18. Business Valuation

Question 1

Outline 5 reasons for business valuation.

Answer 1

1. To determine the value of a private company (e.g. for a management buy out (“MBO”)).
2. To determine the maximum price to pay when acquiring a listed company (eg in a merger or takeover).
3. To aid in decisions on buying/selling shares in private companies.
4. To place a value on companies entering the stock market (ie for an IPO).
5. To value subsidiaries/divisions for possible disposal.

Question 2

State the three asset-based valuation methods (examinable on the FM syllabus).

Answer 2

1. Net book value
2. Net realizable value
3. Net replacement cost

Question 3

Outline the net book value (NBV) method of business valuation. Identify 3 weaknesses of this method.

Answer 3

The NBV method uses the accounting equation.

Equity = assets - liabilities

Weaknesses:
1. Balance sheet (ie carrying) values are often based on historical cost rather than market values.

2. Net book value of non-current assets depends on depreciation/amortisation policies.
3. Significant assets may not be recorded in the statement of financial position (eg internally generated goodwill will not be recognised).

Question 4

Outline the net realisable value (NRV) approach to business valuation. State one shortcoming of this method.

Answer 4

The NRV method estimates the liquidation value of a business:

Equity = estimated NRV of assets - liabilities

This represents what should be left for shareholders if the assets were sold off and the liabilities settled and may represent the minimum price that might be acceptable to the present owner if the business as it ignores unrecorded assets (eg internally-generated goodwill).

In addition, it is also difficult to estimate the NRV of assets for which there is no active market (eg a specialist item of equipment).

Question 5

Outline the net replacement cost method of business valuation and state two disadvantages of this method.

Answer 5

Net replacement cost can be viewed as the cost of setting up an identical business from scratch.

Equity = estimated depreciated replacement cost of net assets

This may represent the maximum price a buyer might be prepared to pay.

Weaknesses:
1. Technological change means it is often difficult to determine comparable assets for the purposes of valuation.

2. It ignores unrecorded assets (eg goodwill).

Question 6

What are the two income-based valuation methods (examinable under FM syllabus)?

Answer 6

1. Price/earnings ratio
2. Earnings yield

Question 7

Outline the price/earnings ratio method of business valuation. State the formulas for P/E ratio, EPS, ordinary share price and value of company.

Answer 7

The published P/E ratio of a quoted company takes into account the expected growth rate of that company (ie it reflects the market’s expectations for the business).

Using published P/E ratios as a basis for valuing unquoted companies may indicate an acceptable price to the seller of the shares.

P/E ratio = market price per ordinary share / earnings per share

EPS =profit after tax and preference dividends / number of issued ordinary shares

Ordinary share price = P/E ratio * EPS

Value of company = P/E ratio * profit after tax and preference dividends

Question 8

What are some problems associated with the P/E ratio and earnings yield methods of business valuation?

Answer 8

1. A suitable “proxy” may not exist (ie no similar company listed on the stock market).
2. Even if a proxy exists it may be under/over-valued by the stock market.
3. The earnings of the unquoted company may be intentionally inflated.
4. The earnings may not be a fair representation of future earnings even if they have not been deliberately distorted. Information asymmetry means that the seller will know more about the company and potentially the industry than the buyer.
5. The P/E ratios might not be appropriate. Share prices can sometimes vary dramatically.
6. A valuation based on earnings is less appropriate for purchases of minority shareholdings.
7. If the unquoted company being valued is loss-making, the P/E ratio method results in a (meaningless) negative value for its equity.

Question 9

Outline the Earnings Yield method of business valuation. What is the formula for earnings yield and how is the ordinary share price derived from it.

Answer 9

Earnings yield is the reciprocal of the P/E ratio.

Earnings yield = (EPS/market price per share) * 100

Therefore:

Ordinary share price = EPS/Earnings Yield

Question 10

State two cash flow-based methods of business valuation.

Answer 10

1. Dividend valuation model
2. Discounted Cash Flow Basis

Question 11

Outline the Dividend Valuation Model of business valuation.

Answer 11

If dividends are forecast to grow T a constant annual rate to perpetuity, the valuation formula is:

P₀ = [D₀(1+g)/(r_e-g)]

Where
D₀ = most recent dividend

g = dividend growth rate

r_e = required return of equity investors (=k_e)

P₀ = current share price

Note that D₀(1+g) is the dividend in one year.

Question 12

State 4 weaknesses of the dividend valuation model.

Answer 12

1. Determining growth rate of dividends.
2. Determining the required return for an unquoted company.
3. It has less relevance for valuing a majority shareholding, as such an investor has the ability to change the dividend policy.
4. Assumes the cost of equity will remain constant and the share price grow at the same rate as the dividend.

Question 13

Outline the discounted cash flow basis of business valuation.

Answer 13

A business can be viewed as a combination of its underlying projects. Similar to how a project’s value is the PV of its future cash flows, so too is the total value of a business equal to the PV of all its future cash flows.

Relevant discount rate in this case is the WACC. The PV of operating cash flows is the value of the company’s assets. The value of equity is then calculated as:

Value of equity = value of assets - value of debt

Question 14

Outline the following practical factors to consider in business valuation:
- marketability and liquidity

Answer 14

1. Marketability and liquidity
   Unquoted companies are less marketable which reduces their value relative to quoted companies.

They are not bound by stock exchange rules and corporate governance codes and are thus perceived more risky.

When there is little to no liquidity in the market shares in even quoted companies will suffer from a lack of marketability.

Question 15

Outline the following practical factors to consider in business valuation:
- information sources and availability

Answer 15

Potential investors generally have more publicly available info when deciding to buy quoted shares (eg published financials, research reports, news etc).

Less info is available for unquoted companies who are usually exempt from publishing financials and are unlikely to be watched by analysts and news agencies.

This leads to asymmetry of information between the managers and potential investors in unquoted companies leading to investors undervaluing the shares.