12) Business Valuation and market efficiency

Question 1

What are the reasons for business vauation

Answer 1

▪ 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

Question 2

What is market capitalisation?

Answer 2

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

Question 3

What are the three methods of equity caluation?

Answer 3

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

Question 4

What are the three types of asset based valuation ?

Answer 4

• NBV (total assets less total liabilities)
• Net Realisable Values (realisable value of assets less liabilities)
• Replacement Cost- Going concern

Question 5

What is NBV Historic Basis and advantage and disadvantage?

Answer 5

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

Question 6

What is net realisable value?

Answer 6

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.

Question 7

What are the advantage and disadvantage of NRV?

Answer 7

Adv: Minimum acceptable to owners. Asset Stripping

Disadv: Valuation problems especially if quick sale. Ignores good will

Question 8

What are the advantage and disadvantage of Replacement basis?

Answer 8

Adv: Maximum to be paid for assets by buyer

Disadv: Valuation problems – similar assets for comparison and also ignores good will

Question 9

What are the disadvantages of Asset based valuations?

Answer 9

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.:
 highly-skilled workforce
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.

Question 10

When are asset based valuation useful? 3 points

Answer 10

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.

Question 11

When are Earnings/Income-based methods the most useful and the types?

Answer 11

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

Types:
PE ratio
Earnings Yield Method

Question 12

What is Price/Earnings method?

Answer 12

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

Question 13

Why would an adjustment to the PE ratio of the similar company be necessary?

Answer 13

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

Question 14

Why would an adjustment to the earnings be necessary?

Answer 14

▪ 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

Question 15

What does a high PE ratio indicate?

Answer 15

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.

Question 16

What does a low PE ratio indicate?

Answer 16

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.

Question 17

What are the Advantage and disadvantage of PE method?

Answer 17

Advantage:

• 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

Disadvantage:

• 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.

Question 18

What is earnings yield valuation method

Answer 18

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.

Question 19

What are the TWO cash flow based valuations?

Answer 19

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)

Question 20

What is Dividend valuation

Answer 20

It values the company/share based on the the PV of the expected future dividends discounted at the shareholder’s required rate of return

Question 21

What is Dividend valuation model used for

Answer 21

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.

Question 22

What is Dividend valuation formula

Answer 22

P0=

[ D0( 1+g) ]
÷
Ke- g

Question 23

if it’s a constant dividend, what formula can you use instead?

Answer 23

Perpetuity formula

Question 24

What are the disadvantages of Dividend valuation

Answer 24

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

Question 25

What is Discounted cash flow

Answer 25

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.

Question 26

tell me discounted cash flow method steps

Answer 26

1) Identify relevant ‘free’ cash flows i.e. excluding financing flows
- Operating flows
- Revenue from sales of assets
- Tax
- 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

Question 27

When is Discounted cash flow used

Answer 27

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.

Question 28

What are the advantages of Discounted cash flow

Answer 28

Advantages

theoretically the best method.
can be used to value part of a company.

Question 29

What are the disadvantages of Discounted cash flow

Answer 29

Weaknesses

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.

Question 30

What must you take into account when valuing a company post take over?

Answer 30

(1) Synergy – any synergy arising from the takeover would be expected to increase the value of the company.
(2) The method of financing the takeover. If cash is used to finance the takeover the value of the company will be expected to fall by the amount of cash needed. If shares are used to finance the takeover then the extra shares issued need to be taken into account when calculating the value per share.

Question 31

What is the value of a bond?

Answer 31

The value of a bond is the present value of the future cash flows that an investor will receive discounted at the investors required rate of return.

The investors required rate of return is the pre-tax cost of debt or yield

Question 32

What is the formula for irredeemable bond?

Answer 32

Annual Interest ÷ Pre tax cost of debt

Question 33

What is the formula for redeemable bond?

Answer 33

▪ The market value of a bond is the discounted present value of future interest payments up to the year of
redemption, plus the discounted present value of the redemption payment.

