<<

. 8
( 9)



>>

43.60
46.74
1 51.93 0.932836
(5.19)
45.24
51.99
2 57.77 0.870186
(5.78)
46.95
57.84
3 64.27 0.811741
(6.43)
48.73
64.35
4 71.50 0.757226
(7.15)
50.57
71.60
5 79.55 0.706369
(7.95)
52.48
79.64
6 88.49 0.658926
(8.85)
54.46
98.45 0.614670
(9.85) 88.60
7
109.53 0.573388
(10.95) 56.52
98.58
8
121.85 0.534877
(12.18) 58.66
109.67
9
135.56 0.498952
(13.56) 60.87
122.00
10




Assessing risk and valuing companies
(481.92)
0.498952
966.34 482.16
966.34
10
0.24

Figure 4.12 Formula to calculate Con Glomerate™s share price to achieve IRR
231
Accounting and Business Valuation Methods

Figure 4.9 makes the judgement that a rate of 12.22%, or 11% net of dividend
tax at the rate of 10%, is the rate to take, so the third judgement is:

(3) That the discount factors used are those for 11%.

The next assumption used is:

(4) That the transaction costs will be 1.5% of the cost of the purchase, to
cover commission and stamp duty, and 1% of the sales proceeds to
cover commission.

The DCF is worked out on the basis that there is £1000 to spend. Note that
this could be any number; a higher number would produce larger numbers,
but discounted back would give the same result.

So if there is £1000 to spend and the price is £3.24 per share, 304.08 shares
can be bought:

£p
304.08 shares at £3.24 per share = 985.22
Commission and stamp duty (1.5%) 14.78
1000.00

The DCF calculation then assumes that the earnings per share are paid out
in full, so current earnings of 21.4 pence per share would give a dividend of
£65.07 and this is the amount that is shown as ˜return™ in year 1 (Figure 4.9).

As stated in the VCVG, another key assumption in DCF calculations is the esti-
mation of the terminal value. It is assumed in Figure 4.9 that because the
earnings per share have been paid out in full, there cannot be any growth in the
share price. Accordingly, the selling price of the share is based on the original
spread:

£p
304.08 shares at £3.21 per share 976.10
Commission (1%) 9.76
Proceeds 966.34

If earnings did not grow in the 10-year period, then our DCF calculation would
end up with a negative figure, indicating that we could not achieve the rate
of return required. We can then calculate the compound growth in earnings

232
Assessing risk and valuing companies

required to achieve this internal rate of return (IRR). If we look down the
˜ask™ column of Figure 4.9, it can be seen that compound growth of 16.5% is
required, against a forecast growth rate of 11.25%.

On the basis of Con Glomerate example, we have assessed that although the
earnings growth of 11.25% is sufficient to justify the capital employed (10.03%
required, see Figures 4.9“4.8), the price of the share is too high. We can then
calculate what the share price would have to be if the IRR was to be achieved
based on the forecast growth. This is shown in the first column (price would
have to fall to 261.5 pence) of Figure 4.9 and the calculation itself is shown in
Figure 4.10.

To demonstrate the validity of the comment in the VCVG that ˜the derived
present value amount is often sensitive to small changes in these inputs™,
Figures 4.11 and 4.12 are identical to Figures 4.9 and 4.10, except that this
time a gross percentage of 8% is used, so that the net discount factors are based
on the rate of 7.2%.

These calculations were then repeated using the original earnings per share of
33.1 pence. The table below shows the results:


Earnings per share (pence)
33.1 pence 21.4 pence
Price of share (pence)

628.0 406.0
IRR Net 7.2%
404.5 261.5
IRR Net 11.0%


Earnings per share (pence)
33.1 pence 21.4 pence
Growth built in at 324 p per share (%)

6.0
IRR Net 7.2% (5.1)
5.7
IRR Net 11.0% 16.5


As can be seen, DCF calculations are highly dependent upon the judgements
and assumptions made. However, this is not a problem, provided the same
assumptions and judgements are made in respect of all valuations. It is for each

233
Accounting and Business Valuation Methods

reader to work out which judgements and assumptions are to be applied, taking
into account his/her risk profile, but provided they are consistently applied,
one share can be reasonably compared to another.



Industry valuation benchmarks
There are various industry benchmarks that can be used in making valua-
tions. Examples of such benchmarks might be ˜price per bed™ for nursing home
operators, ˜price per subscriber™ for cable television companies and ˜price per
square metre™ for property developers. Given a Balance Sheet will be computed
at ˜fair value™, it can be assumed that such benchmarks have been used as
appropriate.



Final Review
Before finally arriving at any valuation, the VCVG suggests that events that
might impact value should be considered. Events that would cause concern
are listed as follows:

• the performance or prospects of the Underlying Business being signifi-
cantly below the expectations on which the Investment was based;
• the Underlying Business is performing substantially and consistently
behind plan;
• the Underlying Business missed its milestones such as clinical trials,
technical developments, divisions becoming cash positive, restructuring
being completed;
• there is a deterioration in the level of budgeted performance;
• whether the Underlying Business has breached any banking covenants,
defaulted on any obligations;
• the existence of off-balance sheet items, contingent liabilities and guar-
antees;
• the existence of a major lawsuit;
• disputes over commercial matters such as intellectual property rights;
• the existence of fraud within the company;
• a change of management or strategic direction of the Underlying Business;
• whether there has been a significant adverse change either in the com-
pany™s business or in the technological, market, economic, legal or regu-
latory environment in which the business operates;

234
Assessing risk and valuing companies

• significant changes in market conditions; and
• the Underlying Business is raising money and there is evidence that the
financing will be made under conditions different from those prevailing
at the time of the previous round of financing.

These events and how they might impact share prices are discussed below
under the heading ˜profit warnings™.

Investment companies value their investments at ˜fair value™ using the VCVG
described above. What these companies are aiming to do is as stated in item
3 of the BVCA Code of Conduct; that is, they are trying to achieve long-term
capital gain rather than generating income. Accordingly, the share price of
these companies will be primarily based on its NAV per share, although other
factors are often taken into account. The case study “ HgCapital Trust plc
illustrates.


Property developers
Property companies would be valued on the basis of their NAV per share, plus
a premium to take into account the market™s view on how property prices are
appreciated. However, if the belief in the market place was that the supply
of commercial property exceeded demand and that rental income per square
metre was likely to fall, then the price of the share might fall to a discount
to its NAV. Those with specialist knowledge in the industry have a distinct
advantage compared with other potential shareholders.


