One of the first things any investor looks at when valuing a company is its profitability.

If you know what a firm is making now and what it should make in the future, you can work out how much you’d be willing to pay for those earnings today. But what profit figure do you use? This year’s profits could be unusually high because of one-off cost-cutting or because the economic cycle is peaking. And trying to predict what’ll happen in five years’ time is a mug’s game.

Enter the concept of “sustainable profits” – a level of profitability that can be maintained through thick and thin. This can be traced back to legendary value investor Benjamin Graham, who reckoned that if you can buy a firm more cheaply than its sustainable profits imply that it’s worth, you’ll have a “margin of safety” and a good chance of decent returns.

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Five tips to estimating sustainable profits

1. Find the base operating profit: Look at the company’s business environment and profit history. Is it in a cyclical industry, such as construction or engineering? If so, are the profits at a cyclical peak or trough? For cyclicals, it’s probably best to take an average of the last five years’ operating profits as your basis for sustainable profits.

2. Calculate the adjusted operating profit: Subtract one-off profits, such as money raised from selling buildings or other assets, and add back any one-off costs, such as redundancies.

3. Calculate the sustainable gross cash flow: Now add back the charges for depreciation and amortisation. This gives you an estimate of sustainable gross cash flow – the amount of money that’s actually coming in to the business.

4. Calculate the sustainable cash operating profit: This is the toughest part – estimating how much to subtract from gross cash flow to account for the capital expenditures needed to maintain and replace assets (the money the company needs to spend to stay in business). The depreciation charge is supposed to reflect this. But it’s often based on costs that are out of date. Adding 10%-20% to the depreciation charge will give you a better estimate of what the firm needs (an exception may be IT firms, where costs tend to fall). From there, you’ll now have a cash-based sustainable operating profit estimate.

5. Adjust for tax: The final adjustment you need to make is to tax this operating profit estimate at a sustainable long-term tax rate. For South African firms, you can generally use the current rate of corporation tax of 29%. The end result is an estimate of sustainable profits that can be paid out to the debt and equity investors.

Using sustainable profits in valuation

If you believe a company can earn a certain level of profits forever (essentially) then with a bit of simple maths, you can value the company on that basis. Just divide the sustainable profit figure by your required rate of return. This figure is the cause of much debate among investment professionals, but you can decide for yourself what would be reasonable.

For example, if a company had sustainable profits of R10 million and the investor wanted a return of 10%, then the value of the firm would be R 100 million (R10 million/10%). In other words, assuming your profit estimate is correct, this is what you’d be willing to pay for the firm today, to get a 10% annual return. You can then compare this with the current enterprise value of the firm (the market capitalisation minus net cash, or plus net debt), to see how your estimated value compares with the market’s view.

Until next week… Here’s to your financial freedom,

Karin Iten

PS: Meet our newest expert...

Before I go, I want to introduce you to a person you'll be hearing a lot more from in your Monday issues of MoneyMorning. His name's Marcelle Van Der Merwe and he's part of the trading desk over at Imara - one of the top brokers in the country. Today, Marcelle gives you the names of two resources shares that hold the most value at these current discounted levels...

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Your broker says…
Resource shares are set to soar during this week’s commodity recovery

By Marcelle Van Der Merwe, Imara Trading Desk

On Monday, we told investors that Uranium won’t be retired yet. There isn’t a more efficient or practical alternative out there and there won’t be for some time to come. And we were right. Uranium shares rallied last week with Uranium One (UUU) adding 27% to brave investor’s portfolios in only five trading days.

In general, commodity prices have overreacted on the back of events in Japan as seen in the general commodity index below.  The CRB Index is a global benchmark on commodity prices that’s calculated daily on the spot prices of 22 commodities that are picked to react swiftly to changes in the market.

CRB Index: Daily Commodity Futures Price Chart 2010    
 

    
Improved commodity prices and a general improvement in sentiment this week helped the Resources Index recover considerably. While the sector hasn’t fully recovered yet, there’s definitely signs that it’s back on the bullish track. And that’s presenting you with some great bargains. You see, most of the high commodity prices aren’t reflected in the current share prices of mining companies. For example, valuations on copper miners are based on copper prices of around $7,000/ton. Even at this 28% discount to current prices, Metorex (MTX) is a solid buy. What is surprising, however, is that its share price movements coincide so strongly with changes in the copper price as you can see in the chart below. These short-term share price changes can easily be attributed to noise that has no fundamental basis and, therefore, no long-term effect.

Why should you care?

Well that’s the easy part! If there’s no change in the fundamental value of a company and the share price declines you have an opportunity to buy at a discounted price. By no means am I saying that resource companies aren’t affected by fluctuations in commodity prices. What I am saying is that if a company’s a buy based on cheap commodity prices, it’s a bargain when even slightly higher than anticipated commodity prices are achieved.

And that’s why I want to introduce you to the two resources shares we think hold the most value at these current discounted levels.

BHP-Billiton (BIL): The world’s largest resources company
BHP-Billiton’s long term objective is to add value through discovery, development and conversion of natural resources. Along with its latest results, the company announced that it’ll be reaffirming its commitment to these objectives by investing $80 billion in capital projects over the next five years. A large amount considering a market cap of $225 billion, the investment will maintain an annual growth rate of 20% over the next five years. BHP’s operating profit is made up of Iron ore (40%), Base Metals (25%) and Petroleum (20%) the remaining 15% is from diamonds, stainless steel, manganese and coal. Considering that BHP’s investment plans equal about 10% of QE2 (Quantative easing in the US of $800bn) it’s an obvious buy at current levels for a return of about 30% by the end of 2011. (Buy)

Pan African Resources (PAN): A “zero debt” gold miner
Pan African mines about 100,000oz of gold at costs below $750/oz – that’s extremely low. The company’s focus is on developing low cost projects with high margins. Pan African's amazing ability to fund investments through cash flows without leverage means lower risk and fixed costs. The company diversified into the platinum industry in 2010 through the acquisition of Phoenix Platinum, which will be operational by the end of the year. A R170 million positive cash balance and no long-term debt allows for further acquisitions this year. IF you get in today, you could see it produce an extraordinary 45% return over the next 12 months as it runs to our R1.70 target. (Buy)

Want to get involved in the stock market and don’t know where to start?

Give me a call at (011) 550-6251 or alternatively visit our website at www.imara.co.

To low-risk returns,

Marcelle Van Der Merwe

Imara SP Reid’s research is focussed on mid-tier companies. Their analysts are very well regarded in the industry and research is based on very conservative estimates.