Wednesday, 25 September 2013

A Portfolio of AIM Shares (3): Murgitroyd Group PLC and RWS Holdings PLC

AIM Stock: Murgitroyd Group PLC

Thomas Edison, holder of 1.093 patents, with the phonograph, courtesy Wikipedia

Murgitroyd Group PLC, based in Glasgow, was founded as a firm of lawyers by Ian Murgitroyd in 1975 and floated on the Alternative Investment Market (AIM) in 2001. The firm provides patent and trademark services in Europe on behalf of companies around the world - USA, Japan and other non-European states. Ian Murgitroyd is Executive Chairman and his son, Edward, who runs the American offices, is Deputy Executive Chairman. Between them they hold one-third of Murgitroyd's shares.
Shares in Murgitroyd are currently free of Inheritance Tax, the company has a 'free float' of 60% of its shares and the bid to offer spread for its shares is 4%. It is valued by the stock market at 45 million pounds. 

Murgitroyd has a good trading record and it is almost free of debt. It is the largest firm of patent and trademark lawyers in the UK. Murgitroyd's staff of 240 includes PhD Patent Attorneys with expertise in engineering, life sciences, healthcare, energy, emerging/alternative technology, electronics and software as well as Trademark Attorneys experienced in the consumer goods, fashion, food and entertainment industries. 

The Group has grown by opening branches in the UK, Ireland, France, Germany, Italy and Finland, sales offices in the United States and by the acquisition of law firms in the UK. By client location, 55% of its revenues of 36 million pounds is sourced from the UK, 24% from the USA and six European countries account for a further 11%. The number of patent and trademark applications in Europe continues to grow: 

2011 annual increase
2012 annual increase
European Patent office
         +  3%
             +  6%
EC Trademark office
         +  8%
             +  3%

The company relies on its reputation, technical skills and 'relationships' with companies. 

Murgitroyd has been an outstanding long-term investment, although it only regained its pre-crisis share price very recently:

Courtesy Yahoo, click to enlarge

Murgitroyd has an excellent trading and financial record:
1. Earnings per share have increased by 20% per annum cumulatively in the last 10 years.
2. Net margins are running at more than 12%.
3. The historical return on equity is 15% and rising, as the return on retained earnings is 22%.
4. The Group has reduced net debt from over 8 million pounds in 2008 to less than 3 million pounds. Net debt now represents 12% of equity.
5. Over the past five years, net operating cash flow of 11.6 million pounds has covered the dividend 2.4 times.

However, 2013 has seen just a 4% increase in pre-tax profit on 2012 and the firm declared a 4% increase in the dividend. The Chairman notes that competition is fierce and there is a downward pressure on fees. To help counter this trend, Murgitroyd is using more lower cost paralegal staff to do the work of attorneys. The Board remains optimistic that the company will maintain its 'steady growth'.
At the present bid price of 520p, Murgotroyd is trading on a PE ratio of 13 and yields 2.4%. My valuation model values the company at around 560p.* However, this assumes an upturn in trading which may not occur. *Assumptions: eps growth 10%, equity per share growth 9%, return on equity 15%, average PE ratio 14.5, dividend payout 34% of eps, all discounted for the years 2014-2018 at 10.8% (3.8% SLXX yield + 2% operating risk + 5% margin of safety).
The cautious investor will note:
1. Although a firm's reputation is important, the barriers to entry in the legal profession, even one as specialised as patent and trademark law, are low.
2. Murgitroyd's growth is currently centred on the United States, which is a notoriously competitive market.
3.  The company has offered no assessment of the impact that the new, proposed, European Union Patent might have on its business. The proposal would dramatically reduce the number of European  countries requiring separate patents.


AIM Stock: RWS Holdings PLC

Martin Luther translated the Bible into German, courtesy Wikipedia

Now let's look at another name in patent services.
Buckinghamshire-based RWS claims to be the world’s leading provider of patent translations. RWS is also one of Europe’s largest providers of intellectual property support services and it has a technical, legal and financial translation service.
2012 revenues of 69 million pounds were derived from patent translation (63%), commercial translation (23%) and patent information (10%), largely via its PatBase online programme.
By customer location, 2012 revenues were 63% sourced from Continental Europe, 24% from Asia and the USA and 13% from the UK. RWS has companies in the UK, Japan, Germany, France, Switzerland, the USA and China. Over half its billings are in the Euro.
RWS listed on AIM in November 2011. The Executive Chairman and leader of the management buyout of RWS, Andrew Brode, holds almost 43% of RWS's outstanding shares. This leaves a 'free float' of 57%. RWS is currently eligible for 100% business relief for inheritance tax.