▪ The cash flows are discounted at the pre-tax cost of debt.

Question 34

What is the formula for convertible bond ?

Answer 34

The market value of a convertible is the higher of its value as debt and its converted value. This is known as its formula value.

Floor value = market value without the conversion option
= PV of future interest and redemption value, discounted at = the debt holders’ required return.

Conversion = market value – current conversion value. premium

Question 35

What is an efficent market?

Answer 35

An efficient market is one in which security prices fully reflect all available information.

In an efficient market, new information is rapidly and rationally incorporated into share prices in an unbiased way.

Question 36

What are the benefits of an efficient market?

Answer 36

▪ To ensure investor confidence- they buy and sell shares. If shares are incorrectly priced, many savers would refuse to invest, thus seriously reducing the availability of funds and inhibiting growth.

▪ Reflect directors’ performance in the share price

Question 37

What is the efficient market hypothesis?

Answer 37

The EMH states that security prices fully and fairly reflect all relevant information. This means that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck.

The idea is that new information is quickly and efficiently incorporated into asset prices at any point in time, so that old information cannot be used to foretell future price movements.

Question 38

Three levels of efficiency are distinguished, depending on the type of information available to the majority of investors and hence already reflected in the share price. What are they?

Answer 38

Weak
Semi strong
Strong

Question 39

What is an inefficient market hypothesis and what would be signs of this and what causes this

Answer 39

An inefficient market is one in which the value of securities is not always an accurate reflection of the available information. Markets may also operate inefficiently, e.g. due to low volumes of trade.

In an inefficient market, some securities will be overpriced and others will be under-priced, which means some investors can make excess returns while others can lose more than warranted by their level of risk exposure.

Question 40

What is the information, evidence and conclusion for weak form efficiency?

Answer 40

Information:

Share prices reflect information about all past price movements. Past movements do not help in identifying positive NPV trading strategies.

Evidence: Lots of evidence

Share prices follow a random walk:
▪ there are no patterns or trends- follow random walk
▪ prices rise or fall depending on whether the next piece of news is good or bad
▪ tests show that only 0.1 % of a share price change on one day can be predicted from knowledge of the change on the previous day.

Conclusion:

future price movements cannot be predicted from past price movements
chartism/technical analysis cannot help make a consistent/abnormal gain on the market.

Question 41

What is the information, evidence and conclusion for semi-strong form efficiency?

Answer 41

Information:

the share price incorporates all past information and all publicly-available information (i.e. a semi-strong form efficient market is also weak form efficient and public information includes past information) this includes immediate response to current public informatoin about the company

Evidence:

Share prices react very quickly to any new information being released and:
▪ rise in response to breaking good news
▪ fall in response to breaking bad news.

Conclusion:

The stock market is (almost) semi-strong form efficient and so:

▪ fundamental analysis – examining publicly-available information – will not provide opportunities to consistently beat the market
▪ only those trading in the first few minutes after the news breaks can beat the market
▪ since published information includes past share prices a semi-strong form efficient market is also weakly efficient.

Question 42

What is the information, evidence and conclusion for strong form efficiency?

Answer 42

Information:

In a strongly efficient market, the share price incorporates all information, whether public or private, including information that is as yet unpublished.

Evidence: Stock markets are NOT strong form efficent

Insiders (directors for example) have access to unpublished information. If the market was strong form

▪ the share price wouldn’t move when, e.g. news broke about a takeover, as it would have moved when the initial decision was made – in practice they do!
▪ there would be no need to ban ‘insider dealing’ as insiders couldn’t make money by trading before news became public – it is banned because they do!

Question 43

..what are the conclusions from strong form market

Answer 43

Conclusion:

The stock market is not strong form efficient and so:

▪ If the market was strong form efficient, investor would only make abnormal gains would be made by luck

Because the market is only semi-strong form efficient, abnormal gains can be made from analysing ‘inside information’. Hence the need for legislation to prevent insider dealing,

▪ insider dealers have been fined and imprisoned for making money trading in shares before the news affecting them went public
▪ the stock exchange encourages quick release of new information to prevent insider trading opportunities
▪ insiders are forbidden from trading in their shares at crucial times.
▪

Question 44

How is insider trading dealt with?

