Qualiport

PizzaExpress -- The Valuation
Friday, 2 October 1998

Are they Qualiport bound?

The last two Qualiport updates have concentrated on determining whether PizzaExpress is a quality company. In the first article, we looked at the company, their restaurants, and their future strategy. Then, on Wednesday, we put PizzaExpress through the rigours of the first 9 criteria that we like to see present in a quality company. Number 10, valuation, only comes after a company has passed tests 1 to 9.

I don't know about you, but I thought PizzaExpress flew through just about all of our criteria. There are some doubts, of course, because no company is perfect. My concerns at the moment would be:

1. Growth will slow from the rates achieved in the past. Oh how we all wish we'd bought into this great success story back in 1994, when the shares were 109p. But those investors who missed out on buying Vodafone at 158p in 1994 could still have jumped on the wagon in 1997 at 330p and seen their investment double. The same holds true for great companies like Coca Cola and Microsoft -- in the last 15 years you could have bought shares in them at just about any point and seen your investment grow significantly. Who knows, PizzaExpress could be the next McDonald's.

2. Future restaurant expansion will be more challenging than the past. Café Pasta and Pasta di Milano are a break from the pizza business, and that sector is more competitive. Overseas expansion has been the bane of many a UK business. Just look at the mess Laura Ashley have got themselves into as an example of what can go wrong.

3. The return on equity (ROE) has been on a downward trend. Ideally you want to invest in a company that is increasing its returns as it grows.

However, taking those reservations into account, I believe PizzaExpress are a quality company and a worthy Qualiport entrant. They pass our first 9 tests, and they do so in a way that some of our existing Qualiport companies don't.

Now that we are willing to add PizzaExpress to the Qualiport, we next must look at their valuation. Fools who witnessed the battle between Dave and myself surrounding Unilever and its valuation will be interested to know that won't happen again (I'm declaring victory). In hindsight (and isn't this always the way) we overpaid for Unilever. With a little patience, we could still have picked up our shares in the company, but at a 20% or more discount to the price we paid. Having learnt from that experience, I'm determined to not let it happen again. Dave would argue that we could miss out on ever buying the shares, as a company could be permanently overvalued. Whilst that is undoubtedly the case with some great companies, over time most companies see their valuation drift back to a normal level.

We are long-term investors, and patient ones. We can afford to bide our time, waiting for an opportune moment to buy shares in a company. There are many different investment styles and strategies, and some involve simply buying the best companies whatever their valuation and holding for the long term. The Cash-King Portfolio at the US Fool is an excellent example of this strategy in action. However, most UK companies are not in the same league as Microsoft, Intel, American Express or Cisco. I argue, therefore, that valuation is important.

The Valuation -- PizzaExpress

For those Fools familiar with our earlier How To Value Shares series, we will now look at the various methods to determine whether PizzaExpress offers value. The current share price is around 690p.

Earnings Growth Rate Projections

  
Year     EPS    P/E   Price   Growth  CAGR   Divs
1998    26.2    26     690                   4.25
1999    33.6    22     739                   5.20
2000    41.2    22     906                   6.32
2001    48.6    20     972                   7.20
2002    57.4    20    1147                   8.21
2003    67.7    20    1354     96%   14.4%   9.36
2004    79.9    18    1438                  10.67
2005    94.3    18    1697                  12.17
2006   111.2    18    2002                  13.87
2007   131.2    18    2362                  15.81
2008   154.9    18    2788    304%   15.0%  18.03
                                           111.11
Share Price         2787.57
Total Dividends      111.11
Total 10-Yr Return 2,898.68   320%   15.4%

The following assumptions were used:

• 1999 and 2000 EPS and dividend figures are as per the latest Hemmington Scott consensus estimates.
• from 2000 onwards, we've used an EPS growth rate of 18% and a dividend growth rate of 14%.

Any forecasting model is only as good as its assumptions. The 18% long-term growth rate I have used above is quite optimistic. Based on their past record, it is conservative. It is very difficult for companies to exhibit sustainable growth of 18%. Only the very best will achieve that goal.

With 12% long term growth and 12% dividend growth, the 10 year compound annual growth rate (CAGR) is 10.9%.

With 15% long term growth and 12% dividend growth, the 10 year compound annual growth rate (CAGR) is 13.1%.

With 20% long term growth and 16% dividend growth, the 10 year compound annual growth rate (CAGR) is 17.0%.

The Qualiport's aim is to grow by 15% per annum. The first model (some would say conveniently) hits that target. It is ambitious and optimistic, but achievable.

