B4. Valuation and the use of free cash flows Flashcards
When are Valuations needed (when we need to know the worth)?
- Takeovers (Price paid would be MV + a takeover premium)
- When setting a price for an I.P.O (Initial Public Offer)
- Selling ‘private’ shares
- When using shares as loan security
- When negotiating a sale of a private company
- For liquidation purposes
What information helps Valuation?
- Financial statements to see a bigger picture
- Non-current asset summaries – individual assets as not provided in FS
- Investments held – individual assets as not provided in FS
- Working capital listing (debtors, creditors and stock)
- Lease agreements - how much capital outstanding/commitments
- Budgets - sales
- Current industry environment - future indicator
What are the limitations of the information provided?
- Does the PPE need a costly revaluation?
- Are there any contingent liabilities not taken into account?
- Has deferred tax been calculated appropriately?
- How has stock been valued?
- Are all debtors receivable?
- Are there any redundancy costs?
- Any prior charges on assets?
- What shareholding is being sold? Does it mean the business carries on?
There are 3 basic approaches to valuation:
- Asset-based models – these models attempt to value assets that are being acquired as a result of acquisition (NAV, book value plus and CIV).
- Market-based models – these models use market data to value the acquisition (P/E, earnings yield and market-to-book ratio).
- Cash-based models – these models are based on a discounted value of the future cash flows relating to an acquisition (dividend valuation, FCF/FCFE and APV).
An acquisition may potentially have an impact on both the financial and business risk of the acquirer. This impact needs to be incorporated into the analysis of the valuation of an acquisition.
Asset- based models
Use the statement of financial position as the starting point in the valuation process.
Asset- based models. There are different ways of measuring assets:
- Book Values. This is poor as it uses historic costs and not up to date values. It can give a ball park figure though.
- Net Realisable Value. This would represent the minimum value of a private company - as it is what the assets alone could be sold for. However, even here there is the problem of needing to sell quickly may mean the NRV might be difficult to value. Another weakness of this is that this gives a value for the assets when SOLD not when IN USE. Therefore, not good for a situation of partial disposal where business and hence assets will carry on
- Replacement Cost. The maximum price predator would buy. Here the valuation difficult - need similar aged assets value. It also ignores goodwill.
Asset- based models.
Net asset value (NAV).
This values the target company by comparing its assets to its liabilities, which gives an estimate of the funds that would be available to the target’s shareholders if it entered voluntary liquidation. For an unquoted company, this value would need to at least be matched by a bidder, and this value is often used as a starting point for negotiating the acquisition price.
Drawbacks of NAV approach. This technique is sometimes used to estimate a minimum value for an unquoted company that is in financial difficulties or is difficult to sell (if company is listed then its minimum value is its current share price). This technique ignores: the value of future profits and value of intangibles.
Asset- based models.
Book value plus.
Because NAV ignores the profit of the target company in the valuation, a premium is normally negotiated, based either on a multiple of the firm’s profits or an estimated value of the company’s intangible assets. This is called a ‘book value plus’ model. In a book value-plus valuation the replacement value of the assets may be more useful than the book value. The replacement value of the assets of the acquisition target would quantify the cost of setting up the company from scratch without an acquisition i.e. by acquiring the assets on the open market.
Asset- based models.
Calculated Intangible Value (CIV).
In many firms intangible assets are of enormous value (knowledge base, brand name, contacts with suppliers and customers etc). CIV assesses whether the company is achieving an above-average return on its tangible assets. This figure is then used in determining the present value attributable to intangible assets. CIV involves the following steps:
• Estimate the profit that would be expected from an entity’s tangible asset base using an industry average expected return.
• Calculate the present value of any excess profits that have been made in the recent past, using the WACC as the discount factor.
Asset- based models.
Drawback of CIV approach.
- It uses the average industry return on assets as a basis for computing excess returns; the industry average may be distorted by extreme values.
- CIV assumes that past profitability is a sound basis for evaluating the current value of intangibles – this will not be true (brand might have been weakened)
- CIV assumes that there will be no growth in value of the excess profits being created by intangible assets.
Asset- based models.
Lev’s method for valuing intangibles.
Lev’s method for valuing intangibles. This method is modification of approach used in CIV and involves adjusting the valuation to reflect that growth will not be zero. It is similar to CIV, but this model then proposes 3 step discounting procedure.
• Discount the first five years at the firm’s current rate of growth
• Discount the next five years at a declining rate that moves towards the industry average
• Discount after this at the industry growth rate.
Market capitalization.
How much the market values the company? It is calculated as follows: Share Price x Number of shares
Market-based models.
A sensible starting point for valuing a listed company is the market value of its shares. If the stock market is efficient the market price will reflect the market’s assessment of the company’s future cash flows and risk (both business and financial). It follows that the relationship between the company’s share price and its earnings figure, i.e. its P/E ratio, also indicates the market’s assessment of a company or a sector’s future cash flows and risk.
High P/E ratio (market price per share/EPS):
• Expectations of high future growth – a high price is being paid for future profit prospects
• Low risk – a low-risk company would be valued on a higher P/E ratio
Market-based models.
P/E method.
P/E method. A P/E ratio can be applied to valuing a takeover target by taking the latest earnings of the target and multiplying by an appropriate P/E ratio.
Market based value=
Earnings of target (shows the current profitability of the company) x
Appropriate P/E ratio (reflects the growth prospects/risk of a company)
Market-based models.
Problems with P/E method:
• Choice of which P/E ratio to use.
o The P/E ratio used should reflect the business and financial risk (ie capital structure) of the company that is being valued (difficult to achieve in practice).
o Also, the P/E ratio will normally be reduced if the company that is being valued is unlisted (by about 30-50%).
• Earnings calculation.
o The earnings of the target company may need to be adjusted, such as one-offs or salaries that will change after takeover.
o Historic earnings will not reflect the potential future synergies that may arise from an acquisition. Earning may need to be adjusted to reflect such synergies.
o Latest earnings may have been manipulated upwards by the target company in anticipation of takeover.
• Stock market efficiency. Behavioural finance suggests that stock market prices may not be efficient because they are affected by psychological factors, so P/E ratios may be distorted by swings in market sentiment.
