Analysis of Great Portland Estates Example for Free

An Investment Analysis of Great Portland Estates, Plc. Chapter 1 – Introduction Great Portland Estates, Plc. – To Buy Or Not To Buy? A glance at the price movement of the common stock of Great Portland Estates in the past year is enough to excite any investor who was fortunate enough to catch the great wave of price increases that took the stock from 353.75p to a current price of 533.25p within the past year (Reuters 2006), an astonishing return of 50.74% in the past year. This price increase closely mirrors the index of real estate stocks in general (Great Portland Estates, Plc. 2006, pp. 3). Clearly these are exciting times for investors of Great Portland Estates, Plc. and for the commercial real estate market in the UK in general. This explosive stock movement is predicated by the “broadly positive” opinion of Great Portland Estates management that they will be able to convert their company into a Real Estate Investment Trust in January of 2007 (Great Portland Estates, Plc. 2006, pp. 31). The question remains for the discerning investor: has the market already discounted the future potential of Great Portland Estates, Plc. as a REIT into the current stock price, or can the investor still make substantial gains by holding the stock? Is it time for current Great Portland Estates, Plc. investors to take profits, or are there even greater increases to be expected from the stock? More importantly, even if the conversion of UK commercial real estate development and management companies to Real Estate Investment Trusts will enable real estate companies in the UK to exhibit accelerated earnings growth in the near future, is Great Portland Estates, Plc. an optimally positioned company to take advantage of the trend? Finally, is the conversion of Great Portland Estates, Plc. into a REIT assured by the current political climate? This analysis will consider these factors, assess the risk of the industry and of the company in general, and provide investors with a sound financial foundation to answer these serious questions. The Role of Financial Analysis in the Investment Decision The opinion of the informed financial research analyst can be pivotal in swaying the investment decisions of potential and current investors relative to any given security. It is the fiduciary duty of the analyst to provide a sound, solid, well-researched, and fully supported investment recommendation to clients and potential end-users of the financial analysis report. The clientele relies on the analyst to synthesize a plethora of often disparate facts and figures to arrive at a conclusive “buy”, “hold”, or “sell” recommendation relative to any individual security or portfolio of similar securities.

This analysis is written with these three goals in mind:

1. The analysis will provide the clientele with a solid theoretical and empirical foundation to make a well-informed investment decision about the common stock and/or bonds of Great Portland Estates, Plc.

2. The analysis will accomplish goal #1 from a “top-down” approach, by first analyzing macroeconomic factors which support an investment decision. Next, the industry sector of commercial real estate development and management in the UK will be analysed to determine if the industry sector is more or less favorable to investment than the economy as a whole. Finally, the analysis will determine if Great Portland Estates, Plc. is well positioned to capture excess profits above what is expected for the commercial real estate development and management industry sector in the UK (or if, conversely, Great Portland Estates, Plc. should be considered as having less potential than the market to profit from the current and upcoming environment.

3. The analysis will proceed from goal #2 by then assessing if Great Portland Estates, Plc. is adequately valued by the market, or if there is opportunity for profits in the current pricing of the securities of Great Portland Estates, Plc. This valuation will focus on two methods: Price to Earnings Multiplier Valuation and Multistage Dividend Discount Model Valuation. Care will be taken by the analyst to ensure that the valuation models are adequately explained to the potential end-users of the valuation, including any assumptions used and difficulties encountered with the valuation methodologies. Full disclosure of assumptions and source materials used for the analysis will help to ensure the integrity of the analysis. Also, disclosure of any potential conflicts of interest and personal biases the analyst may have in delivering the investment recommendation is vital.

It is with these goals in mind that the following support for the investment recommendation is presented. It is hoped that this information will provide utility to seasoned investors, yet remain accessible to financial novices via a thorough explanation of all salient points. Investment Risk Disclosure Statement: The information contained within this report is directed towards assisting in an informed investment decision regarding the securities of Great Portland Estates, Plc. Every investment carries some form of risk, and Great Portland Estates is no exception. Care has been taken in the report to outline potential risk factors that could cause adverse price movement within the security, but there are quite likely other factors that are not included in this report which could cause the securities of Great Portland Estates, Plc. to exhibit more risk and variance in returns than has been implied by the recommendation and valuations presented here. Users of this report should be aware of their own risk tolerances before making an investment decision.