Banks and utility companies
It could be argued that banks and utility companies have collectively just
about reached market saturation. To achieve high levels of profitability, these
companies rely on the apathy of their customers. For example, banks for years
have been charging exorbitant fees to customers who have inadvertently seen
their current account go overdrawn, yet it is only in 2007 that customers have
begun to complain and even fewer have moved their account to another bank.

Utility companies vastly increased their charges for gas in 2006 when wholesale
prices went through the roof, but have been very slow to reduce prices in line
with the reduction in wholesale prices in 2007. The regulatory system is very
weak; the regulator seems to be limited to advising people to switch from the
worst offenders, yet so few do.

235
Accounting and Business Valuation Methods

Such companies could hardly be described as innovative, other than finding
ways of extracting more money from customers for the same level of service.
For these reasons, investors buy shares in banks and utility companies for
income rather than growth, so they can be valued by reference to their dividend
yield and risk profile.

Given these companies are not innovative, the only real way they can increase
the earnings per share in a meaningful way is to take over another company and
save money through synergies and cost cutting. If they increase the earnings
per share, they can increase their dividend. Accordingly, where one bank takes
over another (for example), the price of its share often goes upwards. However,
a failed takeover can have the opposite effect.

In the 1980s/1990s, Lloyds Bank had been on the up by expanding through
acquisition and Lloyds/TSB plc had been formed. Acquisitions continued, but
in the early part of the twenty-first century, this strategy began to falter and
the company™s share price fell from around £10 per share to a low of around
£4 per share. This state of affairs led to the Chief Executive resigning in 2003
to be replaced by another. In March 2004, the company issued their accounts
for the year ended 31 December 2003. Earnings per share of 41.5 pence were
down 6% on the prior year, but the annual dividend of 34.2 pence per share
was maintained.

In buying such shares, investors have to make a judgement as to the likely
future trends and whether the market has got it right, or not as the case may
be. A visit to a branch of Lloyds/TSB on the day the accounts were published
suggested that money deposited with them would earn an interest at the rate
of 4%. However, the alternative, given the price of the company™s share was
445 pence on the same day, was to buy the shares and earn interest at the rate of
7.7%. It did not seem likely that a company of the size of Lloyds/TSB plc would
go under, so the only danger seemed to be that the dividend would be cut, but
with dividend cover being 1.2 and the prospect that the new Chief Executive
would take the company forward, the balance of probability suggested the risk
to be reasonable.


Insurance companies
Insurance companies can be valued using the DCF method, except a valua-
tion on this basis must be modified to take account of the risk profile of the
company. Insurance (as against assurance) can essentially be divided into two

236
Assessing risk and valuing companies

types: insuring regular and irregular events. An example of a regular event
would be motor insurance; thousands of cars will be insured and there will
be a regular stream of claims. An irregular event would be insuring against a
tsunami. There might not be a claim of several years, but when it arrives it will
be of catastrophic proportions.

It can be seen, therefore, that income streams for insurance companies can go
up and down and that investing in such companies can be considered to be
higher risk than the norm.



Biotechnology and similar scienti¬c companies
At the turn of the millennium, biotechnology companies and the like were
seen as the new high-technology companies of the future. It was believed that
the latest scientific knowledge could lead to a cure for more than one type of
cancer, with biotechnology being the answer.

Many high-risk investors put a proportion of their portfolio into such companies
that are run by well-qualified and clever people who have spent many years
as researchers. Apart from the original share capital, these companies generate
income from research grants and deals with drug companies. However, in most
cases, research costs exceed income by a large percentage and investors see
˜cash burn™ year on year.

When research leads to the development of a new drug, such drug must face
three phases of clinical trial. Phase one is done on the smallest scale, phase
two is bigger and phase three is substantial. If a drug passes all three trials,
then it can go before the regulatory authorities for approval. Once approved,
the drug can be sold to the general public.

Shares in these companies are an out and out gamble, with investors putting
their trust in the management team. The price of shares in biotechnology
companies moves up and down rapidly following announcements; a successful
clinical trial will see the price shooting up, while an unsuccessful trial followed
by the drug being abandoned will see the price crashing down.

Of course, investors are betting on a cancer drug going through all its trials
successfully and not only ending up on the chemists™ shelves, but also work-
ing. It will happen one day and one company™s shareholders will hit the
jackpot.

237
Accounting and Business Valuation Methods

Companies owning professional football clubs
Investing in football clubs, for the ordinary investor, is an expensive way to
secure a season ticket. The only possible reason to buy into quoted football
clubs is the love of the game, unless you are very lucky. With the (alleged) best
footballers being paid £120 000 plus per week, most football clubs cannot make
ends meet. Indeed, only the top four clubs in the Premiership, able to play in
the European Champions™ League, are likely to be able to make a reasonable
profit; others find it much more difficult to balance the books.
But hey, who knows? The years roll by and suddenly a wealthy American or
Russian wants to buy your club. So, in the final analysis, football shares are
for fanatics and those who like a punt on the lottery.


General industrial, leisure and retail companies
The BVCA advises that the DCF method of valuation should be used only in
conjunction with other methods, but when using it to value quoted companies,
the base valuation we have is the market price. So the purpose of the DCF
method (being more sophisticated than the ˜earnings multiple™ method) is to
assess whether the market values are valid or not. To illustrate this point, on
a day in April 2007, all house builders were evaluated using the DCF method,
based on the current spread of their share price and the latest earnings per
share available and taking the discount rate to be 11%. Companies about to be
taken over, who share price was virtually based on the agreed takeover price
per share, were ignored, as were those listed on AIM. This left six companies:


Growth-based latest achievement (%) Growth built into share price (%)

Company F 1.160 1.068
Company B 1.140 1.053
Company A 1.090 1.075
Company E 1.157 1.154
Company D 0.970 1.179
Company C 0.860 1.068



The next step in the process is to read the accounts of these companies,
taking note of what the directors are projecting for the future. In addition,
the latest announcements by the companies should be evaluated. Special

238
Assessing risk and valuing companies

attention should be given if any of the announcements relate to ˜events™ detailed
above (see also ˜profit warnings™ below). Assuming that the ˜basic checks™ have
revealed no problems and that nothing untoward has been found in either
reports or announcements, company F would be the preferred investment.



Why the market sometimes gets it painfully wrong
As we have discussed before, many investors are not rational and some can be
overtaken with greed. Two unusual events arriving simultaneously can send
the stock market orbiting the planet, the fantasyland.

