Today is Cup Day.
It’s a public holiday here in Victoria…and it’s bordering on that in most of the other states. I lived in Sydney through many Melbourne Cup days, and by the afternoon the pubs were full and offices all but empty.
Not exactly productivity enhancing behaviour. But that’s alright — we’ve backed China’s economy and property to bring us prosperity. In a sprint, that’s not a bad bet. In a staying race, it’s a 100-1 shot. In case you didn’t know, the Melbourne Cup is a staying race.
Anyway, today’s Daily Reckoning comes to you in the spirit of having a punt. First up, there’s some brief analysis of the Medibank Private float. I sent it to subscribers of Sound Money. Sound Investments. last week. It mainly focusses on whether the offer is good value or not.
In short, the company looks like a good one. But the pricing is outrageous. Punters don’t even know what price they will end up paying if they apply for shares. If you want to have a punt on stag profits, understand that is exactly what it is…a punt.
The second article today is from an old mate of mine, Jason McIntosh. I’ve been working with him for the past six months on a new project. You’ll hear about it shortly. In his essay below, Jason recounts what it was like the first time he stepped onto a trading floor fresh out of uni.
For some, the trading floor of a global investment bank is a punters’ paradise. But Jason discovered a different set of traders who weren’t manic punters. They crunched the numbers and made sure the odds were on their side.
They weren’t punters…they were the house.
Read on below for Jason’s story.
But first, the Medibank float. As you probably know, Australian retail investors have up until 14 November to apply for shares. The stock lists on the ASX on Tuesday, 25 November.
The indicative price range for the shares has been set at $1.55 to $2.00 per share.
At the indicative price range, the market capitalisation of Medibank would be $4.26–$5.508 billion, which places it among the top 100 companies on the ASX.
The business is a decent one. Based on forecasts for 2015, Medibank will generate a return on equity (ROE) of 18.5%. This is only just below the 19.5% ROE forecast for competitor NIB Holdings.
The problem here is the price. I am recommending you do not take part in the Medibank Private offer on the basis of the asking price.
Let me explain…
First, when you apply for the shares, you don’t know what you’ll actually pay. The stock may cost you $1.55 per share or it may cost $2. Based on the interest in the offer, my guess is that the company will come onto the market closer to $2.
At this price range and based on earnings projections for the 2015 financial year ($258.2 million), Medibank will trade on a price-to-earnings multiple of between 16.5 and 21.3 times. That’s quite high for a mature company operating in a competitive marketplace.
The price to book (P/B) value will be between 3.06 and 3.95 times, which is also high. To see why this is the case, take a look at this calculation based on a rough rule of thumb that I use:
The P/B tells you what multiple the market puts on a company’s shareholder equity. As a general rule, the higher a company’s ROE, the higher the P/B should be.
To obtain a rough guide of the return the business will generate for you given the price you will pay, divide the ROE by the P/B.
In this case, it’s:
18.4% divided by 3.06 = 6.01%
18.4% divided by 3.95 = 4.66%
In other words, given the earnings forecasts, the business owner will generate between 4.66% and 6.01% annually, depending on the final price paid.
This is a rough guide only, as it doesn’t take into account reinvested earnings and balance sheet growth, but it’s still a decent indication that the sellers are taking advantage of an expensive market to sell into.
They’re getting a good price…the buyers not so much.
Needless to say, I think those numbers represent a poor risk/reward trade off. It’s important to note also that Medibank generates more than 20% of operational earnings from market-linked investments. Like other insurers, Medibank invests the premiums it receives in financial assets like bonds and equities.
When the markets do well, good investment returns bolster overall profits. But when markets aren’t doing well, profits will take a hit. This aspect of the business clearly increases the risk profile.
To make the investment work for the new owners, you’ll want to see Medibank generate much better returns on equity in the future. That could happen, but it’s operating in a highly competitive environment and is already making decent returns.
Of course, this analysis ignores what the market (as opposed to the business) can do upon listing. There may be additional demand for shares from pension and index funds, which could push the price higher. Those getting in at the float price may get an opportunity to make ‘stag’ profits.
While that is a possibility, I see any price boost as being short lived. This offer is an expensive one and given you won’t even know the price you pay (which could range from $1.55 to $2), I recommend steering clear.
For The Daily Reckoning Australia