Business valuation

Question 1

Organic growth

Answer 1

Organic growth is achieved through internally generated projects
whether funded with retained earnings or new finance (slow)

Question 2

Advantages of organic growth

Answer 2

Organic growth rather than acquisition:
– spreads costs
– no disruption

Question 3

Disadvantages of organic growth

Answer 3

– risk
– slower
– barriers

Question 4

Why might businesses combine

Answer 4

– synergy
– risk reduction
– reduced competition
– vertical protection

Question 5

When is an acquisition considered successful?

Answer 5

An acquisition may be considered successful if it increases shareholder wealth
i.e. if:
– the additional cash flows exceed the cost of acquisition and/or
– overall risk reduction is achieved

Question 6

Disadvantages of growth by acquisition

Answer 6

1. Synergy is not automatic; it must be pursued
2. Restructuring costs following the acquisition may be significant

Question 7

Factors relevant to acquiring a company

Answer 7

How desperate is the seller to sell – do they have any other potential buyers?

How desperate is the buyer to buy – do they have anything else to spend their
money on?

If the target company is listed, what is the existing share price?

Is the consideration to be paid in cash or shares? (see below)

Is the purchase of a controlling interest? (in which case a premium might be
paid).

As well as practical factors such as:
Are key employees or key clients likely to leave after the acquisition? (thus
reducing the value of the target).

Question 8

The 2 main numerical approaches to valuing a business

Answer 8

1. Asset based
2. Income based (future income)

Question 9

Asset based valuation: First step

Answer 9

The net tangible assets of a company divided by the number of shares (historic)

Question 10

Asset based valuation: Second step

Answer 10

Tangible assets/no, shares needs to be adjusted as it is based on historic cost rather than market value (revalued). This adjustment to reflect value can be done in one of two ways:

1. Net realisable value – This is effectively the cash that could be generated from selling off the assets piecemeal. It is effectively a minimum price for a seller.
2. Replacement cost – This is the cost of setting an equivalent business up from
   scratch. It is the maximum price for a buyer

Question 11

Problems with asset based approaches

Answer 11

The value of intangibles not included on the balance sheet will be missed (for
example the value of staff, client relationships, brand value etc.).

Question 12

Digital assets

Answer 12

A digital asset is content that is stored electronically and provides value for the
company, such as digital subscriptions to a newspaper’s website content, or
customer data held. Valuing digital assets is difficult since value is only generated if
the assets are well managed.

The specific valuation of digital assets is outside the scope of the Financial
Management exam, but it is important to note that these assets can be very valuable
and are not taken into account in the traditional asset based valuation

Question 13

Three income based valuation approaches

Answer 13

1. Dividends
2. Earnings
3. Cash flows

Differ only in what is taken as the future income stream (&estimate future income)

Question 14

What is a dividend based valuaiton approach usually ued ofr?

Answer 14

Minority interest valuaiton
I.e. less than 50% ownership

Question 15

What is the value under the dividend valuation model? (If dividends not expected to grow)

Answer 15

The value is simply the present value of the future expected dividend payments
discounted at ke.

Question 16

What is the present value of future division dends under the dividend valuation model? (If dividends not expected to grow - at a constant rate in perpiruity): using D1

Answer 16

PV = D1 x (1/ (Ke - g) )

Simply assumes regular perpituity increasing at fixed rate
(Same formula as for estimating Ke)

Question 17

What is the value under the dividend valuation model? (If dividends not expected to grow - at a constant rate in perpiruity): using D0

Answer 17

PV = D0(1+g) x (1/ (Ke-g) )

Question 18

Dividend yield valuation model calc

Answer 18

Price = Dividend/Yield

Question 19

Problems with dividend based valuation

Answer 19

1. Estimating future dividends
2. Finding similar listed companies
3. If ke is estimated by using the CAPM, or by looking at other quoted companies,
   then a private company valuation will need to be adjusted downwards to reflect
   the lack of marketability (20-30%)

Question 20

Valuation: Earnings based approach: What commonly used to value?

Answer 20

Non-controllig interests

as the investor can control
dividend policy and could therefore extract all of the earnings from the company as
dividends if they wanted to

Question 21

Earnings based valuation approach: 2 methods

Answer 21

1. PE multiple
2. EBITDA multiple

Both are simply a multiple of the relevant earnings for an investor

Question 22

Problems with earnings based valuations

Answer 22

If earnings have been erratic, then the latest earnings figure may be misleading

Accounting policies can be used to manipulate earnings figures (although the
EBITDA multiple attempts to reduce this manipulation)

Finding appropriately similar listed companies

A private company valuation will need to be adjusted downwards to reflect the
lack of marketability.

Question 23

PE multiple valuation

Answer 23

Equity value = Earnings × PE ratio

Earnings = profit after tax and preference dividends, but before
ordinary dividends
The PE ratio is generally found by looking at the PE ratios of a range of similar
listed companies.

It is important to select a PE
ratio from listed companies that have similar growth expectations to the target.

Question 24

What does a high PE ratio imply?

Answer 24

A high PE ratio implies a high level of investor confidence that earnings will
grow strongly

Question 25

What does a low PE ratio imply?

Answer 25

A low PE ratio implies a low level of investor confidence that earnings will
grow strongly.

Question 26

EBITDA Multiple valuation

Answer 26

Enterprise value = EBITDA × EBITDA multiple

Question 27

EBITDA Multiple: What is enterprise value?

Answer 27

Enterprise value = market value of equity + preference shares + Minority
interest + debt – cash and cash equivalents

And so, if we are looking for the market value of equity only, we need to deduct
the market value of other types of finance and add back cash and cash
equivalents.

