RYM - Ryman Healthcare

[Sauce]

Or should I say "will be game continuing for Ryman"

[percy]

Or should I say "will be game continuing for Ryman"

No I think you were right first time.Aussie a lot bigger market.

[Sauce]

Thanks Percy.
Putting together my thoughts on RYMANs value now, will post soon.

[Major von Tempsky]

Tell you what maties, the "licence to occupy" concept must be as dead as a dodo from here on in after huge publicity of the plight of the Kate Sheppard residents and other cases where people have wanted to get out and found that they lose several hundred dollars into the pocket of the undeserving retirement village manager.

Not for me and I'm advising all the old people I know to avoid such arrangements like the plague.

[Sauce]

You obviously didn't watch Campbell Live's coverage of that saga. It was the best free publicity RYM could ever have dreamed of. RYM foresaw this issue and altered their contracts several years ago to ensure residents were to be paid out in such circumstances. They were even introduced by John as "we are now going to talk to an ethical retirement operator". They also have been lobbying the industry body to make standardise this. They are as ethically run as you could possibly hope for Major Von Tempsky.

[POSSUM THE CAT]

Sauce Why are others going freehold title then. Stop being so one eyed. Both have traps depending on the contract

[percy]

Sauce Why are others going freehold title then. Stop being so one eyed. Both have traps depending on the contract

I knew the government were keen on the private sector building prisons,so looks as though you may be the first to buy a freehold cell.!!!!! lol.

[Sauce]

Ryman Healthcare Valuation.

Ok, So much for reverse engineering the shareprice to see what growth the market was factoring… Te Whetu beat me to it with a much better and more technical approach than I would be able to do. Anyway I promised to put my Valuation for RYM up..

Warning: There may or may not be some controversial statements for students of applied finance below. And secondly, there is obviously nothing original in these views. It’s simply a combination of the general approach by Graham & Dodd, Warren Buffett, Roger Montgomery and Bruce Greenwald.

Before assessing the validity of my valuation thesis for RYMAN Healthcare please note the following points about the life cycle of a company:

A company cannot maintain compounding growth above GDP forever (unless you believe it can outgrow the economy). Successful companies usually enjoy excessive returns (returns above the cost of capital) for awhile but over longer periods its advantage is eroded away as competitors find ways to chip away at its armour. Eventually returns drop until they approximate the firms cost of capital, or below if they end up at a disadvantage. When this happens, growth adds no value (or can destroy it) – but all the growth up until this point has value.

Alternatively a company can reach a scale that, combined with its other advantages, means it is virtually impossible for the walls to be breached by competitors and it keeps growing until it has saturated its market. In this case, a rational manager will stop retaining profits for growth and will pay out 100% of distributable earnings as dividends, leaving just enough cash to maintain its competitive position and therefore its unit volume. In this case it still makes excessive returns above its cost of capital, but growth no longer makes up part of its value – and could then be then valued much like a perpetual bond.

Note that the key here is sustainability of the competitive advantage NOT growth in the overall market size (although the size of the market matters – but as I have been learning, niche markets can actually have better competitive dynamics than enormous growing markets). It’s really about the inertia that true competitive advantages/barriers to entry/economies-of-scale have on market share.

So with these thoughts in this in mind we come to the value equation.

Firstly we have to look at the Earnings Power Value or the EPV. As outlined by Graham and Dodd a very long time ago.

The formula is: “adjusted earnings x 1 / R”

Where ‘adjusted earnings’ are the ‘owner earnings’ (as defined by Buffett) which simply means the net cash available to an owner after the cost of maintaining the companies competitive position. And where R is the required return (i.e. cost of capital).

This “adjusted earnings” figure can differ from reported earnings, however luckily for us, RYMAN already provide us this figure (even though they are not required to and could just report the considerably higher net profit figure as most companies do). This is the “underlying cash profit” they state i.e. 72m this year.

The formula above is basically just Profit / 10% if you require a 10% return. So a company returning $100,000 in true profit would be worth $1,000,000. Incidentally this is how you would value any perpetual cashflow i.e. a bond, investment property (think cap rate) etc.