There are no guaranteed returns on securities. Use this investment information at your own risk. Chapter 2 – The Outlook for the Economy   The Current State of the UK Economy The UK economy has been relatively stable over the past year, with only minor changes in inflation (2.5%), employment (-.2%), and manufacturing (.8%) (National Statistics 2006). Concerning to the real estate development market is the fuel-driven increase in producer inputs (measured by PPI, or Producer’s Price Inputs), which has risen 10.9% (Ibid.). The change in inflation is the highest in 9 months, though it is only marginally higher than the bank’s anticipated rate of 2% (Guardian Unlimited Money 2006), and the increase is explainable by rising fuel costs. The production inputs price increases could translate to potentially lowered margins in the real estate market if property price increases do not cover the increases in materials costs. Interest rates have recently risen to 4.75, and the Bank of England has given the market signals that more rate increases could be forthcoming (Guardian Unlimited Money 2006). Increased financing costs for real estate development also threaten the property markets, although developers who finance the sale of property can gain from these increases. Forecasts for the UK Economy Averages of independent macroeconomic forecasts for 2007 chart the UK economy to remain relatively stable, with GDP growth anticipated at an average of 2.4%, and inflation (measured by CPI) anticipated at an average of 2.2%. These figures were provided by the comparison of 21 independent forecasts produced by the private sector, and aggregated by the Treasury (HM Treasury Macroeconomic Prospects Team July 2006). Thus, the economy is expected to remain stable, not exhibiting substantial growth or retraction along leading indicators. Continued increases in interest rates are anticipated to combat a somewhat higher level of inflation than assumed by the Bank of England, as mentioned previously. It is clear that significant assumptions regarding fuel and inputs pricing are intrinsically related to the estimates of all independent forecasters. In particular, growing political concerns regarding conflict in the Middle East and concerns of terrorism at home could significantly impact financial markets and the prices of inputs, which could translate to adverse deviations from forecasted results for macroeconomic variables. For instance, the median price predicted by the 21 independent forecasts for the price of oil is $66.2 per barrel. At the current settled futures price for February 2007 delivery of light sweet crude oil at $78.21 per barrel, with September futures at $74.35 per barrel (New York Mercantile Exchange 2006), it seems that serious doubt should be cast over the assumptions of the forecasters as pertaining to energy prices and the macroeconomic effects of continued energy price increases.

Such increases could feasibly cause economic growth into 2007 to be more stifled than is predicted by the averaged forecasts. Political Climate in the UK The political climate in the UK is one of subdued turmoil. Prime Minister Tony Blair is widely expected to step down from office in mid-2007 amidst allegations of poor management and conflict within his own party (Economist Intelligence Unit 2006). It is unclear whether the recent capture of suspected airline terrorists within the UK will strengthen Blair’s position.

Whilst the political strife has little immediate effect on the pertinent industry sectors for this analysis, political reorganization always carries the risk that seemingly predictable variables (here, particularly the potential for UK real estate companies to convert to REIT status) could become less stable under a new political regime. Relative to the commercial real estate development and management industry sector, no significant political delays or aversions to the planned conversion of real estate companies into real estate investment trusts is foreseen (Haddock 2005, pp. 1). However, it is possible that conflicts with the taxation structure of the UK-REITs could ultimately stall or derail implementation plans. Corporate Expectations for Expansion Potential in the UK in 2007 Based on the lukewarm GDP expectations, uncertainty about energy and input pricing and inflation, and an expected increase in interest rates, it seems unlikely that most UK companies have grandiose expansion plans for the upcoming year. Of course, the outlook for individual sectors of the economy varies based on which sectors are poised to take advantage of the current and foreseeable macroeconomic climate. The specific ability of the commercial real estate development and management industry sector to maneuver within this climate will be discussed at length later in the analysis, followed by a detailed description of Great Portland Estates, Plc.’s ability to take advantage of the economic climate relative to the economy as a whole and the commercial real estate development and management industry sector in particular. Exchange rates and employment rates are of only tertiary interest in this particular analysis, although with further research, commercial property vacancy rates, property ownership to rental ratios, and other industry-specific macroeconomic variables could lead to nuanced conclusions within the analysis. Now that an understanding of the general UK economy has been established, it is prudent to continue to analyze the commercial real estate management and development industry sector within the larger economic framework, to try and understand if the industry sector exhibits any extraordinary opportunities beyond what one could gain by investing in an index representative of the general market.

Following this, the analysis can continue to include the target company within the industry: Great Portland Estates, Plc. Chapter 3 – Structure and Outlook for the Commercial Real Estate Management and Development Industry Sector Relative Outlook of the Industry Sector Relative to the Overall UK Economy Although the general consensus for the overall UK economy’s growth potential in 2007 is lackluster at best, the recent stratospheric rise in stock prices and valuations for real estate companies indicates that the market believes that the UK commercial real estate management and development industry sector will dramatically outperform the overall market in the upcoming year. Obviously, the aforementioned planned conversion of real estate companies into REITs, along with rising property values, is contributing to the market perception that the industry is much more favorable than most in the current investment climate. Let us further analyse the rationale behind the market’s enthusiasm towards the soon-to-be-created REITs, by examining the appeal of REITs as well as the specific risk factors that must be considered with the REIT structure. The Market’s Excitement about UK-REITs – High Dividends and Economies of Scale Studies have shown that REITs offer an investor several advantages over traditional real estate investing. Specifically, REITs offer investors economies of scale that normal investors in real estate would not be able to access. Overall, we find that large REITs are increasing growth prospects while succeeding at lowering costs, leading to a direct relationship between firm profitability and firm size (Ambrose, Highfield, and Linneman 2005, pp. 323). Such potential for economies of scale should reasonably be expected to entice additional investors into real estate. However, most of the companies that will be converting to REITs are already publicly traded companies, which means that investors already had access to the real estate development and management market.