The company has an excellent trading record since floatation:
1. Earnings per share have increased by a compound 15% p.a. and the dividend by 17% p.a.
2. Equity per share has increased by 22% p.a.
3. The historical return on equity is 21% and 25% on earnings retained in the business. The net margin is, at 25%, unusually high even for a service business.
4. RWS held 21-million pounds net cash, or about 9% of its 325 million pound market capitalization, at end March 2013.
5. Operating cash flow, net of capital expenditure, for the 5 years 2008-12 covered the dividend paid 1.6 times. This left 26 million pounds for acquisitions.

RWS' share price has almost quadrupled in the 10 years since flotation. In the past five years, RWS shares (in blue) are well ahead of Murgitroyd (in green), which drinks from the same stream.

Graph courtesy Yahoo, click to enlarge

The Chairman explains RWS's growth strategy in the 2012 Annual Report:
"Our strategy is focused upon organic growth complemented by deploying the Group’s substantial cash holdings for selective acquisitions, providing they can be demonstrated to enhance shareholder value. Organic growth is driven by increases in the worldwide patent filing activities of existing and potential multinational clients, the growing demand for language services and the Group’s ability to increase its market share by winning new clients attracted by its leading position and reputation, in an otherwise fragmented sector." 

Recent acquisitions include:  

1. inovia Holdings Pty Limited, acquired for $29 million September 2013. inovia, based in the USA, is a leading provider of web-based international patent filing solutions. A key aspect of the inovia transaction for RWS is the ability of the inovia filing service to generate translation revenues. From March 2012, when RWS took a first stake in the company, inovia began to direct translation orders to RWS resulting in sales in excess of £1 million. The company reports that "This level of activity has accelerated since 30 September 2012."

2. PharmaQuest Ltd, acquired for 2.3 million pounds in May 2013. PharmaQuest specialises in providing high quality translation and linguistic validation of patient reported outcome measures resulting from clinical trials conducted globally. RWS believes this is the only translation company in the world that specialises in this area.

While both acquisitions are said to be earnings enhancing, no further financial justification is given for their purchase.

At the current offer price of 770p, RWS trades on an historical PE ratio of 25 and yields 2.3%. The forecast for 2013 would reduce the PE ratio to 22 and increase the dividend yield to 2.4%. My valuation model values RWS at around 650p a share.* In the last 12 months, RWS shares have traded at an 806p high this August and at a 525p low last December.*Assumptions: Eps growth 15%, equity per share growth 10%, ROE of 21%, average PE ratio 18, dividend payout 60% of eps, discount rate of 10.8% (SLXX 3.8% + 2% operating risk + 5% margin of safety.

While recent acquisitions should add to growth, and management's ability to add complementary businesses has proven to be successful, doubts remain:

1. With 90% of revenues derived from translation, RWS's business is vulnerable to computer-aided translations. It is not hard to foresee that, at some point, translators will use computer programmes to do the basic translation that will only require revision by a professional. This would lower the cost and so the revenue of translation firms such as RWS.

2. If the European Union Patent ever sees the light of day, this will significantly reduce the requirement for patent translation. The standard languages will be limited to English, French and German. And this is RWS's main market. RWS recognises the risk, but believes that opposition from within the EU (especially Poland, Italy and Spain) will scupper the plan.

Wednesday, 18 September 2013

A Portfolio of AIM Shares (2): Majestic Wine PLC and Abbey Protection PLC

AIM Stock: Majestic Wine PLC

Image courtesy Majestic Wine

After the demise of First Quench (Threshers, Wine Rack and others) in 2009 and Oddbins in 2011, Majestic Wine is, with Bargain Booze, the only national wine retailer left standing. Majestic Wine was listed on AIM in 1996. The company has a good record of earnings growth, it currently yields 3%, holds net cash and it has carved out a niche, as a well-priced retailer with a large wine selection, in the wine trade. These are desirable elements for an investment in AIM, where companies tend to be small and volatile and where they often find it hard to borrow at a reasonable cost.   

