Not so fast. Crunching numbers in a range of valuation exercises for both KCom and Ulster-based radio and TV stations operator UTV Media (UTV) produced disappointing results. That means their shares won't be going into the income fund at anywhere around current prices. Even so, all that spread-sheeting helps illustrate some generic issues at work in the process of valuing shares, so there are points to be made.
Let's focus on KCom. True, its free cash has been comfortably more than the cost of dividends. Or, at least, it has been since the dividend was cut 46 per cent in 2009-10. But there is an important underlying reason for that, which also raises questions about value within the shares. The reason is simple enough - KCom has hacked back its capital spending to the extent that, in the two years to end-March 2011, 'capex' was only half the depreciation charged each year. Clearly, the less it spends on capital account, the greater the chance its free cash will exceed dividend costs. But, by cutting capital spending, KCom's bosses risk undermining the company's ability to create value. That's because capital spending has two functions. The first is to renew a company's equipment, so maximising its chances of maintaining existing revenues. The second is to expand a company's activities, helping it generate additional revenues - and hence additional value.
Separating maintenance capital spending from the expansionary variety is largely guesswork. The easiest way is to define expansionary capex as the amount by which total capital spending each year exceeds the depreciation charge (and that's logical in so far as depreciation is just a smoothed version of past capital spending). And, at KCom, in only one year of the past five - 2011-12 - has capital spending exceeded depreciation. In other words, only once has it done any of the expansionary capex that, theoretically at least, adds value.
Quantifying how expansionary capital spending adds value also owes much to guesswork. Even so, Bearbull puts it into a formula derived from the constant-rate dividend discount model. The first step is to capitalise this expansionary capex, of which KCom does so little, using a company's return on incremental investment as the discount rate. Then - and this is the tricky bit - build in factors that allow for the rate at which this capex will grow and the rate at which its excess returns fade to a bog-standard return on equity.
Obviously there are many assumptions swanning round, so the resultant 'valuation' needs treating with caution. And that's a cue for me to say that all valuation exercises only ever generate approximate figures, the usefulness of which is to test whether a share price might be cheap or dear; they can do no more. Still, the underlying logic of this exercise is clear enough. First, find a value for the average free cash flow that a company looks capable of generating. That's easy enough - capitalise average free cash flow per share for the past five years at the required rate of return. Second, value the expansionary capex, as outlined above. Add the two together and we have a 'value' for the shares; or, more likely, a range of values that varies with changes in the assumptions.
For KCom, it's tough to find good value relative to its 82p share price. Whether I do a similar exercise that draws its per-share data from the p&l account or focus on free cash flow, I get similar valuation figures - around 60p to 70p a share. Then the company seems to generate next to nothing in the way of additional value. That's because its expansionary capital spending has been so pitifully low - it has averaged just 0.1p per share over the past five years - and because its return on equity (RoE) looks so poor. True, I should explain why the RoE looks miserable; it's a key metric that I use as the proxy for the return on incremental investment. The trouble is, the explanation would take a column in itself. Suffice to say it's because accounting rules make such a mess of the book value of shareholders' funds.
| Where's the value? | |||
| Value | KCom | UTV Media | |
| Share price | (p) | 82 | 150 |
| Dividend yield | (%) | 5.4 | 5.1 |
| Implied growth rate* | (% pa) | 3.1 | 3.4 |
| Average free cash flow | (p/share) | 6.0 | 12.5† |
| Value | (p) | 71 | 147 |
| Incremental capital spending | (p/share) | 0.1 | 0.5 |
| Value | (p) | 0 | 6 |
| *Assuming 8.5% target return †Most recent year |
Anyway, neither for KCom nor for UTV Media is there much capital spending for growth, nor a sufficiently high RoE to create much value. True, I could keep it simple and focus on the dividend yield that shares in these two offer (see table). With that in the bag, it would need little long-term growth in dividends for a constant-rate dividend discount model to tell me the shares are cheap.
If I was desperate, I could use that logic to justify a purchase. But I'm not. Besides, I reckon that a valuation based on average free cash flows trumps one based on dividends that may or may not be paid. Back to the number crunching.