Other factors must necessarily explain the market’s enthusiasm towards REITs relative to investing in a publicly traded real estate company. One of the most substantial differences between REITS and normal common stock is their mandated legal structure, which forces the REIT to pay the majority of their net income as dividends. These dividends are taxable, which enables the REIT to avoid (at least a percentage) of taxation at the REIT level (UK Investment Advice 2006). In the booming global real estate market, REITs have been attractive investment vehicles in those markets where they have been implemented (Ibid.). Thus, it is likely that much of the market’s enthusiasm towards UK real estate companies comes from the knowledge that after the conversion, the companies will be paying high dividends on profits gained from an accelerating real estate market. The Darker Side of REITs – Additional Risks REITs are not perfect investment vehicles, however. There are several risks that the REIT structure entails which the standard real estate company would not have to endure. For instance, the costs of compliance with the REIT regulations can be a major burden on REITs. Default risk is also increased by the mandated dividend payout, as the REIT will have less capital at its disposal to handle unforeseen problems.

This lack of capital will also lower the flexibility of the REIT, as it will be unable to reinvest as large a percentage of its profits in future real estate investments than a normal real estate firm would. These risks must be factored into the REIT’s weighted average cost of capital, which is more difficult to determine for this structure than it would be for a normal real estate company (Nwogugu, 2005. pp. 2-3). It is also unclear how UK-REITs will be taxed, further leading to uncertainty and risk surrounding the implementation of UK-REITs. If the REITS are taxed unfavorably to investors, the decline in real estate stock valuations could be substantial. Further, if the taxation structure is not fully resolved, these administrative delays would also be likely to have an adverse effect on the valuations of the would-be UK-REITs. It seems from current valuations of real estate companies that the market is certainly willing to accept the risks involved with REITs in order to cash in on high dividend payments during a booming real estate market. Industry Structure in UK Commercial Real Estate Development and Management The commercial real estate development and management industry sector is projected by Euromonitor International to grow by a modest 5% until 2009 (Global Market Information Database 2006), indicating that forecasted growth in real estate values is not responsible for the aggressive pricing of real estate company stocks. The market for commercial real estate in the UK is highly fragmented, with no company holding more than 10% of the overall market share (Ibid.). Land Securities, Plc. holds the largest share of the UK commercial real estate market with 10%, whilst British Land Company, Plc. and Slough Estates, Plc. hold 7% and 6%, respectively (Ibid.) All of these companies have lessened their diversification in recent times, instead focusing their efforts on the areas of the commercial real estate market in which they hold core competencies (Ibid.) It should be noted that this lowered diversification increases the market-specific risk of holding any stock in this industry. Thus, the industry as a whole is becoming somewhat more risky.

Couple this additional market risk with the new risks associated with the REIT structure (discussed previously), and the real estate stocks in the UK are adding risk at a rate that should also be reflected in the cost of equity demanded of their securities. The lack of dominant market share by any one company or small group of companies indicates that the UK market for commercial real estate is highly competitive, and is dominated by no monopolies or oligopolies. The industry is primarily devoted to the development and sale of capital goods, although the companies often engage in servicing activities related to real estate development, such as property management.

Based on the structure of the market and the lack of a dominant monopoly or oligopoly to interfere with the price mechanism, companies in the commercial real estate industry should be considered “price-takers” who must adapt to the pricing demands of the real estate market. Changes in the value of real estate can be expected to have dramatic effects on the companies engaged in commercial real estate, so these companies can expect to carry a greater degree of market-related risk than they would if any company held a larger percentage of the market and could exert pricing control. Firms in this environment must instead attempt to add value by purchasing and developing properties that are underutilized (as does Great Portland Estates, Plc., which will be discussed explicitly later in the analysis). The industry is in a growth phase highlighted by recent trends in the real estate market, and is undergoing dramatic changes based on the introduction of the REIT structure. It follows that some companies may attempt to expand their market share by using the increased capital associated with a market “rush to REITs” to engage in takeovers and acquisitions of competitors. Should the real estate market begin to “cool off”, however, acquisitive maneuvers are much more likely to occur. Porter’s 5 Forces in the UK Commercial Real Estate Development and Management Industry Sector A solid framework to utilize in the analysis of any industry is Porter’s 5 Forces.

According to the model, the main forces that affect an industry are the Degree of Rivalry, the Threat of Entry, the Threat of Substitutes, Buyer Power, and Supplier Power (Collis and Montgomery 1998, pp. 51). Since no monopolies or oligopolies exist and land zoned towards commercial use is a finite resource, it is safe to assume that there is a high degree of rivalry between companies in the industry. The threat of entry is also great in the industry, as the barriers to entry are quite low (entering the industry is only as expensive as the price of the first piece of property to be developed). The threat of substitutes is high between companies, but low between industries (companies may find several bidders for their commercial developments, but they will be hard-pressed to find substitutes for commercial real estate in general). These threats are also increased by access to information available on the internet, as well as the threat of telecommuting and the internet which can mitigate the need for some commercial “brick and mortar” spaces in both retailing and office space. The power of buyers in the market is typically high, as the industry has bee previously defined as a “price-taking” marketplace. This buying power oscillates with the market, however, and in an inflationary real estate market buyers have less power than in a stable or contracting market. The power of suppliers is also a market-relative variable, this time more relating to the pricing and relative scarcity of building materials at any given time.

