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This is a compelling argument, I believed it -- at first -- but now I have to add my voice to this debate! Assuming that eventually Freeserve will trade on a PSR of "only 2" is wrong: why should they? So the average PSR in the FTSE 100 may be true, but Freeserve will never ever be an average company! In my view they will always deserve to trade on PSRs much higher than 2 in the future. Why? Well, read on.
Valuing companies based on price to sales ratios has come into fashion because so many of the exciting go-go growth stocks don't make any money, and so conventional valuation techniques are unable to help us. But simply looking at Freeserve's current projected sales and extrapolating a value from this is badly flawed. In Freeserve's case we need to look more at the potential profit generation ability of the company in the future: you can not compare sales generated by Freeserve with sales generated by conventional businesses. A manufacturing company, or a retailer, will have far higher fixed costs than Freeserve is ever likely to have, and as a result as Freeserve's sales rise at a rapid pace the fixed and variable costs are very unlikely to have to rise so quickly. This means that in the medium term Freeserve's profit margins are very likely to be very large, and much of the increased sales is likely to drop straight through to the bottom line as profits; it could easily have operating margins as high as 80%. How many of the current FTSE 100 index have operating profit margins of 80% or more? None. Land Securities come close, with a margin of 79%, and they have a PSR of nearly 8. If we assume that Freeserve will also trade in the long term at a PSR of 8, then they only need to grow sales at 30% for 5 years to get to that level. The fact is that Freeserve's sales are likely to grow much faster than 30% a year for the next five years! Beware of using one-dimensional valuation tools!
Continuing the theme of the relative valuations of companies, a message on the Freeserve board caught my eye this morning. It was from dkbrown2, and asked: "I read today that at the current share prices, the market gives Freeserve a higher capitalisation value than its 'parent' company, Dixons, which owns 80% of FRE. How should we interpret this?"
What a great question to ask. I thought I would check out the validity of this statement, and based on today's share prices the respective valuations of Dixons (LSE: DXNS) and Freeserve are as follows:
· Dixons' current market capitalisation is £6167.159 million.
· Freeserve's current market capitalisation is £4839.878 million.
Dixons (LSE: DXNS) is actually more highly valued than Freeserve, but only just. If we strip out their 80% stake in Freeserve we find that the core Dixons retail business has a value of 'only' £1328 million, which is equivalent to about 284p per share, putting the core business on a trailing price to earnings (P/E) ratio of only 7. This makes Dixons look well undervalued to me. But being wary about using a one-dimensional tool again I thought I would extend the idea of using the PSR ratio introduced by Bruce to see what that would do for the valuation of the core Dixons business.
Currently Dixons (including its 80% stake in Freeserve) is trading on a PSR of about 1.83, which puts it towards the top of the PSR league table for retailers. The top spot is currently being fought over by Matalan and Ted Baker, both of which have a PSR of about 4.
It is interesting to compare that statement to the situation with Dixons if we remove the Freeserve element. If we take Freeserve's market capitalisation of price of £4839 million from Dixons' market capitalisation we get a core business valued at £1328 million. Compared this to sales last year of £3156 million will give the Dixons "core business" a price to sales ratio of only 0.42.
If we accept Bruce's statement about most FTSE 100 companies trading on PSR's of less than 2, and that in the long run they will tend to move to that level of PSR then it would appear to indicate that Dixons is currently severely undervalued. My own view is that you can not compare dissimilar companies' PSR's and get any sort of meaningful figure; we need to compare like with like. Looking at Dixons compared to its peers in the General Retailing Sector we find that with a PSR of 0.42 it is valued less highly that those mighty retailers Courts (LSE: CRTO), Wickes (LSE: WKS), and Grampian Holdings (LSE: GRMP). Debenhams (LSE: DEB) is more highly valued with a PSR of about 0.5, Moss Bross (LSE: MOSB) has a PSR of 0.56, Blacks Leisure's (LSE: BLSA) is 0.62, Great Universal Stores (LSE: GUS) is 0.7, Clinton Cards (LSE: CC.) is 0.81 and the even the Body Shop (LSE: BOS) is rated at 0.84. Not only that JJB (LSE: JJB) has a PSR of about 1.48, and Dobbies Garden Centres (LSE: DGC) has a PSR of about 1.8 -- yes, Dobbies Garden Centres -- if you know anything about them tell us on the All UK shares message board.
So where does that leave the respective valuations of Dixons and Freeserve? Clearly Dixons were very clever to launch Freeserve when they did. Freeserve has been such a success because they got the timing perfect, and they were able to capitalise on Dixons' presence on the high street and as the biggest retailer of computer products in the UK to promote the service widely. Dixons' share price has increased based on the fantastic performance and valuations being put on the share price of Freeserve, but based on both the price to earnings ratio and the PSR the underlying valuation of the Dixons core business has actually suffered.
Lets have a look at where Dixons were before Freeserve burst onto the world. If we go back to December 1998, the share price of Dixons was 737p and they traded on a PSR of about 1.14. If we assume that core business of Dixons deserves to be on a rating of about 1, based on their latest set of trading accounts, showing sales of £3156 million then they should have a total market capitalisation of about £3156 million. This is equivalent to a share price of about 675p: add in the valuation of the 80% stake in Freeserve gives a 'justifiable' price for Dixons of 1136p + 675p = 1811p, compared to an actual share price of about 1420p, implying that Dixons is undervalued by some 391p or about 28%.
Now before you all rush out and buy Dixons on this basis, you have to recognise certain things. Buying into Dixons at the current share price is not the same as buying into Dixons the electrical retailer, with predictable long-term sales revenues. You are buying about 282p worth of a predictable electrical retailer and about 1138 pence worth of a totally unpredictable, fast growing, cutting-edge Internet company, which may, or may not, be wildly overvalued.
You must also ask some hard questions about the value of Dixons 80% stake in Freeserve. Firstly, is their 80% really worth as much as the 20% currently traded on the London Stock Market? Imagine what would happen to the Freeserve share price if Dixons announced today that they were to sell their stake in its totality? More supply of shares would possibly tip the supply demand balance and the price of Freeserve's shares would probably fall, so it may be that the calculations shown above are not at all realistic.
Using PSR as a way of valuing the core business of Dixons is also probably flawed. PSR simply looks at the value of sales generated by a company; it does not look at the company's ability to turn those sales into profits. One of my old employers, ASW (LSE: ASW), a steel company based in Cardiff, had sales last year of nearly £500 million and their price to sales ratio is about 0.02. This is just about the lowest of all companies listed on the London Stock Market; they even made an acquisition at the start of the year that will take sales up to about £600 million, which will make the PSR look even more attractive. The trouble is they don't turn those sales into profits, and the company has a market capitalisation of only £23 million, so using the PSR on its own as a way of valuing companies is a flawed tool.
Beware using any one-dimensional tool as the basis for valuing companies, because it will be wrong! Feedback on what we should do with 'one-dimensionalists' to the Fool's Eye View message board, please!
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