Following publication of the Royal Mail Shares IPO prospectus in advance of Royal Mail issuing shares on the UK stock market, popular questions at the moment are “should I buy Royal Mail shares” or “are Royal Mail Shares a buy?”

The answer to questions such as these, of course, depends on the share price you will have to pay at the time of the IPO (which we now know will be somewhere within the range 260p to 330p).

With 1,000,000,000 ordinary shares in issue at the time of the IPO, the intended share price range puts a valuation on Royal Mail of £2,600 million to £3,300 million.

So, if you think the business is worth more than this valuation, then the shares are a buy.

And if you think the business is not worth that, then avoid the shares and hope/wait for them to fall in price before buying via your stockbroker in the normal way.

But how do you know whether Royal Mail’s valuation is high, low or about right?

What Is Fair Value For Royal Mail?

Valuing a company is not quite as straight-forward as you might think.

As I explained in my article on Valuation Methods, there are 3 main ways of valuing a company, the first two of which we will apply to Royal Mail now.

The data we will use is taken from the Royal Mail plc prospectus recently published by the UK Government here.

Net Asset Valuation Method

At the end of June 2013, Royal Mail’s net assets were valued at £1,376 million.

So the UK Government’s valuation of Royal Mail is between 1.9 and 2.4 times book value.

As a comparator, Royal Mail’s competitor DHL is currently valued at 3.17 times net assets and TNT at 1.31 times.

These ratios are known as Price to Book Value (PBV) ratios and the comparison suggests that Royal Mail is being priced somewhere in the middle.

Price To Earnings Comparison Method

Royal Mail made £562 million profit after tax in its last full financial year to March 2013, otherwise known as earnings.

At a float price of 260p per share, this values Royal mail at 4.6 times earnings and at a price of 330p, 5.9 times earnings.

These multiples are known as PE Ratios and at this level are very low, especially when compared with DHL on a PE ratio of 17.8.

Unfortunately, TNT has been making a loss for the last two years so we can’t calculate its PE for now.

Digging slightly deeper into the accounts of Royal Mail though, we see that £284 million of those profits were deferred tax credits from earlier years.

We should really strip these tax credits out because they distort the financial picture, hence, Royal Mail’s true profits are really £278 million.

It’s PE ratio therefore jumps to a range of 9.4 to 11.9 times, depending on the initial share price at the time of the float.

These are nowhere near as low and exciting as previously calculated but they are comfortably below DHL’s 17.8 times.

How Does Royal Mail Make Money?

Royal Mail is a logistics company and a household name in the UK, delivering mail and parcels to UK and European customers.

It operates through two core divisions – UK Parcels, International and Letters (UKPIL) and GLS.

UKPIL operates the Royal Mail and Parcelforce services in the UK and is the market leader, handling more than a billion parcels a year.

It is also the only mail company obliged to provide a universal delivery service to all 29 million addresses in the UK for one single price.

GLS operates a parcel business outside of the UK across 22 European countries, its main ones being Germany, Italy and France contributing 71% of GLS’ revenue.

Who Are Royal Mail’s Competitors?

The most obvious competitors are other mail and parcel delivery companies such as DHL and TNT mentioned earlier.

DHL is by far the largest and is a fast growing company, hence its valuation described earlier.

TNT is loss making though and is clearly struggling, which demonstrates that logistics is a low margin business, sensitive to scale.

The fact that Royal Mail is the largest in the UK is a comfort in the early years but is it’s position going to be eroded after it becomes a private company?

Royal Mail’s Future Prospects

Not so long ago, Royal Mail was seen as a ‘basket case’ and definitely not worthy of our investment.

However, in recent years, the UK Government has been sprucing it up for sale.

It has been going through a big transformation, improving its business processes, delivery systems and cutting costs, saving something like £500 million a year compared to previously.

The Government has also removed the £8 billion pension liability that it once had, shifting that onto the UK taxpayers instead.

Thanks for that!!!

Also, the postal regulator, Ofcom, has publicly stated that Royal Mail should be allowed to make a profit margin of 5% to 10% on its universal delivery service obligations, which is a very healthy margin for a logistics business.

All of this has helped Royal Mail’s profits to turnaround in recent years from a loss of £553 million in 2011 to the profit of £562 million mentioned earlier.

That’s great, but what will it take to keep those profits growing?

The mail delivery side of the business should be okay if Ofcom sticks to its word and allows it to make a profit margin of 5% to 10%, although snail mail is fading away as it gets replaced by email and social media messaging.

So the key to growth at Royal Mail lies with its parcel businesses, which is also where it faces the most competition.

That said, it has been facing this same competition for some time now and the growth in Internet shopping should see sales and profits continue to rise.

What About Income?

Royal Mail has already declared that its annual dividend payout is expected to be £200m or so to start with and will be looking to grow it from this level.

If it can continue to grow its earnings and cash flows, then this should be achievable.

Royal Mail accounts also show that it spent £242 million in 2011; £280 million in 2012 and £230 million in 2013 on transformation costs.

As the major transformation programme of recent years reaches completion, it’s reasonable to expect some of this cash to be released to shareholders as future dividends.

Even if it doesn’t, £200m of dividends is equivalent to 20p per share, which is a healthy dividend yield between 7.7% (at a float price of 260p) and 6% (at a float price of 330p).

Should I Buy Royal Mail Shares?

Royal Mail is clearly a large, steady, blue chip company with a very healthy dividend yield, some potential growth prospects and some competitive risks.

So if you’re a growth investor, it is never going to set your pants alight with fast growth like a penny share.

Rather, it is a defensive income stock at a reasonable price.

So if you are looking for a large, blue chip, high yielding share for your portfolio, I believe this is being floated at a price that makes it worth buying.

And as a UK investor (NOTE: these shares are only available in the IPO to UK investors), make sure that you buy the shares inside your stocks and shares ISA or your Self Invested Personal Pension (SIPP).

That way, you will avoid paying income tax on your dividends and capital gains tax on any share price gains.

I’ll be buying some of these Royal Mail shares for my ISA next week – how about you?  Let me know your thoughts and plans below.