Flashcards in 12) Business Valuation and market efficiency Deck (63)
What are the reasons for business vauation
▪ The business may want to list on a stock market so need to decide the share price
▪ Valuing a target company in an acquisition
▪ When a parent company wishes to dispose of its subsidiary
▪ When a shareholder wishes to dispose of their investment in a privately owned company
divorce settlements, etc
What is market capitalisation?
The market capitalisation is the term given for the market value of the equity in a company that is listed on a stock market.
The market capitalisations is:
The share price x number of ordinary shares in issue
What are the three methods of equity caluation?
Asset-based – based on the tangible assets owned by the company.
Income/earnings-based – based on the returns earned by the company.
Cash flow-based – based on the cash flows of the company
What are the three types of asset based valuation ?
• NBV (total assets less total liabilities)
• Net Realisable Values (realisable value of assets less liabilities)
• Replacement Cost- Going concern
What is NBV Historic Basis and advantage and disadvantage?
This will normally be a meaningless figure, as it will be based on historical costs. However, with fair value accounting the book value of many assets and liabilities will be the fair value and therefore will be relevant for valuation purposes. It represents effectively a MINIMUM price for a seller.
Adv: Book values are relatively easy to obtain
Disadv: Historic cost value (although could be fair value which is less of a problem)
(Ignores Intangible assets e.g. Good will as well as future because it is historical and in a point in time
What is net realisable value?
the break-up value of the assets in the business will often be considerably lower than any other computed value.
It normally represents the minimum price that should be accepted for the sale of a business as a going concern, since if the income based valuations give figures lower than the break-up value it is apparent that the owner would be better off by ceasing to trade and selling off all the assets piecemeal.
It should be noted that the market values of debt, such as bonds are calculated pre-tax.
What are the advantage and disadvantage of NRV?
Adv: Minimum acceptable to owners. Asset Stripping
Disadv: Valuation problems especially if quick sale. Ignores good will
What are the advantage and disadvantage of Replacement basis?
Adv: Maximum to be paid for assets by buyer
Disadv: Valuation problems – similar assets for comparison and also ignores good will
What are the disadvantages of Asset based valuations?
Asset based methods usually give a value lower than market value of all the company's shares.
it ignores future cash flows generated by the assets
Market/Investors do not normally buy a company for its statement of financial position assets, but for the earnings/cash flows that all of its assets can produce in the future. we should value what is being purchased, i.e. the future income/cash flows.
The asset approach also ignores non-statement of financial position intangible ‘assets’, e.g.:
strong management team
competitive positioning of the company’s products.
It is quite common that the non-statement of financial position assets are more valuable than the statement of financial position assets, especially for service organizations, which may not hold many non-current assets at all.
When are asset based valuation useful? 3 points
Asset stripping- To value companies that are going to be asset stripped or closed down; company is going to be purchased to be broken up and its assets sold off. Valued the assets at realizable value
To set a minimum price in a takeover bid- Shareholders will be reluctant to sell at a price less than the net asset valuation even if the prospect for income growth is poor. A standard defensive tactic in a takeover battle is to revalue statement of financial position assets to encourage a higher price. Valued the assets at replacement value
To value property investment companies The market value of investment property has a close link to future cash flows and share values, i.e. discounted rental income determines the value of property assets and thus the company.
When are Earnings/Income-based methods the most useful and the types?
Earnings/Income-based methods of valuation are when valuing a majority shareholding/Controlling interest:
ownership bestows additional benefits of control not reflected in the dividend valuation model
majority shareholders can influence dividend policy and therefore are more interested in earnings as you value that more
Earnings Yield Method
What is Price/Earnings method?
This is where the value of the company= Total earnings x P/E ratio
Price per share/Earnings per share (EPS)
This can then be used to value shares in unquoted companies as:
Value of company = Total earnings × PE ratio
Value per share = EPS × PE ratio
Why would an adjustment to the PE ratio of the similar company be necessary?