This can be expected to rise with increases in energy costs and the corresponding increases in materials for commercial real estate developers. Firms that focus on property management face lowered exposure to supplier power based on a lowered reliance on building materials and their costs. Still, the commercial real estate developer must obtain necessary supplies, and none can be expected to produce their own inputs. The level of vertical integration of the supply chain in the commercial real estate development and management industry sector can ultimately be expected to remain low, though the REIT vehicle could potentially give firms the economy of scale to manage some level of vertical integration.

With little opportunity for supply chain integration, the power of suppliers can be expected to remain high for the foreseeable future in this industry. Armed with a solid understanding of the UK commercial real estate development and management industry sector, including the complications and opportunities of the forthcoming implementation of the REIT structure, the analysis may now proceed to the target of the report: the attractiveness of the stock of Great Portland Estates, Plc. First, a discussion about the company and an analysis of its place within the industry is in order. Following this company outline, it will be necessary to perform a valuation of the company to understand how the market is currently pricing the security, and if there is any potential for profit in the stock based on the current market pricing. This analysis and pricing will finally coalesce into an investment recommendation. Chapter 4 – Review of Great Portland Estates, Plc.’s Relative Investment Appeal   The Function of Dividend Strategy and the High-Dividend Appeal of Newly-Formed UK-REITs Financial literature dictates that the dividend decision is a critical determinant of a stock’s value, as well as a self-selecting factor regarding those who will purchase the stock. The clientele effect dictates that certain classes of investors are drawn to dividend payout scenarios that reflect their cash flow and taxation needs (Ross, Westerfield, Jaffe 2005, pp. 522). The taxation differences between dividends and capital gains influence persons and corporate entities in higher tax brackets to prefer their gains distributed to them as dividends, and those in extremely low tax brackets prefer the cash flow advantages of regular dividend streams (Ibid.). Since the dividend policy of REITs will be regulated by the government, REITs will necessarily be high-dividend securities as the majority of the earnings of REITs must be transferred to the shareholders in the form of dividends. Thus, the appearance of REITs in the UK real estate market would draw out many investors who might not otherwise invest heavily in real estate.

The blossoming global real estate market offers even further incentives to investors to find a scalable, tax-friendly, high-yielding investment vehicle to claim profits while the market continues to gain. Current real estate companies in the UK suffer from the problem of double-taxation: corporate earnings are taxed, and then as they are distributed to investors in the form of dividends, they are taxed again. This double-taxation issue causes these companies to suffer a discount on the value of their equity (Bond and Scott, 2006. pp 3). Obviously, based on the rapid share appreciation of Great Portland Estates, Plc.’s common stock, investors are eager to gain the tax advantages of holding the company as a REIT, rather than receiving the tax-diluted dividends of the public company (which are then to be taxed again at the individual level). One can assume also that the mandated dividend decision will affect the optimal capital structure of the company.

Real estate companies have generally been less conservative in their use of debt, since their assets hold high collateral value. Yet, with the mandated high-dividend payout of the REIT structure, the risk of financial distress increases (since the company will have less of its earnings to safeguard itself from defaulting on loans) and one can expect that the leverage ratio, while still high, will decrease to afford the company flexibility in paying its creditors (Ibid, pp. 8). Of interest in the discussion of dividends relative to REITs is the notion that the dividends are relevant due to their signaling power (the notion that cutting dividends is an implication of financial difficulty, and that increasing dividends implies that management is confident in the ability to sustain earnings), but dividend policy is irrelevant due to the idea that investors can create “homemade dividends” by reinvesting dividends or selling stock to achieve the desired payout (Ross, Westerfield, Jaffee 2005, pp. 508). In the case of the REIT, however, it seems that both the dividend and the accompanying dividend policy are relevant to the investment decision, because it is the regulated dividend policy that allows the REIT its special tax advantages. Modigliani and Miller considered the implications on dividend payouts when opposed to positive net present value projects, and concluded that a dividend increase, or first dividend, should never be chosen over a positive net present value project (Ibid, pp. 509). Thus, an interesting question to consider is the loss in flexibility that the REIT structure will impose upon Great Portland Estates, Plc. in financing high net present value projects, as they adjust their capital structure to accommodate the high dividend payouts. Will Great Portland Estates, Plc. gain more from the increases in access to the capital markets via the REIT structure than it loses in flexibility to pursue high net present value projects? This will ultimately depend upon the scale of the operations and the amount of excess capital that Great Portland Estates, Plc. is able to extract from the capital markets based on the REIT structure. If the past year’s stock performance is any indication of the willingness of the market to finance the projects of Great Portland Estates, Plc., then the company may indeed overcome this hurdle. Valuation Implications for Entities with “Once-Taxed” Dividends The tax-friendly structure of the REIT does not come without a price, and the structural changes mandated by the REIT regulation will dictate or limit many of the variables that are used in valuation models. REITs must seek financing from capital markets frequently, because their mandated dividend policy limits the amount of leverage they can feasibly utilise.

