Business and securities valuation

Question 1

Equity valuation

Answer 1

In an exam question you may be asked for a specific method of valuation or a range
of valuations.
If asked for a range of valuations, then aim for 2 – 3 different methods:
 Start with the net asset method (Section 6) as this is often the easiest
 Utilise any market information that you have such as the PE ratio method
(Section 4)
 Utilise the discount rate by discounting:
– Dividends (Section 4) or
– Earnings (Section 4) or
– Cash flows (Section 5).
 A discounting calculation will often include a delayed perpetuity (Section 3)
 Be prepared to discuss the merits of each method (Appendix 2) and apply the
general principles where necessary (Section 2).
This chapter focuses on the detailed calculations and theory, but often the exam
questions provide simplified numbers and only a few marks per calculation. The bulk
of the marks tend to be for applying a discount rate.

Question 2

Business valuation – general principles

2.1 Use of listed company data to value unquoted firms

Business valuation is not a precise, scientific process. There is an element of
judgement involved.

Answer 2

2.1 Use of listed company data to value unquoted firms
The models shown below often value unquoted firms using data derived from proxy
quoted companies e.g. Ke, beta, dividend yield, P/E ratio.
In practice, it can be difficult to find a similar quoted company.
The final answer may have to be discounted by ¼ to ⅓ to account for:
 relative lack of marketability of unquoted shares
 lower levels of scrutiny
 higher risk.

Question 3

Business valuation – general principles 2.2 Distortions in accounting figures

Answer 3

It is important when valuing a business that professional scepticism is applied.
Scepticism doesn’t assume things are wrong, but it appreciates that there may be
bias or omissions that would mislead users.
When reviewing data for a valuation, any distortions in accounting figures should be
identified. It may then be necessary to produce a normalised earnings figure that
represents expected earnings once the company has been bought.

Question 4

Business valuation – general principles 2.3 Valuation of a company making a loss

Answer 4

Normal models are more difficult to apply, as they are likely to generate a negative
value and there may be more uncertainty around the data used.
Consideration of why the company is loss making is important. If it is a temporary
loss then normalised earnings could be calculated and used for a valuation.

Possible approaches include:
 Fair value of net assets, although due diligence will be required to determine fair
value
 If the losses have been incurred by one-off items, such as impairment, then it
may be that we can predict future profits and use an earnings-based approach
 A company that is loss making may still be generating a positive cash flow and
therefore a discounted FCF method could be appropriate.

Question 5

Business valuation – general principles 2.4 Valuation of a start-up company

Answer 5

Valuation of a start-up company has a new set of issues.
 Often the revenue is growing, but there is little track record to determine an
ongoing trend
 Revenues and costs may be increasing at different rates as new customers can
be gained before any efficiency savings are made
 It could have a negative cash flow, or be making losses in the first few years
 It will not have an established customer base, or market presence

Question 6

Business valuation – general principles 2.4 Valuation of a start-up company Approach

Answer 6

Discounted cash flow:
 Identify the drivers of value in the business
 Determine the time horizon, usually needs to be long-term (more than 7 years)
to give the revenue growth and cost savings a chance to stabilise
 Determine the expected growth, in comparison to market expectations
 Discount revenue and costs separately if they are expected to grow at different
rates.

Market based valuation:
 Compare to a similar company at a similar stage that has already been sold.

Question 7

Business valuation Discounting delayed perpetuities

Answer 7

When using discounting techniques to value companies, the default assumption is
that the cash flows go on forever.
Hence, most DCF valuations will involve a perpetuity calculation (usually a perpetuity
which starts later than T1). So, it is vital you are comfortable with this type of
calculation.

