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A B C D E F G H I J K
Notes on Rafford plc and Otnes plc
Prepared for: Tilliam Well
Prepared by: XXXX
Date: XX/XX/XXXX
Four issues have been raised:
- Financial eprformance of Rafford
- Valuation of Rafford
- Comparison w/ Otnes
-Accounting treatment of PENSION SCHEMES
1 In dealing w/ the analysis of Rafford's performance measure, has increased by 75% (63/36) - 1), when its revenue
has increased by 66% (1410/851) -1), implying an icnrease in net margin. In 20x7 the net margin was 4.5% (63/1,4
10) [OP PROF/REV] and in x6 it was 4.2% (36/851).
But both years are affected by profit on sales and leasebacks less restructuring costs and x7 by a change to t
he terms of its final salary pension scheme which cannot be repeated in the future. Stripping these net credits
out of operating profit results in the following:

20x7 £m 20X6
2
£m
3 Profit from operations 63 36

4 Less: sale and leaseback profits [NOTE 2] (4) (4)

5 Pension scheme curtailment gain [NOTE 2] (15)

6 Add: restructuring costs [NOTE 2] 2 2

7 Adjusted profit from ops 46 34

8 Revenue 1,410 851

9 Adjusted net margin 3.3% 4.0%

1
0
So on this basis Rfford's performance was worse this year (x7) than last year.
But Rfford has made SUBSTANTIAL ACQUISITIONS in both years, so to obtain a clearer INSIGHT INTO LIKE FO
R LIKE PERFORMANCE:
- Adjustments should be made to the x6 results to include the effect of the x6 acqn for the full year.
1 - adjustments should be made to the x7 results to exclude the effet of the x7 acqn.
1 The results will then reflect only those businesses which were owned by Rafford for the WHOLE TWO YEA
R PERIOD.
This analsysi is best made for the two operating segments separately.

1 Construction x7 House building x7 Construction X6 House building x

2 £m £m £m 6 £m
1 Revenue
3
1 Per FS [note 1] 1,069 340 626 224
4
1 Less re x acqn [note 3] (66)
5 7
1 add re x6 acqn 249 29
6
1 Adjusted revenue (A) 1,003 0 340 0 875 0 253
7 (A)
1
8
1 Profit from operations [NOTE
9 1]
Per FS 17 39 11 31

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2
0
2 Less re 20x7 acqn (3)
1
2 Add re 20x6 acqn 3 3
2
2 Adj profi from ops (B) 14 0 39 0 14 0 34
3 t
2 Adjusted net margin (B/A) 1.4% 11.5% 1.6% 13.4%
4
2
5
Analysis on this annualised basis confirms that Rafford has done less well in X7 than in x6 even in its very low mar
gin construction business.
This raises the question as to why Rafford is making acquisitions in both years in the low-margin construction busin
ess.
(b\) Valuation of Rafford
It is not usual to value a business by reference to its revenue. Earnings or dividends are a more normal basis of val
uation.
The realistic market price of a share can be derived from a valuation of estimated future dividends. The value of a s
hare will be the present value of all future expected dividends on the shares, discounted at the shareholders' cost o
f capital.
Alternatively, but using the same logic, the value of a share can be said to be the present value of all earnings avail
able for distribution to the shareholders (potential dividends or increases in the share price).
On these bases Rafford is valued:
- On a price/earnings ratio calculated as:
-- Earnings (PFY) £44m
- weighted average shares in issue 305m [GIVEN IN OTHER INFO]
2 -- Earnings per share 14.4p (44/305)
6 --P/E ratio of 3.7 (53(Share price)/14.4
-- DIVIDEND YIELD (DIV/SP) = 3p/53p = 5.7%
Both of these show a weaker valuation than for Otnes plc (see next)
There are a number of factors which contribute to this low valuation,many of which may be seen as different aspect
s of the business being in a period of rapid change. Visibility of FORWARD EARNINGS PROSPECTS is usually Q
UITE POOR when businesses are CANGING RAPIDLY; this leads to lowered valuations.
- Rafford has increased its share capitl very substantially over the last two years. The end-2007 capital is 210m (19
m share capital and 191 million share premium. The statement of changes in equity shows that capital has been in
creased by shares issuing totalling 191 million (144m in CY issued and 47m last year issued) over the two years.
- Rafford is growing very quickly by acqn. The goodwill acquired in the x6 and x7 business combinations can be cal
culated as:

2 Consolidation Net assets acquired Goodwill £m

7 £m £m
2 20X6 acquisition 101 44 57
8 s
2 20x7 acquisition [note 3] 111 59 52
9
3 109
0
3
1
3 These are the amounts carried in the x6 and x7 SoFP, which imply that Rafford has ONLY BEEN MAKING ACQUI
2 SITIONS IN THE LAST TWO YEARS.
Visibility of forward earnings prospects is usually quite poor when substantial acquisitions are being made. Mgmt m
ay be confident about future prospects, but investors often are not.
Rafford is making ACQNS IN BOTH YEARS IN THE VERY LOW MARGIN CONSTRUCTION BUSINESS. Busine
sses usually TRY TO IMPROVE MARGINS BY ACQNS, not reduce them.
The SUBSTANTIAL INCREASE in the carrying amount of land held for development is putting increasing pr
essure on company's current asset/liability position

