07/02/2024

On the back of Nick Scali’s 1H24 results announcement today and a 17.5% hike in the share price to over $14 per share, I thought I should revisit my previous valuation of $16 per share back in August 2023.

My previous valuation was based on McNiven’s formula which estimates future owners annual return by considering forecast normalised ROE as the internal rate of return (IRR), the percentage of reinvested earnings, the current equity value, and dividends paid to shareholders (including franking credits).

I have received a number of questions lately from fellow Strawpeople in regards to what inputs I use, and where I source my data from for the formula. As I work through this valuation for Nick Scali I’ll attempt to explain this (just this once, I promise!).

McNivens Formula is not a ‘magic black box’ you can plug in known variables to come up with an exact valuation. Far from it! In fact, I think 6 people using the same formula would come up with 6 different valuations for the same business, and that’s how it should be! The formula should be used looking forward, not backwards.

It’s been a while since I’ve used McNivens Formula to calculate manually. I decided to build an excel spreadsheet after @PortfolioPlus asked if I had one (what better excuse!). Since then rather than spend time on manual arithmetic, I can test different scenarios instead, eg. what happens when I change my estimate for future ROE, or the percentage of earnings reinvested, or percentage franking, or what happens to valuation if I change my required annual return.

Recently @Chagsy asked where I source the data from for the formula. Firstly, let’s look at the formula:

V = E (APC/RR x RI + D)/RR

Where,

V = valuation

E = shareholder equity per share (Book Value)

APC = Adopted performance criteria. I use an estimate of future normalised ROE.

RR = Your required (or perhaps desired) annual return as an investor, risk adjusted for the reliability of the business you are valuing

RI = Reinvested Income (reinvested earnings)

The formula is reasonably simple, but the valuation can be very different depending on what inputs you choose for APC, RR and RI. I also adjust the dividend component for franking credits (D/0.7) because these are very significant to your annual returns if the dividend component is high and dividends are fully franked.

It’s worth reading the supporting information here to get a better understanding of how the formula works. I believe the fundamentals behind the formula are sound.

Stepping through how I come with the input data:

Shareholder Equity (E)

Last time I valued NCK I worked this out by dividing the total shareholder equity by the number of shares ($179.6 shareholder equity / 81 million shares). Shareholder equity is not a subjective figure and can be sourced from the latest financials, the Commsec website (Book Value), or data sources such as Simply Wall Street or possibly Tickr. The book value on Commsec is only updated once every year after the FY financials are lodged, and this normally takes a number of days. You can easily work it out yourself by sourcing data from the latest financials. Looking at the 1H24 financials on page 7. Total equity at 31 December was $192 million, there were 81 million shares outstanding, so shareholder equity in the business has increased from $2.22 per share to $2.37 per share.

Adopted Performance Criteria (APC)

For APC I use a 3 to 5 year estimate of future Return on Equity (ROE). This is the most important variable and the hardest to estimate. ROE = EPS/Equity per share. There are a few things I consider in coming up with the estimate, historical ROE trend, headwinds or tailwinds that will influence future ROE, and analyst future earnings estimates. Last time I assumed a forward ROE of 40%. Looking at 10 years of historical ROE data, a forward ROE of 40% seems achievable based on track record.

Source: Commsec website

Looking forward, NCK is planning to roll out more stores across Australia and New Zealand, and gross profit margins have improved to 65.6%.

Source: NCK 1H24 Results Presentation

Currently analyst consensus EPS for FY26 is $1 per share. Based on current shareholder equity of $2.37 per share, that would put future ROE at 42%. NCK has just announced basic half year EPS of 53.1cps for 1H24, so FY26 EPS of $1 per share and ROE of 40% looks achievable.

Of course, GDP growth could struggle and this might be a headwind for NCK. The need for more housing is a possible tailwind.

Overall, a ROE of 40% looks OK.

Reinvested Income (RI)

Last time I assumed payout ratio of 70% and 30% reinvested earnings. 1H24 payout ratio is 66%, so I’m happy to assume 30% RI going forward.

Dividend (D)

I’m assuming a payout ratio of 70%. D in the formula is APC x payout percentage = 40 x 70% = 28%.