The following is another way of expressing the same Earnings Power Value for the purpose of valuation that I think is much more preferable as it better reflects the underlying economics of the earnings machine:

Return on Equity / Cost of Capital * Equity

The profit (‘owner earnings’) generated by the business is ultimately a product of the investment made by the shareholders of the company. This is the equity in the business. So the real return should be a multiple of the equity in the business, as described in the formula above. We can use the forecast RYMAN profits for this year against the current equity invested to check this formula is indeed consistent with Graham & Dodds earnings power value:

Adjusted earnings / 1 – R = EPV

83m / 0.10 = 830m

Is the same as:

(ROE / COC) * E = EPV

(30% / 10%) * 276m = 830m

So, in theory, if RYM was operating in a mature but stable position in its market, and paying out 100% of its owners profits as dividends, it would be worth $830m on this years earnings.

But RYM is not mature. It’s growing, and it retains 50% of its profits to fund that growth. Those profits are reinvested in new villages to create increased future cashflows. This creates an issue for our valuation formula, as we will be receiving less money immediately (bad) for the benefit of receiving more money in the future (good).

To value the growing company that is successfully reinvesting its profits in future excess returns the formula is:

(Return On Equity / Cost of Capital) ^ 1.8 * Equity

What we are doing is taking the real return (i.e. the return discounted for its time value) and firing it out exponentially (to represent the compounding growth). It is basically a ‘straight line’ discounted cash flow. For RYMAN:

(ROE / COC) ^ 1.8 * E

(30%/10%) ^1.8 * $276m = $1,994m

So if RYMAN were reinvesting 100% of its profits at a 30% return, and you believed this was sustainable for a long time, this would be its current value ($1,994m).

Of course we have so far avoided the issue that RYMAN does not retain 100%, it re-invests only 50% in growth. Of course this is easy to sort out. Just value the portion retained for growth and the portion paid as a dividend separately, add the two figures together and you have your intrinsic value estimate.

If we try this for RYM:

EPV = (30% / 10%) * $276m = 830m * payout ratio 50% = $415m

GROWTH = (30%/10%) ^1.8 * $276m = $1,994m * retained ratio 50% = $997m

EPV + GROWTH VALUE = $1,412m

(DIVIDED BY 500,000,000 SHARES ON ISSUE)

ESTIMATE OF INTRINSIC VALUE: $2.82 per share

My Maths is terrible and this simple stuff is as far as I go, I believe the algebra is:

VALUE = (ROE/COC) * E * D% + (ROE/COC) ^1.8 x E * (1-D%)

Where:
ROE = Return on Shareholders Equity
COC = Cost of Capital or Required Return
E = Shareholders Equity
D = Dividend Payout Ratio

However, the compounding growth portion of this this formula is reliant on the on the 30% Return on Equity being sustainable for 11.9 years (in this case). Alternatively, a combination of slightly lower returns (but still in excess of the cost of capital) with longer timeframes would work so its as good an estimate as you need if you have the life cycle of a company as described above in mind. And for those who I haven’t bored to death and are still reading all this diatribe, here in lies the point, I believe, of both Te Whetu and myself: You have to understand the business.

You can run a few reality checks; You need to know that you Return on Equity figure is realistic, and for some businesses it can be helpful to look at the ROE for the previous ten years, and perhaps use an average; especially for cyclical businesses that might be at the top or bottom of their cycle. One very important thing to do is look at the implied growth rate assumption which is the formula Te Whetu mentioned: Return on Equity * Retention Rate. For RYM this is: 30% * 50% = 15% This allows us a reality check i.e. is 15% growth sustainable for 12 years? Or, as Te Whetu brilliantly put it, “can RYMAN be 8 times the size in 15 years…” which is the same thing said another way but is perhaps a better way to look at it.

Where we differ (I think? sorry Te Whetu, correct me if I am wrong) is how you handicap the odds. I do not believe you need to do detailed financial modeling to give you an edge, in fact I believe it can lead to hubris. Otherwise the world would be full of super rich accountants and mathematicians. I believe that it is the competitive dynamics of the industry that will ultimately determine the stability of Excess Returns. Competitive advantage and barriers to entry provides a natural inertia that pulls market share towards it.