There are also restrictions on active management of REITs, and thus the potential growth rate of a REIT is somewhat capped by the regulations placed upon it (Damodaran pp.754). Further, external financing that is made available to the REIT will (in the case of US REITs) cause the number of shares in the firm to increase, diluting any existing shares in the REI (Ibid). Thus, the valuation of the REIT will differ substantially from a company with similar holdings, in regards to the types of assumptions that must be made for growth rates, leverage rates, and potential share price appreciation. Indeed, research has shown this to be the case: REITs typically trade at a statistically significantly higher value than the net value of their assets, based on investor pricing of the taxation benefits of the REIT structure (Gentry, Kemsley, and Mayer 2001, pp. 22). It should be stated that the regulations surrounding REIT implementation in the UK could change substantially from those of the US model before the process is finalized (although this seems unlikely), but these caveats seem well-positioned at this point, as it appears that the UK-REIT model will in many ways mirror that which has been implemented in the US, and the assumptions will be closely monitored in the valuations produced later in the analysis. Chapter 5 – Analysis of Great Portland Estates, Plc. Position of Great Portland Estates, Plc. Within the Industry With a solid foundation and understanding of the commercial real estate development and management industry sector in the UK, it now becomes relevant to discuss the position of Great Portland Estates, Plc. within this industry. As has been identified earlier, the market is fragmented and competitive, and among the stiff competition, Great Portland Estates, Plc. does not even rank in the top ten according to market share. Nevertheless, the company has had a tremendous year, riding a global real estate boom and the expectations of investors that the company would convert into a REIT in January 2007. The company has solid short, intermediate, and long-term plans relating to real estate development, which include several ambitious commercial development projects. A brief run-through of the strategic and tactical plans of the company is in order, assessing the potential value and risks of the projects announced by the firm The following summaries only include those projects announced and uncompleted by the firm, and large enough to merit inclusion in the annual report. Great Portland Estates, Plc.’s portfolio also includes rental properties and other holdings that are not in the active development pipeline. Active Real Estate Development Pipeline for Great Portland Estates, Plc.

1. 180 Great Portland Street – This project highlights a type of near-term opportunity that Great Portland Estates, Plc. is capable of exploiting in a short amount of time. The project entails revamping a corporate office building and “modernizing” space that was determined to be outdated and undesirable. The firm estimates that the rental value of the property once renovated is A£3.7M (Great Portland Estates, Plc. 2006, pp. 9). This is an example of a very short-term opportunity that Great Portland Estates, Plc. can quickly act upon in the current market; the anticipated completion date is December of 2006. The main risks with this project are potential increases in rental vacancies once the building is complete and possible declines in rental values into the future.

2. 208 & 222 Regent Street – This recently acquired retail property consists of two adjacent buildings in a busy retail district, and has an expected rental value of A£4.1M. The plan is to turn the two buildings into 22 storefronts (all large, well-respected brands) using the 63,200 ft.2 that will be available at the location once Great Portland Estates, Plc. has renovated the adjacent buildings. The expected turnaround time for this project is 18 months, so this project is a near- to intermediate-term project in the pipeline of the firm (Great Portland Estates, Plc. 2006, pp. 11). The main risks here are materials and inputs price increases, rental vacancies, and potential declines in future real estate and rental values.

3. Tooley Street – Although most of the active projects of Great Portland Estates, Plc. involve renovating and improving existing structures, the Tooley Street project shows that the Great Portland Estates, Plc. strategic vision also includes the development of entirely new structures. This project will be situated on a previously undeveloped plot of land owned by the firm. The plan is to create a modern and impressive office complex, with a large atrium in the center of the building. This 200,000 ft.2 project has an expected rental value of A£6.7M. Great Portland Estates, Plc. anticipates that this project will be completed in a surprising 18 month timeframe, placing the Tooley Street development in the intermediate-term pipeline for the firm (Great Portland Estates, Plc. 2006, pp. 13). Here, the main risks the company assumes in the project are materials price increases, potential increases in rental vacancies, potential regulatory hurdles that the company may have to overcome before completion of the planning stage of the project, and potential declines in future rental and real estate values.

4. Titchmor – Here, Great Portland Estates, Plc. is taking existing office space and horizontally expanding the building by constructing another high-rise adjacent to the existing structure. The existing retail and office complex will be expanded from 70,000 ft.2 to a 109,000 ft.2. The anticipated turnaround on the development is just over two years, placing this in the intermediate pipeline for Great Portland Estates, Plc. The firm expects rental value of A£4.55M from the development (Great Portland Estates, Plc. 2006, pp. 14). With this project, the company assumes the risks of increased materials costs, potential increases in rental vacancies, potential regulatory hurdles that may arise before the company completes the planning phase, and potential declines in future real estate values.

5. Blackfriar’s Road – This project is an interesting blend of short and long-term projects in the company’s pipeline. Consisting of two stages, this development will earn the company rents on the existing 30,000 ft.2 space. When the current lease expires, Great Portland Estates, Plc. intends to use the space to create a 15 storey office complex, expanding the available space to 130,000 ft.2. The construction of the new building is scheduled to begin in January 2009 and complete in October of 2010, placing this project in both the near- and long-term pipeline (Great Portland Estates, Plc. 2006, pp. 16). Here, the company faces the most risk: potential increases in vacancy in the short term, potential increases in vacancies in the long-term (once the new structure is in place), potential increases in materials costs before 2009, potentially unforeseeable regulatory hurdles between now and 2009, and potential declines in future rental and real estate values.

