8. Business Valuations Flashcards
What are the 5 reasons that a valuation may be necessary?
- Seeking stock market flotation
- Considering buying another business
- Looking to sell part of the business
- Valuation of potential borrower
- Tax purposes (e.g. passing on the business)
What are the 3 categories of methods for valuing equity?
- Asset based
- Earnings based
- Cash flow based
What are the 3 asset based methods of equity valuation?
- Historic cost
- Replacement cost
- Realisable value
What are the 2 earnings based methods of equity valuation?
- P/E ratio
- Earnings yield
What are the 3 cash flow based methods of equity valuation?
- Discounted cash flows
- Dividend yield
- Dividend growth model
What is the equation for market capitalisation?
Number of shares x share price
Although using different valuing methods, what is the equation for equity value using asset based methods?
Net assets -> Non-current assets + Net Current Assets - Long term liabilities
= Total assets - total liabilities
What is the pro of using book value in an asset based valuation?
Easy to determine
What is the con of using book value in an asset based valuation?
May be historic cost and not representative of current market values
What is the pro of using realisable value in an asset based valuation?
Give a better indication of price in a sell off or asset stripping situation
What is the con of using realisable value in an asset based valuation?
Realisable values need to be known, and may be lower than market values
What is the realisable net asset value often used for?
The minimum price a seller of a business may accept
What is the replacement cost net asset value often used for?
The maximum price a buyer might consider paying for a business
What are the 2 advantages of asset based valuations?
- Quick and simple to estimate
- Gives a good minimum/starting point
What are the 3 disadvantages of asset based valuations?
- Not as good at valuing ongoing earnings
- Does not consider values of intangible assets
- Reliant on accounting conventions
What is the equation for the P/E ratio?
Market capitalisation / earnings
OR
Share price / EPS
What does the P/E ratio give an indication of?
The markets perception of the future growth of the business (the higher, the better)
How can we estimate the market value of equity, given the P/E ratio?
P/E ratio x current earnings
What is the equation for earnings?
PAT minus pref dividends
How can we estimate the value of one share, given the P/E ratio?
P/E ratio x EPS
How do we estimate the market value of equity in an unquoted company, with no P/E ratio?
Use the P/E ratio of a similar company, adjusted to reflect any differences
Why do we need to adjust down another company’s P/E ratio when using it to value an unquoted company?
As listed companies are more desirable than private companies due to liquidity of shares
When valuing a company undergoing change, what value should be used for the earnings element of the calculation?
The sustainable earnings available to ordinary shareholders (so removing any distorting/one off costs or revenues)
What are the 4 main advantages of P/E based valuations?
- Quick to calculate
- Considers future potential
- Can value unquoted companies
- Can value a controlling interest
What are the 3 main advantages of P/E based valuations?
- May need adjustments to the P/E and earnings figures
- Calculations are based on profits rather than cash flows
- Uncertainty around what P/E ratio to use
What is the equation for earnings yield?
Earnings / Market capitalisation
or EPS / Share Price
or 1 / P/E ratio
When is the present value of cash flows suitable for valuing a shareholding?
For controlling interests
When dividend based cash flow methods suitable for valuing a shareholding?
For smaller shareholdings
What 2 discount factors can you use when valuing a company by cash flow?
Cost of equity (Ke) or WACC
When using the cost of equity cash flow valuation method, what cashflows are used?
Free cashflows to shareholders - cash flows after interest and tax
When using the WACC cash flow valuation method, what cashflows are used?
Free cashflows to all investors - cash flows before interest but after tax
What is the resulting figure from the cost of equity cash flow valuation method?
The market value of equity
What is the resulting figure from the WACC cash flow valuation method?
The market value of equity + market value of debt
What are the 4 steps applied to PBIT for both free cash flow to equity and free cash flow to all investors?
- Add back depreciation/amortisation
- Add proceeds from capital disposals
- Deduct capital expenditure
- Add decrease/ deduct increase in working capital
What are the 2 additional steps applied to PBIT for cash flow to equity?
- Deduct interest
- Add new debt raised/ deduct debt repaid
What is the tax deducted from PBIT for both equity and investor cash flow valuations?
(PBIT - interest) x tax
and
(PBIT) x tax
((or + deprn - tax deprn))
What is meant in an exam by just ‘free cashflow’?
Free cashflow to equity
Once the free cashflow to equity has been determined, what is the valuation equation?
MV EQUITY = FCF * (1+g) / Ke - g
Once the free cashflow to investors has been determined, what is the valuation equation?
MV EQUITY + MV DEBT = FCF * (1+g) / WACC - g
What are the 3 advantages of using cash flow valuation methods?
- Consider future potential of the business
- Can be used to value any business
- Considers the time value of money
What are the 2 disadvantages of using cash flow valuation methods?
- Future cash flows will be estimates only
- Requires a cost of capital to be estimated
What is the dividend yield equation?
Total dividend / market capitalisation
For an ordinary share, paying an annual dividend d, growing at rate g, what is the ex-dividend value of the share?
d*(1+g)/ ke - g
What are the 2 advantages of using the dividend growth valuation model?
- Considers future cash flows to shareholders
- Good for minotrity interests
What are the 3 disadvantages of using the dividend growth valuation model?
- Assumes dividends grow at a constant rate forever
- Requires a cost of equity to be estimated
- Strange results when companies dont pay dividends, or where g > ke
What are the 3 types of intellectual capital?
- Human knowledge/skills
- Intellectual assets (e.g. reports, software)
- Intellectual property (patented/copyrighted)
What 2 things do the value of digital assets heavily depend on?
- Usage rights of the company (e.g developed or by 3rd party)
- The impact of regulatory changes on a company’s ability to utilise
What are the 3 methods for valuing intangible assets?
- Market approach
- Cost approach
- Income approaches
What is the issue with valuing intangible assets at cost?
Ignores future revenue generating potential
What are the 3 income approaches for valuing intangible assets?
- PV of cash flows generated
- Relief from royalties
- Calculated Intangible Value (CIV) method
What are the steps of the Calculated Intangible Value (CIV) method?
- Estimate average excess return expected on tangible assets (PBT - Industry return on assets % x year end tangible assets)
- Estimate PV of excess returns as a perpetuity (Excess returns x (1 - tax rate) / WACC)
- Estimate the total value of the business (Value of tangibles + CIV)
What are the 5 attributes of an efficient market?
- Share prices are fair
- No individual dominates
- Transaction costs are not significant
- Share prices follow a random walk (rise good, fall bad)
- Share prices change quickly to reflect information about a company
What is the efficient market hypothesis?
The EMH considers how quickly and rationally share prices react to new information, labelled as weak form, semi-strong and strong form efficiency
What does the share price reflect in a weak form efficient market?
Information about past price moves and past information which has become fact
How do you beat the market in a weak form efficient market?
Analyse forecasts and the actions of the company
When is a positive NPV project reflected in a share price within a weak form efficient market?
When its value has been reflected and evidenced
What does the share price reflect in a semi-strong efficient market?
All publicly available information
How do you beat the market in a semi-strong efficient market?
Insider trading (illegal)
When is a positive NPV project reflected in a share price within a semi-strong efficient market?
When a project is announced
What does the share price reflect in strong form efficient market?
All information about a company
When is a positive NPV project reflected in a share price within a strong form efficient market?
When the board agree to undertake a project
How do you beat the market in a strong form efficient market?
Luck
What 2 reasons justify offering about current share price?
- Economic efficiencies from the takeover
- Acquisition of a controlling interest
Under EMH, which form of efficiency is assumed to generate a fair share price?
Semi-strong efficiency