Percy understands this perfectly. In pointing to my post #459 and the discussion of RYMs competitive advantage he was, more succinctly than me as usual, making exactly my point.

What are the odds that outsized returns are sustainable? Understanding the competitive mold of the industry, and how a business fits within that mold, is very subjective and also one of the hardest things to truly have insights into – most people could learn valuation theory, but learning to understand subjective competitive dynamics is not so easy. This is literally Warren Buffetts competitive advantage. Of course he has a lifetime of fanatical research of businesses competitive dynamics and a rational genius intellect – almost impossible to replicate.

Students of valuation and finance learn invaluable skills and I am sure that I would be a better investor if I understood more of the theory & mathematics behind detailed financial modeling. However, it’s equally important to recognise that empowering someone with the tools to generate precise models is dangerous – as humans we are apt to search for a hard number to a soft problem by creating complex models. The more complex the model, and the longer the time spent determining the inputs, the more we tend to trust the output as if it was fact.

In summary:

Precise cash flow forecasts are dangerous, can lead to overconfidence, and are more likely to be wrong than be right. Detailed models are therefore unnecessary to make profitable investments. No one can accurately model Rymans cashflows out for the next 20 years or even for the next 10 years. Not even Rymans management could do it (and be right). As investors, we should be assessing the underlying economics of the business, then assessing how sustainable those economics are - i.e. looking for a MOAT. The way to know how sustainable returns are is by understanding the competitive dynamics of industry and the business within it, not by modeling the industry growth rate vs possible company growth rate to try and predict the likely cashflow at year 13 etc. This doesn’t mean we should not learn to value a business – indeed understanding the true underlying economics of a business and being able to hang a value on the cashflow and future growth is essential. And I think checking your assumptions against the size of the potential market is important. And finally, growth should only be valued and paid for when you feel the assumptions are almost certain and/or, a very large discount to that value exits, so that if your assumptions miss the mark you do not lose money.

PE ratios are not a valuation.

For those that believe Charlie & Warren engage in detailed financial modeling: Some comments from Warren Buffett & Charles Munger:

Charlie: “We are very inexact… How certain we are is the most important part. We never sit down, run the numbers out and discount them back to net present value”

Warren: “We believe if you can pinpoint it, your kidding yourself”

Charlie: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, your not going to make much different than a 6% return – even if you originally bought it at a huge discount. Conversely, if a business earns 18% on capital over 20 – 30 years, even if you pay and expensive looking price, you’ll end up with a fine result”

And this lecture by Alice Schroeder:

http://www.youtube.com/watch?v=PnTm2F6kiRQ

Alice was given unfettered access to all his files and notes on every Berkshire and partnership investment and spent 2000 hours with Buffett when writing his biography. She does not believe buffet performs any forecasting or DCF valuation at all when making investment decisions, contrary to what most people think, and provides an interesting example in this seminar.

By posting these quotes I am not advocating buying companies at an expensive price. In fact if you read back earlier in the thread, I valued RYM at $2.67 back when it was trading around $2 and I believed a margin of safety existed – I put my money where my mouth is and it has been a wonderful investment so far returning me 39%, including dividends, in less than 8 months.

With Regards,

Sauce

[buns]

Might take me the weekend to digest this one.

In advance, great work and many thanks.

[troyvdh]

...WOW...Sauce...very very impressive...the "thing" about RYM is that on the face of it ...is well ,its the perfect investment.
But that in itself is a worry...which I believe you have very well articulated spelt out.
To my mind there have been perfect stories...Microsoft,Apple,BHp...where mkt dominance has reigned....in NZ ....we tend to have bursts....BIL,RJI...TEL....then pooph.....

...could RYM be the exception.....our little "Microsoft"...they are off to OZ....a graveyard mostly for NZ companies , but not for NZ indviduals....

...say in 10 years ...could RYM have 10000000 shares ..having had multiple 1 for 5 issues and each share worth what they are now...and all current holders all very happy self satisfied chappies congratulating ourselves that were indeed very wise indeed in believeing .... the odd hiccup of course (sorry...I meant buying opportunities...like a 20 months ago when RYM were just above a dollar......)....

again a very good read....with a brain like your I really hope your really rich..and enjoying it to....

troy