In 1999, two such events happened. The first event was the ˜millennium bug™.
We were told that all computers™ operating systems would crash on 1 January
2000. The reason was that these operating systems were first developed in the
1980s when the memory available was only a fraction of what it would be
25 years later. Because of this limitation, computers had been programmed to
run from 00 to 99, rather than from 1900 to 9999. So on 1 January 2000, the
lights would go out and aeroplanes would fall from the sky.

Governments, local government and major industries simply dare not risk
falling foul of the millennium bug, so there was a mad scramble for IT con-
sultants, who could name their price. Shares in IT companies went through
the roof.

The second event was the Internet that, although in use for a few years in the
United States, suddenly hit the United Kingdom. We were told by the gurus
in the City that we were entering a new paradigm. Companies were no longer
being valued by earnings per share; indeed earnings were no longer relevant.
Also, measures such as ˜return on capital employed™ were simply old hat. No,
the new paradigm was ˜hits™ on company™s website.

Start-up companies developing websites suddenly found themselves with
unbelievable valuations. It seemed investors simply could not wait to get a
slice of the action, no matter what the price was. It got to the point that com-
panies were overvalued even based on hits, so the gurus told us that we have
moved on to valuing companies based on ˜potential hits™. The theory was that
as advertisers would pay so much per hit, it was only a matter of time before
these new high-technology companies were raking in a fortune.

So some IT specialists left safe employment to develop websites for these new
start-up companies. With investors willing to spend money as if it had gone out

239
Accounting and Business Valuation Methods

of fashion, it was a case of develop websites by day and party in style by night.
The ˜in-phrase™ became ˜cash burn™, the amount of cash being used on website
development, salaries and expenses, without any revenue being generated. But,
no worries; share prices continued to soar.

In such an environment, it is very easy to see how the rightly cautious are
sucked in. Mr Cavalier gives Mr Cautious a tip about a new high-tech issue to
hit the market the next day. The following day the share opens at 100 pence
and closes at 215 pence. The next day the share hits 300 pence, before falling
back to 250 pence. Mr Cautious cannot see suggests Mr Cavalier that there is
easy money to be made out there.

So Mr Cautious joins the bandwagon and high-tech and IT shares start trading
on P/Es well above 100. The dreaded day of 1st January 2000 arrived, but the
lights stayed on and aeroplanes landed safely. The millennium bug turned out
to be a myth, as did the dot-com boom. Sure, some of the original movers in
the United States, such as Google, have netted a fortune, but for the majority
of hopefuls it was all a mirage.

There might have been hits on websites, but advertisers were not that inter-
ested. Nobody seemed to understand that they focus their marketing budget at
target markets and unless the website owners could demonstrate that their hits
matched the target there was nothing doing. Google et al. resolved this problem
by the sheer volume of hits they achieved, but for the majority of hopefuls the
numbers simply did not add up.

Then some people started to worry about cash burn, for they could see that the
big danger was that the investment money was about to run out. The bubble
was about to burst.

Investment rule 4: If the price of a share defies every type of financial logic
imaginable and its price is being valued using a new paradigm, there is a
chance you will make a killing if your timing is spot on, but a far greater
chance is that you will not have sold before the bubble bursts.


Restructuring “ a strategy to move the share
price upwards
It is relatively rare for even a strong management team to continuously find
new growth opportunities and rather than sit on a pile of cash that is not
working for the company, some managers make the decision to either buy back

240
Assessing risk and valuing companies

their own company™s shares or instead go for a higher-profile restructuring.
The logic for this is explained in the case study “ Topps Tiles plc.


Pro¬t Warnings
It is said that a private investor will never be able to beat specialist fund
managers because they get information before the general public. Under stock
exchange rules, directors must make an announcement if they believe their
actual performance will be materially different from that expected based on
its last publicly disclosed profit forecast, estimate or projection. Such ˜profit
warnings™ are made available to everyone at the same time, and they will hit
all the dealing screens at the same time. However, many private investors will
get their information on websites such as ˜hemscott™ and ˜iii™ and these often
work on a 15-minute time delay. So the information will be available to the
professionals a few minutes before it is available to the general public.

Bad news you might think, but in reality, this situation can give a significant
advantage to the private investor. The reason for this is that because one
institution cannot be seen to respond slower than their competitors, many will
have computer systems that will immediately trigger a sale if a profit warning
hits the screens. So any profit warning will usually result in the affected share
falling between 20% and 30% instantaneously. However, what these computer
systems cannot do is to distinguish between a serious profit warning and one
that is of little consequence and is issued merely to meet compliance rules.

There are various types of profit warning and these were listed by the BVCA
as events that would likely cause concern.


Deteriorating performance
This profit warning will often include the words ˜profits will be substantially
below market expectations™. Such warnings are often like buses in that they
come in threes. The key to understanding such warnings is to look at the track
record of the management team making the announcement. Some management
teams are ultra-cautious, while others tend to play down what has gone wrong.

A well-informed, but cautious, board will quantify the problem and will usually
specify the maximum likely hit, with words such as ˜we are still investigating,
but the impact of profits will be no more than £5 million.™ In such cases,
it is possible to work out what the P/E ratio was immediately prior to the

241
Accounting and Business Valuation Methods

warning and what it was immediately after the warning, after the share price
had collapsed. In such cases, if the P/E ratio has fallen, it is likely that the
market has overdone the hit and investors are left with a buying opportunity.
The case study “ Paddy Power plc illustrates this point.

On the other hand, a warning that simply states there is a problem but makes
no assessment of the likely impact on profitability is altogether a different
matter. In such cases, the safest option would be to sell the share.


Missing milestones such as clinical trials, etc.
This usually refers to biotechnology or similar companies when a drug, on
which many hopes rest, fails a clinical trial. This will usually set the price
of the share spiralling downwards and whether it will recover or not will be
something of a gamble.


The company has breached banking covenants, defaulted on
obligations or off-balance sheet items, contingent liabilities
and guarantees are discovered
Any of the ˜events™ must be considered to be serious and staying with a company
in this situation is like doing the lottery; vast rewards are possible, but losing
the whole of the investment is more likely.


Serious legal issues, such as fraud, have come to light
Any issues such as these have to be analysed thoroughly before a decision can
be made. Such issues are very difficult to determine for the ordinary investor
and selling a share under these circumstances might be the safest option.


Key personnel suddenly resign and/or sell a signi¬cant
tranche of shares
If the reason for resignation or significant sale is detailed and believable, then if
the company is relatively large (in the FTSE 100, for example) it should be safe
to hold onto the shares. However, if the Chief Executive Officer or Finance
Director in a smaller company suddenly resigns or sells a significant tranche
of shares without warning, it can be a sign of a major problem that is yet to
surface. For example, the words, ˜Mr X today sold 75% of his entire holding to

242
Assessing risk and valuing companies

an unspecified buyer at a price that was 15% below the then prevailing market
price. Mr X said that he had to sell his shares for personal reasons™ should be
regarded with utmost suspicion.



