Qualiport

Bruce values them and gets an amazing result.

Before kicking off today's report, I'd like to report an error I made in Wednesday's report on EMAP. This was kindly pointed out to me by the vigilant CapPickard on the AOL message boards. Well done, and thanks Captain. The archived report has now been updated.

Here's what happened. Using a calculation based on EMAP's return on equity, I hypothesised that in 10 years time they could have a market capitalisation of £4.9 billion. This was correct. Then I said "Compare that to today's market capitalisation of £2.35 billion, and the 10 year average compounding rate of return is 15.9%." This is wrong. As the Captain rightly pointed out, the average compounding rate of return is actually 7.6%. My apologies -- I didn't check the formula in my spreadsheet and actually calculated the annualised return based on 5 years instead of 10. This reminds me of something I learnt in my first ever Lotus spreadsheet training course. You should spend 60% of your time constructing the spreadsheet, then the next 40% checking it. I goofed.

A potential annualised rate of return of 7.6% versus 15.9% obviously makes quite a bit of difference to EMAP's valuation. After I look at Capital Radio and Reuters, I will compare and choose the winning stock to join the Qualiport -- we're after a very well managed company bought at a reasonable valuation.

Capital Radio

Way back in the dim and distant past of the Qualiport's history (all 5 months of it), we had a close look a Capital Radio, and at what they do. For a recap, click here. The thing to remember about Capital Radio is that they are more than a London FM radio station. They've got radio stations in other parts of the country too, and 1548 AM Capital Gold is the fourth most popular radio station in London. Personally I found this fact the most startling -- Capital Gold to me is some raving lunatic football commentator shouting and screaming down the microphone on winter Saturday afternoons.

Anyway, to kick off the valuation exercise I'll look back to the 25th February Qualiport report, where I looked at some potential returns for the four short listed media companies. Just to reiterate, this was used principally as a screening tool, and for Capital Radio we used the following numbers.

Share price (24/2/98)            625p
1997 EPS                        33.6p
Compound EPS growth               15%
2007 EPS                       135.9p
2007 P/E                           18
2007 Share price              2446.8p
10 Year growth                   291%
Annualised compounded growth    14.6%

Capital Radio's share price has been quite strong over the past month, and it is now around about 705p, having hit a high of 747p. Plugging 705p into the spreadsheet (double checking as I go) reduces the 10 year annualised compounded growth rate to 13.3%. A 13% short term rise in the share price can have quite an effect on the long term growth rate of your investment.

Return On Equity (ROE)

I will attempt to use the same calculation method as I used for EMAP on Wednesday. Why concentrate on ROE? I'll let Warren Buffett explain for me. "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed and not the achievement of consistent gains in earnings per share." A company will increase its earnings per share if it increases its return on equity. However, a company may increase its earnings per share whilst its return on equity reduces. Ideally, you'd like to invest in companies that do the former.

Capital Radio's balance sheet as at 30th September 1997 shows their net assets as £9.5m. Doesn't seem quite right, does it? The biggest commercial radio station in the country must have a book value a little more than £9.5m. This is where goodwill written off on acquisition distorts the equity base. I'll briefly try to explain using Capital Radio's acquisition of restaurant group My Kinda Town as an example.

My Kinda Town (MKT) had a book value (assets minus liabilities) of £4.9m. When acquired by Capital, various "fair value" adjustments were made, such as a revaluation of assets to reflect their current worth, a write down of excess stock and a provision for doubtful debt. Note that these adjustments are almost always negative, i.e. reducing the book value of the company even further. This is done deliberately. After the fair value adjustments were made, the book value of MKT was reduced to a negative £1.3m.

Capital Radio paid a total of £52.4m for MKT. The acquisition goodwill is calculated by taking the net assets (negative £1.3m) from the total consideration (£52.4m), which gives £53.7m. Instead of being added to assets, the UK accounting standards allowed for this amount to be written off completely to the profit and loss reserve. This treatment of goodwill arising on acquisition has been changed for companies reporting results for year ends after 31st December 1997. From then, the amount will be included on the balance sheet as an intangible asset and amortised over 20 years. This will have the effect of reducing profits as they would have been reported under the old accounting standards.

Anyway, to calculate the true shareholder's equity, or net assets, it is necessary to add back the total goodwill written off on acquisition. This gives a much better indication of the return on equity a company is achieving. In the case of Capital Radio, their adjusted equity base is £112.4m because a cumulative total of £102.9m has been written off to the profit and loss reserve. Their post tax profits before dividends was £23.6m. Divide £23.6m by £112.4m and ROE is 21%. Divide the same profit figure by the average of the starting and closing shareholder equity figures (£112.4m +£98.6m / 2 = £105.5m) and return on average equity is 22.4%

Company REFS, published by Hemmington Scott, states Capital Radio's ROE as 260% and its Return On Capital Employed (ROCE) as 105%. They obviously don't add back the goodwill written off on acquisition, and in my opinion this distorts the true return. When using that publication, it is useful to remind yourself that acquisitive companies can have their ROE figures distorted by goodwill written off on acquisition.

