Business valuations and market efficiency

Question 1

Valuations of shares in both public and private companies are needed for several purposes by investors including:

Answer 1

 to establish terms of takeovers and mergers, etc.
 to be able to make ‘buy and hold’ decisions in general
 to value companies entering the stock market
 to establish values of shares held by retiring directors, which the articles of
a company specify must be sold
 for fiscal purposes (capital gains tax (CGT), inheritance tax)
 divorce settlements, etc

Question 2

the three main approaches to valuations are:

Answer 2

 Asset-based – based on the tangible assets owned by the company.
 Income/earnings-based – based on the returns earned by the company.
 Cash flow-based – based on the cash flows of the company

Question 3

Market capitalisation

Answer 3

A firm’s market capitalisation is found by multiplying its current share price by
the number of shares in issue. However, this may not represent an appropriate
figure for the purposes of a business valuation due to:
 The share prices of companies on stock exchanges move constantly in
response to supply and demand, and as they move, so do market
capitalisations.
 The values calculated in this way do not necessarily reflect the actual
market value of companies, as is shown when one company launches a
takeover bid for another and (as frequently happens) pays a premium over
the pre-bid price.
 A market capitalisation will not be available for a company that is not listed
on a stock market.

Question 4

The real worth of a company

Answer 4

Valuation is described as ‘an art not a science’. The real worth of a company
depends on the viewpoints of the various parties:
 the various methods of valuation will often give widely differing results
 it may be in the interests of the investor to argue that either a ‘high’ or ‘low’
value is appropriate
 the final figure will be a matter for negotiation between the interested
parties

Question 5

Valuation: An art and not a science

Answer 5

The acquisition of a major competitor may enable a company to secure
a dominant position in the market place. It is therefore likely to place a
higher value on the target company than a potential purchaser from
outside the industry.
A realistic valuation will therefore require a full industry analysis rather
than an isolated assessment of the business to be valued. In some
cases, the circumstances giving rise to the valuation may call for ‘a
value as would be agreed between a willing buyer and a willing seller’
and may often be subject to independent arbitration.

Question 6

What are the strengths and weaknesses of book values

Answer 6

Book values are relatively easy to
obtain

Historic cost value
(although could be fair
value which is less of a
problem)

Question 7

What are the strengths and weaknesses of NRV

Answer 7

Minimum acceptable to owners
Asset stripping

Valuation problems especially if quick sale
Ignores goodwill

Question 8

What are the strengths and weaknesses of replacement cost

Answer 8

Maximum to be paid for assets by
buyer

Valuation problems –
similar assets for
comparison?
Ignores goodwill

Question 9

Problems with asset-based valuations

Answer 9

The fundamental weakness:
 investors do not normally buy a company for its statement of financial position assets, but for the earnings/cash flows that all of its assets can produce in the future
 we should value what is being purchased, i.e. the future income/cash flows

Subsidiary weakness:
The asset approach also ignores non-statement of financial position intangible
‘assets’, e.g.:
 highly-skilled workforce
 strong management team
 competitive positioning of the company’s products.
It is quite common that the non-statement of financial position assets are more
valuable than the statement of financial position assets, especially for service
organisations, which may not hold many non-current assets at all.

Question 10

When asset-based valuations are useful

Answer 10

 For asset stripping.
 To identify a minimum price in a takeover.
 To value property investment companies

Question 11

Asset stripping

Answer 11

Asset valuation models are useful in the unusual situation that a
company is going to be purchased to be broken up and its assets sold
off. In a break-up situation, we would value the assets at their realisable
value

Question 12

To set a minimum price in a takeover bid

Answer 12

Shareholders will be reluctant to sell at a price less than the net asset
valuation even if the prospect for income growth is poor. A standard
defensive tactic in a takeover battle is to revalue statement of financial
position assets to encourage a higher price. In a normal going-concern
situation, we value the assets at their replacement cost

Question 13

To value property investment companies

Answer 13

The market value of investment property has a close link to future cash
flows and share values, i.e. discounted rental income determines the
value of property assets and thus the company.