Takeover bids
There has been much research on the topic of takeover bids and it seems
pretty conclusive. This research suggests that shareholders of the companies
being sold on the whole do a lot better than the shareholders of the company
acquiring other businesses.

Companies wishing to acquire another do so because they believe that increased
market share will enable them to compete better and that due to synergies, a
reasonable level of cost cutting will be achieved.

The main problem for the potential acquirer is that the seller will attempt to
get a high price through promoting competition. If two companies want some-
thing really badly, they tend to offer what can sometimes be regarded as an
unrealistic price that can only be justified if all the potential benefits actually
accrue.

What the acquirer often finds is that there is a cultural clash between exist-
ing and acquired employees, who see themselves as underdogs and accord-
ingly become resentful. Acquisitions require sympathetic management from
the acquiring company. Then the acquirer finds that making cost savings in
practice is usually far more difficult than making cost savings on paper. Add to
this the fact that the acquirer™s management is trying to do two jobs, their own
job together with trying to integrate the two companies, and it will be obvious
that the atmosphere can become fraught.

A venture capitalist will invest in a good management team with a reasonably
good idea, but they will not invest in a poor management team with a brilliant
idea. On the other hand, investors are looking at the same thing from the
opposite point of view. Investors look for a company operating in a good market
with growth potential whose share price has fallen because the company™s
management are not up to the job, for the simple reason that such company will
be vulnerable to a takeover bid. For example, a large private equity company
will buy a company, install its own management to turn it around and then
sell it on. The skill is trying to work out which companies the private equity
companies are likely to bid for, before they actually do it.

243
Accounting and Business Valuation Methods

Even successful takeovers take time and energy as illustrated by the case
study “ Morrison (William) Supermarkets plc.


Case study “ Amanda “ the conclusion
Over a year had elapsed since Amanda had sold her business and although
she was happy she felt there was something missing in her life “ the thrill of
being an entrepreneur. So she asked a group of students to come up with some
ideas. They came up with 48 ideas, some ingenious, some bizarre, which she
reduced to 10:
• Toilet seat heater
• Cake shop, printing own pictures on cakes
• Mixed duvet (each half has a different toggle strength)
• Machine to take pictures of individual with hair style of choice
• Digital wallpaper (changeable on demand)
• Making electricity from energy created in leisure centres
• Electronic cook book
• Restaurant where personal backdrop can be created
• Dummy controller (changes colour if germs are on dummy)
• International beer bar selling a wide variety of different beers.

She knew that she had learnt a lot from the experience of running her own com-
pany and set out, in her spare time, to research each idea. She was determined
to become a serial entrepreneur.




244
Assessing risk and valuing companies


Discussion Questions
1. If you believe it is possible to interpret published financial accounts to
gain a small advantage in the market place, what academic theory must
you believe is invalid?

2. When analysing published accounts for investment purposes, what is
the prime objective?
3. Why is buying options far riskier than buying ordinary shares?

4. If the analysis of a particular set of accounts revealed that ˜cash inflow
from operating activities™ was lower than ˜operating profit™, what would
be the next analytical steps that should be taken?

5. Why would you not value a property company using the DCF method?

6. Give four reasons why 3i Group plc™s ordinary shares usually trade at
a premium to the net asset value?

7. Sometimes markets overheat badly so that a major fall is inevitable.
What causes this phenomenon?
8. How can you distinguish between a profit warning that is potentially
disastrous from one where the company is likely to recover?

9. Why does share buybacks and share restructuring often lead to short-
term gains in the share price?

10. Assuming that the information supplied below is accurate, put the com-
panies in order of preference from a potential investment perspective, on
the basis that the IRR rate to be used for the DCF valuation method is 11%.


Price of share (pence) Earnings per Projected
share (pence) growth (%)
Ask Bid (pence)

Company A 800 798 44 12.5
Company B 500 496 31 18.0
Company C 247 244 25 6.0
Company D 350 346 20 15.0
Company E 402 400 19 20.0
Company F 260 245 9 30.0
Company G 100 99 9 10.0


245
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Case studies
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Case studies



Case Study “ HgCapital Trust plc
Private equity simply refers to investment in private and unlisted compa-
nies where the objective is to achieve capital gain. Many funds investing
in private equity are also private and unlisted. Some of these funds oper-
ate ˜closed-end funds™ normally for a fixed 10-year period, whereas most
quoted companies are open-end funds, although the objective for both
types of fund remains the same, as stated in HgCapital™s Annual Report
for 2006:

The objective is to achieve higher returns than public equity over a rolling
period of five to ten years. Investments are typically held for three to seven
years and are realised through an initial public offering, a trade sale, or a sale
to another financial institution. Interim proceeds are sometimes possible
through recapitalisations.

The essential difference between closed-end funds and open-end funds
is that the former have to be fully realised by the end of the 10-year
period. Normally such funds will have a primary investment period of
5“7 years. In the latter years of a fund™s life, the business focus will be
on divestment. This can result in slow-moving investments being sold at
less than optimum value.
The company now known as HgCapital Trust plc was formed in 1982
and the fund was initially managed by Grosvenor Venture Managers. In
February 1994, that Manager was acquired by another fund management
company that now trades as HgCapital.
It is the Manager who is choosing investments and controlling risk for the
fund, and it is the specialist employees working for the Manager who are
under pressure to perform, especially as this is exactly what the investors
want. From the opposite perspective, the fund will not be able to attract
new or repeat investors if it does not perform. Given, therefore, a strong
performance is required from every perspective, the specialist employees
working for the Manager need to be given an incentive to perform.
The incentive given for such specialist employees is called ˜carried inter-
est™, which usually takes the form of an agreement between the Manager
and the fund. A hurdle is agreed, being the effective cost of money to the
investors, after which the fund manager will take a negotiable percentage


249
Accounting and Business Valuation Methods



of any net capital gain achieved by the fund; such gain is to be dis-
tributed amongst the employees. In closed-end funds, when investments
are realised after the end of the primary investment period, any resultant
capital gains are distributed to investors. Once the hurdle on the overall
fund™s performance has been exceeded, the carried interest is distributed
to the fund manager in parallel to the distribution to investors.

Open-end funds do not always operate ˜carried interest™ incentives, but
rather charge a larger management fee, being a set percentage of the fund™s
NAV. The Manager of HgCapital Trust plc was paid such a fixed fee until
the end of 2002.

