Royal Mail Shares Were Not Sold Too Cheaply

| About: Royal Mail (ROYMF)

Suddenly everyone’s an expert on the stock market. Apparently it was obvious that Royal Mail (OTCPK:ROYMF) shares were too cheap at the IPO price of 330p, and now Vince Cable has now called in Lord Myners to review the whole affair.

Some examples:

  • On the news the other day a politician (who shall remain nameless) offering up the nugget of wisdom that the low price had “cost” the taxpayer hundreds of millions of pounds.
  • A newspaper article which said the government had lost out on £750 million (equivalent to 34,000 NHS nurses apparently) by not pricing the IPO at 455p, the price of the shares at the end of their first day of trading.

Okay, so the share price went up by 38% on the first day of trading; that does look suspicious. But is it really evidence of an excessively low price?

I don’t think it is.

330p to 615p in 3 months, it must have been a fix

By mid-January the 330p IPO price was looking even more ridiculously cheap. The shares had climbed to 615p and looked odds-on to double in price within the first six months.

Surely the IPO price must have been too low if it almost doubled in a few short weeks?

If only it were that simple.

615p to 470p in 6 months, perhaps valuing companies isn’t as easy as everyone thinks

That 615p price lasted for just a fleeting moment. Today the shares are trading at about 470p, down almost 24% in six months.

So if 330p is obviously too low and now 615p seems to be obviously too high, what price should the IPO have been?

Valuing Royal Mail using its expected dividend yield

Unlike those who think it’s all so obvious, I don’t think there’s a clear answer, but I’ll take a stab at it anyway using the trusty old dividend yield as a starting point.

The full year dividend is generally expected to be around 21p and so the IPO price of 330p put the dividend yield at 6.4%. For context the FTSE 100 yield was 3.5%.

To price Royal Mail shares in line with the market yield the IPO price would have been 600p.

Clearly that’s a lot higher than 330p. But generally IPOs are launched with a 10% or so discount relative to a reasonable estimate of the expected market price.

This helps to ensure a “smooth getaway” for the IPO and in this case it would have put the IPO price at 540p and the yield at 3.9%.

That all seems very sensible but Royal Mail had just been through a restructuring, it didn’t exactly have a strong record of profitability and it had workforce relation issues. And as an IPO there was less transparency in its results compared to listed companies, so valuing it in line with the market would have actually over-valued it.

To price in that uncertainty a discount should be applied, but what discount?

In other words, are there any other companies out there that are broadly comparable in terms of size, potential and uncertainty, so that we can look at their valuation multiples and dividend yields and apply them to Royal Mail?

If Royal Mail was Tesco, 330p wouldn’t be cheap at all

I’ll use Tesco as the comparison company because it’s another large, well-known company surrounded by a fair degree of uncertainty. If you don’t like Tesco feel free to use any company you like.

Tesco currently has a dividend yield of 5.3%, well above the market average because investors are afraid of the impact of Lidl and Aldi on the established supermarket leaders.

Let’s assume that a 5.3% yield is reasonable for a well-established company which is under pressure; one where the dividend isn’t expected to be cut, but where there are problems to be resolved.

If Royal Mail had been launched with a dividend yield equal to Tesco’s at 5.3% then its IPO price would have been 396p. That’s less than the 455p it closed at on the first day and just 20% higher than the actual IPO price.

But don’t forget that 10% discount which is required for a smooth IPO. Apply that and we’d end up with an IPO price of 357p, just 8% above the actual IPO price.

Of course that’s an incredibly simplistic valuation, but I think it’s probably as robust as anything the investment banks came up with, and it shows that 330p wasn’t necessarily all that cheap; certainly not cheap enough to require a review by Lord Myners.

Instead what we have with the Royal Mail IPO “crisis” is a lot of political mileage being made out of something that, once you look into it, is almost completely un-noteworthy.

Disclosure: I own shares in Tesco, and Tesco is a holding in the UKVI model portfolio.