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Are Saudi companies over-valued? Corporate Finance view

Date: June 1, 2015 Author: Ramzi Watfa
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Of the 55 listed Saudi companies chosen for this survey with a total capitalization of SAR 989 million, and by using a simple perpetuity calculation, it seems that their Enterprise Values (EV) reaches only SAR 72 million. In other words, the portfolio was over-valued by SAR 717 million or 93% above their worth.Tadawul logo

From a Corporate Finance perspective, the valuation methodology used here is a simple perpetuity calculation that:

  1. Uses 2014 financials for each company, we calculated the Free Cash Flow
  2. Assumes a Growth rate of 5%;
  3. Uses a Weighted Average Cost of Capital (WACC) of 15% – appropriate for such an emerging market;
  4. Calculate Perpetuity, and
  5. Added Cash Balances, and subtracted Total Bank Debt.
By comparing the resultant EVs with each of the company’s current capitalization, you quickly discover that:
  • Only one was under-valued, whilst the rest were way over-valued; and
  • 40 of the total (or 73%) had no Enterprise Values at all!

Then why are most Saudi companies so over-valued?

Saudi companies are over-valued for various reasons, the most obvious ones are:

  1. Substandard quality of investors: “I invest in whatever is currently popular like everyone else”;
  2. Too much liquidity chasing after short term investment with focus on equities and land trading. Very limited long term real estate development opportunities or appetite; and no other capital market alternatives.
  3. Focus remains on Earnings for evaluations – a big mistake as earnings are not cash, just simply a method to balance the financial statements.

We also see evidence of over-spend in the stock market from the financials of many industrial and trading companies. Much of the cash flow that is generated, and indeed in many cases a large portion of the bank debt that is borrowed, ends up in investments. More money seeking the same small pot results in over-valuation.

Credit Risk is also high

We already highlighted this fact in our previous article on “How Risky is a Saudi Portfolio? A selection of Credit Risk Ratings” in which of total 79 companies that were then listed on the Saudi stock exchange, 13 were rated above 6.5 (watch-list and worse) using 6 Sigma’s risk rating system. The conclusions were that in addition to weak business engines (assessed using 6 Sigma’s signature credit risk analysis methodology), they were financed by bankers with total disregard for their risk ratings. There were many reasons for this lack of foresight as explained in the article.

In this survey, several companies were rated above 6.5. One in particular, risk rated 7.55, had a capitalization of SAR 767 million…. Imagine. That’s 76 million shares at SAR 10.10 per share. Yes I had to redo the calculation several times.

Are we being too strict in using FCF?

Using a discounted cash flow method is now recognized as a standard methodology in analyzing company values. At 6 Sigma we took the further step of introducing the Business Model analysis which broadens the analytics further and provides for a wider description of corporate performance. Moving away from income statement figures to cash flow analysis is a must.

Remember, profits or earnings in the world of valuations were invented by Luca Piccioli back in the 1400s as a means to balance the balance sheet in his invention of the double-entry booking keeping methodology. Over time, the notion of profits was made into a more elaborate analytical tool simply because of lack of understanding of business models. Looking at the income statement only to make a valuation assessment is not really useful. The cash flow is where the main focus should be. However, by itself, the cash flow would have to be presented in such a manner as to portray the events that have taken place, and to provide the reader with enough data to judge whether the company has the right business dynamics or not. The latter we call the cash flow or business “Engine”.

As such, valuations based on Free Cash Flow are appropriate particularly in this case. What would be a valid issue to argue is whether a perpetuity methodology on one year’s FCF is substantive enough to make a judgment on values. My argument is that even if this was a little too aggressive, the variation in value on the Saudi stock market is so large that even with adjustments to the perpetuity FCF would not make much difference n the final result. The Saudi stock market remains way over-valued.

Are we heading to a bubble?

We are not heading to a bubble. We are already in one. In fact this is not the first bubble the Saudi stock market experienced. Another one a decade ago experienced 5% price rises per month; then it all came crashing down. Seems another one is not too far off. This is especially true with computer trading, which if not there yet, then wait for the foreigner buyers (speculators) who can now own 10% of the market.

If you are interested in more detail on our findings, and a listing of the companies that were under-valued, please do not hesitate to contact us on ramzi.watfa@6sigmagrp.com.

© 2015 6 Sigma Group

While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma.

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