After the wheels started to fall off the formerly motoring Blue Sky Alternative Investments Ltd [ASX:BLA], I did some simple valuation analysis for you to determine whether the initial share price fall represented a buying opportunity.
The short conclusion was no, it did not.
In that same spirit, I thought today we should look at the latest corporate basket case — AMP Ltd [ASX:AMP]. The stock price is down from nearly $5.50 in mid-March, to around $4 today. That’s roughly a 25% share price decline in about six weeks.
So is AMP now good value, or should you simply avoid the company that has suffered (near) irrevocable brand damage?
Before I answer that question, first things first. This tells you why actions (and numbers) speak louder than words. It’s also a reminder that large swathes of companies’ annual reports are simply marketing documents.
Here is the introduction to the 2017 annual report from (now departed) Chairman Catherine Brenner:
‘At AMP, we have been helping people own tomorrow and achieve their financial goals for almost 170 years. This strong sense of social purpose drives the AMP culture and all that we do. Three core elements underpin our culture — integrity, help and performance. Integrity ensures we use our expertise to do the right thing; help is at the core of how we support our customers, and we’re driving our performance edge to deliver the best results we can for shareholders and customers.’
I think that’s known as a platitude, to put it mildly. Some AMP customers wouldn’t be so kind. Given what we’ve heard over the past few weeks, it’s solid gold comedy.
Anyway, moving on…
AMP is broadly classified as a wealth management (including funds management) and insurance business. There is also the AMP Bank arm, which is considered the fifth pillar of the Australian banking system.
In 2017, AMP generated an underlying profit from operations of $1.04 billion on equity capital of $7.202 billion, which represented a return on equity of 14.4%.
It distributed roughly 80% of earnings as a dividend, and therefore reinvested 20% back into the business.
Assuming a required return (or discount rate) of 8%, what would you pay for the business?
What Would You Pay for the Business?
Using these inputs, I get a ‘fair value’ of a little over two times book value, which equates to around $5.15 per share. With a current share price around $4, AMP appears to be good value.
However, it’s not quite so simple. This estimate uses 2017 earnings and doesn’t factor in the massive poo storm that has just hit the company via the royal commission.
At the centre of the royal commission’s focus on AMP, is the abominable behaviour of the financial services division. This includes AMP’s vast financial planning network. In 2017, this division accounted for over 35% of total after tax profit.
There is a good chance that earnings from this division will take a decent hit in the light of the various revelations coming out of the royal commission. Will they be short-term, or terminal?
No one knows. But because of this uncertainty, the prudent investor should make two adjustments when trying to estimate fair value. You should increase the discount rate and reduce the profitability of the company, as measured by return on equity.
An increase in the discount rate is a rough way of saying AMP is now a riskier investment (because earnings are more uncertain), and therefore investors want a higher rate of return before investing. Let’s assume the discount rate is now 10%. Also, let’s assume a permanent hit to profits, and that the sustainable return on equity is now 12%.
Using these two new inputs, and assuming 80% of profits are still paid as a dividend, with 20% reinvested, I come up with a fair value of around 1.25-times book value, or about $3.15 per share.
That’s now well below the current price, which has already declined 25% from the March peak. Not looking like good value now, is it?
The message here is that the market is pretty much clueless on how to value AMP right now. It’s simply impossible to know what the fallout from the royal commission will be. That means it’s impossible to know what AMP’s future earnings will be. And therefore impossible to put a value on it.
I’d rather rely on the lower value as a more realistic guide. But there is also the possibility that the bumbling giant may be broken up, in which case the value parameters change again.
The final thing to note is the chart. The market very quickly realised the damage done to AMP’s business by the royal commission’s revelations. The price pretty much collapsed. This is a nasty downtrend and is not the sort of chart I would even think about buying in my Crisis & Opportunity newsletter.
Sure, it’s oversold in the short-term. There will probably be a bounce. But buying here is a low probability way of making money.
Also, note the volume. As the price collapsed, volumes jumped. That tells you big investors want out.
The thing with financial services companies is that there isn’t much tangible value on offer. It’s all about the brand and the AMP planners that bring the money into the ‘system’. This money earns an ‘advice’ fee, it generates an ‘admin’ fee by sitting on a platform of some kind, and it generates a ‘management’ fee when an AMP owned fund manager invests it.
That brand is now badly damaged. It threatens to reduce the flow of funds that AMP feeds off of, which will in turn damage earnings and the company’s value.
So my ‘general advice/this doesn’t take into account your personal situation and please see your (hopefully non-AMP) financial planner’ message is: stay away, investors here are flying blind.
Editor, Crisis & Opportunity