Answer 44

most stock markets have codes of conduct and most countries have introduced legislation to curb insider dealing.

Companies must release price sensitive information quickly e.g. LSE has strict guidelines to encourage companies to make announcements to the market asap on such matters as current trading conditions and profit warnings

Completely prohibit certain individuals from dealing in a company shares at crucial time periods. E.g. LSE precludes directors of quoted companies and other employees in the possession of price sensitive information from trading shares for a period of two months before the announcement of annual results.

The Code also precludes dealing before the announcement of matters of an exceptional nature involving unpublished information, which is potentially price sensitive.

Question 45

What are the conclusions for the market?

Answer 45

If the market is semi-strong form efficient then a number of key conclusions can be drawn:

▪ shares are fairly priced – the purchase is a zero NPV transaction (unless you are an insider dealer!)
▪ managers can improve shareholders’ wealth by investing in positive NPV projects and communicating this to the market
▪ most investors (including professional fund managers) cannot consistently beat the market without inside information.

Question 46

What is the efficient market paradox?

Answer 46

In order for the market to remain efficient, investors must believe there is value in assessing information. Because they assess it continuously, the information is reflected in the share price as soon as it is released and an investor cannot beat the market.

The continuous actions of fundamental analysts ensure that the market reacts almost instantaneously to the disclosure of new information. Their actions safeguard market efficiency and are thus self-defeating, as they cannot then individually beat the market. Their collective value to the market is that they guarantee its efficiency.

If investors believe in the Efficient Market Hypothesis (EMT) then they believe that the market efficiently incorporates all old and new pieces of information and thus the quest to beat the market is a losing proposition and everyone should just buy index funds.

But, if enough people believe that the market is efficient then no one will engage in active management, thereby decreasing the overall efficacy of the now not-so-efficient market by slowing the diffusion of information into market prices.

Therefore, if enough people actually believe that the market is efficient then that belief actually ensures the falsity of the theory itself, ergo, a paradox forms.

Question 47

What is behavioral finance?

Answer 47

A consequence of the efficient market hypothesis being true would be that share prices would only rise and fall in response to breaking good or bad news about the company and that investors behave in a rational way by weighing up to risk and potential return through assessment and finally deciding to buy or sell.

In real life, there are often large movements in share values that are unrelated to such breaking news, where investors appear to be acting irrationally.

Question 48

What are the behavioural finance terms?

Answer 48

Herding
Stock market bubble
Noise traders
Loss aversion
Momentum effect

Question 49

What is stock market bubble

Answer 49

Stock market bubble – where a herd instinct has led to a sharp rise in the value of shares in a certain sector that is unsustainable. This doesn’t just apply to shares – house prices in the US rose massively in the mid-2000s, only to reach a peak and then decline by as much as 40% in some areas when the bubble burst.

Question 50

What is noise trader

Answer 50

Noise traders – stock market traders who do not base their decisions on professional analysis, who make poorly timed decisions and follow trends.

Question 51

What is loss aversion

Answer 51

Loss aversion – where investors avoid investments that have the risk of making losses even though long-term analysis would suggest significant capital gains may be made. This can lead to choosing investments that are safe but low earning and away from investments that have high gain potential.

Question 52

What is momentum effect

Answer 52

Momentum effect – Once a trend is seen in share prices, the market may become optimistic (if prices are rising) or pessimistic (if prices are falling) and this will stimulate or stifle further investment and lead to the trend continuing.