Question 8

Business valuation Discounting delayed perpetuities 3.1 Delayed perpetuities – a general formula

Answer 8

PV of whole CF stream =

CF (at the start of the delayed perpetuity)
×
PF (either with or without growth)
×
DF (for the period before the delayed perpetuity starts)

PF without growth = 1/r

PF with growth = 1(r – g)

Question 9

Business valuation – income based
measures 4.1 Price Earnings (P/E) method

Answer 9

This method is very commonly used in practice.
Theory

P/E ratio = Share price/EPS

Or
P/E ratio = Market capitalisation/Total earnings

Or
P/E ratio = 1/Ke

If the market is efficient, assets with similar risk and growth prospects should trade at a similar multiple of earnings.

Trigger
Question asks you to do an earnings based valuation using P/E information or provides P/E ratios for similar companies.

Approach
MV equity = P/E ratio × earnings
‘Earnings’ = PAT (less preference dividends if relevant)

Complications
 The valuation will need to be adjusted downwards, if listed company data is
used to value an unquoted company
 For controlling interests, the valuation may need to be adjusted upwards to
reflect the value of synergies
 The EPS used should be adjusted (normalised) to reflect the sustainable
earnings of the company

Question 10

Business valuation – income based
measures 4.2 Dividend valuation model (DVM)

Answer 10

The DVM is generally used for valuing minority shareholdings, as minority
shareholders don’t control the whole earning stream of the company but only how
they spend the dividends they receive.

Theory
Theoretically, the share price should be equal to the present value of future dividends, discounted at the cost of equity.

Triggers
 The requirement asks you to value a minority holding
 You are provided with Ke and dividend information

Approach
 Apply the DVM formula (assuming constant growth):
P0 =

D0 (1 + g) / (Ke – g)

or
D1/(Ke – g)

The Ke is very likely to be given in the question and may have been calculated using data taken from a similar quoted company.

Note: The DVM is just a more specific version of the perpetuity with growth formula.

Question 11

Business valuation – income based
measures 4.3 Discounted earnings

Answer 11

This method is conceptually similar to the free cash flow (FCF) method (covered later).

The theory
The PV of future earnings discounted at the shareholders required rate of return equals the market value of equity.

Triggers
 The requirement asks you to discount earnings or to use a discounted earnings based model
 The discount rate given in the question is the cost of equity

Approach
 Take the earnings figure from the scenario (PAT less any preference dividends if relevant)
 If requested to do so, you should adjust the earnings figures used to reflect the sustainable (normalised) earnings of the company
 Discount at the cost of equity
 The resulting PV = MV of equity

Note: The adjustments required to normalise earnings will be financial reporting adjustments.
The aim is not to make the earnings figure a better approximation of cash flows but simply to make it more representative of future sustainable earnings.
Adjustments may include:
 Additional depreciation of FV of assets
 Adjusting directors’ salaries to reflect the market rate
 Removal of one-off items
 Stripping out the impact of aggressive revenue recognition/estimates

Question 12

Business valuation Business valuation – cash based
measures 5.1 Free Cash Flow method

Answer 12

This method of business valuation is similar both to the discounted earnings approach (above) and NPV method of project appraisal.

The theory
Free cash flow = the total free cash flow which is available to reward all of the investors (shareholders and lenders).
Hence, FCF is the total CF remaining after capital expenditure and tax but before interest and dividend payments.
The PV of future FCF (the total CFs available to reward all investors) discounted at the WACC (the cost of meeting the required rate of return of all the investors) equals
the enterprise value (the MV of the debt plus equity).

Triggers
 The requirement asks you to use the discounted free cash flow method
 The discount rate given in the question is the WACC
 The MV of debt is likely to be provided in the scenario

Approach (estimating FCFs)
Standard approach to estimating FCF from accounting information:
Earnings before interest and tax (EBIT)
Less: Tax @ the standard rate
Add back: Non-cash items (e.g. depreciation)
Less: Capital expenditure
Less: Working Capital investment
= Estimated FCF

Note: The existing tax figure from the P&L should not be used as this includes a tax saving on interest which is already reflected in the discount rate (WACC).