These projects are included here to demonstrate the strategic goals and long-term planning of Great Portland Estates, Plc., and they illustrate the types of projects that the firm is financially and logistically capable of developing. Comparison of Great Portland Estates, Plc. to the Industry – Project Nature, Scale, and Scope With an understanding of the announced projects by Great Portland Estates, Plc., a comparison can be made to the rest of the industry to determine the position of Great Portland Estates, Plc. within the industry. These are the types of projects that other companies in the commercial real estate development and management industry sector would undertake. The differences in project scope and scale would be directly related to the size of the company.

Hence, the company is developing projects that are in line with other firms in the UK commercial real estate development and management industry sector, although other firms may have larger or smaller projects in their portfolio, depending on the size of the organization and the amount of financing they are able to secure for any given project. The future will be interesting to watch in this industry: as the companies convert to REITs, will the extra dividends inhibit the financing of the company and stall growth into larger ventures, or will the REIT investment vehicle provide enough financing and economies of scale to allow the firms to take on larger projects? Managerial Quality and Impact Upon Performance at Great Portland Estates, Plc. Great Portland Estates, Plc. seems to have competent management, judging by the extent of the planned projects and the ability of management to deliver past projects in a timely manner, meeting budgeted figures for these projects, in profitable development areas in the UK (Great Portland Estates, Plc. 2006, pp. 11). The REIT structure will likely impose restrictions upon management and their ability to raise financing and take as active a role in the development of these properties, as has been the case regarding US REITs (Gentry 2001, pp. 5). Thus, although Great Portland Estates, Plc. seems to be a well-managed company, the relevance of management in the returns of the common stock is likely to be lessened, to some degree, in the future as the company converts to the REIT structure. Outlook for Great Portland Estates, Plc. Although the company seems well-positioned with its current project pipeline, exhibits strong management, and will soon have the benefit of the REIT structure to entice further investment, there are several lingering risks that the company will have to face in the near future. The company faces risk based on the vicissitudes of the market for its goods, services, and supplies. The REIT structure is likely to increase competition in the commercial real estate development and management industry sector, as increased capital begins to seek a finite number of projects. The real estate market in general is always a worrisome variable that Great Portland Estates, Plc. seems to have little expertise in hedging against.

The vacancy rates of commercial real estate vary with the general economy, and the general economic outlook (discussed previously) is lackluster at best. Energy prices continue to soar, which will put pressure on materials prices for the company’s developments, and may cause projects to exceed budget if these fluctuations are not conservatively accounted for in the company’s revenue projections. Still, the outlook for Great Portland Estates, Plc. seems to be “cautiously optimistic”, as evidenced by the market’s support for the stock in recent history.

This increased confidence will ease the firm’s access to capital markets and make financing future projects a relatively easy task. All in all, barring a convergence of all potential risks (increased competition, increased inputs prices, a real estate market slump, and an economic downturn leading to high corporate vacancy rates), the outlook for Great Portland Estates, Plc. in the near future seems bright, considering the projects in the pipeline and the opportunities generated by the convergence to the REIT structure. All companies in the commercial real estate development and management companies face basically the same set of risks and opportunities, and although Great Portland Estates, Plc. does seem to have many positive and exciting opportunities, it does seem that larger players in the industry would find themselves in better positions to exploit the economies of scale offered by the REIT structure. With this understanding of the firm’s strengths, weaknesses, and position in the industry and economy as a whole, the analysis can move forward to valuation of the company to determine if the stock is “overbought”, “oversold”, or adequately priced. With the evidence from the valuations and the subjective evidence presented here, a well-reasoned investment recommendation will be derived and presented. Chapter 6 – Valuation of Great Portland Estates, Plc. Price to Earnings Valuation Method for Great Portland Estates, Plc. The analysis now turns to valuation of Great Portland Estates, Plc. using the popular PE multiplier. Using the fundamentals of Great Portland Estates, Plc., it is easy to compute the expected Price to Earnings ratio.

Since the PE ratio is a function of the payout ratio, the cost of equity, and the growth rate of the firm, the following formula can be used to determine what the PE ratio should logically equal. Once this ratio has been determined, it can be compared to the current PE of the security, so that either the assumptions of the model may be revisited, or the stock can be valued relative to its current price. The formula for computing the expected PE ratio (in terms of the stable growth dividend discount model) is: P0 /EPS0 = ( Payout Ratio * ( 1 + gn )) / ( ke – gn ) Where: gn = Stable Growth Rate Payout Ratio = Percentage of Earnings Paid in Dividends = 1 – gn / ROEn ke = Cost of Equity EPS1 = Expected Earnings Per Share in Year 1 P0 = Stock Price in Year 0 Let’s compute the variables required. First, for the cost of equity, we will apply the dividend capitalization model (we could also apply CAPM to determine the cost of equity, and we would indeed be forced to if the stock did not pay dividends). Here, the formula required for the dividend capitalization model is: ke = (Dividends Per Share / Current Stock Value ) + Growth Rate in Dividends From the annual report, we know that dividends per share were 11.0p, and the Growth Rate in Dividends Per Share was 2.3%. The current stock value, as previously mentioned, is 533.25p. Quick arithmetic gives us: ke = ( 11 / 533.25 ) + 2.3 = 0.043628223 That figures intuitively seems a bit low for the cost of equity. Of course, one must consider that the pricing of the stock is actually reflecting the expectation of much higher dividends per share. So here, we’ve run into the interesting situation with the company and the market’s price ramp-up in expectation of the REIT conversion that causes the dividend capitalization model to be woefully inadequate. However, it seems that it should still be possible to determine exactly what dividends the market is discounting into the current price. After all, the most recent 11.0p dividend is certainly not the dividend that the market is concerning itself with, since it is common knowledge that a very high, mandated dividend will follow the conversion. So, perhaps with a few assumptions, the model will still hold. Checking the current profile for the stock, we note that the payout ratio of Great Portland Estates, Plc. is an extremely low 12.1% (Reuters UK 2006). Understanding as we do that this ratio will be inverted once the company converts to a REIT, and that investors are aware of the dividend increases forthcoming, it is obvious that the dividend assumption used in the pricing model is inadequate. Thus, we will use the expected growth in dividends to adjust the dividend priced in the model. If we were to adjust the growth rate in dividends, we would quickly find that the extreme growth from the non-REIT dividend to the REIT dividend would skew the cost of equity into a nonsensical figure.

