Qualiport

[ August 25, 1999 ]

Learning Collectively

By Bruce Jackson (TMFGoogly@aol.com)

Baker Street, London -- I spent a few hours this morning looking at the current valuation of EMAP (LSE: EMA). Not surprisingly, it wasn't a simple task.

You see, EMAP have only recently made a big acquisition, buying Petersen of the US for £720 million. This was partly funded by a 1 for 5 rights issue priced at 875p, and debt facilities. As at 31st March 1999, just a month after the acquisition, EMAP's total borrowings were £728 million. The acquisition puts a whole new complexion on EMAP's balance sheet.

Not unconnected to the valuation conundrum, and following on from this comment in Monday's column:

"I calculate Marks & Spencer's cost of capital at 10.6%, and their return on capital at about 7%. They are destroying value, and it will take a long time, if ever, to turn things around."

a rather lively discussion emerged on the message boards, starting with this post by lazylubby. Feel free to follow the thread through, via some Qualiport bashing, and you'll come across this fantastic message from regular poster, Bribbler, and very occasional Qualiport guest writer thefrasers (aka FatMan). After reading that message, fellow Fool Alan Oscroft (TMF Alan) said "Each week Investors Chronicle talks about the equity risk premium, but I've never once seen it written as clearly as it was by thefrasers. I'm sure he won't mind reproducing most of the post here.

"Shareholders expect higher returns commensurate with the risk implicit in an equity holding. Standard capital markets theory assumes the cost of capital, in the sense of what a shareholder wants for his/her investment, for a firm is as follows;

risk free rate + (equity risk premium x Beta)

Where risk free rate = govt. t-bill or bond yield

equity risk premium = amount extra investor expects to be compensated for additional risk of being in the equity market

Beta = measure of relative volatility of individual stock to the market.

Measures of Beta's and the equity risk premium according to taste. A study by my own firm for the US market a few years ago put the equity risk premium at 5%.

Assuming a Beta of 1 (normal market stock) this would give a required return of

5.5% (long bond yield) + 5% (risk premium) = 10.5%

I am not saying the above is the correct calculation for M&S, only that it gives some indication of the bogey they need to beat before a shareholders money would be better employed elsewhere."

Summing up, on a different post he went on to say;

"…if you have a choice between a 10 year govt. bond which will pay you 10% for certain for the next 10 years, and an equity which has an expected return of 10%, but which may go bust, why would you ever buy the equity?"

Thanks FatMan. Collectively, through the Internet and particularly the Motley Fool message boards, we can all learn so much more than the individual alone. This real money portfolio aims to educate the individual investor, although ultimately the philosophy and stock picking decisions -- and therefore the poor 1999 returns -- are down to myself. I'm still learning, and I hope you are too.

Partly as a result of the above thread, and during the process of valuing of EMAP, I started to re-reference a couple of books I've got on Economic Added Value (EVA). Rather than try to explain it myself here, I'll point you to the explanation and definition on the Stern Stewart site, the acknowledged experts in this field.

I'm quite a way into the (long) process of learning EVA myself, and part of that learning involves getting a grip on the "cost of all capital invested in an enterprise." This is different to the equity invested in a business.

For example, here's a couple of numbers from EMAP's 1999 accounts.

Shareholder's Funds (equity)        £898.3m
Net normalised profit               £ 61.6m

From that, a simple return on equity (ROE) calculation (£61.6m/£898.3m) comes up with 6.85%. Yikes! On that basis, it appears EMAP would be better off investing in no-risk bonds.

However, it is worth remembering that the equity base has recently been significantly boosted by the Petersen induced rights issue, but only one month's profits are included in the profits for 1999. By definition, the fiscal 2000 ROE should be quite a bit higher.

But, is "cost of all capital invested in the business" the equivalent of shareholder's equity? I'd argue not. Some definitions take:

"Total assets less non-interest bearing current liabilities"

The latter part of the definition refers to things like accounts payable and deferred revenues. These are effectively interest free loans made to a company, and therefore not capital invested in the business. Other definitions deduct goodwill from total assets, as this is simply a non-cash accounting charge, and the cost of the goodwill is reflected in other places, such as in the interest charge and the cost of capital.

I've run out of time and space to continue this today, so will do so on Monday. Rob is back on Friday, bursting with suggestions and ideas. As for EMAP, I don't feel entirely comfortable putting a valuation on the company at this stage. I figure there's no rush, as doing the homework in advance of any top-up decision is the priority. After all, we're looking to hold these shares for a long period of time.

Post your comments and questions to the Qualiport board.

Qualiport Numbers
25/8/1999 Close

Company  Change    Bid
DELL(US)+0.60    46.20
EMA     +0.04     9.84
IIG      0.00     2.87
MSY     -0.02     5.41
PIZ      0.00     7.55
RTO     +0.12     2.55
 ULVR    -0.02     5.95


Qualiport Stocks

Last Rec'd  Total # Company    Buy  Current Change
 27/10/98   755     Indep Ins  2.58  2.87    11.2%
 27/01/99    74     Dell (US) 44.63 46.20     3.5%
 19/12/97   783     Rentokil   2.55  2.55     0.0%
 04/11/98   245     Pizza Exp  7.93  7.55    (4.7%)
 22/04/99   347     Misys      5.76  5.41    (6.1%)
 17/04/98   169     EMAP      11.34  9.84   (13.3%)
 17/07/98   266     Unilever   7.53  5.95   (20.9%)

Last Rec'd  Total # Company     In At  Value   Change

 27/10/98   755     Indep Ins  1972.64 2166.85  194.21
 27/01/99    74     Dell (US)  2007.42 2072.00   64.58
 19/12/97   783     Rentokil   2046.53 1996.65  (49.88)
 04/11/98   245     Pizza Exp  1966.34 1849.75 (116.59)
 22/04/99   347     Misys      2028.71 1877.27 (151.44)
 17/04/98   169     EMAP       2341.32 1987.68 (353.64)
 17/07/98   266     Unilever   2052.00 1582.70 (469.30)

Cash:                                       £3,433.46
Current Total :                            £16,966.36

Total Invested:                            £18,184.62
Profit/(Loss) :                            (£1,218.26) 

Value Per Share

                    Day      Month      Year      
Qualiport          0.69%    -0.03%     -9.78%
FTSE 100           0.86%     2.21%      8.28%
FTSE All Share     0.78%     2.09%     11.68%