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3 20x7 20x6
3
3 £m £m
4
3 Current assets A 1,024 490
5
3 Less land held for development (548) (209)
6
3 B 476 281
7
3 Less dev opment in progress (157) (75)
8 el
3 C 319 206
9
4 Current liabilities D 711 353
0
4 A:D 1.44:1 1.39:1
1
4 B:D 0.67:1 0.8:1
2
4 C:D 0.45:1 0.58:1
3
4
4
4
5
Profitability is poor. The low net margins in the two segments have already been referred to. The x7 ROCE IS ALS
4
O POOR [PARTICULARLY WHEN the one-off net credits have been stripped out) and shows a sharp fall compare
6
d to the previous year
4 20x7 £m 20x6 £m
7
4 Return = adjusted profit from ops (as above) 46 34
8
4 Borrowi : Non-curre 88 14
9 ngs nt
5 current 50 4
0
5 Cash and cash equivalents (40) (22)
1
5 Net debt (cash) 98 (4)
2
5 Equity 307 120
3
5 Capital employed 405 116
4
5 Return o capital employe 11.4% 332.7%
5 n d
5
6
5 The 20x7 acquisition took place late in the year (the revenue included of £66m is orughly a quarter ot the total attri
7 butabel to it for the year (£66m + £175m)). If this acquisition had been made at the start of the year, the profit from
operations would have been £10 million higher; [note 3]; the return on capital employed on this basis would be 13.
8% ((46 + 10) as % of 405, still less than half that of x6. Investors would be RIGHT TO BE CONCERNED ABOUT
SUCH A DETERIORATION IN PROFITABILITY OVER A SINGLE YEAR.
- Gearing is not a reason for the low valuation. Rafford had net cash at the end of x6 and net debt as a percentage
of equity was only 32% (98 net cash/307 eqiuty) at the end of x7.
Asset based valuation, Rafford
Net assets per SoFP: £307m.
An asset based valuation method is often used for companies whose value can be acccurately reflected by the val
ue of the assets held, for example, property development companies. For many companiies, there are sources of v
alue which are not reflected in the SoFP For many copanies, there are source of value which are not reflected in th
e SoFP (for example, brands, staff experise) and so this method undervalues the business. It is sometimes used,
therefore, to obtain a minimum valuation. In Rafford's case, its current market value (380m shares in issue [other in
fo] * 53p = £201.4m) is way below its net asset value.

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It would be useful to have info about the market values of its assets and liabilities, and it may be appropriate to ma
ke an estimate of future losses, given the current problems and uncertainty in the property market.
However, on the strength of the info provided, it would appear that the share price may reflect an underestimate of
Rafford's value, for the reasons outlined above.
Other useful info:
- market value of assets
- Existence and value of intangibles
- More detailed analysis of profits between ordinary recurring items and exceptional one off items, which may have
distorted the profits in individual years.
- Details of costs or income that may be avoided or lost if a significant stake in the company is acquired, such as di
rectors' remuneration
-More detailed/reliable growth forecasts
-Detailed risk analysis
-Cash flow details, to obtain a more fundamental cash-based valuation
Summary
Rafford operates in TWO BUSIENSS SEGMENTS, house buildings and construction. House provided a net margin
(after adjustments) of 11.5% in x7 down from 13.4% in the previous year. Construction achieved a wafer-thin margi
n of 1.4%, marginally down on the previous year.
Rafford has expanded very quickly by ACQUISITION in the last 2 years, which are centred on the low margin const
ruction business.
W/ poor FORWARD VISIBILITY and low profitability, the market is putting a low value on this company.
(c) Valution of Otnes
- On a P/E ratio calcualted as:
- Earnings x7; £28m
- shares in issue other info: 150m
- EPS 18.7p (28m/150m)
- p/e ratio of 149/18.7 =8
-On a dividend yield of 2.2% (3.3p/149p)
Both measures together indicate that the market appears to value Otnes more highly than Rafford.
There are a number of reasons:
- There have been no share issues for Otnes during either year, SO ITS BUSINESS IS NOT CHANGING RAPIDL
Y
- There is no specific mention about acquisitions or the absence of them, but the fact that the CARRYING AMOUN
T OF GOODWILL IS THE SAME AT BOTH YEAR ENDS indiates that there have been none in x7 at least.
- Profit from ops has increased by 20% (36/30) -1) when its revenue has increased by 42% (142/100)-1 implying a
decrease in net margin. In x7 the net margin is 25.4% (36/142) and in x6 is 30% (30/100). The margins achieved b
y Otnes are very much higher than those of rafford, suggesting a less risky as well as relatively more profitable bus
iness.
B/c one of Otne's is poroperty development it will AIM TO MAKE GAINS ON ITS INVESTMENT PROPERTIES. So
it is safe to leave the INVESTMENT PROPERTY GAINS ON DISPOSAL and inceases in FV as part of recurring an
nual profit.
The relative profitability of the two operating segments can be calculated as:

5 Property and land 20x7 £m Construction 20x7 Property and land Construction x6
8 £m x6 £m
5 Revenue (A) 81 61 43 57
9
6 Profit from operations (B) 35 6 29 6
0
6 Net margin ((b) as % of (A))) 43.2% 9.8% 67.4% 105%
1
6
2
6
3
6 The development business is clearly very profitanle. The constuction business is less so, but it is much more profit
4 able than the construction operations of Rafford.