However, we should be able to assume a current dividend as if it were distributed under a REIT regime. Thus, we’ll set up a quick equation to determine what the dividend would have been under the REIT payout regime, assuming 90% REIT payout. 11x = 12.1% yx = 90% Where x = multiplier applied to current dividend to yield current payout y = adjusted dividend (dividend as if paid under 90% REIT structure) Solving for x yields 0.011. Substituting for x in the second formula gives us an adjusted dividend of 81.82p per share. Using this adjusted dividend, the dividend capitalization model gives the following cost of equity: ke = ( 81.82 / 533.25 ) + 2.3 = 0.176436474 or 17.64% This cost of equity is much more reasonable, considering all of the aforementioned risks and uncertainties involved with the company. Now let’s assume that the current increase in ROCE will be equal to the growth rate of the company. According to the annual report, ROCE increased 11.4% (Great Portland Estates, Plc. 2006, pp. 3). Although such growth should be considered difficult to maintain, let’s assume, for the moment, that this growth will continue for a reasonable amount of time, so that we may use it for the constant growth rate. gn = 11.4% Returning to the formula, now that we have our variables: P0 /EPS0 = ( Payout Ratio * ( 1 + gn )) / (ke – gn ) P0 /EPS0 = ( 12.1% * ( 1 + 11.4% )) / ( 17.64% – 11.4%) Yielding an anticipated PE ratio, based on the firm’s fundamentals, of: P0 /EPS0 = 2.1606 This seems to be inconsistent with the thoughts of the market, which has priced the stock so that the PE ratio currently equals 6.33 (Reuters UK 2006). Let’s check the assumptions in our model. There seems to be an inconsistency with using the current payout ratio in the PE formula, but deriving the cost of equity from the predicted payout ratio. Using the predicted payout ratio in the PE formula yields: P0 /EPS0 = ( 90% * ( 1 + 11.4% )) / ( 17.64% – 11.4%) = 16.067 …which still seems somewhat unreasonable. Let’s revisit our constant growth assumption, and use an average of the current growth and the expected growth of the industry (mentioned above, source: Euromonitor), 5%. This gives us a constant growth variable of 8.2. Trying this value in the formula leads to our most theoretically sound PE ratio as of yet: P0 /EPS0 = ( 90% * ( 1 + 8.2% )) / ( 17.64% – 8.2%) = 10.29661 Thus, after several iterations, our calculated PE ratio indicates that at a REIT payout ratio, the stock of Great Portland Estates, Plc. is still undervalued compared to the market-driven PE of 6.33. This could be a function of the many assumptions of the PE model used, or it could be indicative of general uneasiness by the market to fully price the future dividends into the current price of the stock.

There are enough risks and uncertainties regarding the company’s future to make a very strong case for this possibility. As it stands, this analysis finds that the valuation of Great Portland Estates, Plc. indicates that the stock is still undervalued and has much room to grow based on the forthcoming increases in dividends based on the REIT conversion. PE Analysis – Current PE Comparison to Comparable Companies No Price to Equity analysis would be complete without a review of the PE multiples of comparable companies. For this, we will use the current PE ratio derived from the market, 6.33, and compare to some of the main competitors in the UK commercial real estate development and management industry sector. According to the Great Portland Estates, Plc. 2006 Annual Report, the main competitors of Great Portland Estates, Plc. are:

1. Brixton Plc.
2. CLS Holdings Plc.
3. Derwent Holdings Plc.
4. Development Securities Plc
5. Grainger Trust Plc
6. Hammerson Plc
7. Helical Bar Plc
8. Land Securities Groups Plc
9. Liberty International Plc
10. London Merchant Securities Plc
11. Minerva Plc
12. Quintain Estates and Development Plc
13. Shaftesbury Plc
14. Slough Estates Plc
15. St. Modwen Properties Plc
16. The British Land Company Plc
17. Warner Estate Holding Plc
18. Workspace Group Plc

