06 - Valuing Business Interests Flashcards
What is the Intrinsic Value Method?
This method is particularly applicable to investment and property businesses because the value of these businesses are mainly in the assets.
The intrinsic value method values the business as the difference between the assets and the liabilities
It is also call the net asset value method.
What are the steps to the Intrinsic Value Method?
Establish the total value of the assets at an acceptable market value.
Establish the total liabilities
Deduct the liabilities from the market value of the assets. = Intrinsic value of the business
What are the advantages of the Intrinsic Value Method?
The method can be used if the business entity’s value is demonstrated mainly in its assets.
The calculations are easy as the figures are taken directly from the balance sheet.
What are the disadvantages of the Intrinsic Value Method?
This method does not take any future growth in the business into account.
On some occasions, the book value is far below the real market value.
There are no guidelines for establishing the market value of assets unless you involve a valuation expert.
It is hardly used in the first 5 years of the life of a business entity, as a result of the small expected net asset value due to the loan accounts and accumulation of other liabilities.
What is the Earnings Yield Method?
This method is applicable where the asset base is not directly related to the earning potential of the business, for example a business that provides professional services or a trading business.
The actual value is derived from the net earned income after tax generated from the services delivered.
What are the steps to the Earnings Yield Method?
1) Establish the future annual net income after tax
- The current net income after tax can be taken straight from the income statement
- Multiply this figure by an appropriate annual increase factor to calculate the future expected net income after tax.
2) Establish a reasonable fair rate of return.
3) Capitalise the annual future net income at the fair rate of return.
- It is important to consider the net earning in detail
- Once off amounts such as exception profits, or major expense outlays, can impact the net income of the business in a particular year and should sometimes be excluded.
- This is a complicated area and care must be taken to only adjust the income where really deemed appropriate.
What are the advantages of the Earnings Yield Method?
This is a forward looking method and values the future net income streams of the business. It is a good method because it is based on the present value of the expected future income. Therefore it provides the assessor with an idea of the possible future earnings of the business entity assuming option or steady economic growth.
The method is most applicable where the asset base is not directly related to the earning potential of the company e.g. services companies.
It is widely used in the insurance industry.
What are the disadvantages of the Earnings Yield Method?
Care must be taken when consider the appropriate fair rate of return.
This method ignores the capital employed in the business.
It treats profit as ceaseless.
What is the Dividend Yield Method?
This method is applicable when valuing minority shares in a larger established business that provides a steady stream of dividend income.
What are the steps to the Dividend Yield Method?
1) Establish the future divided declaration This can be calculated from the current dividend declaration
2) Multiply the current dividend declaration by an appropriate annual increase factor to calculate next year’s divided declaration.
3) Establish a fair rate of return
4) Capitalise the annual future divided declaration
5) Multiply this capitalised value by the number of shares held.
What are the advantages of the Dividend Yield Method?
Most suitable when valuing shares related to a small percentage shareholding in a business entity.
What are the disadvantages of the Dividend Yield Method?
Seldom used in the insurance industry
Ignores value of the assets.
What is the Super Profits Method?
The super profits method is essentially a combination of the intrinsic value method and earnings yield method.
It thus takes the asset value as well as the future expected income of the business into account with the intention of arriving at a business value.
It is an appropriate method to use where the value of the business is contained in its assets as well as in its future earning potential.
The super profits method takes int account the present value of the future expected earnings, assuming a reasonable fair rate of return is used.
These ‘super’ earnings or profits are then capitalised over a predetermined period, during which the business is reasonably expected to maintain this high level of return on investment. A five-year period is commonly used for the purpose of this time value of money calculation.
Once the present value of the super profits during the proposed five-year period has been calculated, the net asset value of the business is added to arrive at the total business value.
What are the steps to the Super Profits Method?
1) Establish intrinsic or net asset value
2) Determine annual expected income after tax. These allow for the super profits expected.
3) Determine a reasonable fair rate of return and the number of years over which super profits are expected.
4) Calculate what is considered as fair income i.e. the assets employed X a reasonable fair rate of return.
5) Calculate the super profits = projected income - calculated fair income.
6) Calculated the discounted value of the super profits over a number of years by using the assumptions.
7) Final value of the business = value of assets + discounted value of super profits.
What are the advantages of the Super Profits Method?
This method is the most suited for valuing a majority holding in a business entity.
It takes both asset value as well as expected income into account, offering a fair approach to the valuation.
