EV”), Seikitokyu’s EV/EVITDA is 1.7x.
EV is the present value of future earnings gained by investment in such as production equipment funded by shareholders and creditors. And how much profits are earned from investment is measured by Return on Invested Capital（hereinafter referred to as “ROIC”）. If ROIC is higher than return required to the company, EV becomes larger than invested capital.
For Seikitokyu, low EV/EBITDA means that, as a result of not using its invested capital effectively, its ROIC falls below Weighted Average of Cost of Capital (hereinafter referred to as “WACC”)（*）.
*based on the concept that the lower ROIC which falls below WACC, the lower EV which falls below invested capital.
As stated above, investors consider the cost of capital. However, it is also important for investors to know what level of cost of capital a company recognises and use it for effective dialogues.
There is no explanation regarding cost of capital in the medium-term management plan Seikitokyu released. Seikitokyu set a target of ROE as 13% and such level of the target is not bad. However, its PBR is lower than 1x and it strikes us that Seikitokyu’s cost of equity is higher than its ROE. One of the measures to improve its valuation is to lower the cost of equity. This is why we expect Seikitokyu to disclose its cost of capital. Such disclosure will help accelerate our dialogues regarding how to lower the cost of equity lower.
Seikitokyu’s medium-term management plan
| Items | FY2017 | FY2020 |
| Revenue | 81.6 bil | 80.5 bil |
| Operating profit | 6.2 bil | 6.5 bil ⇒ 5.4 bil(**) |
| Net profit | 2.2 bil | 5.2 bil ⇒ 4.4 bil(**) |
| Equity capital | 28 bil | Ca. 40 bil ⇒ Ca. 37.5 bil(**) |
| (FYI)ROE | 8.4% | Ca. 13.0% ⇒ Ca. 11.7% (**) |
| Investment plan | Total | Per annum |
| Plant maintenance or acquisition | 7.5 bil | 2.5 bil |
| M&A | 3 bil | 1 bil |
| Total | 10.5 bil | 3.5 bil |
（Source：Press release on March 10th 2018）
（FYI）Supplemental explanation of “Residual income valuation”
General equation is as following.
（Source：CFA Institute）
Assumption
- Ｂ_0=Ｂ_(ｔ-1)
- RI grows at the permanent growth rate of g per year
- ROE is fixed
And then, divide both sides of equation by Ｂ_(ｔ-1).
Below is an arrangement to indicate theoretical PBR.