(Great Portland Estates, Plc. 2006, pp. 43) Next, searches were performed on Reuters UK to determine which companies were publicly traded and of those, which companies had meaningful PE ratios to compare to the PE of Great Portland Estates, Plc. These remaining competitors and their PE ratios were compiled into the following table for analysis:

Company Name	PE	Diff. from GPOR.L
1. Brixton Plc.	6.03	0.30
3. Derwent Holdings Plc.	7.82	-1.49
4. Development Securities Plc	10.01	-3.68
5. Grainger Trust Plc	21	-14.67
6. Hammerson Plc	6.32	0.01
8. Land Securities Groups Plc	5.44	0.89
10. London Merchant Securities Plc	6.9	-0.57
12. Quintain Estates and Development Plc	15.47	-9.14
13. Shaftesbury Plc	7.57	-1.24
14. Slough Estates Plc	7.8	-1.47
16. The British Land Company Plc	5.72	0.61
17. Warner Estate Holding Plc	5.04	1.29
18. Workspace Group Plc	6.08	0.25
Great Portland Estates, Plc	6.33
Average	8.395
Median	6.615
Standard Deviation	4.487728139

As you can see, the PE ratio of Great Portland Estates is well below the average (which would indicate that the stock is undervalued relative to the market, all other things being equal). However, this is likely strongly affected by the presence of outliers (Grainger Trust, for instance, has a PE almost 15 higher than Great Portland Estates, Plc.). The median gives a much better representation of the “middle of the road” in PE values for this industry, in this case. Here, the median indicates that the PE ratio of Great Portland Estates, Plc. is only somewhat below normal. Also, considering that the difference between the median PE ratio and the PE ratio of Great Portland Estates, Plc. falls within one standard deviation of the mean, this discrepancy may not be statistically significant.

Thus, the comparison of PE ratios in the industry shows that Great Portland Estates, Plc. may be slightly undervalued relative to the market. However, it is worth noting that many of the companies in this sample would also be subject to the same market uncertainties as Great Portland Estates, Plc., in that they will likely convert to REITs, and the uncertainty surrounding this transition is likely priced into their securities as well. Multi-Stage Dividend Discount Model Valuation for Great Portland Estates, Plc. In order to perform the multi-stage dividend discount model valuation for Great Portland Estates, we can use many of our previous assumptions from the PE valuation, only expanded to include several stages of growth in dividends. This seems to be a more appropriate valuation method, considering the dramatic changes in dividends that can be expected to occur. The inputs required for the multistage dividend discount model are:

1. Net Income
2. Book Value of Equity
3. Current Earnings per share
4. Current Dividends per share
5. Beta of the stock
6. Risk-free rate
7. Risk Premium
8. Length of high growth period
9. ROE (high-growth period)
10. Retention Rate (high-growth period)
11. Growth rate in stable growth period
12. Stable payout ratio

Fortunately, these are easy variables to obtain. Net Income, Book Value of Equity, Earnings per Share, Dividends per Share, the risk-free rate, and Beta are all obtained from the Great Portland Estates Annual Report (Great Portland Estates, Plc. 2006, p3) and Stock Overview (Reuters UK 2006). The Market Risk Premium will be assumed here to be 5.5%, as this is a standard figure indicating the difference between common stock returns and the risk-free rate of return. The length of the high-growth period will be assumed to be 5 years, and the growth rate in the stable growth period will be equal to the expected growth of the industry sector (discussed above) at 5%. The theoretical framework for the multistage dividend discount model relies on discounting future dividends that will occur at some different rates of risk and return than those which occur in the near future.

Typically, this model is used for firms expecting high-growth phases, which eventually taper down into stable growth (usually matching that of the overall growth rate of the economy). There is a model available at Damodaran Online which will process these inputs and generate a multistage dividend discount valuation. Once the value of the common stock is determined by the model, this value will be divided by the number of shares outstanding to arrive at a dividend-based valuation of Great Portland Estates, Plc. Without further ado, the following inputs are loaded into the “Dividend Ginzu”:

Inputs from current financials
Net Income =	A£148.30	Last year
Book Value of Equity =	A£654.70	A£516.00
Current Earnings per share =	A£0.84	(in currency)
Current Dividends per share =	A£0.11	(in currency)
Inputs for Discount Rate
Beta of the stock =	1
Riskfree rate=	4.85%	(in percent)
Risk Premium=	5.50%	(in percent)
Inputs for High Growth Period
Length of high growth period	5
Do you want to calculate the growth rate from fundamentals?	No	(Yes or No)
If no, enter the expected growth rate in earnings in high growth period=	8.00%
Do you want me to gradually adjust your inputs during the second half?	Yes
Inputs for Stable Growth Period
Enter growth rate in stable growth period?	5.00%	(in percent)
Stable payout ratio from fundamentals is =	82.60%	(in percent)
Will the beta to change in the stable period?	Yes	(Yes or No)
If yes, enter the beta for stable period =	0.80
Enter the risk premium to use in stable period =	5.50%

Which generates a multistage dividend discount model valuation for Great Portland Estates, Plc. of:

Output from the program
Cost of Equity =		10.35%
Net Income =		$148
Earnings per Share =		$0.84
Growth rate in EPS =		8.20%
Payout Ratio for high growth phase=		13.10%			</td

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