Qualiport

EMAP is analysed every which way.

Last week we began our look at EMAP. For those that missed it, or would like a recap, click here to look at all the archives of the Qualiport.

Once we've identified quality companies, learnt about the business and looked over the numbers on their financial statements, the final piece of the stock analysis jigsaw is ready to be fitted. Today we shall look at the current valuation of EMAP. There are many ways to value shares, and we'll be briefly covering a few of them today. In the coming weeks, as the Fool content expands (for your reading pleasure, and of course as we attempt to educate the individual investor) we shall look into valuation methods in more detail.

EMAP

Since it's freshest in the mind, we'll give EMAP our first look. They are an international media business comprising 5 divisions, 50 companies and over 470 products. They publish the country's top selling monthly magazine, FHM, and own various radio stations including Kiss 100 FM. They also have recently bought Melody 105.4 FM.

Remembering back to one of our earlier media sector reports, I initially had a stab at projecting some potential returns for the four short-listed media companies. This was used as part of the screening process, as we had to reduce the 121 media companies down to a manageable number. For EMAP, I hypothesised the following:

Share price (24/2/98)        1099p
1997 EPS                       38.0p
Compound EPS growth            16%
2007 EPS                      167.6p
2007 P/E                       20
2007 Share price             3352.7p
10-year growth                205%
Annualised compounded growth   11.8%

That's one way of looking at valuation. It makes a lot of very subjective assumptions, in particular the 16% compounded EPS growth and the 2007 P/E of 20. Changing the EPS growth rate by only 1% or 2% can make a huge difference to the returns. Since the return you can get by leaving your money in the building society is only about 6%, the almost 12% return for EMAP looks attractive. But, so it should. The building society will give your money back to you after 10 years -- it's a risk free investment, and in return for that comfort you expect to receive a lower rate of return. Compare that to a bet on a 10/1 horse at the bookmakers. In theory, you have a 10% chance of returning 100% (and you only have to wait a few minutes to do that), but you also have a 90% chance of losing 100% of your money. The potential premium return is at the risk of losing everything.

Risk. We are surrounded by risks every day of our lives. Take the horse racing scenario referred to above. With the Grand National coming up on Saturday, many people will be having their once a year flutter. They will do so knowing full well that the bookmakers will be the winners. They have a flutter because it is fun, and the thrill of winning is everything. Most of us will only wager a small amount of money, though -- money we can afford to lose. The risk factor is high, as are the potential returns, but we don't risk too much money. Most of us can afford to lose a fiver, but if the minimum bet the bookmaker was prepared to accept on the 10/1 horse was your house, you'd be happy just watching the race on TV.

Since the original 11.8% ten-year compounded return on EMAP was calculated, things have moved on. The share price now is now 1124p and the Footsie above 6000. One thing we didn't take into account back then is that EMAP's 1998 financial year ended yesterday. Current estimates have them earning 45.1p, which would put EMAP on a trailing P/E of 25. This is not cheap, but nor is the market. However, irrespective of what the rest of the market is doing, we have to be convinced that we are happy with the risk/reward ratio of our investment. Starting today, and using exactly the same calculation as above, EMAP's 10 year annualised compounded growth rate is expected to be 13.5%. If I was being a little more conservative and reduced annual growth rare from 16% to 15% and the 2008 P/E from 20 to 18, the 10 year annualised compounded growth rate falls to 11.3%.

Would we buy at either of those two valuations? Maybe, as the expected rate of return is well above the risk free rate of return of about 6%.

Before we move on to an alternative method of valuation, readers may be wondering what's happened to the dividend. It has been deliberately ignored so far.

Return On Equity

Return on equity is one of the most commonly used, yet least understood, phrases used in stock analysis. This simple example may go some way to explaining it.

It's 2020 and you are going to buy a property for investment purposes only. Having already made millions out of the stock market, you decide that you can get great returns from buying a mansion in Mayfair. It costs £1m, you estimate the annual rent to be £100,000, and you are going to pay cash. With interest rates now down to 3%, sterling at DM25, and the Footsie at 200,000 you reckon a 10% return is not bad. That 10% is your return on equity. Come the end of year 1, you don't pay a dividend and retain the £100,000 in your property company, meaning your equity is now £1,100,000.