Shares in Majestic Wine are currently eligible for 100% business relief for Inheritance Tax, the company has a 'free float' of 98% of its shares and the bid to offer spread for its shares is just 0.8%. It is valued by the stock market at 333 million pounds. 

The UK market for wines has been static, in volume terms, for the past five years. And yet Majestic's revenues have grown by 36% over this period and its shares (in blue) have been an excellent investment, far superior to other food and drink related retailers such as J Sainsbury (in green).

Graph courtesy Yahoo, click to enlarge

In the 2013 Annual Report, Majestic's CEO explained its growth strategy:

"Majestic has a clearly defined growth strategy which has four key components; the continuing growth of sales through our core estate coupled with its expansion, growing sales to business customers, increasing ecommerce traffic and developing sales of fine wine."

So, how have the four key growth components developed over the last 5 years (2009-13)? 

1a. Sales per UK store have declined by 8% these past 5 years. The average price per bottle has increased by 19% in this period. The average drop in volumes per retail outlet would seem to be 23%. (Note: included in these figures are business to business sales amounting to 50 million pounds in 2013 and not segregated in 2009. So the figures are indicative).

1b. The number of UK stores has increased from 149 to 193, or by 30%. The company has identified a further 140 sites as suitable for new stores.

2. Sales to business customers declined by 20% in 2013, compared to 2012. This followed Majestic's decision to exit the wholesale wine trade. 

3. Ecommerce sales have increased by 59% in the past five years and now account for 11% of Majestic's retail sales. These are serviced from the nearest Majestic branch.

4. Lay and Wheeler, the fine wine merchants purchased in 2009, recorded sales of 18 million pounds and operating profits of 1.7 million in 2013, both slight declines on 2012. This is seen by Majestic as a blip.  

Not everything is going to plan. 

However, Wine Report 2011 by Neilson includes some favourable comments from wine producers about Majestic. One winemaker remarks, Majestic is going from strength to strength – a good, well-funded company selling keenly-priced, excellent wines with knowledgeable staff will always find a place in the market.” 

But there is also a caveat from the UK Managing Director of Cordoniu, the premier producer of Spanish cava: Majestic has a very successful model, both commercially and with the right people in the business who know and understand it, to make it work. Looking more widely at this channel, overheads are one of the key issues, so independent shops and small regional chains, where costs can be controlled, are the sustainable way forward. Driving consumers through the door is ultimately what makes a business work, so marketing, range, pricing, margins, supplier relationships, store location and people are all key ingredients.” 

A visit to a Majestic Wine store is a much more rewarding experience than visiting a supermarket, in terms of wine selection and description, service and even price. But the supermarkets take 84% of the wine business, by volume, in the UK. 

Majestic has keenly controlled administrative expenses, which in 2013 are below 2009's level. And the company has a good training programme for its employees. In the 2013 Annual Report, the CEO writes:
   "We have built a team of personable, articulate and knowledgeable individuals who take great pride in exceeding our customers’ high expectations. . ." and, "We have an extensive training programme designed and delivered in-house that is widely recognised as amongst the best in the industry."  

Turning to trading results and financials, Majestic has weathered the adverse retail environment well:

1. Earnings per share have increased by almost 8% p.a. cumulatively in the last ten years.

2. The historical return on equity is a healthy 20%, and a similar 19% on retained earnings.

3. Net margins are a healthy 8-9%.

4. The company has net cash of 3 million pounds at April 2013.

5. Operating cash flow, after deducting capital expenditure, has covered dividend payments 1.2 times on average these past 5 years.

6. Majestic has no defined benefit pension scheme obligations. 

At the current offer price of 508p, Majestic is on an historical PE ratio of 19 and yields 3.1%. My valuation model values the company's shares at about 460p.* At this price Majestic shares would be on a prospective PER of 16 and yield a prospective 3.7%. Majestic shares reached a 12-month high in August 2013, at 535p and a 12-month low of 397p in April. *Assumptions: eps growth of 7.7% p.a.; equity per share growth of 10% p.a.; ROE 19%; average PER 17.5; 60% eps paid out as dividends and 40% retained; discount rate of 11.8% (3.8% investment grade corporate bond + 3% operational risk + 5% margin of safety).  