In ten months of fiscal 1997, Capital Radio Restaurants (the new name for MKT) contributed only £1.7m pre tax profit against the £52.4m purchase price. Pro rata that profit figure up for a full year gives £2m, deduct tax at 31% and you are left with £1.4m returned on the £52.4m investment. You don't need the calculator to work out that this is a paltry return so far for Capital Radio. They'd have been better off leaving their money in the bank, or investing it in some common stocks, which have returned 11% compounding over the years.

It is hard to judge what Capital's ROE will be going forward. The radio business is obviously strong, and should keep on earning the company good returns. The restaurant business is the much harder one to value. Based on the 1997 figures, it would appear to be trading on a price-to-sales (PSR) ratio of 1.9 and a price earnings ratio of 40. Pizza Express, with its much higher margins and proven formula, trades at 6 times sales and 37 times earnings. If the restaurant business could get its operating margins up from 6.8% to anywhere near the 21.4% of Pizza Express, the valuation could be anything. In 1993, Pizza Express had operating margins of 8.7% -- it's easy to see why they've been (and maybe still are) one of the great growth stocks of our time.

Valuation

I don't feel comfortable using the EMAP ROE model to value Capital Radio. The two very separate and distinct businesses of radio and restaurants have very different rates of return. This doesn't lend itself to our being able to estimate with any confidence the group's anticipated return on equity. Instead, I'll try valuing the two businesses separately and adding them together to see what we come up with.

Radio made pre tax profits of £31.0m in 1997, with an operating margin of 36%. In comparison, radio group GWR's operating margins have drifted between 15.7% and 10.7% in the last 5 years, and they are valued at about 19 times their 1998 forecast profits. Deduct a 32% tax charge from Capital's radio profits, and that gives you earnings of £21m. Assign a conservative P/E of 18 on that business and it is valued at £378m. I say conservative, because Capital's radio business would be worth about double that of GWR's, and they trade on a forward P/E of 19. OK, I'll roll out the wagon and give Capital's radio business a P/E of 20, giving it a valuation of £420m. During their faster growth phase of 1994 to 1996, Capital traded on an average P/E of about 25.

Now the hard part -- the restaurants. This is completely different from the radio business. It is very competitive and there are no barriers to entry like there are in radio. Capital deemed that they were worth £52m a year and a quarter ago when they bought MKT. They'd be pretty disappointed if they were now worth less than that, especially given the investment in time and money they've pumped into it. As was calculated above, annualised post tax profits for 1997 were only £1.4m. Capital would have hoped to improve that number significantly in the current year. Let's say they grow earnings by 75% to £2.45m, and give them a forward P/E of 25. That would infer a capitalisation of £61m, not much higher than the purchase price. Ouch. Pizza Express is capitalised at about £530m -- way above our valuation of the radio business alone!

As you can see, this is no easy task. There are a lot of uncertainties surrounding the restaurant business. In 10 years' time, it could be worth £500m if it could start earning something like the margins that Pizza Express commands. I'm going to pluck a number out of the air for the restaurant business -- £100m. That equates to just above 40 times the £2.45m estimated 1998 earnings. Would anyone pay £100m for the restaurants? Hmmmm.

Add the radio value of £420m to the £100m for the restaurants, and we get a total of £520m. With the current share price around 705p, the whole of Capital Radio has a market capitalisation of £519.585m. Amazing. I promise you I've not written this last paragraph first. Either I'm a genius or the market is efficient. Or, since both of the previous statements are obviously wrong, something fishy is going on around here.

On my calculations, I would say that Capital Radio is fairly valued.

Next Step

Next week, I will try to pull together what we've learnt about the valuations of EMAP and Capital Radio. I've learnt that it is an exhausting process, for which there is no one correct answer. That's why we have a market where shares trade, and everyone can cast their vote as to a share's valuation by buying them, selling them or just looking on from the sidelines. How boring it would be if everything we did were like a math equation, where you are either right or you're wrong. In stock analysis too you are eventually proven either right or wrong -- it just takes a hell of a long time to learn the answer.

Comments, help and feedback as usual to the message boards. Have a great weekend, Fools.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

This Week's Numbers          Week Ending 03/04/98

          Change     Bid
          pence       £

RTO       -0.08     3.86


Rec'd        #     Stock      Buy      Now  % Change  £ Change

19/12/97   1565  Rentokil     2.55     3.86   51.4%      1.31
19/12/97   1565  Rentokil  4040.63  6040.90   49.5%   2000.27


                    Day        Week       Year      History

Qualiport          -2.0%      10.3%       46.2%       49.5%
FTSE 100            0.2%       1.6%       18.1%       20.8%
FTSE All Share      0.2%       1.3%       17.5%       19.9%