The price of a share of an investment trust investing in private equity is
strongly influenced by four factors:

• Size of market capitalisation
• Liquidity
• Proportion of the fund that is in cash
• Investors™ perception of the fund manager™s performance, relative to
their peer group.

In private equity, critical mass is important, where anything less than
£100 million is seen as being too small. Liquidity refers to supply and
demand for a particular company™s share; if there is an active market for
a company™s share, the spread will be small. If a private equity company
has too much cash as a percentage of its net assets, then it suggests that
the fund manager cannot identify sufficient viable investments. A high
proportion of cash in a portfolio has a negative impact on the likely return
and the NAV. Lastly, the NAVs of all quoted investment companies are
published and investors will obviously choose those companies with the
best track record.

With regard to quoted companies investing in private equity, 3i Group
plc, being the market leader, sets the standard for the industry. Its shares
usually trade at a substantial premium and on 31 March 2006 this pre-
mium was 27.3% (share price 940.5 pence against a NAV per share of 739
pence). However, most of their competitors™ shares trade at a discount, but
the Manager will strive to turn this into a premium. As Roger Mountford,


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Case studies



HgCapital Trust plc™s Chairman, said in his Statement in the 2006 Annual
Report:
Recognition of the Company™s success helps to build liquidity in the Com-
pany™s shares, which in turn can help to avoid the shares trading at a
discount to their net asset value. The Board believes it is in shareholders™
interests to encourage greater understanding of the private equity market
and the potential benefits to long-term investors of investing in private
equity investment trusts, such as HgCapital Trust.

In the 1990s, HgCapital Trust plc was yet to achieve critical mass, but
it was growing steadily and this growth was reflected in diminishing
discounts. Then in the early part of the new millennium, the stock market
bubble, caused by the dot-com boom, burst and with investors panicking
the discount hit a massive 34.1% in 2002, as the table below shows:


Year ended NAV (£™000) NAV per ordinary Ordinary share Discount (%)
31 December share (pence) price (pence)

1995 49,029 189.1 140.0 26.0
1996 60,313 232.6 176.0 24.3
1997 66,796 257.6 193.0 25.1
1998 66,851 257.8 208.0 19.3
1999 89,863 346.5 289.0 16.6
2000 103,521 411.0 356.5 13.3
2001 95,795 380.3 294.0 22.7
2002 83,837 332.9 219.5 34.1



At this time, in order to better align the interests of the fund manager
with the interests of the investors, an innovative scheme was agreed, as
described in the 2006 Annual Report:
Investment management and administration

A management fee of 1.5% per annum of NAV, excluding investments in
other collective investment funds is payable.

In 2003, the Board of HgCapital agreed to introduce a carried interest in
which the executives of HgCapital participate in order to provide an incen-
tive to deliver good performance. This arrangement allows for a carried
interest of 20% of the excess annual growth in average NAV over an 8%


251
Accounting and Business Valuation Methods



preferred return, based on a three year rolling average NAV, calculated
half-yearly and aggregated with any dividends declared by the Company in
respect of that financial year. The first carried interest under this arrange-
ment accrued in the year ended 31 December 2005.

Under the terms of the agreement made in 2003, this arrangement could
be terminated by giving two year™s notice and a safeguard was put in
place whereby the Manager would receive the same compensation as a
minimum under the new arrangements as under the old contract, until
April 2006.
Following the introduction of this scheme, the results have been as
follows:


Year ended NAV (£™000) NAV per ordinary Ordinary share Discount (%)
31 December share (pence) price (pence)

2003 99,987 397.0 289.5 27.1
2004 122,040 484.5 451.5 6.8
2005 156,487 621.3 583.5 6.1
2006 187,135 743.0 731.0 1.6



By 2005, the company had grown and made constant progress to allow it
to be included in the FTSE 250 index. As can be seen from the above, as
investors™ confidence improves, the discount is dissolved away. Starting
at 2002, a 34.1% discount had practically disappeared by the end of
2006 and by April 2007 the shares were trading at a 15% premium. This
premium reflects critical mass, improved liquidity and the perception that
the Manager has performed well to date and offers good prospects for
continuing to do so, when compared to its peer group.
The 2006 annual accounts showed a revenue return of 17.94 pence per
ordinary share and with the 5-year growth rate of 22.23%, the price of
the share would have to fall to 348 pence, to meet the 11% discount
rate. Alternatively, on an income basis, the growth built into the price
of the share at the end of April 2007 was calculated to be 42.61%.
Of course, all this proves is that shares in investment trusts are not valued
on their income potential, but rather on their ability to generate growth
in NAVs.


252
Income Statement of HgCapital Trust plc



Revenue Capital Total Revenue Capital Total

Year ended 31 December 2006 31 December 2005
£™000 £™000 £™000 £™000 £™000 £™000

Gain on investment and government securities 34,919 34,919 37,706 37,706

(4,737) (4,737) (2,976) (2,976)
Carried interest
Income 7,769 7,769 4,963 4,963
Investment Management Fee (730) (2,191) (2,921) (587) (1,761) (2,348)
Other Expenses (636) (636) (498) (498)

Return on ordinary activities before taxation 6,403 27,991 34,394 3,878 32,969 36,847


Tax on ordinary activities (1,884) 657 (1,227) (913) (385)
528

4,519 28,648 33,167 2,965 36,462
33,497
Transfer to reserves

Return per ordinary share (pence) 17.94 113.74 131.68 11.77 132.99 144.76




Case studies
253
Accounting and Business Valuation Methods
254




Balance Sheet

Year ended 31 Dec 06 31 Dec 05
£™000 £™000
Fixed assets at fair value
Quoted at market valuation 18,736
14,255
Unquoted at Directors™ valuation 109,504
134,287
Fixed Assets 128,240
148,542

Current assets
Debtors 6,609
10,005
24,515
34,284
Government securities
Cash 867
2,268

Current Assets 31,991
46,557

Creditors 3,744
7,964

Net current assets 38,593 28,247


Net Assets 187,135 156,487

Net asset value per ordinary share (pence) 743.0 621.3

Reproduced by kind permission of HgCapital Trust plc
Case studies




Cash Flow Statement of HgCapital Trust plc



Total Total

31 Dec 06 31 Dec 05
Year ended
£™000 £™000

Total return before taxation 34,394 36,847

Gains on investments held at fair value (34,919) (37,706)
Movement on carried interest 1,761 2,976
(Increase)/decrease in accrued income (3,613) 77
Increase in debtors (20) 0
Increase/(decrease) in creditors 385 (250)
Tax on investment income included within gross income (261) (402)