The cautious investor will note: 

1. The overall wine market in the UK is static and dominated by the supermarkets. Majestic can only grow by gaining market share by opening new stores and outwitting the competition.

2. Tesco claims to have the largest online sales of wine in the UK, at 200 million pounds a year.

3. Majestic faces competition from the supermarkets, regional chains, independent vintners and online wine clubs. It may have received a temporary boost from the demise of First Quench and Oddbins that flatter the growth figures between 2009 and 2011.

4. The company's main reason for listing on AIM may have disappeared. One founder owned 15% of the company's stock, but he has been liquidating his holding. Majestic might move to the main list. Good for the shares but bad for investors seeking AIM stocks to reduce inheritance tax.

5. Recent shareholder transactions have all been sales. Three directors sold 386,000 shares in July and August at prices ranging from 501p to 510p a share.

6. The company's share price has increased by 28% in only 5 months. This positive sentiment could easily fade.


AIM stock: Abbey Protection PLC



Civil Law Notary, by Quentin Massys, Flemish 16th Century, courtesy Wikipedia 

Abbey Protection claims to be the leading insurer of legal, tax accounting and professional fees for small and medium sized enterprises (SMEs) in the UK. Abbey has a large consultancy/advisory business and a properties facilities business. With the acquisition of a firm of solicitors, it will begin to offer legal services to its SMEs in 2013. Abbey derives 67% of its revenues from consultancy/advisory and 31% from writing insurance premiums.  

In the 2012 Annual Report the CEO writes, "Our objective is to achieve strong, sustainable earnings and a progressive dividend yield through a strategy of driving organic growth, developing opportunities for the Group’s consulting divisions and making selective and complementary acquisitions." 

Floated on AIM near the peak of the stock market (November 2007), Abbey's shares have proved to be an excellent investment:


Graph, courtesy Yahoo, click to enlarge 

Abbey Protection shares are currently eligible for 100% business relief for inheritance tax, and it has a free float of 43% of its outstanding shares, well in excess of the 25% minimum that gives outside shareholders a genuine say in company affairs. Five directors and senior managers hold 52% of Abbey's shares.  

Abbey's development since floatation has been smooth and the company is well financed. Consider:

1. Earnings per share have increased by a compound 7% p.a. since 2008 and equity by a compound 14%.

2. Cash and financial investments totalled 43 million pounds at the end of 2012. The company is valued on AIM at 119 million pounds.

3. At end 2012, Abbey had twenty-two times the minimum required eligible assets available to support its UK intermediation activities and over five times the minimum required eligible assets available to support its Guernsey based reinsurance activities. 

4. Since floatation, net operating cash flow covered the generous dividend 1.9 times. 

However, as note 24 of the Balance Sheet states: "The nature of insurance business makes it very difficult to predict with certainty the likely outcome of any particular claim and the ultimate cost of notified claims." At the end of 2012, outstanding claims were estimated at 9.7 million pounds by the company. Essentially, claims estimates are based on historical data. While Abbey follows the established method for estimating claims, there have been horrible surprises that, in some instances, have bankrupted the insurer. Investors, recognizing the nature of the risk, award low PE ratios to insurers even when premiums account, as here, for less than one-third of the business. Otherwise, the balance sheet is clean of defined benefit pension scheme liabilities and derivative assets and liabilities. 

At the current price of 121p, Abbey shares trade on an historical PE ratio of 15 and yield 4%. The current share price, according to my valuation model, is about right.*
*Eps  growth 7%, equity per share growth 14%, return on equity 25%, average PE ratio of 12.5, 40% of eps retained and 60% paid out as a dividend, discounted at 10.8% (3.8% SLXX + 2% operating risk + 5% margin of safety). 

Prospective investors will note:

1.  The current share price is at an all-time high and 34% higher than last year.

2.  The new legal services business is an unknown.

3. The first half of 2013 ended with the same pre-tax profit as the first half of 2012. A decline in underwriting profits was compensated elsewhere. However, Abbey raised its interim dividend by 14% and paid out a 5p per share special dividend in the period.

4.  5 directors and senior managers have large stakes in Abbey, with far more to lose, if things go wrong, than outside investors.