Year 2 comes along, and another £100,000 rent comes in. But, on a £1,100,000 starting equity point, this is a return of only 9.1%. Your return on equity has reduced. Year 3 it would have reduced to 8.3%, and so on. If, however, instead of leaving the first year's earnings in the business, you decided to take out the £100,000 in the form of dividends (we'll ignore tax here), your year 2 return on equity would have remained at 10%. Getting the idea? Think of a company's return on equity as if it was your own money. If a company can reinvest the money it earns back into its business and achieve above average returns, then it should do so. If instead it achieving a poor return on equity, it's better off closing down and redistributing all the equity back to shareholders.

Back to EMAP. Nothing is straightforward when it comes to accounting, and goodwill written off on acquisition is an anomaly that throws off return on equity calculations. Without getting into any detail at all, you need to add the £304.5m goodwill reserve back to EMAP's net assets of £248.8m to work out their equity base of £553.3m. For the year ended March 1997, they made a normal profit after tax but before dividends of £80.3m. Simply dividing £80.3m by £553.3m gives a return on equity of 14.5% (13.1% in 1996). If you divide the same profit by the average equity base from this year and the previous one, return on equity rises to 16.5%.

Whilst 16.5% is nothing super fantastic, it's a better return than leaving the money under your pillow or in the building society. The £80.3m is return on equity before dividends, which is otherwise known as profit attributable to shareholders. The dividend is then deducted, and the balance added to opening shareholder's equity. This is where the dividend payout ratio becomes important. If EMAP can return 16.5% on shareholder's money, why pay any of it out at all in the form of dividends? Unless they desperately needed the income, shareholders are better off leaving EMAP to retain all earnings and keep on returning 16.5% on them. The compounding effect would make it all add up over the years.

EMAP retained 66.4% of their £80.3m earnings in the business in 1997. Over the past few years, as the company has been growing rapidly, they have consistently been raising the dividend, but by less than the growth in earnings. If they can continue to return 16.5% on equity, the more money retained in the business the better.

Starting with 1997 shareholder's equity of £553.3m, EMAP would be expected to make post tax 1998 profits of £91.3m in 1998 (16.5% of £553.3m). The earnings retained ratio could rise to 70%, meaning shareholder's equity rises by £63.9m to £617.2m. Earn 16.5% on that new starting point, a retention ratio of 70% maintained, and a-compounding-we-a-go. After 10-years of this, EMAP would be expected to earn £272.4m -- multiply that by a P/E of 18 and we have a market capitalisation of £4.9 billion. Compare that to today's market capitalisation of £2.35 billion, and the 10-year average compounding rate of return is 7.6%. And we still haven't looked at dividends.

All this may seem a bit difficult to follow. As we want to make a decision on our next buy for the Qualiport before Easter, it is necessary to go through these calculations before we take the plunge. In the coming weeks, we'll go into a little more depth about how return on equity works, what goodwill is all about, and other ways of valuing shares.

Next Step

On Friday, we'll return to Capital Radio and look at its valuation. We won't be going into as much depth as we have here, but will make some of the same calculations. In the meantime, I'll set myself some extra homework by looking into Reuters in more depth.

Feel free to bombard me with questions or comments via the message boards. There is no definitive way to value shares, and it is area open to much debate. Why, if it were as easy as picking up a calculator and plugging in a few numbers, every share would be fully valued all the time and life would be very boring indeed.

Have a great All Fool's Day. We're having a great time.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

This Week's Numbers          Week Ending 01/04/98

          Change     Bid
          pence       £

RTO        0.24     3.74


Rec'd        #     Stock      Buy      Now  % Change  £ Change

19/12/97   1565  Rentokil     2.55     3.74   46.7%      1.19
19/12/97   1565  Rentokil  4040.63  5853.10   44.9%   1812.47


                    Week          Year          History

Qualiport           5.1%         32.6%            35.6%
FTSE 100            1.1%         16.2%            18.9%
FTSE All Share      1.3%         16.0%            18.4%