Business Valuations And Market Efficiency Flashcards
What is the valuation of shares?
Valuations of shares in both public and private companies are needed for several purposes by investors including:
to establish terms of takeovers and mergers
to be able to make ‘buy and hold’ decisions
to value companies entering the stock market
to establish values of shares held by retiring directors, which the articles of the company specify must be sold
for fiscal purposes (capital gains tax, inheritance tax)
divorce settlements, etc
What is market capitalisation?
Market capitalisation of public companies = current share price × number of shares in issue
share prices are constantly moving
a premium may be paid if purchasing a controlling interest.
What is book value?
Value is largely a function of depreciation policy.
For example, some assets may be written down prematurely and others carried at values well above their real worth.
Thus, this method is of little use in practice.
What is replacement value?
Useful for the buyer.
If the buyer wants to estimate the minimum price that would have to be paid to buy the assets and set up a similar business from scratch (especially if an estimate of intangible value can be added on).
What is breakup / net realisable value?
Useful for the seller.
Considers the amount they would receive if they were to liquidate the business as an alternative to selling the shares.
Also useful for a buyer if their intention is to strip the assets and sell them off.
What are the problems with asset-base valuation?
Asset based valuations do not value what is being purchased, i.e. the right to future earnings/cash flows of the company.
Asset based valuations ignore intangible assets, such as goodwill (particularly relevant for service companies which may have skilled workers, strong management, or a strong customer base relative to its competitors)
The following are extracts from the statement of financial position of MNM Co, an unquoted company, as at 31 December 20X6.
$
Non-current assets (written down value) 2,292,000
Net current assets 395,000
$0.50 ordinary shares 1,500,000
Reserves 687,000
8% loan notes 500,000
Further information is provided as follows:
A recent valuation of the non-current assets put them at 45% above their current written down value.
The loan notes are redeemable at a 10% premium.
There is a long outstanding debt of $20,000 in receivables that is not expected to be received.
Calculate the value of a share in MNM Co.
Total value of assets:
$2,292,000 × 1.45 + $395,000 – $20,000 = $3,698,400
Less: redemption value of debt: $500,000 × 1.10 = $550,000
Value of all shares = $3,148,400
Number of shares in issue: $1,500,000/$0.50 = 3,000,000
Value per share: $3,148,400/3,000,000 = $1.05 per share
What are income/earnings based valuation?
These methods are particularly useful when valuing a majority shareholding.
They reflect that the investor has additional benefits of control which mean they have access to the earnings of the business, not just the dividends (as they can influence dividend policy)
An unquoted company will not have a market-driven P/E ratio, so an industry average P/E, or one for a similar company, will be used as a proxy.
If a quoted company proxy is used, it may need to be adjusted to reflect the position of the business being valued:
Private company shares are less liquid – adjust down
The company may be more risky than the proxy – adjust down
The company may have a higher projected growth level – adjust upwards.
Arbitrary rule – 10% per reason
What is the dividend valuation model (DVM)?
This method can be used for valuing a minority shareholding in a company. Minority investors have little influence on how earnings are spent/distributed and rely on dividends as the source of income from their investment.
Strengths and weaknesses of the DVM
problems estimating a future growth rate
growth assumed to be zero or at a constant rate
high sensitivity to changes in the assumptions used
few advantages over earnings based methods for controlling interests.
What are the steps for the discounted cash flows valuation basis?
Identify the free cash flows
Select a suitable time horizon
Calculate the PV over this time period (this gives the total value to all providers of finance, i.e. equity and debt)
If valuing equity only, deduct the value of the debt (which is now a liability for the new owner) to give the equity value.
What is the concept of market efficiency?
An efficient market is one in which security prices fully reflect all available information (i.e. they are fairly priced).
In an efficient market new information is rapidly and rationally incorporated into share prices in an unbiased way.
Fairly priced shares ensure investor confidence and reflect director performance.
What are the efficient market hypothesis?
There are three forms of efficiency based on different theories about where this new information comes from:
Weak - Past share price movements
Strong - All information (all public and private)
Semi strong - All public information (including – past share price movements)
How do you identify weak form efficiency?
In a weak form efficient market share prices reflect information about all past price movements.
Past movements do not help investors in identifying positive NPV trading strategies.
Evidence
Share prices follow a random walk:
There are no patterns or trends.
Prices rise or fall depending on whether the next piece of news is good or bad.
Very little of a share price movement on one day can be predicted from knowledge of the change on the previous day.
Conclusion for the stock market
It is weak form efficient.
Future price movements cannot be predicted from past price movements.
Chartism/technical analysis cannot help make consistent gains on the market
How do you identify semi strong form efficiency?
In a semi-strong form efficient market share prices incorporate all past information and all publicly-available information.
Semi-strong market efficiency incorporates weak form market efficiency.
Evidence
Share prices react within 5 – 10 minutes of any new information being released:
rising in response to good news
falling in response to bad news.
Conclusion for the stock market
It is also semi-strong form efficient.
Fundamental analysis – examining publicly-available information will not provide opportunities to consistently beat the market.
Only those trading in the first few minutes after the news breaks can beat the market.