Net cash inflow/(outflow) from operating activities (2,273) 1,542

Taxation recovered 2,666 352




Capital expenditure and financial investment
Purchase of fixed asset investments (45,266) (35,376)
Proceeds from the sale of fixed asset investments 59,805 48,831

Net cash inflow from capital expenditure and 14,539 13,455
financial investment

Equity dividends paid (2,519) (2,015)

Net cash inflow before management of liquid resources 12,413 13,334

Management of liquid resources
Purchase of government securities (111,342) (50,890)
37,246
Sale/redemption of government securities 100,334

(13,644)
Net cash outflow from management of liquid resources (11,008)


Increase/(decrease) in cash in the period 1,405 (310)
(4) (3)
Exchange movements
Net funds at 1 January 867 1,180

Net funds at 31 December 2,268 867

Reproduced by kind permission of HgCapital Trust plc




255
Accounting and Business Valuation Methods




Case Study “ Topps Tiles plc “ Restructuring
Topps Tiles is the biggest tile and wood-flooring specialist in the United
Kingdom. On 30 September 2006, it had 271 stores throughout the coun-
try, with the objective over time of increasing this to 400 stores.
The company, renowned for sponsoring weather forecasts, was floated in
1997. Since flotation, the company has seen its earnings per share achieve
average annual compound growth of over 35%, a significant achievement
even for a company with a dominant market position. Such growth has
been delivered with a four cornerstone strategy of store locations, store
layout, stock availability and customer service.
In the early years, growth was phenomenal. The company™s shares took
off in 2003 and in an 18-month period they went from 50 pence to close
to 300 pence by the end of 2004. However, the reality for any company is
that as it gets bigger, growth gets harder and by the spring of 2005 it was
apparent that growth was slowing. The company™s share price reflected
this concern and fell back to 170 pence.
The 2005 accounts confirmed slowing growth, as in that year earnings per
share had only grown by 17.7%, a commendable figure in most situations,
but well behind the historical average. Now, a major problem for a market
leader such as this company is that it can generate cash faster than it
needs to spend it.
Many companies find themselves in this position and come up with the
solution of buying back their own shares, something they need shareholder
approval to do. As they buy their own shares and cancel them, the num-
ber of shares issued decreases and assuming earnings stay flat the earnings
per share must increase. Assuming the P/E ratio for a particular company
is maintained, the the share price increases by the earnings multiple. This
way, the share price continues to grow, even when earnings fail to do so.
On the front page, Topps Tiles™ 2006 accounts show a face, with the words
˜think big™ inside and in 2006 this is exactly what the management did.
Rather than a timid share buyback, they opted for a complete restructur-
ing. Shareholders were given three ordinary shares of 3.33 pence each
for every four existing ordinary shares of 2.5 pence each. In addition,
shareholders were given one redeemable B share of 54 pence or one


256
Case studies



irredeemable C share of 0.1 pence for every existing ordinary share held.
C shares were to be compulsorily purchased by the company for 54 pence
each by 31 March 2007.
Shareholders received a total of £122.4 million for their B and C shares,
and the company was rewarded by seeing its share price climb back to
around 300 pence. However, the Balance Sheet moved from a position
of being relatively strong to that of being relatively weak with negative
equity of £62.296 million at 30 September 2006. However, such weakness
is not likely to be a problem, given the company is highly cash generative,
whereas other types of business may not survive going so highly geared.




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Accounting and Business Valuation Methods


Consolidated Balance Sheet of Topps Tiles plc



As at 30 September 2006 2005 2004

Non-current assets
Goodwill 551 551 551
Tangible assets 36,857 32,072 29,236
Joint venture undertaking 281 225 193
Trade and other receivables 115 110
37,689 32,963 30,090

Current assets
Inventories 27,031 25,338 24,373
Trade and other receivables within one year 5,528 4,071 3,809
Cash and cash equivalents 16,533 27,829 29,624
49,092 57,238 57,806

Total assets 86,781 90,201 87,896




Current liabilities
Trade and other payables 25,837 23,138 18,758
Bank loans 4,900
Current tax liabilities 7,507 3,640 3,942
9,719
38,244 26,778 32,419

Non-current liabilities
Bank loans 110,600 6,000
Other payables 3,394 7,571
Deferred tax liabilities 1,233 1,799 844
111,833 11,193 8,415

Total liabilities 150,077 37,971 40,834


Net assets/(liabilities) (63,296) 52,230 47,062


Equity
Share capital 5,773 5,655 5,673
Share premium 531 5,575 4,889
Merger reserve (399) (399) (399)
Share based payment reserve 166 100 35
Treasury shares (733)
Capital redemption reserve 20,254 190 137
Retained earnings (89,621) 41,109 37,460
(63,296) 52,230 47,062

Net (Debt)/Funds (98,967) 21,829 29,624



Reproduced by kind permission of Topps Tiles plc



258
Case studies




Case study “ Paddy Power plc “ What
˜pro¬ts™ warning™?
A prerequisite for successfully investing in stocks and shares is knowledge
of the particular industry, which is the subject of the proposed investment.
In addition to understanding the players in a particular industry, so that
comparisons can be made, it is important to research industries; so when
a set of published accounts is being reviewed, the reviewer knows what
to expect. For example, a food retailer might have about two days™ stock, a
chemical manufacturer might have forty days™ stock, while a house builder
(counting the land purchased as stock, as the idea is to build houses on
the land and sell them) might have four hundred days™ stock.

Bookmaking is all about expertly analysing events so that the true prob-
abilities (a horse winning a particular race, a particular football match
ending in a draw, etc.) can be assessed. The starting point in the process
of setting odds is to establish what they would be if there were no inbuilt
margin. This is known as the 100% book, and an example of this is shown
below.

Suppose in a four-horse race, bookmakers assess the true probability of
each horse winning, as 0.40, 0.32, 0.20 and 0.08, then the ˜true™ odds (one
leaving them with no margin) will be:



Horse Probability Odds

A 0.40 6/4
B 0.32 85/40
C 0.20 4/1
D 0.08 11/1
1.00



The next step it to adjust the ˜true™ odds to bring in a margin in their favour.
If we imagine that bookmakers operated in an uncompetitive environment
(which they do not) and they wanted to achieve a theoretical margin of
around 11%, then the revised odds would be as below:


259
Accounting and Business Valuation Methods




Horse Probability ˜True™ odds Revised odds Revised probability

A 0.40 6/4 6/5 0.450
B 0.32 85/40 7/4 0.360
C 0.20 4/1 7/2 0.225
D 0.08 11/1 10/1 0.090
1.125



In this example, bookmakers would expect to pay out for every
E1000
E1125 taken, giving them a theoretical margin of 11.1%.

