Some Simple Valuations for Elsoft Research kcchongnz

The secret to successful investing is to figure out the value of something-and then pay a lot less.”         Joel Grenblatt

My last article shows that Elsoft seems to be a good company from every angle. It is a high growth company with high margin and return on capitals as compared to its peer and the industry average. It has excellent cash flow throughout the years. It has a clean balance sheet.

A good company may not be a good investment as it depends on what is the price. Often your return on your personal investment I shares depends on the price you pay. So is the price of Elsoft at RM1.91 worth investing? This is what we are going to deal with here.

Market Valuation

As on 31/12/2014, Elsoft has an equity of RM73.2m. With RM18.1 m share capital at 10 sen par value, the outstanding number of share is 181m. The book value is hence 40 sen per share. Revenue was RM45.1m with net income of RM19.8m. Earnings per share worked out to be 10.9 sen.

Elsoft closed at RM 1.91 on 10^th April 2015. The price-to-book ratio is a very high at 4.7, way above the bench mark of 2. If the company goes bankrupt, shareholders can only get back about 20% of what they pay. But wait, are we investing with the fear of a company will go bankrupt? Is P/B of 2 a bench mark? What kind of industry is Elsoft in? Aren’t other similar technology stocks also sell at this kind of P/B value, or even higher?

Technology stocks are basically asset light kind of stocks and their valuation derives from their earnings as going concerns. Is Elsoft expensive earning wise?

The price-earning-ratio is at 17.5. This ratio appears to be a little high, or is it? Flipped it over, the earnings yield (E/P) is about 5.7%. Isn’t this higher than what you can get from fixed income, albeit with some risk? This P/E ratio may be reasonable considering its great financial performance and potential high growth. With an expectation of more than 20% growth for the next few years, the Peter Lynch Price-earnings to growth, PEG ratio (17.5/20) is still attractive at less than unity. With the high growth in earnings E, earnings yield will quickly expands. Of course the caveat is the expected growth in the future must be 20% or more to justify it.

In the last five years, revenue and net profit of Elsoft grows by a CAGR of 50% and 66% respectively as described in the previous article of mine for this company. Of course it is the future growth which matters, not the past. Do we know for sure about the outcome of future growth? I don’t. As a small time retail investor with limited information and capability, I have to base my judgment, judgment basing on the company specific, its management, past performance, the industry outlook, etc, most of them are company specifics. For example, its high return on invested capitals of more than 50% is able to fund its growth internally, if the demand of its service and products continues continue to grow.

Let us examine some relative valuations of Elsoft as compared to its peers and the industry.

Relative Valuation of Elsoft

When you go to buy a particular house say in Subang Jaya Section 18, you will check around the neighbourhood there and see what the range of prices there is. What is the price of an average house there? What are the prices of houses transacted? How does the house you are thinking of buying compare to the other houses in the block? Of course not every house is the same; some are better taken care off, better finishes, extensively renovated or not etc.

Similarly in this exercise, we examine the performance of four other technology companies listed in Bursa as shown in Table 1. Note that although they are all in the same technology sector, their business models can be completely different. Hence the comparative performance may not be exactly comparative. However, it does serve as a good guide.

Table 1: Financial Performance of some technology stocks

Company	Elsoft	KESM	MMSV	Globtronics	Vitrox	Benchmark
Net profit margin	43.8%	5.0%	26.3%	18.1%	28.9%	7%
ROE	27.0%	5.1%	33.3%	22.6%	28.1%	15.7%
ROIC	63.7%	8.9%	64.5%	47.1%	41.2%

Table 1 above shows that Elsoft, MMSV and Vitrox have the higher profit margin and return on capitals, very high indeed, compared to the others, and KESM has the lowest. Elsoft and MMSV both have quite similar business models in research, design and development of test, burn-in and application specific embedded system and machine designing, fabrication and automation. Vitrox is involved in the development of three dimensional (3D) and line scan vision inspection system. KESM is more capital intensive kind of business as it actually carries out the semiconductor burn-in, testing of semiconductor integrated circuits and assembly of electronic components. Globtronics is more of a contract manufacturer for semiconductor LED and manufacturing of mobile components.

Table 2 below shows some valuation metrics of Elsoft compared to the rest. You can refer to what I have written in my article in “Some Valuation Techniques” here if you wish to.

http://klse.i3investor.com/blogs/kcchongnz/54664.jsp

Table 2: Simple valuation metrics for some technology companies

Company	Elsoft	KESM	MMSV	Globtronics	Vitrox	Bench mark
Price	$1.910	$2.780	$0.765	$5.640	$3.590
PE Ratio	17.5	9.3	11.9	24.6	17.0	35.0
Price/Book	4.7	0.5	4.0	5.6	4.8	2.8
Price/Sales	7.7	0.5	3.1	4.5	4.9	7.1
EV/Ebit	15.5	4.1	10.4	19.1	15.5
Earnings Yield	6.5%	24.5%	9.6%	5.2%	6.5%
Price/CFFO	24.8	11.0	14.1	19.4	23.9	15.4
Price/Free Cash Flow	26.0	18.4	15.4	29.6	28.9	28.9
DY	3.7%	1.1%	2.6%	2.7%	1.1%	2.1%

Elsoft appears to be expensive if you just look at its P/B (4.7), P/S (7.7), especially if you compare with its close peer MMSV. Compared with Globtronics and the industry, it is cheaper though. KESM has a very low book value valuation relatively. The high P/B value of both Elsoft, MMSV and Vitrox can be due to their asset light, high return on capitals, low capital expenses requirement kind of business. Technically, companies with high return on capitals generally traded at high P/B value.

Earnings valuation metrics of Elsoft are okay as argued above, similar to Vitrox. It even has reasonable good cash flows and dividend yield of 3.7%. Its valuations are actually inexpensive when compared to Globetronics and the industry. For example, its PE ratio is 17.5, much lower than that of Globetronics (24.6) and the industry (35). Its enterprise value (EV) at 15.5 times earnings before interest and tax, or EBIT, is also substantially lower than that of 19.1 for Globetronics. Comparing to its close peer MMSV, Elsoft is much more expensive. But the market could have given a high earnings valuation for Elsoft in anticipating its high growth in the future. Again KESM is very cheap relatively due to its relatively inferior performance metrics. Because of its cheapness, KESM may warrant a closer look at its viability as an investment.

The above relative valuation techniques of comparing the price of a company with its peer and the whole industry may not be a wise thing to do to decide on investing in a company if the whole industry is overvalued, such as during the Dotcom Bubble in 2001 or during our Second Board euphoria in 1997. Those metrics also do not take growth into consideration. We do know that if the above valuations of a high growth and a low growth company are the same, their values are not the same; a high growth company will definitely worth more.

Hence we should carry out an absolute valuation technique in discount cash flow analysis of Elsoft to determine what its intrinsic value is, and also carry out an exercise to gauge what is the expectation the market has for Elsoft. This will be what we are going to do next.

So do you want to learn the secret to successful investing?

For those who are interested to learn about valuation techniques, please contact me at

ckc15training2@gmail.com

K C Chong (15^th April 2015)