Return On Equity

Year    Equity   Profits  Dividend  Retained
1998    66,839   18,036    2,833     15,203
1999    82,042   22,200    3,445     18,755
2000   100,797   27,300    4,190     23,110
2001   123,907   29,738    4,758     24,980
   
and so on, until...
   
2008  448,142  107,554    17,209     90,345

The PizzaExpress current market capitalisation is £474m. A 2008 P/E of 18 multiplied by the 2008 profits of £107.55m gives an implied market capitalisation of £1,936m. Add to that the total dividends received of £89m, and you have a total 2008 value of £2,025m. From the current capitalisation of £474m to the 2008 projected capitalisation of £2,025m, that gives a CAGR of 15.6%.

The following assumptions were used:

• 1999 and 2000 profits and dividends are calculated from latest estimates.
• from 2000 to 2008, a return on equity figure of 24% was used. The 1998 actual return on starting equity figure was 27%.
• from 2000 to 2008 we assumed that 16% of profits were paid out as dividends, and therefore 84% were retained and added to the equity based.

Again, these are only assumptions. A sustainable 24% return on equity is no easy task. The ROE figure has been on the slide in recent years, as the company has expanded rapidly.

With a long term ROE of 18% and a dividend payout ratio of 18%, the CAGR is 9.0%.

With a long term ROE of 20% and a dividend payout ratio of 18%, the CAGR is 11.2%.

With a long term ROE of 28% and a dividend payout ratio of 16%, the CAGR is 19.7%.

Price To Sales Ratio (PSR)

The PSR is simply calculated as:

  
 Market Capitalisation
-----------------------
        Sales

PizzaExpress' current PSR is 4.8. The PSR is not a valuation tool in itself, and there is no number that jumps at you and says "overvalued" or "undervalued." The number is much dependent on the sector a company operates in and its margins. For example, the highly competitive supermarket chains have a PSR of about 0.6. The high flying and highly valued telecommunications sector has a PSR of about 6. PizzaExpress is in the breweries, pubs and restaurants sector, which has a PSR of about 1.4.

Over time, as companies grow, PSRs head back towards a normal level. If you say a normal level for a company like PizzaExpress is 2.5, you can get some sort of future valuation for the company.

If sales grow 18% every year for the next 10, they will be £521m in 2008. Multiply those sales by a PSR of 2.5 and you get an implied market capitalisation of £1,302m. The current market capitalisation is £474m, giving a 10 year CAGR of 10.6%.

On sales growth of 15% per annum and a PSR of 2, the CAGR is 5.4%.

On sales growth of 20% per annum and a PSR of 3, the CAGR is 14.6%.

Bringing It All Together

                   High    Mid   Low
Earnings Growth    17.0%  15.4% 10.9%
Return On Equity   19.7%  15.6%  9.0%
PSR                14.6%  10.6%  5.4%

I'm not going to make a decision today on whether PizzaExpress are a buy. Having only just got this far prior to the publication deadline, I don't want to rush the decision. Also, I want to have another look at some of the assumptions I have used. And finally, and most importantly, I want your feedback. Do you like the company? What do you think of the assumptions? Do you think PizzaExpress are a buy? I'm looking forward to sharing thoughts on the Qualiport message board.

Have a great weekend, Fools. Anyone planning on visiting a PizzaExpress over the weekend?

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers       Date    2/10/98


                    Day     Month     Year    History
Qualiport         (1.67%)  (4.49%)   16.17%   18.79% 
FTSE 100          (3.22%)  (6.20%)   (7.50%)  (5.37%)
FTSE All Shares   (2.99%)  (5.78%)   (8.37%)  (6.44%)

Qualiport Stocks

Last Rec'd  Total # Security   In At   Current   Change
 17/04/98    337      EMAP    £11.998   £8.500  (29.16%)
 11/05/98    736      MKS      £5.604   £4.550  (18.80%)
 19/12/97   1565      RTO      £2.582   £3.340   29.36% 
 17/07/98    595      ULVR     £6.804   £4.850  (28.72%)


Last Rec'd  Total # Security   In At     Value    Change
 17/04/98    337      EMAP   £4043.37  £2864.50(£1178.87)
 11/05/98    736      MKS    £4124.37  £3348.80 (£775.57)
 19/12/97   1565      RTO    £4040.63  £5227.10 £1186.47 
 17/07/98    595      ULVR   £4048.38  £2885.75(£1162.63)


Cash:               £67.82
Current Total:  £14,393.97
Profit/(Loss): (£ 1,837.60)