The reality is, however, that bookmakers operate in a very competitive
market and they have to frame their odds to attract turnover. Horses with
the best form and ridden by top jockeys will be assessed by both book-
maker and punter alike as to being the ones most likely to win. Accord-
ingly, punters tend to back favourites; it is estimated that, on average,
60% of punters™ money will be on the favourite, while 90% of their money
will be confined to the first three in the betting.
Therefore, to attract turnover, bookmakers will take a lower margin on the
favourites and will compensate by taking a higher margin on the outsiders.
Therefore, the odds might come out, as below:



Horse Probability ˜True™ odds ˜Actual™ odds Revised probability

A 0.40 6/4 11/8 0.421
B 0.32 85/40 15/8 0.348
C 0.20 4/1 100/30 0.231
D 0.08 11/1 7/1 0.125
1.125



From the time the odds are first framed, it is all about controlling the
˜book™ using risk management techniques, but these techniques have a
cost. Once betting has started, market forces will dictate in which direction
the odds for each horse should go. The odds for heavily backed horses
will contract, while those virtually ignored in the market will see their

260
Case studies



odds pushed out. The end result is that while in the long term there
is a relationship between turnover and gross margin, the expected gross
margin percentage will be substantially lower than the theoretical margin
percentage as calculated above.
Paddy Power is a well-known innovator in the art of offering concessions
to punters with a view to maximising turnover and managing risk. For
example, the concession might be:
If you back a horse and it is beaten by a short-head we will refund your
stake.

This concession will have the effect of increasing the turnover, but reduc-
ing the margin, but the mathematical model will assess the likely outcome.
The Cheltenham National Hunt Festival in March is the highlight of the
jumping season and is well attended by Irish horses and Irish punters;
betting turnover is immense. Irish trained horses often win a significant
number of races at this meeting and when an Irish favourite wins, there
can be a large hole in bookmakers™ pockets, especially those operating in
Ireland. So Paddy Power might offer the concession:
If you back an English trained horse and it finishes second to the Irish
trained favourite, we will refund your stakes.

This concession would reduce the overexposure on a particular horse
thereby improving the risk profile on the race, at the expense of margin.
A really good example of risk management was the concession offered by
the company for the 2007 Derby.
On 28 September 1996, Frankie Dettori, the Italian jockey, had made
history by winning all seven races at the Ascot festival. Ever since then
the jockey has been the public™s favourite, so much so that due to heavy
demand his horses usually go off at a price shorter that their form (their fin-
ishing position in previous races, taking into account the class of the race
and weight carried) indicates they should. But by the end of May 2007,
the jockey had never won the Derby in 14 attempts, despite having won
every other classic twice. In 2007, Dettori™s employer, Sheikh Mohammed,
had released him to enable him ride the Derby favourite ˜Authorized™. At
the ˜Breakfast with the Stars™ event, organised by Epsom racecourse just
over a week before the Derby, this horse™s trainer, P.W. Chapple-Hyam,


261
Accounting and Business Valuation Methods



categorically stated that his horse would win the Derby and that he would
settle for a short head victory. So with the best horse in the race being
ridden by the jockey most of the general public wanted to win, in the last
week before the event the win odds for ˜Authorized™ was around ˜evens™.
If there was one thing that could stop Frankie Dettori from winning his
first Derby it was the might of the famous Irish trainer, Aidan O™Brien, who
had no less than eight out of the eighteen runners. But even in Ireland,
the sentiment was with the Italian jockey; so all bookmakers, including
Paddy Power, had massive liabilities if he won. To alleviate this risk,
the company came up with an ingenious concession to try to bring more
balance to their book so that any punter who wanted to back a horse other
than ˜Authorized™ might have their bet with Paddy Power:

If you back a horse that beats Authorized but fails to win the Derby we will
refund your losing stakes.

Authorized won by five lengths.
One way bookmakers increase their overall margin is by encouraging
multiple bets. A multiple bet is one where a number of horses are backed
in different combinations. For example, a popular bet is a ˜Lucky 15™ that
consists of selecting four horses and having fifteen bets, being four singles,
six doubles, four trebles and one four-fold accumulator. Now if the net
margin against the punter in any particular race or series of races was
1.04 per race, the margin on the double, treble and accumulator would be
1.08, 1.12 and 1.17, respectively. Therefore, bookmakers like to encourage
multiple bets and accordingly might offer the following concession:

If you do a Lucky 15 and have only one winner, we will pay you double the
odds of that winner for your singles bet, subject to a maximum stake of E50
per bet.

Diversification also helps to maximise turnover and reduce volatility and
given that there is a relationship between this and gross profit, in the long
term increased turnover will lead to increased profits.
Paddy Power™s strategy to increase turnover proved very effective between
2000 and 2002 as it increased by over 35% compound in that period.
Anyone reviewing their accounts for the year ended 31st December 2002
would see what could be described as an exemplary set of figures, with


262
Case studies



earnings per share of E0.29, return on capital employed of 40.9%, return
on equity of 36.8% and a net cash mountain of E36 million. As shares
go, this is just about as risk-free as it gets. But published accounts are
not just about reading figures as they contain much information written
by the directors with a view to enabling shareholders to understand the
business.
In particular, Paddy Power™s Chairman frequently points out the vari-
ability of bookmakers™/punters™ fortunes. He often writes stating that the
company operates on the basis that the expected gross margin is x%, with
a minimum of x’% and a maximum of x+%. Over time, the company™s
gross margin is expected to settle down at x%, but in the short term it
could be anywhere between x’% and x+%.
So having read the 2002 published accounts, shareholders should have
felt comfortable. Then on 16th April 2003, Paddy Power plc issued a
˜profit™ warning. The company stated that their recent gross margins had
been impacted by racing results favouring punters. In particular, they had
had a disastrous Cheltenham Festival meeting where a record number of
favourites had won. On top of this, a strongly fancied horse had won the
Grand National at Liverpool and the combination of these results had left
a E4 million hole in the company™s bank balance.
They went on to say that they did not expect such extraordinary results
would continue and that they forecast their overall gross margin percent-
age would recover, so that for the year as a whole it would be within
their expected range, although it was likely to be at the bottom end of
this range. However, they were expanding by bringing more betting shops
on stream in both Ireland and the UK and were also growing in the field
of telephone and computerised betting. Accordingly the Board remained
confident that their long-term prospects were undiminished.
Now, but for stock exchange compliance rules which insist upon share-
holders being advised of the exact position, this ˜profit warning™ could
have been shortened to:
We have had a bad Cheltenham and Grand National that has cost us E4
million, but don™t worry, we did have E36 million in the bank and with our
turnover ever increasing, we will soon get it back.