Note: This standard approach assumes that depreciation approximately equals capital allowances.
Hence, tax should be calculated before adding back depreciation to ensure that the tax saving on depreciation/capital allowances is correctly included as a cash flow.

Approach (discounting FCFs)
Discount estimated FCFs at WACC
Resulting PV = Enterprise value (MV of debt plus MV of equity)
Less the MV of debt
= MV of equity

Common errors in FCF calculations
 Including interest costs (as an outflow) within FCFs
 Failing to deduct the MV of debt from the enterprise value to get the MV of
equity
 Errors in delayed perpetuity calculations (if relevant)

Question 13

Business valuation Business valuation – cash based
measures 5.2 Free cash flow to equity

Answer 13

This is similar to the discounted earnings approach above, except earnings are now adjusted to make them more like CFs.

Theory
The PV of future CFs attributable to equity shareholders discounted at the shareholders required rate of return equals the market value of equity.

Triggers
 The requirement asks you to use a DCF approach and the discount rate provided in a cost of equity
Note: This approach is not explicitly defined in the ICAEW Workbook but it is used in the question bank.

Approach

Calculate/obtain forecast PAT from the scenario (remembering to include any interest costs as an expense)

Estimate FCFs to equity from the PAT figures, making the following adjustments
as necessary:
– Add back depreciation
– Deduct actual capital expenditure
– Deduct incremental working capital investment

Discount FCFs to equity at Ke to obtain the MV of equity

Note: Interest costs should be included as an outflow withinthe FCF to equity figures as they are not reflected in Ke.

Question 14

Business valuation Business valuation – cash based
measures 5.3 Adjusted present value approach

Answer 14

The APV approach to investment appraisal was covered in FM and was very similar to NPV.

The APV = Base case NPV + PV of the tax shield
Thus APV of a project is essentially a modified NPV calculation.
Similarly, the APV valuation approach is essentially a modified version of the discounted FCF approach.

The theory
APV is based on M&M’s with tax theory, which states:
The value of the leveraged firm = The value of the unleveraged firm + PV of the tax shield

The company is valued in two parts:
1 The base case PV (total FCFs discounted at the unleveraged cost of equity)
2 The PV of the tax shield (the tax savings on interest discounted at the pre-tax cost of debt)
Hence APV separates the calculation of the asset values from the effects of the financing.

The key advantage of APV over a WACC based FCF valuation approach:
 It is better suited to valuing a company where the target capital structure is expected to change over time
Note: Using a constant WACC (in a based FCF valuation) implicitly assumes that the gearing of the target company (based on market values) is to remain constant over
time.

Triggers
 The requirement may ask you to use the APV valuation method
 The discount rate given in the question is the unleveraged cost of equity
 The scenario states that the gearing of the target is going to change over time

Approach
 Estimate the FCFs (using the same approach as for the FCF method)
 Discount estimated FCFs at the unleveraged cost of equity (Keu)
 Equals the base case PV
 Forecast the tax savings on future interest payments on the target company’s debt
 Discount these future tax savings at the pre-tax cost of debt (which reflects the required rate of return of the lenders and thus the risk associated with these CFs)
 Equals the PV of the tax shield
 APV = Base case PV + the PV of the tax shield = The enterprise value (MV of equity + MV of debt)
 Less the MV of debt
= MV of equity

Note: Keu represents the required rate of return of 100% of the investors, thus discounting total FCFs at this rate gives the enterprise value (ignoring the benefit of the tax shield).

Question 15

Business valuation Business valuation 5.4 Value Based Methods (VBM)

Answer 15

These methods align the strategic, operational and management processes to focus
management decision-making on what activities create value. Value is only achieved
when returns are in excess of the cost of capital.
The first of these methods was introduced in previous studies.