5. The only investment analyst to follow Abbey has moved his recommendation from Buy to Hold.





Wednesday, 11 September 2013

A Portfolio of Shares in AIM (1)

And The Stanley Gibbons Group PLC

Image, courtesy Wikipedia

Since August 2013, investors are permitted to include shares quoted on AIM (the Alternative Investment Market) in ISAs (Individual Savings Accounts). The specific advantage of this new ruling is that, under certain conditions, AIM shares are subject to 100% business relief for Inheritance Tax. For the conditions set out by HMRC, a history of AIM and further comments on AIM see an earlier article on this website:

As most AIM shares are exempt from the 40% rate of Inheritance Tax, AIM shares are highly attractive to investors who want to leave their wealth to the next generation. 

However, investors should heed the truly terrible investment that AIM shares have represented. Over the last 12 years, the FT AIM Index has lost 60% of its value. Losses have been concentrated in mining, oil exploration, biotechnology and internet start-up sectors. Companies headquartered outside the UK, have been particularly bad investments.  

This leaves a good number of companies that are worth considering in a portfolio of AIM shares. This and several subsequent sections on this blog will cover AIM shares that, in addition to the usual requirements for an investment:  

1. Are exempt from Inheritance Tax. This excludes AIM stocks that are also quoted on a recognized overseas exchange and AIM companies that wholly or mainly deal in securities, stocks or shares, land or buildings, or hold investments.

2. Have a 'free float' well in excess of 25%. 'Free float' is the proportion of shares that are freely traded in the market compared to the number held by all parties. Free float is important because companies can be taken private by their owners at the price they choose if they control 75% of outstanding shares.

3. Are domiciled and have their headquarters and main assets in the UK. Companies with their assets located in emerging markets have been particularly prone to disappointment.

4. Have a good trading record, low debt or net cash and a clean balance sheet. This avoids start-ups and other companies that trade more on their promise than on results.

5. Have good governance. The loose requirements for listing on AIM have attracted managers that do not always look after the interests of outside shareholders.

6. Trade on a bid to offer spread of no more than 8%. The shortage of market makers and low market capitalizations of AIM companies have resulted in wide bid to offer spreads on this market. The price quoted in the text always refers to the offer price. 

Note: Although HMRC requires a 2-year holding period to be eligible for tax relief, this does not lock in a particular stock for this period. AIM stocks may be sold during the 2-year period and count towards the 2-year qualifying period provided the proceeds are reinvested in another AIM stock. 

Previous articles have valued two potential companies quoted on AIM that comply with these additional requirements. They are James Halstead (see and Personal Group Holdings (see  Note: valuations were based on information available at publication.


The Stanley Gibbons Group PLC - AIM

Stanley Gibbons colour chart, courtesy Wikipedia

Stanley Gibbons, well known for its philatelic business, has a growing and profitable business in other collectibles as well - First Day covers, rare coins, medals and memorabilia. While sales from the London, Jersey and Hong Kong offices, including email campaigns and auctions, contribute the bulk of revenue and earnings, the company is working hard to develop its online business in both the UK and the USA. This is partly in response to the growth in eBay, which enables collectors to buy and sell stamps and coins easily and at a low cost.  

The Chairman explains the internet strategy in the 2012 Annual Report: 

Sales from our core website,, were up 55% in the year after a 27% rise in the preceding year, highlighting the successful execution of developing most of our online offering. Whilst this growth in revenues from e-commerce activities from our own products online is encouraging, in the future it is expected that our website will deliver substantial additional revenues. This will include online commissions generated by third party sales via a global online collectibles trading platform, together with subscription revenue from online services, including virtual catalogues, up to date pricing information and an extensive archive of philatelic articles dating back to 1890. 

Earnings have continued their rise post the financial crisis and the company's net cash is currently worth 8% of its market capitalization of 90 million pounds. 

Stanley Gibbons' share price since 2000 has fluctuated wildly. This illustrates the changing sentiment for a small trading company in an unusual market niche rather than any underlying fundamentals in the business. Stanley Gibbons (in blue) has easily outperformed the very disappointing FT AIM Index (in green).

Graph courtesy Yahoo, click to enlarge

At the current offer price of 315p, Stanley Gibbons is trading on an historical PE ratio of 17 and yields 2.1%. The present high market rating is based on: 

1. Earnings per share these last 10 years have grown at a compound 16% p.a. and the dividend has grown in proportion.

2. Equity per share has grown at a compound 15% p.a. over the same period.

3. The promise of further growth from the online business.

4. The historical return on equity is a healthy 17%. However, the return on retained earnings since 2003 has declined to 13%.