Required Return (RR)

Your Required Return (RR) is totally up to you. It should be higher than the risk free rate of about 5% to 6%. I like to use a RR of between 10% and 15% depending on how predictable future earnings might be. However, I find the market is prepared to pay very high premiums for the most popular high growth/High ROE businesses that can reinvest most of their earnings. For example when I value Promedicus (PME) using McNiven’s Formula and assuming a forward ROE of 46% and 100% reinvested earnings, I need to be happy with an annual return of 3.5% at the current share price of $108. Either McNiven’s formula doesn’t work for these types of businesses…or they are overvalued? CSL, RMD, ALU, COH, IEL all offer less than 8% annual shareholder returns at the current prices according to McNivens formula. So, for these types of businesses (and I have a few) I am happy to accept and use a 7% to 8% RR for valuation using the formula.

NCK is not a PME so I’d be looking for a 10% to 15% RR, and for poorer quality businesses even higher, perhaps up to 20%. But these types of poorer quality ‘value’ businesses are not that attractive on the metrics, and I’m preferring to stay away from them.

Valuation

Now that I’ve explained how I come up with the inputs and where I source and estimate the data, I will jump straight into the valuation using my spreadsheet.

Assuming ROE of 40% (APC), E of $2.37, 30% of earnings reinvested at a required return of 10% I get a valuation of $19 per share. Accounting for more risk and requiring a return of 15% I get a valuation of $11. If I assumed future ROE will decline to 35% and I work on a required return of 12%, I get a valuation of $14.80. This is the beauty of a spreadsheet where you can play around with some different assumptions to see how each impact valuation.

So what valuation should I use? I think the economy might be slowing a little over the next few years and I’m more risk adverse, and a little less bullish than my previous valuation for NCK. Therefore I’m going with a future ROE of 35% and a required return of 12%, to come up with a valuation to $15.

Having said that, today I lightened off some of our NCK holdings IRL when it went over $14 per share. Why? NCK has grown to over 9% of our total IRL portfolios and I think we need to reduce some risk. It’s also an easier decision to make when there is no longer any capital gains tax to pay in the super fund :).

I hope this drawn out valuation process has helped a few fellow Strawpeople to understand how I use McNivens Formula. I also tend to cross check my valuations with PE x future earnings which is more commonly used, trading ranges (which most brokers seem to use), and technical analysis can also help in buy and sell decisions. Feel free to ask any questions if I’ve totally confused you! ;)

12/08/2023

It’s been a while since I’ve revisited my valuation for Nick Scali (August 2022). The FY23 results are testament to the quality of this business. Thank you @mikebrisy and @Strawman for your excellent summaries.

@Strawman said “It kind of feels too good to be true. Is the market really that silly? Or just too focused on the short term?”

I think it’s a case of the market focusing too much on the short term, and not believing that the incredible returns on shareholder equity (ROE) this business has been able to achieve for over a decade are in fact sustainable. There is something unique about Nick Scali’s business model that sets it apart from most other retailers (bar Lovisa).

For 10 years Nick Scali has returned investors an average 50% on shareholder equity. That’s the bit that is almost ‘too good to be true’. BUT, can this incredible ROE continue into the future? Perhaps not? With higher interest rates and the lowest housing turnover in 20 years (see my straw “Time Horizon Arbitrage?”) the revenue growth, margins and ROE might all come down? Or, perhaps not?

Australia is in desperate need of housing. There is a pent-up demand for housing which at some point in time needs to be met. You could argue we are currently going through a low ebb in the housing cycle and there is a bull case for Nick Scali when the supply of housing meets the demand.

So what should we expect of ROE going forward? What was the ROE for FY23?

I couldn’t find a ROE figure quoted anywhere in the reports, but it’s a very simple calculation from the reported figures (4E and Annual Report):

• Total shareholder equity = $179.6M (page 47)
• NPAT = $101M (page 21)

Therefore FY23 ROE = 101/179.6 = 56%

Again, Nick Scali has not disappointed with a ROE of 56%.

Nick Scali reinvests a sizeable amount of its earnings back into growth, this year it’s 40%, but usually around 30%. So the growth equation is also simple, 30% x 50% which is 15%. This makes the annual 13.5% increase in dividends that @strawman referred to possible. This year Nick Scali can pay dividends with a gross yield of 10% (including franking credits) and still grow earnings at 15%. There is not magic, just simple maths.

Valuation

What about the future? Let’s assume Nick Scali can maintain a ROE of 40% for the next 5 years on a current shareholder equity of $2.22 per share ($179.6M equity / 81M shares). Using McNiven’s StockVal formula to work out the valuation assuming 30% of earnings are reinvested and we require an annual return of 12% (including franking credits), I get a valuation of $14.80. If I were happy with a 11% annual return (including franking credits) I could pay up to $17 per share.