Question 16

Business valuation Business valuation 5.4 Value Based Methods (VBM) VBM: Shareholder value analysis (SVA)

Answer 16

Theory
SVA is the present value of future cash flows, but presented using the seven value drivers.
 increase sales growth
 extend the competitive advantage period
 increase operating margins
 reduce working capital investment
 reduce the cost of finance
 reduce the cost of capital investment
 use tax planning, to reduce the tax paid

Approach
This method is the free cash flow method, with a presentational difference and the
approach is the same as the free cash flow method.
1 Calculate the PV of future cash flows
2 Add back short term investments
3 Deduct the market value of debt
= market value of equity.

Question 17

Business valuation Business valuation 5.4 Value Based Methods (VBM) VBM: Economic value added (EVA)

Answer 17

Theory
EVA is an estimate of the amount of shareholder value created year by year. It is conceptually similar to residual income and is calculated as:
Net Operating Profit after Tax (NOPAT) – (WACC × Capital Employed)

NOPAT is essentially EBIT × (1 – T), however in theory the accounting figures should be adjusted to make them more meaningful (e.g. current values rather than historic
costs, R&D expenditure is capitalised).
Use the capital employed at the start of the period.

EVA valuation approach
EVA can be used as the basis of a business valuation method as follows:
1. Estimate the NOPAT and capital employed for each year in the future.
2. Use the NOPAT and capital employed estimates to calculate the EVA for each year
3, Discount the EVA figures to present value using the WACC
4. The PV of future EVA + the opening invested capital (the book value of debt plus equity on the valuation date) = Enterprise value
5, Enterprise value – value of debt = MV of equity

Note: The EVA® valuation approach can be seen as an alternative way of presenting
the FCF valuation approach and both should give the same result.

Question 18

Business valuation Business valuation 5.4 Value Based Methods (VBM) VBM: Market value added (MVA)

Answer 18

MVA is the present value of the future EVA of the business (calculated in Step 3 above).
It shows how much value the management have created, above the value of the capital invested by the finance providers.

Question 19

Business valuation – asset based
measures 6.1 Net assets approach

Answer 19

Theory
The starting point for an asset valuation is the NBV of the company’s net assets (the book value of total equity).

Advantages of using the net assets approach include
 It may be used as a ‘floor value’ when selling a company, or as a measure of
the asset backing security in a share value. The asset backing for shares provides a measure of the possible loss.

However, this figure is unlikely to represent the acquisition value of the company as:
 NBV is based on historic cost and doesn’t reflect current market values
 Many intangibles are not recognised on the SFP
Ideally the NBV of equity should be adjusted to reflect the fair value of the net assets.

(Guidance on measuring the fair value of assets and liabilities is provided by IFRS 13 (see Appendix 3).)

Approach
 Take the NBV of equity from the SFP
 Adjust this figure to reflect fair values (using information from the scenario), often uplifting land and buildings to fair value is the only adjustment required

Concerns
 The valuation of many intangible assets is subjective
 Financial liabilities recorded using the amortised cost basis may not be
reflective of fair value
 The valuation of pension assets/liabilities are highly sensitive to changes in the
underlying assumptions (such as the discount rate used)

Question 20

Brand valuation 7.1 Basic approach

Answer 20

According to IFRS 3, brands acquired should be valued at ‘fair value’.
IFRS 13 defines fair value as “the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants
at the measurement date”.
IFRS 13 requires the fair value to be determined on the basis of its ‘highest and
best use’ from a market participant’s perspective. This needs to consider what is
physically possible, legally permissible and financially feasible.

Question 21

Brand valuation 7.2 Methodologies for valuing brands

Answer 21

There are several different methodologies for valuing brands, with no general
consensus as to which is best. Therefore, a number of different models have been
developed:

Research-based – this approach performs research on customer perspectives of the
brand to identify its value

Cost-based – this defines the value of the brand as the costs incurred to bring the
brand into its current state

Premium price – the value is calculated as the NPV of the price premiums generated
compared to an unbranded equivalent

Economic use – future earnings are discounted to an NPV

Question 22

Brand valuation 7.3 Hierarchy of inputs

Answer 22

IFRS 13 requires that entities should maximise the use of relevant observable inputs
when determining fair value. Thus IFRS 13 presents a fair value hierarchy (with level
1 inputs being preferred):

Level 1 inputs are quoted prices in an active market for identical assets. This is not
normally reasonable for a brand given its unique nature.