5. Net margins are a healthy 15%

6. Net cash at June 2013 was 7.7 million pounds, after a 6-million pound fundraising in 2012 to purchase an online platform in the US and develop the company's online capability.

7. Operating cash flow for the years 2008-2012 covered capital expenditure, a big build-up of inventory for future sale and 80% of the dividend payments.  

8. The deficit on the defined benefit pension scheme, at 3 million pounds, is the one element that is likely to cause further charges. The scheme was closed to new members in 2002.

The interim results to June 2013 point to a halt or even reversal of growth in earnings per share for 2013. The 42% decline in first half earnings per share is attributable to the development of the online business, the start-up of the Singapore office, and a shortfall on the provision for the defined benefit pension scheme due to 'administrative errors'. The directors have responded with satisfaction at the growth in revenue and adjusted trading profits, and they have increased the interim dividend by 9%. 

This leaves the investor with two broad scenarios. 

The optimistic investor will go along with management's goals of building up capacity in online selling, its new business in the US (based on an online platform called bidStart, for which it paid $1 million) and its new office in Singapore. Supposing that Stanley Gibbons' business performs as in the past, the company's stock, according to my valuation model, is worth 358p a share. * Stanley Gibbons is then a buy at its current price, particularly when the benefit of its IHT exempt status is factored in.
*Eps growth of 16% p.a., Equity per share growth 15% p.a., 13% return on equity, average PE ratio 17, all discounted at 10.8%, less the dividend yield, for the years 2013-2017. 

However, the cautious investor will have doubts that reduce expectations for the company. 

1. What if the US venture, which competes with eBay, fails?

2. What if the online business degrades the Stanley Gibbons brand by selling lower quality products, for example the First Day covers of Benham, which it purchased in 2010?

3. The company notes in its 2013 Annual Report that it is short of expertise on rare coins and medals. Does this suggest that it is at a disadvantage with companies, such as Noble Investment, that specialise in these areas?

4. And what if the lack of control that was the cause of the shortfall on the defined benefit pension scheme has spread to other areas of the company? 

Factoring lower expectations for the company reduces its value, according to my model, to 278p.* And this does not allow for a change in sentiment. Stanley Gibbons' share price has increased by 56% since its 12-month low of 202p in October 2012. And the really cautious investor will not include any value for its IHT exempt status, given that this could be annulled by HMRC or by the company transferring its listing to the main LSE market.
*Eps growth and equity per share growth reduced to 5% and 10% respectively.  

Note 12 September: Today Stanley Gibbons and Noble Investments have announced they are in conversations that could lead to the acquisition of Noble by Stanley Gibbons for a total of 42 million pounds in shares and cash.

Wednesday, 4 September 2013

The Ins and Outs of Company Valuation

And A G Barr

Two readers of this blog have asked how the model used here for valuing a company's share price works. What follows might not be to the taste of all readers.
The chess grandmaster, Aron Nimzowitsch, titled his book on chess theory and practice My System. Most experienced investors probably regard their methodology in the same light.
So it is with the Joyful Investor. The inspiration for 'my system' is Buffettology (Simon & Schuster, 1997), authored by Mary Buffett and David Clark. Mary Buffett is Warren Buffett's former daughter-in-law and David Clark is an old friend of the Buffett family. Whether they describe Warren Buffett's method as they claim or not, their system is convincing. For a brief and incomplete outline of the method used to select stocks prior to the valuation model, see  and
Once a company has passed the initial hurdles, the valuation process commences. The aim of the model is to use three different approaches to find, in a fuzzy way, a company's intrinsic value. The three sub models  project earnings per share, 1 based on historical data; 2 based on equity per share and the return on projected retained earnings using historical data; and 3 based on projections for equity per share and return on equity using historical data. The formulae are included below at the end of this section.
As this is an earnings-based model, it is incomplete for businesses, such as banking, property and insurance, that require a balance sheet approach.
While it is impossible, in the space available, to explain in detail all the ins and outs of the methodology, in summary it works as follows:
1. Projecting earnings per share (eps) based on historical data V1 = (eps X (1+g1)n X PER)/ (1+d)n).