Question 53

What are other factors to consider in the valuation of shares and businesses for unlisted companies

Answer 53

▪ Marketability and liquidity of shares in private companies- This is why values from methods such as PE ratio and Earnings Yield are downgraded

▪ Available information- Information for unlisted companies are less readily available. This can be due to weaker control environment, unaudited financial statements, few compliance regulations to comply to, no tradition of sharing information so no channels of commination set up and less detailed record keeping processes. Due to this, the initial valuation is also downgraded

▪ Equilibrium prices-

Question 54

What is equilibrium prices?

Answer 54

In reality, the market does show sudden price fluctuations that cannot be explained simply by the information being newly released. If a share price is highly volatile, then it is considered not in equilibrium.

Prices used to provide data for the valuation of unlisted shares need to be in equilibrium if meaningful values are to be obtained. If only a few similar companies exist, and their shares are not in equilibrium, any share price calculated must be treated with caution.

Question 55

what is the formula for working out the retained earnings for the gordons growth approximation?

Answer 55

e.g. dividend per share= 18c
paid on EPS of 25
Payout ratio is 72% therefore retention is 28%

Question 56

When calculating discounted cash flow to value equity , what are the relevant cash flows

Answer 56

Operating profit (Revenue- expenses)
Tax to pay= Profit * rate of tax
tax relief on depreciation =TAD x rate of tax 

Cash free cash flow= Profit - Tax + Tax relief

Question 57

What is technical anaysis/chartism?

Answer 57

An investor believes that they can make abnormal returns by studying past share price movements

Question 58

What is technical anaysis/chartism?

Answer 58

An investor believes that they can make abnormal returns by studying past share price movements

Question 59

What is the theoretical value of the company?

Answer 59

PAT divided by the WACC

Question 60

WHAT are the assumptions of Dividend growth model

Answer 60

Investors make rational decisions
Dividends show either constant growth or zero growth
The dividend growth rate is less that the cost of equity

Question 61

when we are looking at VALUING, it is from an investors perspective- and MV of debt what is the formula

Answer 61

discounted at the investors required rate of return so pre tax (NOT business’/post tax)

Question 62

Discuss the significance of the efficient market hypothesis (EMH) for the financial manager.

Answer 62

INTRO: Capital market efficiency is concerned with pricing efficiency when weak form, semi-strong form and strong form efficiency are being discussed. In relation to pricing efficiency, the efficient markets hypothesis (EMH) suggests that share prices fully and fairly reflect all relevant and available information. Relevant and available information can be divided into past information, public information and private information

If the EMH is correct and share prices are fair, there is no point in financial managers seeking to mislead the capital market, because such attempts will be unsuccessful.

Window-dressing financial statements, for example, in order to show a company’s performance and position in a favourable light, will be seen through by financial analysts as the capital market digests the financial statement information in pricing the company’s shares.

Another consequence of the EMH for financial managers is that there is no particular time which is best for issuing new shares, as share prices on the stock market are always fair.

Because share prices are always fair, there are no bargains to be found on the stock market, i.e. companies whose shares are undervalued. An acquisition strategy which seeks to identify and exploit such stock market bargains is pointless if the EMH is correct.

It should be noted, however, that if real-world capital markets are semi-strong form efficient rather than strong form efficient, insider information may undermine the strength of the points made above. For example, a company which is valued fairly by the stock market may be undervalued or overvalued if private or insider information is taken into account

Question 63

“When a listed company publishes accounts which show a loss, one would normally expect the share price of that company to fall.”

Using the efficient market hypothesis critically comment on this statement.

Answer 63

Whether or not the share price will fall depends upon the efficiency of the market.

If the market was strong form efficient then the publication of accounts showing a loss would not be telling the market anything it did not already know and hence the share price should remain unchanged.

If the market was semi-strong efficient than any impact on the share price would depend upon the extent to which the publication of the accounts made new information publicly available. Normally companies will manage the market’s expectations by indicating to the market the likely level of profit and loss prior to the publication of accounts. If this has occurred then the publication of the accounts will have little impact on the share price.

If the market was only weak form efficient than any impact on the share price would depend upon the extent to which the publication of the accounts resulted in new information reaching the market.