Level 2 inputs are inputs other than quoted prices which are observable. This might include prices in markets which are not active.

Level 3 inputs are unobservable inputs, including internal company data.

Question 23

Brand valuation 7.4 Valuation bases

Answer 23

IFRS 13 sets out 3 possible valuation techniques, which can be used to value a brand (the most appropriate technique to use is partly determined by the quality of
inputs available – see above):

The market basis – this uses market price and other market transactions. Given the nature of a brand is unique this would be difficult to use. Often a question states ‘an offer to purchase the brand was made, but it was rejected.’ This would be the market basis had it not been rejected. But, as it was rejected it is not an acceptable value.

The income basis – This would consider the present value of the incremental income generated by the brand. Note: A recognised brand may enable a firm to sell
at a higher price or in greater volume or both. E.g. if the brand sells 40% more volume than an equivalently priced unbranded product, we could calculate the
present value of this 40% extra volume, if provided with numbers.

The cost basis – this is the current replacement cost of the brand. Thus this would
be an estimate of the PV of costs (R&D, advertising, promotion etc.) that would need
to be incurred to develop a comparable brand from scratch.
Any such estimate would be highly judgemental and provided in the scenario to use.
More detail on IFRS 3, 13 and valuing other intangible assets under IAS 38 are
included in the CR appendix.

Question 24

Valuation of debt 8.1 Theory

Answer 24

The market value of any investment is PV of future cash flows to the investor discounted at the investors’ required rate of return.
Hence for debt:
The current MV = future interest payments plus any capital redemption discounted at the investors’ required rate of return (yield to maturity).

Discount at RoR

Question 25

Valuation of debt 8.2 Summary of assumed knowledge

Answer 25

Irredeemable debt
P0 = i/r
Where r = the required rate of return of debt holders.

Redeemable debt
MV = add together 1. & 2.

1.
Time: T1 – Tn
CF: Interest
DF @ investors required rate of return: Annuity factor T1 – Tn
PV: CF × DF

2.
Time; Tn
CF: Redemption value
DF @ investors required rate of return: Discount factor Tn
PV: CF × DF

Or using the spreadsheet function
=** PV(required rate of return, number of payments, interest, redemption value)**

Convertible debt
As for redeemable debt except the redemption value used is the higher of the conversion value and the cash redemption amount.

Question 26

Valuation of debt 8.3 Floating rate debt

Answer 26

Floating or variable rate debt is difficult to value using standard DCF techniques as the future coupon rates are unknown.

The mechanics of floating rate debt:
 The coupon rate is reset to reflect prevailing interest rates at each payment date
e.g. if the interest rate on similar risk assets falls to 3% during the year, then thecoupon rate will be reset to 3% at the next payment date.
 The next interest payment is set on the previous payment date
e.g. if the coupon rate is reset t0 10% at t0, then the t1interest payment will be £10 per certificate. However, the t2 interest payment is uncertain at t0 as it
depends on what the coupon rate is reset to at t1.
Implication: Immediately after the coupon has been reset it will reflect the opportunity cost of capital and as the coupon rate is applied to nominal value the bond must be valued at par.

Alternative explanation: The EVA of the bond is zero; the income of £10 per year exactly equals the finance charge per year of £10 (invested capital of £100 × the cost of capital of 10%). Thus book value = market value.
As we know that the market value of a floating rate bond will be £100 (par) on the reset date, the value now can be calculated as:
P0 = (Next coupon + Par value)/(1 + (r × d/365) )
Where d = number of days until next coupon date