Question 14

If we are valuing a profitable quoted company, in reality the
minimum price that shareholders will accept will probably be the

Answer 14

market capitalisation plus an acquisition premium and not the net asset valuation

Question 15

Book (nominal / carrying) value

Answer 15

his will normally be a meaningless
figure, as it will be based on historical costs. However, with fair value
accounting the book value of many assets and liabilities will be the fair
value and therefore will be relevant for valuation purposes

Question 16

Break-up value

Answer 16

he break-up value of the assets in the business will
often be considerably lower than any other computed value. It normally
represents the minimum price that should be accepted for the sale of a
business as a going concern, since if the income based valuations give
figures lower than the break-up value it is apparent that the owner
would be better off by ceasing to trade and selling off all the assets
piecemeal. It should be noted that the market values of debt, such as
bonds are calculated pre-tax

Question 17

Replacement cost and deprival value

Answer 17

this should provide a
measure of the maximum amount that any purchaser should pay for the
whole business, since it represents the total cost of forming the
business from scratch. However, a major element of any business as a
going concern is likely to be the ‘goodwill’. Since this can only be
defined by determining the ‘income-based value of business less
tangible assets’ it may be seen that there is no real way of applying a
pure ‘asset-based value’ to a business – it is always necessary to
consider an ‘income-based value’ as well.

Question 18

Income/earnings-based methods

Answer 18

Income-based methods of valuation are of particular use when valuing a
majority shareholding:
 ownership bestows additional benefits of control not reflected in the
dividend valuation model (see later)
 majority shareholders can influence dividend policy and therefore are
more interested in earnings

Question 19

PE ratio method

Answer 19

PE ratios are quoted for all listed companies and calculated as:
Price per share/Earnings per share (EPS)

Question 20

Value of company =

Answer 20

Total earnings × PE ratio

Question 21

Value per share =

Answer 21

EPS × PE ratio

Question 22

Arbitrary rule:

Answer 22

Adjusted by 10% per reason – but amounts are less important
than the explanation.
 It can be difficult to estimate the maintainable or normal ongoing level of
earnings of the company being valued. It may be necessary to adjust
these earnings to obtain a maintainable figure, e.g. change a director’s
emoluments from an abnormal to normal level or strip out a one-off debt
write-off.

Question 23

For example a high PE ratio may indicate:

Answer 23

 growth stock – the share price is high because continuous high
rates of growth of earnings are expected from the stock
 no growth stock – the PE ratio is based on the last reported
earnings, which perhaps were exceptionally low yet the share
price is based on future earnings which are expected to revert to a
‘normal’ relatively stable level
 takeover bid – the share price has risen pending a takeover bid
 high security share – shares in property companies typically have
low income yields but the shares are still worth buying because of
the prospects of capital growth and level of security

Question 24

Similarly a low PE ratio may indicate:

Answer 24

 losses expected – future profits are expected to fall from their
most recent levels
 share price low – as noted previously, share prices may be
extremely volatile – special factors, such as a strike at a
manufacturing plant of a particular company, may depress the
share price and hence the PE ratio.

Question 25

Earnings yield

Answer 25

EPS/price per share

Question 26

Value of company =

Answer 26

Total earnings × 1/
earnings yield

Question 27

Value per share =

Answer 27

EPS × 1
/earnings yield

Question 28

Value of company =

Answer 28

earnings × (1 + g) /
(earnings yield – g)

Question 29

Valuing shares using the dividend valuation model (DVM

Answer 29

This method can be used for valuing minority shareholdings in a company,
since the calculation is based on dividends paid, something which minority
shareholders are unable to influence. The DVM was discussed in detail in the
chapter on cost of capital. It is summarised again here

Question 30

Discounted cash flow basis

Answer 30

This alternative cash flow-based method is used when acquiring a majority
shareholding since any buyer of a business is obtaining a stream of future
operating cash flows

Question 31

DCF - The maximum value of the business is:

Answer 31

PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used