During 2013, I've looked at most shares in the FTSE 100 and graded them against these five quality and value indicators:
- Dividend cover
- Price to earnings
Some companies scored highly against the "business quality" indicators of level of borrowings, earnings growth record, and outlook. Others scored highly against the "value" indicators of dividend cover and price-to-earnings ratio (P/E).
Quality and value in harmony
However, the most promising investment opportunities scored well on both business-quality and value indicators.
In this mini-series, I'm revisiting some of the highest-scoring shares to look at events since the original article and to assess the quality of the investment opportunity now. Some of these high-scoring firms could be investment winners for 2014 and beyond so, today, I'm revisiting postal and delivery service provider Royal Mail (LSE: RMG), which scored 21 out of 25 in October.
Shares in Royal Mail are up nearly 10% to around 540p since October and they've been higher. Perhaps inevitably there's been a chorus of indignant cries about the company's 330p valuation at flotation -- some think it was undervalued because ... the shares have gone up!
However, I think it's worth remembering that Royal Mail was embroiled in an industrial relations dispute with its workforce at the time of its flotation, perhaps a one-off event, perhaps a big red flag advertising the nature of the culture within. Either way, it's significant because Royal Mail essentially is its workforce and very little else.
A bumpy road ahead?
So, as with any investment, investors had to take a leap of faith to invest, and I reckon there's a lot that has potential to go contrary to plan at Royal Mail. I see the firm's operations as something of a commodity-type business characterised by a lack of differentiation, fierce competition in its profitable markets such as parcel post, and low margins. The company is likely to be engaged in a constant battle to control costs and squeeze ever-greater profitability from its operators and automated processes. Just when it starts to gain advantage, the competition is likely to come up with something better and the whole process starts again!
Perhaps I'm being too pessimistic, but I do reckon Royal Mail investors need to buckle up because they're unlikely to face an easy ride, going forward
Royal Mail's total-return potential now
But my opinion is practically worthless without hard facts and figures to back it up, so thank goodness the firm has announced it intends to release its half-year results on 27 November. In the meantime, my business-quality and value scores remain unchanged based on the assumptions made from what little is currently know.
1. Dividend cover: forward earnings likely to cover the first dividend around twice. 4/5
2. Borrowings: net debt is just above the level of underlying operating profit. 4/5
3. Growth: rising revenue has generated robust cash flow and growing earnings. 5/5
4. Price to earnings: a forward11compares well with growth and yield expectations.4/5
5. Outlook:good recent tradingand, given recent flotation, an optimistic outlook. 4/5
Overall, I score Royal Mail 21 out of 25, as in October.
Although based on assumptions and estimates, Royal Mail still scores well on all my business-quality and value indicators, but I'm not keen on the firm's labour-intensive business model or the highly competitive sector in which it operates. Business growth for the firm seems as if it will depend more on parcel-market growth than anything else, and such growth is far from inevitable.
City forecasters expect Royal Mail's forward dividend yield for 2015 to be around 3.9% at current share price levels. That's not enough to tempt me so the firm goes back on my watch list for the time being.
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> Kevin does not own Royal Mail shares.