I’m going somewhere in the middle to arrive at a valuation of $16, the same as my previous valuation 12 months ago.

Disc: Held IRL (10%), SM (17.5%)

22/08/2022

It is an extra busy time with reporting this week, so here is a quick back of the envelope valuation for Nick Scali based on the FY22 results.

The business performed as I expected, except there weren’t enough lounges delivered to customers homes by 30 June to tip the earnings into record profit territory. Anthony Scali said the availability of delivery drivers is the hold up in the supply chain. Delivery is also the biggest impact on increased costs at the moment.

The huge positive is the back log of outstanding orders yet to be delivered, up 67% on FY21. Gross Margins are slightly down from 63.5% to 61%, mostly due to the dilutive effect from the Plush acquisition. However, Anthony Scali said they are working toward changing half the product line offering at Plush to increase profit margins. One popular line they introduced this year had a gross margin of over 60%, so lounge by lounge, month by month, the margins at Plush will improve over the next few years.

I have done some quick calculations on Return on Equity (ROE) and come up with underlying ROE of 57%, and statutory ROE of 53% (will check again later). The ROE trend looks pretty good which makes Nick Scali one of the best performing retailers on the ASX (bar Lovisa!)

Extrapolating from Commsec chart

Using McNiven’s StockVal formula and variables, ROE (APC) = 50%, Equity (E) = $1.74 per share (FY22), RI = 26%, FY Dividend = 70c (6.8%, or 9.7% incl. 100% franking credits), and a Required Return = 10%.

StockVal = $20.51, say $20

Sounds too high and I don’t expect Nick Scali will reach these prices any time soon because of the economic climate for discretionary spending which could come under some pressure from rising inflation and interest rates.

However, Nick Scali is forecasting higher revenues for FY23 (Outlook), and if the business can maintain current gross margins (circa 60%) and ROE (50%) over coming years, I can see no reason why Nick Scali won’t reach the share price highs achieved during 2021 (+$16). Therefore my current valuation is $16.

April 2022

I think Nick Scali is a wonderful, well-managed business which is now in the BUY zone. I’ve bought and sold Nick Scali a few times IRL. The only reason why I have sold each time was because I thought it had became overpriced. Last time I sold NCK the shares went on to gain another 25%. I got that one wrong!

Nick Scali has been on my watch list again lately, and today with more than 4% off the share price I jumped in!

It’s hard to find another retailer that can match Nick Scali with its track record of consistently high Return on Equity (ROE) and earnings growth.

(Source: Commsec, April 2022)

Nick Scali increased ROE from 30% in 2012 to 50% in 2019, and during the pandemic ROE pushed through 80% in 2020. I’m not aware of any other retailer that has matched Nick Scali’s ROE over the past 9 years.

Over the same period of time earnings have grown 10 fold, from 10c to over $1 per share. As you would expect using the valuation formula, V= E x PE, NCK became a 10 bagger in November 2021 before the price began to fall from its all time high of $16.00. Today NCK closed at $10.68, down 33% from its peak 5 months ago.

So why the big change in sentiment? As @Noddy74 pointed out in his straw HY results 3 months ago “I'm getting a bit jack of hearing about how Nick Scali has been a COVID beneficiary as consumers spend more time at home and have less to spend discretionary funds on, and how this will reverse”

To be fair I think Nick Scali has benefited more than usual from COVID, however I expect (and so too do the brokers) ROE to return to approx 50% from here on.

Using Brian McNiven’s StockVal formula (McNivan, 1985) and using ROE of 50%, we could expect Nick Scali to return investors 12% per year going forward based on the current share price of $10.68.

Alternatively, using the formula V = E x PE and discounted at 10% per year where E23 = $1.05 (Average of 4 Analyst Earnings Estimates, S&P Global, Simply Wall Street data) and a PE of 13, we get a discounted valuation of $10.92. This value excludes dividends likely to be over 6% fully franked going forward.

Citi’s Target Price:

According to Tristan Harrison from The Motley Fool :

“Broker Citi currently rates Nick Scali as a buy with a price target of $17.60. That implies a possible rise of around 60%. Citi thinks that Nick Scali will pay a grossed-up dividend yield of 9.9% in FY22 and 10% in FY23.”

Summary

To sum up, I feel very comfortable buying Nick Scali shares at the current price of $10.68 where I expect a return of at least 12% per year over the next few years. If the share price were to reach Citi’s target of $17.60 in the next 12 months, I think I would be taking some profits.