How to analyse housebuilders

Housebuilders have overcome most of their post-Brexit blues, clawing back a substantial chunk of their horrific losses. But how do investors decide whether to keep backing them?  To help answer this, we're republishing this classic copy from former City trader and Interactive Investor writer Peter Temple: 

As cyclical sectors go, it doesn't get much more cyclical than housebuilders.

You might think that an environment where house prices are showing only tentative signs of recovery and where funds for mortgage lending are tight might be a negative environment for housebuilders, many of whom are currently loss-making or making a fraction of their peak profits.

But the market often doesn't think quite along these lines. And there is more to analysing housebuilding companies than simply looking at profits, sales and cash flow. As with most cyclical companies, price/earnings (PE) ratios are often not a particularly good guide to value. Housebuilders will sell on very high PE ratios (or negative ones) at the trough of the cycle, and very low multiples of earnings at the peak.

Looking at price/cash flow is a little better, but still not infallible.

It's best, however, to look at housebuilders and their earning and cash flow generating capacity over the course of a cycle, however long that might be. One way of viewing housebuilders is as property companies that have a means of converting land into cash generating assets.

Builders cannot be studied at without looking at what analysts term their 'land banks'. These are the parcels of land that these companies accumulate patiently in the hope of being able to get planning permission for future housing developments as and when market conditions permit.

It's best to look at housebuilders and their earning and cash flow generating capacity over the course of a cycle

Housebuilders' land banks can be divided into two segments: plots with planning permission and those without. Many housebuilders and analysts work on the basis of five housing plots per acre of land. Housebuilders differ considerably in the proportion of their land bank that has outline planning permission and that is awaiting market conditions to be right for development to begin.

A crucial point to look at when analysing companies like this is to work out, particularly at this stage in the cycle, how ready a company might be to take advantage of an upturn in demand.

One can do this by looking at the number of plots with planning permission granted and comparing it with a typical number of housing completions by the company in a typical year. In normal years, many builders will have two to three years' supply. In the rare instances of companies with appreciably more than this, they may become attractive as takeover targets when market conditions improve.

Crest Nicholson, taken over in 2007, is an example of company being acquired essentially for its land bank assets. Although the company was acquired by private equity investors, it had previously been pursued by Gerald Ronson's Heron International. At the time of Heron's first tilt at the company, it had land bank assets amounting to six years' supply, roughly double the industry average at the time.

Another technique is to relate the land bank to market value by multiplying the available plots with planning permission attached by the average selling price per house. This provides a measure of the ultimate capital value locked up in the land bank, a number which can then by compared with the stockmarket value of the company. It is often the case that shares trade at a sizeable discount to the imputed value of the land bank.

Peter says...

It's impossible to look at housebuilders without considering their different areas of specialism, and looking at this in the context of housing market conditions.

Geographical differences in housing market conditions, and whether or not the company is focused towards developing high-end properties or those at the cheaper end of the market, is also important. There are also specialists in particular areas of the market, including regenerating old industrial properties for residential use, retirement properties and the like.

Equally housebuilders vary in their degree of sensitivity to trends in the housing market, in the quality of their management, and in the extent to which they have other interests. Investment in them needs to be looked at on a case-by-case basis.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.