263
Accounting and Business Valuation Methods



But did the ˜market™ understand this? Not on your life; immediate panic
set in and the price of the share fell nearly 20% from close to E6 per share
to less than E5 per share, providing an unbelievable buying opportunity.
The share soon recovered to get above E14 per share, but by Easter 2005
it had fallen back a bit to E13 per share. However, price falls in this share
often appear to be unjustified and by the end of the 2006/2007 tax year,
it was above E20 per share.
Sooner or later, punters will have a good run, thereby taking a slice out
of the company™s profits. If the share price collapses as a result, it would
be a reasonable bet to think it would soon recover again, even if there are
no certainties when it comes to gambling.




264
Accounting Statements of Paddy Power plc



31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03 31 Dec 02 31 Dec 01 31 Dec 00
Year ended
‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000

Turnover 1,795,090 1,371,710 1,165,165 913,624 673,788 461,075 362,825

Cost of sales (see script chapter 3) 1,611,474 1,236,140 1,041,960 825,429 599,581 404,624 316,511

Gross profit 183,616 135,570 123,205 88,195 74,207 56,451 46,314


Distribution and Administration 138,154 105,452 92,071 68,563 57,124 47,944 35,685

Operating profit/(loss) before amortisation 45,462 30,118 31,134 19,632 17,083 8,507 10,629

Goodwill/amortisation/impairment/exceptional (2,098)

Operating profit/(loss) 47,560 30,118 31,134 19,632 17,083 8,507 10,629
Interest payable/(receivable) (2,139) (1,226) (1,006) (778) (739) (585) (321)
Tax on profits 8,454 4,390 4,662 2,859 3,029 1,763 2,937

Earnings 41,245 26,954 27,478 17,551 14,793 7,329 8,013
Dividends 16,500 10,300 9,340 6,160 4,809 2,404 1,756

Retained profit/(loss) for the year 24,745 16,654 18,138 11,391 9,984 4,925 6,257

Number of ordinary shares (™000) 51,238 50,397 50,590 50,117 51,000 50,922 47,510




Case studies
265
Accounting and Business Valuation Methods
266



31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03 31 Dec 02 31 Dec 01 31 Dec 00
Year ended
‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000 ‚¬™000

Intangible assets 11,140 5,495 1,759 904 1,025 1,146 1,267
Tangible Assets + other long term assets 76,435 72,567 60,651 41,571 24,994 22,749 21,336
Fixed Assets 87,575 78,062 62,410 42,475 26,019 23,895 22,603

Stock
Trade Debtors 4,203 2,134 2,290 2,188 1,570 1,110 671
Other debtors/current assets
Cash at bank 87,061 52,318 47,206 39,173 36,373 18,307 16,054
Total Current Assets 91,264 54,452 49,496 41,361 37,943 19,417 16,725

Trade creditors 6,261 5,594 4,570 3,670 2,190 1,765 1,141
Other creditors 56,112 36,502 34,671 26,494 19,715 8,777 12,099
Bank Overdraft and Loans 421 254 213
Total Current Liabilities 62,373 42,096 39,241 30,585 22,159 10,755 13,240

Net Current Assets/(Liabilities) 28,891 12,356 10,255 10,776 15,784 8,662 3,485

Total Assets less Current Liabilities 116,466 90,418 72,665 53,251 41,803 32,557 26,088

Other long term liabilities (creditors) 0 843 876 977 1,177 1,031
Long term debt 480 793

Net Assets 116,466 89,575 71,789 52,274 40,146 30,733 26,088

Share capital 5,124 5,040 5,005 4,781 4,714 4,714 4,714
Share premium account 10,163 7,548 6,680 3,975 3,305 3,305 3,585
Other capital reserves (1,601) (787) (1,384) 922 922 922 922
Profit and Loss Account 102,780 77,774 61,488 42,596 31,205 21,792 16,867
Other revenue reserves
Equity shareholders™ funds 116,466 89,575 71,789 52,274 40,146 30,733 26,088

Net (Debt)/Funds 87,061 52,318 47,206 38,752 35,639 17,301 16,054

Paddy Power plc currently publish their accounts using IFRS. The accounts reproduced above retain the old
Note:
format so one year can be compared to the next. Where no dividends are shown in the published accounts
(IFRS), their cost has been taken from ˜notes™ in the accounts.

Reproduced by kind permission of Paddy Power plc
Case studies



Case study “ Morrison (William) Supermarkets plc
With regard to food retailing in the United Kingdom, Marks and Spencer
and Waitrose pitch themselves at the quality end of the market, while
Wal-Mart and Tesco™s strategy is to pile it high and sell it cheap. Other
companies in this market, such as Morrison, Sainsbury and Safeway, take
the middle ground.
As is often the case, it is those who face the greatest difficulties that take
the middle ground, as they do not offer either the best quality or the lowest
prices. In this middle ground, it is the survival of the fittest and of the
three middle ground companies; there was no doubt that Morrison was
faring the best in the early part of the millennium as it was getting the
right mix in terms of quality and price for their market, being mainly in
the north of the country. At this time, Sainsbury was losing market share
and Safeway was struggling to maintain an identity that differentiated
itself in the market place.
In the four years from 1999 to 2002, Morrison had steadily grown, with
both turnover and operating profit increasing over 12.5% compound in
that time. Turnover had increased from £2970 million to £4290 million,
while Operating profit had increased from £183 million to £270 million
in the same period.
However, by the end of 2002, it was difficult to see where further organic
growth was coming from as the company was becoming increasingly
frustrated by tight planning controls that made it extremely difficult to
find new sites. So, Sir Ken Morrison, Chairman of Morrison™s, came
up with an audacious plan; he made a takeover bid for Safeway, the
fourth largest food retailer in the United Kingdom, a company larger than
his own.
The bid in January 2003 was an all share offer, which, based on the value
of each company share price at the time, represented a fair premium
for Safeway™s shareholders. However, the market was not happy as there
was a great deal of concern that the management of the smaller Morrison
would not be able to integrate the larger Safeway, so on the day following
the bid, Morrison™s share price went down 20 pence to 190 pence and
Safeway™s shares shot up 54 pence to 267 pence, helped by rumours that
Wal-Mart and Sainsbury would make a counter bid. This see-saw in share


267
Accounting and Business Valuation Methods



price meant that by the third week of January, Morrison™s offer did not

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