Raisings can lower returns ::

Author: Bina Brown
Date: 23/09/2006
Publication: The Australian
Section: Finance
Page: 040

BUYER BEWARE

THE stock exchange is a well-known vehicle for capital raising but shareholders who are continually being asked to put hand in pocket might need to start asking questions. Depending on when the shares were bought, many people might not be getting the rate of return they first thought.

Raising capital might be boosting the profit of the company. It might also ensure the company is included in one of the indices (an important factor in attracting index-hugging fund managers) but if the profitability of a company doesn't follow then the share price could easily fall in a heap. Capital raising also dilutes the shareholding of those who don't participate and can also reduce the internal rate of return for existing shareholders.

Just because a company's earnings are rising and its balance sheet ratios are adequate doesn't mean its shares are worth buying at any price.

According to Roger Montgomery, the chairman of asset management company Clime Capital, at least 10 per cent of Australia's largest companies have adopted what he calls the ``rocking chair principle'' -- they have grown earnings simply by raising more capital from shareholders.

Some have adopted the principle to such a degree that the internal rate of return to shareholders over five years is less than they could have got in the bank, without the risk.

Company earnings growth may be impressive but, as Montgomery says, if you give a company more money this is nothing remarkable. When a company raises money from shareholders via a placement, a share purchase plan or a dividend reinvestment plan, or it retains profits, investors shouldn't be too impressed by rising earnings.

"A person in a rocking chair would earn more interest by injecting an extra billion into their bank account," says Montgomery.

He uses the example of a childcare company, whose reported earnings have grown an average 86 per cent a year since 2002. Subsequently the shares have jumped from $2.39 to a high of about $8.35. More recently they have traded around $5.90.

Throughout the past four years the company has asked shareholders for about $1.6 billion, including a recent $600 million at $7.50 a share from institutions.

Consequently, the annual rate of return has gone from about 50 per cent in 2002 to about 11 per cent in 2006. Dividends might have been paid but that money has gone straight back to the business and investors have paid tax on the dividends.

So at what price do the shares represent value? If you have $1 of equity earning, say, 10 per cent and you want a 20 per cent return on your money, the right price to pay is a discount to the $1 of equity.

Using the previous example, assume a continuation of the current 11.6 per cent return on equity -- which seems optimistic -- and a required return of 14 per cent. Taking the equity per share of $3.97 (as it was in April this year) the only sensible price to pay for this business is a discount to the equity per share of $3.97.

Clime does its own valuation modelling which indicates the shares are worth $2.95 for every $3.97 of equity.

If around that level represents value, a share price for this company hovering around the $8.00 level is way out of whack.

Clime estimates the return on equity would have to rise to a sustainable 21.5 per cent to have justified the price of $8.00. Hence, he says, the subsequent fall to around $6.00 -- even now it may not be bargain.

Remember, this company isn't the only one trading above its probable valuation. For investors without access to a formal valuation model, Montgomery advocates the "business owner" approach to investing which is based on the work of financial gurus and renowned value investors Benjamin Graham and Warren Buffett.

"If you owned the business outright, it would be all injections at this stage. You own a business producing an 11 per cent return on your money provided you continue working really hard. As an owner, the right question would be: if my return is going to continue at 11 per cent, is that satisfactory now that I have injected almost $2 billion?"

While there may be nothing inherently wrong with the business, can the price be justified on present performance? It's just as important to avoid companies whose shares are well above their value as it is to buy shares in those with sound economics, good management and trading at a rational price. binab@mediamatters.com.au

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