To make it more suitable if the company being valued is:
A private company; their shares are less liquid
The company is more risky i.e. fewer control, management knowledge,
The company has a higher projected growth level
Why would an adjustment to the earnings be necessary?
▪ Earnings are taken as profit after tax and preference dividends (because the earnings must be the future maintainable earnings i.e. everything after the obligations)
the valuation should reflect future maintainable earnings prospects and therefore should be adjusted to reflect this
What does a high PE ratio indicate?
growth stock – the share price is high because continuous high rates of growth of earnings are expected from the stock
no growth stock – the PE ratio is based on the last reported earnings, which perhaps were exceptionally low yet the share price is based on future earnings which are expected to revert to a ‘normal’ relatively stable level
takeover bid – the share price has risen pending a takeover bid
high security share – shares in property companies typically have low income yields but the shares are still worth buying because of the prospects of capital growth and level of security.
What does a low PE ratio indicate?
losses expected – future profits are expected to fall from their most recent levels
share price low – as noted previously, share prices may be extremely volatile – special factors, such as a strike at a manufacturing plant of a particular company, may depress the share price and hence the PE ratio.
What are the Advantage and disadvantage of PE method?
* It is forward looking. by multiplying by PE ratio, - it's potentially looking at earnings and having an estimate of where we think we are going to be in the future
• establishing PE ratio
• difficulty deciding which earnings to use- latest, last 5 years, what we might earn in the future?
• Difficult to find a similar company with similar growth prospects
• reported earnings are based on historical cost accounts, which makes no sense when trying to compare two companies.
What is earnings yield valuation method
The earnings yield is the inverse of the price/earnings ratio. (Earnings/Price).
To value a comapny using this, divide the earnings by the yield: Earnings/Earnings yield
As with the P/E method this is used to value a controlling interest in a company.
What are the TWO cash flow based valuations?
Dividend valuation model-> Cash to shareholders
Discounted cash flow-> Cash flow generated by the business (Value of company = PV of the future cash flows at WACC)
What is Dividend valuation
It values the company/share based on the the PV of the expected future dividends discounted at the shareholder's required rate of return
What is Dividend valuation model used for
This method can be used for valuing minority shareholdings in a company, since the calculation is based on dividends paid, something which minority shareholders are unable to influence.
What is Dividend valuation formula
[ D0( 1+g) ]
if it's a constant dividend, what formula can you use instead?
What are the disadvantages of Dividend valuation
Investors make rational decisions
▪ It assumes that there is constant dividends growth or constant dividend OR or zero growth
Problems estimating future growth rate
▪ Assumes future dividend growth is predicted from past results
▪ Cost of Equity may fluctuate in the future
▪ It assumes that the growth rate is lower than the shareholder's required rate of return. What if Ke is less than the growth rate?
The dividend growth rate is less that the cost of equity
It is highly sensitive to changes in its assumptions
What is Discounted cash flow
Value of company = PV of the future cash flows at WACC
the value of the firm should be the present value of its future cash-flows discounted at the weighted average cost of capital or enough information so that we can use CAPM to calculate it
Theoretically it is the best method of valuation. It is based on forecasting future cash flows and effectively calculating an NPV.
tell me discounted cash flow method steps
1) Identify relevant 'free' cash flows i.e. excluding financing flows
- Operating flows
- Revenue from sales of assets
- Synergies arising from the merger
2) select a suitable time horizon
3) calcuate PV over this horizon. This gives the value to all providers of finance i.e. equity + debt
4) deduct the value of debt to leave the value of equity
When is Discounted cash flow used
This alternative cash flow-based method is used when acquiring a majority shareholding since any buyer of a business is obtaining a stream of future operating cash flows.
What are the advantages of Discounted cash flow
theoretically the best method.
can be used to value part of a company.
What are the disadvantages of Discounted cash flow
it relies on estimates of both cash flows and discount rates – may be unavailable
difficulty in choosing a time horizon
difficulty in valuing a company’s worth beyond this period
assumes that the discount rate, tax and inflation rates are constant through the period.