Question 28

EBITDA multiple calculation

Answer 28

Enterprise Value / EBITDA

(Same formula as valuation…)

Generally based on the company buying i think

Question 29

What does an EBITDA multiple indicate?

Answer 29

An EBITDA multiple indicates how long it would take for an acquisition to earn
enough to pay off its cost and so a high valued company will have a high
multiple

As with the PE multiple, in an exam question it is important to use a multiple
that is not of the company you are valuing, otherwise it doesn’t give us a useful
valuation.

Question 30

Will a company be willing to pay more due to syneregies?

Answer 30

Yes

Question 31

Cash flow valuation: Used to value what soert of invesmnenet?

Answer 31

Controlling interests

Question 32

Cash flow valuation: Process

Answer 32

The value is calculated by estimating the post-tax operating cash flows
of the target company to infinity and discounting at the investing
companies WACC. (Normally a detailed cash flow forecast is done for
the next few years and then a simplifying assumption is made about
cash flows from that point to infinity).

Question 33

Cash flow valuation: How to arrive at the equity value?

Answer 33

The value calculated will be the value of both equity and debt together, therefore the
market value of debt will need to be deducted to give the equity value.

I.e. remove the market value of debt
AND add back investments

Question 34

Cash flow valuation: WHat to do if the copany has any investnets?

Answer 34

Added back separately

Question 35

Problems with cash flow based valuation

Answer 35

This is theoretically the best approach, however it may be difficult to estimate
the future cash flows and the relevant discount rate.

Question 36

Valuation: What is one common way of estimating the cash flows to infinity

Answer 36

Use estimates of the seven value drivers of shareholder value analysis listed earlier

The value drivers are estimated for the competitive advantage period (normally three or five years) and then an assumption is made about cash flows from that point to
infinity.

As for normal cash flow valuation, the value calculated will be debt plus equity,
therefore the value of debt must be deducted.

Question 37

Difficulet of valuing start ups/tech compaines

Answer 37

No profits, unknown competition or the volume of digital assets

Question 38

Possible approaches tp value start ups and tech companies

Answer 38

Asset method
This can be difficult to apply because the value of tangible
assets may not be high. Value could be assessed by estimating how much it
would cost an investor to create the assets of the company from scratch,
including R&D etc.

Earnings method
There may be no earnings in the early years, or suitable PE
ratio to apply. Therefore, this is not a suitable method.

Dividend method
It is unlikely that a dividend will be paid and so this method
is not appropriate.

Market multiples
It is possible to use ratios based on other valuations of
similar companies. However, it may be difficult to find a similar company, or the
stock market may have over-valued that sector.

Discounted cash flow
This is likely to be the most valid approach. Different
scenarios and cash flows could be modelled based on companies with a similar
business model. Cash flows should be discounted at a risk adjusted discount
rate.

Question 39

Aquisiiton: Methods of payment

Answer 39

1. Cash
2. Bid company shares
3. Loan stock (debt)

Question 40

Paying for acq in cash: Advantages and disadvantages

Answer 40

Advantages
1. The buyer gets full control of the target as well as full entitlement to future profits
2. In addition, the seller may prefer this method, as they receive a certain,
unconditional amount.

Disadvantages
1. The buyer will have to find the cash from somewhere
2. Also, the seller’s expertise may be lost from the business as there is no
motivation for them to stay to ensure the success of the new venture
3. Capital gains tax liabilities arise immediately

Question 41

Paying for an acq with bid company shares: Advantages and disavantages

Answer 41

Advantages
1. No need to fund a cash payment
2. Also, the seller is motivated to stay to work for the success of the combination
3. CGT effects are deferred.

Disadvantages
4. Control is diluted and future profits will be shared with the seller.

Question 42

Paying for an acq with loan stock: Advantages and disavantages

Answer 42

This has the advantages of a cash payment without the need to find immediate
finance

The buyer will of course have to pay interest on the debt until it is redeemed.

Question 43

Acquisition: Divetsment

Answer 43

Selling subsidiarues

Question 44

Reason for dovestment

Answer 44

1. Raising cash
2. Lack of fit
3. Diseconomies of scale
4. Cheaper than liquidation.

Question 45

Methods of divestment

Answer 45

1, MBO
The existing management (an MBO) – this can be difficult to finance and often
involves the use of junk bonds or mezzanine debt

2. MBI
An external management team (an MBI)

3. Trade sale
Another established business (a trade sale).

4. Spin off

Question 46

What is a spin off divestmnet?

Answer 46

Where shares in a subsidiary company are ‘given’ to the shareholders of the parent
in proportion to their shareholdings.

Thus a group of companies are split into two separately held entities. No cash
changes hands.

Question 47

Reaosns for a spin-off divestment?

Answer 47

Lack of fit
Diseconomies of scale
Forced division due to a competition commission ruling.

Question 48

What is a share purchase?

Answer 48

Where a company buys back shares from its shareholders. Either:
1. In proportion to their shareholdings
2. Or from a single shareholder

Question 49

Some reasons for a share purchase in proportion to the sharholders holdings?

Answer 49

1. To reduce the level of equity and therefore increase gearing
2. To get unused funds back into the hands of the shareholders
3. To maintain EPS following divestment.

Question 50

Some reasons for a share purchase for a single shareholder?

Answer 50

1. To provide an exit route for an investor
2. To take a listed company off the market and back into private ownership.

Question 51

What is a debt for equity swap?

Answer 51

Where creditors (normally banks or bond holders) give up their debt in return for an
equity stake in the company.
This generally happens if a company is in trouble and is unable to pay the interest
and/or repayment on its debt. The lenders COULD force the company into liquidation
– but that way, they might get nothing at all. By taking equity and allowing the
company to continue, they might feel they stand a better chance of a decent return.

Often the shareholders will lose a significant amount of control as a result.