Comment & Analysis

Friday May 30, 02:45 PM
What Not To Buy: Paying Ten Times Sales Is A Gamble

By Alun Morris

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Let's say you have a successful small business -- a shop or plumbing service, but it's time to move on. What is your business worth?

The hard assets (an old van and tools, a shop lease and fittings) are probably only worth £10,000.

It's the business name, location and reputation that have value. This is goodwill. You could use last year's profit, projected profit or maybe average profit to value the whole business, but there's another way.

Accountants need some excitement a few times a year and in a daring leap they will get out a rule of thumb from the naughty cupboard. They will quickly estimate goodwill to be between 0.8 and 1.2 times annual sales.

So, if your Dead Centre business sold £150,000 of funerals last year, your business is worth (on a balance sheet at least) £10,000 (tangible assets) plus £180,000 of goodwill. (A recession-proof business deserves a premium rating). That's a total of £190,000.

If you sold the business for this, it would have a price-to-sales ratio (PSR) of 1.27. For comparison the PSR of the whole FTSE 100 is higher, at 2.68. This is justified by the companies having substantial fixed assets, intellectual property or good growth.

So in my search for the next addition to my What Not To Buy portfolio, I ran a filter to find shares with the highest PSR. To eliminate blue sky companies that have very small revenue and no profits and also shares that have good future earnings, I required that the price-earnings ratio (PE) and prospective PEs be consistently above 15. The filter was:

PSR >10 Historic PE >15 Forward PE >15 Forward+1 (year after) PE >15

I got twelve hits. After eliminating resource and property companies, where current sales are no guide to value, six remained:

Name

PSR

Forward PSR

Forward PE

Forward+1 PE

Price

Autonomy Corporation [LSE:AU.]

10.6

7.6

54.7

30.2

25.3

854p

IG Group Holdings [LSE:IGG]

10.6

7.2

19.8

16.5

390 p

YouGov (LSE: YOU.L - news) [LSE:YOU]

11.6

4.1

28.6

21.3

17.5

172p

DataCash Group [LSE:DATA]

9.9

30.8

27.1

21.1

279p

Playtech (LSE: PTEC.L - news) [LSE:PTEC]

22.1

12.5

33.1

16.4

543p

Radicle Projects [LSE:RDP]

304

4.2

9.6

24.9

7.3

64.5p

Figures from digitallook, with corrections

Forward PSR is a better guide to value than historic PSR for rapid growth shares. I could not filter for forward PSR but have added it to the table. Playtech, a developer of software for online poker, casino and conventional gaming operators, is the clear winner. Its forecast revenue of £94m gives it a 2008 PSR of 12.5, at share price of 543p.

I had not heard of it but Playtech is the second largest company on AIM. By capitalisation (£1176m) it's bigger than easyjet [LSE:EZJ], Currys and PC World owner DSG International (LSE: DSGI.L - news) [LSE:DSGI] or Premier Foods (LSE: PFD.L - news) [LSE:PFD].

Playtech's forward PE of 19 is also quite high. One reason the PSR is so high is Playtech's exceptional forecast operating margin of 68% of sales. This makes its profits robust compared to sales but also makes it vulnerable to competition. There is no technical difficulty in developing an online poker or roulette system.

Playtech's high PSR means future success is in the price and any disappointment will hammer the shares, so it's my May What Not To Buy pick.

Here's the WNTB table to date. Cost is the best quote from an online broker.

Buy date

Company (CPNY3.SA - news)

Cost p

Now p

Gain/ (Loss) %

March

Griffin Group (LSE: GFF.L - news) (LSE:GFF)

2.5

(60)

April