Are Ocado shares a good buy?

It is the ultimate Middle England investment opportunity. Ocado, which delivers Waitrose food and drink up and down the country, wants customers to pick up some shares along with their groceries. But even if you're delighted with your weekly shop, there are lots of questions you should ask before you put your nest egg into Ocado's basket.

The company has become a household name since it was founded by three former Goldman Sachs bankers in 2002. Its distinctive delivery vans, links with the John Lewis Partnership and one-hour delivery slots have ensured it a place in the hearts of cash-rich, time-poor consumers. The company has won a string of awards and its iPhone application is ensuring that it is becoming ever more popular.

But some City experts fear that the price toted for the group, which makes it more expensive than either Tesco or Sainsburys, is far higher than the company deserves.

If you're eligible to buy shares when the company lists on the stock exchange, you should know by now. Ocado emailed its legions of customers this month, saying that anyone who had spent over £300 in the last six months will be able to buy shares. If the company floats successfully, the rest of the stock will be taken by big institutional investors, such as the companies which hold your pension funds, as well as by employees of Ocado itself.

While many companies the size of Ocado would restrict their shares to institutional investors at flotation, Tim Steiner, the group's chief executive, wants customers to be able to invest.

The company is banking on its growth prospects, technology and beloved status to appeal to customers, but shoppers should only become shareholders if they're sure about what they are getting into.

"Customers should remember that delivering a good service is very different from being a good business," said Clive Black, retail analyst at Shore Capital. "I would only be happy to see shoppers buying these shares if they went into it with their eyes open." Here's a crib sheet for anyone thinking of adding Ocado to their shopping list.

Ocado is not John Lewis

Many people assume that Ocado is part of John Lewis, like the Waitrose brand, but it is not. The company is owned by a conglomerate of investors including Swiss bank UBS, consumer goods giant Procter & Gamble and the Tetrapak billionaire Jorn Rausing. The John Lewis pension fund owns 25 per cent, but much of that is expected to be sold off in the flotation.

The company has a deal to deliver Waitrose products. This has just been renegotiated, and the company has the right to sell the goods for the next 10 years and is able to use the brand on its vans. However, Waitrose also owns a competitor brand, Waitrose Deliver, which is expanding fast. The new deal is understood to include the expansion of Waitrose Deliver into Ocado's heartland within the M25 next year.

"Waitrose and Ocado have worked together for many years and are complementary businesses," a spokesman for Waitrose said yesterday. However, when the 10 years is up, the deal will need negotiating, which could leave the company high and dry.

Philip Dorgan, retail analyst at Ambrian, said that the new deal contains a clause that could see either side terminate it as early as 2017, presumably with penalty clauses.

"Ocado is dependent on another business," said Mr Black, at Shore Capital. "That makes it less valuable than Tesco and Sainsburys, which are in control of their own destinies."

It needs your cash ...

Like almost all companies that list on stock exchanges, it wants to raise money to expand. Ocado has one big warehouse in Hertfordshire, where it picks out all of its deliveries, and wants to build another one in the Midlands to help it to expand in the North of England.

The move will also allow some owners to cash in some of their stakes. The John Lewis Partnership needs to sell a large part of its stake, because it is risky to hold so much of its pension fund in one stock. However, it is expected to retain a 13 per cent holding.

Ocado will issue £200 million of new shares and existing investors, including John Lewis, are expected to offload stakes worth a further £200 million. We don't know what the banks advising Ocado think the company is worth, but rumours are suggesting up to £1 billion.

... and has never made a profit

Despite expanding fast, Ocado has never made a profit, even though it has sales of £500 million. This suggests that the company's model of picking everything from a central warehouse rather than in-store is very expensive. The company says that it will become profitable as it grows, and that it will be able to make more money selling non-food ranges and by delivering in other areas of Britain.

Analysts are using a measure called an enterprise value multiple to work out what the company might be worth. This takes the valuation of the company and divides it by its earnings before interest, taxes, depreciation and amortisation (ebitda). The company made £8 million on this basis in the first quarter, and analysts reckon it could make £25 million for the full year.

Mr Black, at Shore Capital, said a £1 billion valuation would see the company trade at 40 times ebitda, compared with Tesco and Sainsburys, which trade on seven and eight times respectively.

Supporters of Ocado say that the company deserves a higher rating because it is more like internet retailer Asos, which has an enterprise value to ebitda rating of around 30. "If you'd invested in eBay, Asos, Netflix or Amazon early on then you would have made a lot of money," said one analyst, who felt £1 billion was fair value.

"I'd struggle with a valuation of £500 million," said Mr Black at Shore Capital. He described a £1 billion valuation as "stratospheric". Mr Dorgan, at Ambrian, agreed. "It's not an Amazon and it shouldn't be rated as such," he said. "It has some very big and very nasty competitors."

Flotation is not certain

Just because a company wants to float doesn't mean that it will. The stock market is highly volatile at present and investors are nervous. Fashion group New Look has been forced to abandon plans for a float recently, as have travel services and IT provider Travelport and Legoland owner Merlin Entertainments.