Business Valuation and Market Efficiency Flashcards
Identify 6 reasons for valuing business and financial assets
- Establish terms for takeovers/mergers
- Make ‘buy and hold’ decisions
- Value companies entering the stock market
- Value shares for retiring directors which articles of a company specify must be sold
- Fiscal Purposes (CGT, Inheritance tax)
- Divorce settlements
What are the 3 main approaches to valuations?
- Asset Based ( Tangible assets owned)
- Income/earnings based ( returns earned)
- Cashflow based
How is a firm’s market capitalisation found?
By multiplying its current share prince with the number of shares in issue
The real worth of a company depends on the viewpoints of various parties and is therefore …
Subjective.
Give 5 examples of things which could be useful in valuing a business.
- Financial statements
- Supporting listings (inc NCA and Depreciation schedule)
- Details of existing contracts
- Budgets/projections for the future
- Background info on industry and key personnel
Give 3 types of asset based valuation measures
- Book Value
- Net realisable value ( Minimum acceptable to owner)
- Replacement cost - going concern ( Maximum to be paid by buyer)
Identify 2 fundamental weaknesses of asset based valuations, and a subsidiary weakness
- Investors normally buy a company for its earnings/cashflow, not its statement of financial position
- We should value based on what is being purchased. Ie future income/cashflows
- Ignores Non statement of FS intangible assets such as a skilled workforce, strong management team and competitive position of the company’s products.
How do you calculate a PE ratio?
Earnings per share
How do you use a PE ratio to value a company?
Value of company = Total earnings x PE ratio
Value per share = EPS x PE ratio
You may need to adjust the PE ratio (10%per reason) if the company be valued….:
- is a private company as its share may be less liquid
- is a more risky company with fewer controls and management knowledge
- has a high projected growth level
What does a high PE ratio indicate?
- Growth stock - continuous high rate of growth expected
- no growth stock- PE based on low past earnings, Price based on future earnings.
- take over bid
- High security share
What could a low PE ratio indicate?
- Losses expected
* Share price is low (volatile)
What is the earnings yield valuation method?
EPS/ share price
How do you value one share in a company using the Earnings Yield?
Value of one share = EPS of company/ Suitable earnings yield
As with the P/E method, earnings yield is used to value a …
controlling interest in a company
Give two methods of cash flow based valuations
- Dividend valuation model
2. Discounted cash flow
What is the dividend valuation model?
The growth model which values a business based on the present value of future dividends discounted at the cost of equity.
What are the weaknesses of the Dividend valuation/growth model?
Assumes that dividends grow at a constant rate
Future dividend growth is predicted from past results
Cost of Equity may fluctuate in the future
What if Ke is less that the growth rate?!
Discounted cashflows is based on forecasting future cash flows and effectively calculation an NPV. What are its weaknesses?
Estimating the cashflows
Finding a suitable discount rate
The present value of the future cash-flows that an investor will receive, discounted at the investors required rate of return is…
The value of a bond
In valuing bonds, the investors required rate of return is the same as…
pre-tax cost of debt or yield.
Irredeemable debt is where interest will be paid in…
perpetuity
The market value of a bond is the discounted present value of future interest payments up to the year of redemption, plus the discounted present value of the redemption payment. This is the value of:
Redeemable debt.
When valuing redeemable debt, the cashflows are discounted at…
pre-tax cost of debt.
Efficient Market Hypothesis is concerned with what?
How efficient the stock markets are at pricing shares and whether they accurately reflect the information about a company.
What are the three types of efficiency regarding EMH?
- Weak form
- Semi-strong
- Strong
‘Past share price movements, past information such as sales volume, earnings etc are already reflected in the share price of a company.’ Which type of efficiency is this?
Weak Form
‘There’s no point in an analyst looking at historic information to predict the share price as it’s already reflected.’
Weak Form
If a market is efficient a share price will follow …
a random walk
Share price is considered to reflect all past information and all publicly available information. New information released is reflected immediately in the share price
Semi-Strong form
There is no point in an analyst studying pubilcally available information to predict future share price .
Semi-strong form efficiency
This type of market reflects all information whether publicly available or not.
Strong form market.
How does the EMH assume investors behave?
Rationally
Give 3 reasons an investor may behave irrationally?
Herding
Loss aversion
Momentum effect
What is herding?
They do it because everyone else is. This can result in stock market bubbles or crashes
What is loss aversion?
The fear of making a loss and therefore choosing low, stable profits over distorting demand for shares.
What is the momentum effect?
If Share prices start to rise significantly, investors become optimistic about the future. The opposite is also true, making booms and busts last longer.
