Business Valuation Flashcards
When a share valuation is required: Unquoted companies [5]
- The company wishes to go public and must fix an issue price for its shares.
- There is a scheme of merger.
- Shares are sold.
- Shares need to be valued for the purposes of taxation.
- Shares are pledged as collateral for a loan.
When a share valuation is required: Subsidiary companies
For subsidiary companies, when the group’s holding company is negotiating the sale of the subsidiary to a management buyout or to an external buyer.
When a share valuation is required: Any company
- Where a shareholder wishes to dispose of his or her holding.
- When the company is being broken up in a liquidation situation or the company needs to obtain finance, or re-finance current debt.
When a share valuation is required: Quoted companies
When there is a takeover bid and the offer price is an estimated fair value in excess of the current market price of the shares.
Information requirements for valuation [6+2+2+3]
Financial statements:
* Statement of financial positions (balance sheet)
* Income statements
* Statements of shareholders equity for the past five years
Summary of non-current assets and depreciation schedule:
* Summary of the company’s non-current assets (property, plant, and equipment)
* Depreciation schedule for these assets
Marketable securities: List of marketable securities held by the company
Inventory: Inventory summary
Major customers: List of major customers by sales
Organization chart:
* Outline of the company’s structure
* Management roles and responsibilities
Advantages of net assets based valuation method
- Simplicity: It’s a straightforward method, especially when compared to other valuation methods like discounted cash flow or earnings multiples.
- Tangible basis: It provides a concrete value based on tangible assets, which can give a clear baseline for what the company might be worth if it were to be dissolved.
- Clear starting point: For businesses in distress or liquidation scenarios, this method can give a clear baseline for what the assets might be worth if the company were to be dissolved.
Disadvantages of net assets based valuation method [4]
- Ignores earning power: It doesn’t consider the earning capacity of a business, which is often more important than just its assets.
- Not suitable for all businesses: For service-based or technology companies with few tangible assets but strong cash flows, this valuation method might significantly undervalue the business.
- Market value discrepancies: The book value of assets on the balance sheet may not reflect the current market value, leading to potential inaccuracies.
- Ignores intangibles: Intangible assets like brand reputation, customer loyalty, and skilled workforce are not always reflected on the balance sheet but can significantly contribute to a company’s value.
Key adjustments for net asset valuation [8]
- Revaluation of assets (all at fv)
- Intangibles with no fair value shouldn’t be considered in the valuation.
- Identifying valuable intangibles (off books recognized)
- Contingent liabilities: book all
- Obsolete inventory: book nrv losses
- Bad debts: all factored in
- Tax liabilities: factored in
- Deferred tax assets
Price Earnings (P/E) ratio method
- This is a common method of valuing a controlling interest in a company, where the owner can decide on dividend and retentions policy.
- The P/E ratio relates earning per share to a share’s value.
- Formula: P/E = Market price per share / Earnings per share (EPS)
- The basic choice for a suitable P/E ratio will be that of a quoted company
High P/E reasons [4]
A high P/E ratio can indicate:
(a) Growth Stock: The share price is high because the company is expected to have continuous high rates of earnings growth.
(b) No growth stock: Share price is current while earning is from last audited FS which was relatively low hence overstating the PE
(c) Takeover bid - Share price has risen pending a take over bid
(d) high security share - Low income but low risk companies have high share prices due to prospects of capital growth and security
Low P/E reasons [2]
- Expected losses - future profits are expected fall hence price is decreased (while earning is based on last FS)
- Share price undervalued: Other factors affecting the share price like a strike by workers resulting in fall in share price even though earnings are high.
Advantages of PE ratio as valuation technique [5]
- Easy to calculate and understand
- Considers market price and liquidity
- Enables industry and market comparisons
- Offers a quick valuation tool
- Can be used across various sectors
P/E Ratio Disadvantage [6]
- Fluctuations in earnings can distort valuation
- Not suitable for companies with low/negative earnings
- Overlooks growth prospects, debt, cash flow, etc.
- Focuses on short-term earnings, neglecting long-term value
- Market sensitivity can lead to misleading valuations
- Differences between companies make comparisons challenging
Earning Yield Method: formula
EY % = EPS/MV
SO, MV = EPS/EY%
Advantages of using EY as valuation technique
- Provides an intuitive understanding: The earnings yield expresses the return on investment as a percentage, which many investors find easier to understand than ratios like the P/E ratio.
- Enables comparison across investments: The earnings yield allows you to compare the expected return on a stock to other investment opportunities, including bonds or even other stocks.
- Offers insights into business cycles: Earnings yield can offer insights into where a particular company or sector stands in its business cycle. A low earnings yield may suggest a peak, while a high yield could suggest a trough.