 i.            Preferably, the last three years and the first three years of a 10-year earnings record are averaged and provide an historical base for the company's compound growth rate(g1).

ii.            Eps are adjusted only for discontinued and/or new operations and truly extraordinary gains and losses.

iii.            Management guidance, depending on past reliability, recent trends in eps, broker forecasts and a review of external factors (competition, regulators,  overall  market) are taken into account.

iv.            The projection is limited to 5 years (n). Presently  2013-2017 or 2014-2018 depending on the company's year end.

v.            The 5-year projected eps is multiplied by the average valuation that the stock market has put on the company's earnings per share (Price Earnings Ratio -PER) in the past. The PER of competitor companies is taken into account.

vi.            The resulting future share price is discounted at a rate (d) that includes the cost of the company's debt, the company's operating risks and a margin of safety. The share's dividend yield is deducted from the discount rate. See for a further discussion of the discount rate.  

2.  Projected earnings per share based on equity per share and the return on projected retained earnings using historical data V2 = (eqps X (1 + (ROE%/100 X RET%/100)n) + eqps X PER)/(1+d)n)

 i.            The latest equity per share (eqps) is used as a base. As eqps is multiplied by the historic return on equity (ROE), it is immaterial whether assets are held at market value or cost or are tangible or intangible. Where equity is negative, one uses return on capital employed (debt + equity).

ii.            Here return on equity focuses on the return on new equity, for the most part retained earnings. The return on new equity per share is calculated by taking, preferably, the last 10 years eps and deducting the dividends per share paid in this period. The difference between the latest 3-year average eps and the first 3-year average eps provides the added return from the new use of capital derived from retained earnings and other sources.

iii.            Going forward, retained earnings per share (RET) are based on the historical record of retaining earnings and management policy, where this is stated.

iv.            Steps iv, v and vi above are repeated.

3.  Projected earnings per share based on projections for equity per share (eqps) and return on equity using historical data (V3 = (eqps X (1 + g2)n X ROE% X PER)/ (1 + d)n)

 i.            The same figure for eqps is used as in 2.i above.

ii.            The projected annual compound growth rate (g2) in equity per share is based on historical data, preferably, for the last 10 years.

iii.            The growth in eqps takes into consideration items that do not normally pass through the income statement. This includes charges/gains on defined benefit pension plans, share issues/buybacks, asset sales and certain tax items.

iv.            Recent historical data is used to arrive at the projected return on equity. This takes into account the variation, where significant, between the historical ROE and the ROE on new equity.

v.            Steps iv, v and vi of 1 above are repeated.

As with any model, there is the risk of 'garbage in, garbage out'. The following are some checks on the model.
a.       The model also produces valuations for 10 years forward. By comparing these values with the 5-year projection, odd results can be detected.

b.      It is easy to apply a sensitivity analysis to key assumptions - growth being the most significant.

c.       A significant change in the debt to equity ratio can distort results, and this may require adjustments to the data.

d.      Results that are quite out of line with the present share price need reviewing.

e.      Further valuations are based on the lowest PER reported in recent times and on the eps divided by the 10-year yield on corporate bonds of the same creditworthiness as the company. These provide both low and high range valuations.
The wise investor will use the valuation of a company produced by a financial model with a great deal of caution. It is a useful indicator, nothing more, and ignores:

1.       A change in management that can dramatically alter the expectations for a company.

2.       The chance of a takeover, a major disinvestment or acquisition.

3.        Sudden changes in the marketplace.

4.       Environmental, governance and political disasters.

5.       Big bumps in the stock market.

6.       The consequences of large-scale cluster buying or selling of the company's shares by its directors. 

And it is a salutary reminder that for every buyer of a stock who believes it is undervalued, there is a seller who believes it is overvalued at that same price.

