pumped and dumped?

There is no doubt the Myer float is popular ? 146,000 people have apparently registered for a Myer prospectus ? but you can?t buy what is popular and expect to do well.

Popularity or otherwise aside, the way to put the odds in your favour is to buy shares below their intrinsic value. Before floating and selling my last funds management business, I bought The Reject Shop at $2.40 (now $13) and more recently bought JB HiFi at $8.50 (now $19), Fleetwood at $3.50 (now $8.00), I sold my Platinum Asset Management shares at more than $8.00 on the morning they listed (now $5), and warned investors who attended my ASX investor seminars to get out of ABC Learning at $8.00 (last traded at 54 cents before delisting) and to get out of Wesfarmers at $38 as they acquired Coles (recently traded less than $20).

In all these examples, I simply assessed the price by comparing it to the intrinsic value of the company. And the calculation for the intrinsic value of a company is simple. It?s just a multiple of equity based on the profitability of that equity. For example, if a company has $1 of equity per share and it will forever generate a 20% return and pay all the earnings out as a dividend, then an investor seeking a 10 percent return can pay no more than $2 for every dollar of equity. There?s a little modification for a company that retains profits but essentially that?s all there is too it. And provided you are not in too much of a hurry, it works really well.

Three years ago, Myer was purchased from the Coles/Myer Group by a private equity team called TPG/Newbridge. The Myer Family were also involved and together the consortium acquired Myer for $1.4 billion. The group used $400 million of their own money and borrowed the rest. Before the first anniversary, a very long-term lease on Melbourne?s Bourke Street store was sold for about $600 million and a clearance sale, reduced inventory and netted $160 million. All this additional cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and a capital return of $360 million. In other words, before the first year was out the owners had received all of their $400 million outlay back, and arranged a free ride on a business with $3 billion of revenue.

But you are not being invited to pay $1.4 billion, which was 8.5 times the earnings before interest and tax (EBIT). You are being asked to stump up to $2.9 billion or more than 11 times forecast EBIT. You are also being asked to replace the vendors as owners and while they know a lot about extracting maximum performance out of department stores, you don?t.

In estimating an intrinsic value for Myer, I have ignored the fact that the balance sheet includes $350 million of acquired goodwill as well as $128 million of capitalized software expenses. I will also ignore the addition of sales made by concession operators ?to provide a more appropriate reference when assessing profitability measures relative to sales?, the removal of the incentive payments to retain key staff ? not regarded as ongoing costs to the business, costs associated with the gifting of shares to employees and most interestingly, the reversal of a write-off (meaning it has been left in) of $21 million in capitalized interest costs; all regarded as non recurring.

While ignoring these in my estimate of intrinsic value seems irresponsible, it merely means that whatever number is produced by the calculation, it is going to be higher than it really should be. That?s fine; I just have to ensure a larger margin of safety.

Taking a net profit after tax figure for 2010 of $160 million and assuming a 75 per cent full-franked dividend payout, I arrive at a return on equity of about 28 per cent on the stated equity of $738 million ? equity that could have been higher after the float if $94 million in cash wasn?t also being taken out of retained profits. Using a 13 percent required return I get a valuation of $2.90.

Alternatively, I am buying $738 million of equity that is generating 28%. If I pay the $2.9 billion that is being asked for that equity or 3.9 times, I have to divide the return on equity by 3.9 times which produces a simple return on ?my? equity of 7.2 per cent. For ?my? money it?s just not high enough for the risk of being in the department store business.

And in the future things don?t become dramatically more attractive either. Based on the numbers in the prospectus I estimate that the value only rises by 6 per cent per year over the next five years and delivers a value in 2015 of $3.90 ? the price being asked today.

I am going to pass on My piece of Myer.