Qualiport

[ October 19, 2000 ]

Emap's Digital Dilemma

By Maynard Paton (TMFMayn)

Carburton Street, London -- Falling share prices always inspire me to revisit my valuation calculations. And there have been plenty of falling shares lately. Of course, the Qualiport hasn't escaped the latest market wobbles. For example, I've noticed Independent Insurance (LSE: IIG) shedding 20% from its recent high.

Another Qualiport company whose share price has declined of late is Emap (LSE: EMA). I last looked at Emap over three months ago when I reviewed the media company's annual results. Back in early June, the Emap share price was 1185p. They've since slumped to 830p today, having dropped below 800p last week.

Over the past few months, nothing fundamentally has changed at Emap. Alongside the launch of overseas versions of its FHM magazine and the securing of digital radio licences, Emap have also been very active in the online world. Recent examples of the group's Internet expansion include Clickmanchester.com, a venture with HMV record stores and a B2B e-commerce partnership with the construction industry.

Digital Investment

However, it's this investment in new media that causes a valuation dilemma for the potential investors. In March, Emap announced a significant investment in Internet and digital ventures:

"Emap expects to spend up to £75 million on digital activity in the year to March 2001 and between £200-250 million in total in the three years to March 2003. These figures include launch and development costs, expected to be some £50 million in 2001, and capital investment."

To put those figures into perspective, Emap generated an operating profit of £224m in its latest full year.

Accounting for growth

How this expenditure is accounted for will depress reported profits over the next few years. Money spent on marketing and branding, key factors for Emap's digital success, is always written off as incurred.

Let's look at the affect of the forthcoming digital expenditure from the earnings per share (EPS) perspective. In the year ending March 2000, Emap reported EPS of 53.7p. However, consensus forecasts for 2001 and 2002 hover around the 37.7p and 41.2p levels respectively, the lower profits being due to the digital investment "write-offs".

It's also interesting to note how the quaint characteristics of accounting can alter profit forecasts. Had Emap intended to spend all of the money on, say, a new factory, earnings forecasts wouldn't have been affected. Instead, that tangible capital expenditure would have only been accounted for within the company's cash flow statement with accounting profits left untouched.

Everything boils down to cash

But regardless of whether the expenditure is written off in the profit and loss account or not, it's still an outflow of cash. And in that case, the accounting niceties are neither here nor there. As Warren Buffett once wrote: "The intrinsic value (of a business) can be defined simply: it is the discounted value of the cash that can be taken out of that business during its remaining life."

But producing discounted cash flow valuations, which in time will prove to be reasonably accurate, is not the easiest of tasks. I always prefer to look for obvious and immediate value in companies, rather than to peer distantly into the future to discover undervaluations.

Take your valuation pick

So here's Emap's digital dilemma. How do you evaluate the upcoming expenditure without getting bogged down in complicated cash flow forecasting?

There are three ways of viewing Emap's forthcoming digital expense.

1. Take the pessimistic view and assume all of the digital expenditure is wasted and will never generate a return. In this gloom-laden scenario, the investor just takes the "digital write-off" forecasts to form his valuation. So, at a share price of 830p, the pessimist assumes Emap stands on a prospective price to earnings (P/E) ratio of 22 (830p / 37.7p).

2. Take the optimistic view and assume that today's digital expense will ultimately be insignificant compared to the fantastic returns it will generate. In this blue-sky scenario, the investor ignores the digital expenditure and instead uses historic profits to form his valuation. If historic EPS grows at 10% from 53.7p (i.e. representing growth at the non-digital part of Emap, which has been indicated to grow at "double digit" rates), the optimist assumes Emap stands on a prospective P/E of 14 (830p / 59.07p).

3. Take a mixture of options 1 and 2.

Rough and ready

The third method is the best. It's a fair bet that Emap will create some long-lasting shareholder value from the upcoming digital expense. But whether the rate of return will be fantastic, average, or mediocre, and over what timescale any return will be generated, is anyone's guess.

To get a rough and ready handle on Emap's immediate value, I'll refer back to the Qualiport's own Quick Fix Valuation Guide. The Guide revolves around the earnings yield, as described below:

"The inverse of the P/E is the E/P, otherwise known as the earnings yield. It is easiest calculated as 1 divided by the P/E -- the result is exactly the same as E/P. A P/E of 10 translates to an earnings yield of 10% (1 / 10 = 0.10 = 10%), and that can be compared to other forms of investment. For example, with base interest rates currently standing at 6%, by comparison a 10% earnings yield sounds attractive."

Middle ground

So let's take the middle ground between options 1 and 2. The average of the two ends of the prospective earnings spectrum is 48.38p ( (37.7p+59.07p)/2 ). Let's also assume that any company that has the potential of ongoing double-digit earnings growth (like Emap), and has a prospective earnings yield equal to that of base interest rates, can be deemed "good value". In this case, "good value" for Emap shares would be 806p (48.38p / 6%).

That 806p figure is by no means a cast-in-stone "top-up" level. From these and other calculations, my gut-feel is that Emap shares would look "great value" some way below the 800p level.

Nevertheless, the calculations do give a reasonable fix on the immediate value of Emap at the moment, albeit very dependent on your view of how the company's digital expenditure will fare. Emap's interim results are due next month, when they'll no doubt update shareholders with their digital plans (and costs!).

Where Next?

• Review the Conclusions from Emap 2000
• All you ever wanted to know about valuation... the Quick Fix Valuation Guide and the Fool's School of Valuation
• Share your thoughts with Emap investors on the company's discussion board