The formula for the model is:
V = ( V1+V2+V3)/3
V1 = ((eps X (1+g1)n) X PER/ (1+d)n
V2 = (eqps X (1 + (ROE%/100 X RET%/100)n) + eqps) X PER)/(1+d)n
V3 = (eqps X (1 + g2)n X ROE% X PER)/ (1 + d)n
V = Value per share
eps = current earnings per share
g1 = annual compound growth in earnings per share%/100
g2 = annual compound growth rate in equity per share%/100
n = number of years
PER = average Price Earnings Ratio
d = discount rate%/100
eqps = current equity per share
ROE% = Return on Equity percent
RET% = Retained Earnings as a percent of earnings per share


A G Barr PLC


Image courtesy Wikipedia
A G Barr, the Scottish based soft drinks company, has a consistently good record of revenue and profit growth in the UK. Originally in the carbonated drinks market, with its lead brand Irn-Bru (formerly Iron Brew), the company now generates 22% of its revenue from still drinks and water. It acquired the water brand Strathmore in 2006 and the still drinks brand Rubicon in 2008. In 2012, it began marketing Rockstar, an American competitor to Red Bull, in the UK as franchisee. It has also launched a range of ice creams under the Rubicon label. The company is completing a new canning plant in Milton Keynes, which will double its canning capacity. 

In its 2013 Annual Report the CEO explained,

Our consumer base is growing in number, location and diversity. We aim to build long term relationships with all our consumers through our brands by appealing to both traditional and new tastes as well as by bringing exciting innovation to the market. We believe people want choice and we aim to build brands and develop innovation which meets this need. 

In 2012, A G Barr announced an agreed merger with its larger British competitor, Britvic. After a long delay caused by the Competition Commission, Britvic renounced the agreement. Given the very high indebtedness and spotty trading record of Britvic, A G Barr's shareholders seem to be the main beneficiaries of the failed merger. 

A G Barr shares (in red) have been an outstanding investment compared to the FTSE 250 (in orange) these past 5 years:


Image courtesy Investors Chronicle, click to enlarge 

Over the last decade, A G Barr has grown at a fast clip: 

1. Earnings per share have increased every year except 2013, cumulatively averaging 13% per annum.

2. Equity per share has increased by 12% per annum and dividends by 10% per annum cumulatively.

3. Return on Equity is an historical 21% which is equalled by the return on retained earnings, at 22%.

4. Net margins, a healthy 11% in 2008, are now an even healthier 14.7%.

And the company is financially in good health. Consider: 

1. Net debt is 19% of equity, and this is historically high only because of the 2008 purchase of Rubicon, the funding of the new canning plant and a 9-million pound special dividend paid in 2012. Net debt could be paid off with one year's post tax profits.

2. Operating cash flow for the period 2009-2013, once capital expenditure is deducted, covered the dividend payment 1.5 times. Once the dividend was paid, A G Barr was still left with 23 million pounds these last 5 years for acquisitions and the special dividend.

3. The defined benefit pension fund, now closed to new entrants, is in deficit to 3 million pounds. This is just 0.5% of the company's market value of 632 million pounds.  

The Barr family still controls 15% of the company's shares. One Barr, formerly Chairman, is on the Board and another is Company Secretary. Between April and June, there have been 2 director sales of shares at 546p and 503p worth 2 million pounds. And 2 director purchases at 543p and 536p worth 0.5 million pounds. Judged by their purchases, the weight of director opinion is not favourable, but might have been related to the end of the merger between Barr and Britvic. 

With its fine trading record, A G Barr commands a prospective price earnings ratio of 21 and a prospective yield of 2% at its present price of 544p. My model values A G Barr at 526p. This is based on a continuation of historical growth rates for earnings and equity, as well as maintaining the current return on equity and dividend payout. It uses the average PER of 20 and a dividend payout of 52% of EPS. All for the years 2014-18. 

The discount rate of 11.8% used for the model includes 3.8% for investment grade corporate bonds (from SLXX), 3% for operating risk and 5% as a margin of safety. 

The prudent investor will note: 

1. The failed attempt at the merger with Britvic by the first management team not to be led by a Barr could be followed by another grand scheme that will not prove, necessarily, to be beneficial for shareholders.

2. While the stalling in earnings growth in 2013 can be attributed to the cost, both in pounds and management time, of the failed Britvic merger, it nevertheless breaks a long-term growth record held by the company.

3. The franchise arrangement with Rockstar is a departure from the company's practice of only promoting its own brands. Franchise arrangements can end in tears.

4. Competition from Coca Cola has knocked Irn-Bru off its perch as the favourite carbonated drink in Scotland.

5.  Accounts receivable have been lengthening. They have increased from 57 days in 2009 to 63 days in 2012 to 72 days in 2013. The company explains that the 2013 increase was due to prepayments to be recovered and the earlier year-end closing date.