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Otnes return on capital employed can be calculated as:

6 20X7 20X6 £m
5 £m
6 Profit from operations 36 30
6
6 Borrowings: non-current 28 20
7
6 current 3 4
8
6 Cash & cash equiv (15) (3)
9 ale
7 Net debt 16 0 21
0
7 Equity 139 116
1
7 capital employed 155 137
2
7 return on capital employe 23.2% 21.9%
3 d
7
4
- Gearing is not a problem, being 11.5% (16/139) at the end of x7 and 18.1% (21/116) at the end of x6.
7 - The carrying amount of land held for development is not putting much pressure on Otne's current asset/liability po
5 sition

7 20X7 20X6
6 £m £m
7 Current assets A 127 110
7
7 Less lan held for de opment (50) (38)
8 d vel
7 B 77 0 72
9
8 Less development in progrsss (45) (50)
0
8 C 32 22
1
8 Current liabilities D 59 54
2
8 A:D 2.15:1 2.04:1
3
8 B:D 1.31:1 1.33:1
4
8 C:D 0.54:1 0.41:1
5
8
6
8 - There are substantial amounts of property in the course of construction held within PPE. Perhaps in the future thi
7 s property will be classified as investment property. If this is the case, there ciould well be substantial INVESTMEN
T PROPERTY GAINS to be recognised in the coming years.
Asset based valuation of Otnes
Net assets per SoFP: £139m.
For the reasons discussed above, the net asset value is likely to be a significant underestimate of the market value
of the company.
Summary
Otnes operates in two businesss segments, property and land, and construction. Property and land provides very a
ttractie margins, while construction achieves lower margins.
Otnes is concentrating on organic growth, since there have been no acquisitions in the last two years.
W/ good cforward visibility and high profitability, the market is putting a high vale on this company.
(d) ACCOUNTING TREATMENT OF PENSION SCHEMES
The liability for retirement benefits is the difference between the actuarial measurement of the obligation to employ
ees and the assets in the retirement scheme to meet that obligation.
Both amounts are rather volatile for various reasons.

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- The values of pension fund assets change as a result of changes in the market prices of the investments that the
pension fund holds. Often these are shares and bonds (corporate bonds and govt bonds), whose values can move
by relattively large amounts within a financial period.
- The obligation changes as a result of increases in life expectancy; salary increases (on which the pesnsion is bas
ed) being different from those previously expected; and employee turnover (and therefore length of pensionable se
rvice) being different from that previously expected.
- The PV of the obligation is arrived at by DISCOUNTING the estiated future liability. Under current accounting stan
dards the discount rate used should be BASED ON THE YIEDS OFFERED BY HIGH QUALITY CORPORATE BO
NDS (normally AA-rated)> If market interest rates move then the discount rate used by companies to value their fut
ure lliabiltiies will also move: a fall in the discount rate would result in an increase in the present value of a fixed fut
ure cash amount There is some balance built into the system however; economic factors which cause interest rate
s to fall often also cause the value of assets that the pension fund invests in (such as equities and bonds) to rise - s
o the net liability (or asset) may well change by less than would otherwise be expected.
- The actuary's expectations of interest on plan assets and on the liabiltiy may not match with the actua interest. Th
is is referred to as the 're-measurement (actuarial) difference'. Gains on re-measurement in one period may be rev
ersed by losses in the immediately following period as the actuary's estimates are updated.
- The question of affordability of final salary pension schemes is one that has been widely discussed recently, and i
t is true that there has to be some doubt over whether the amounts disclosed by companies in general today are a
n accurate estimate of the true value of future payments.
IAS 19, Employee Benefits stipulates that re-measurement losses MUST be recognised inOCI in the period in whic
h tey arise. This eliminates volatility from the SPLOCI, but does not eliminate it altogether.
It will be necessary to adjust Otne's FS onto the same basis as Rafford's to conform w/ IAS 19, by recognising all f
ains in the year they arise, but in the 'other comprehensive income' section of the SPLOCI, but it does not eliminate
it altogether.
Adjustments to Otnes results:

8 20x7 £m 20x6 £M
8
8 Profit fom operations
9
9 Per FS 36 30
0
9 Remove gains recognised in year (7) (5)
1
9 Adjusted profit from ops 29 0 25
2
9
3
9 PFY per FS
4
9 Remove gains recognise d in year as above 28 24
5
9 (7) (5)
6
9 21 0 19
7
9
8
9 OCI per
9 FS
1 Gains recognised the year 7 5
0 in
0
1 OCI for t year 7 5
0 he
1
1 Total co income for 28 24
0 mp yr
2

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