Business valuations and market efficiency Flashcards
Valuations of shares in both public and private companies are needed for several purposes by investors including:
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
the three main approaches to valuations are:
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
Market capitalisation
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.
The real worth of a company
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
Valuation: An art and not a science
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.
What are the strengths and weaknesses of book values
Book values are relatively easy to
obtain
Historic cost value
(although could be fair
value which is less of a
problem)
What are the strengths and weaknesses of NRV
Minimum acceptable to owners
Asset stripping
Valuation problems especially if quick sale
Ignores goodwill
What are the strengths and weaknesses of replacement cost
Maximum to be paid for assets by
buyer
Valuation problems –
similar assets for
comparison?
Ignores goodwill
Problems with asset-based valuations
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.
When asset-based valuations are useful
For asset stripping.
To identify a minimum price in a takeover.
To value property investment companies
Asset stripping
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
To set a minimum price in a takeover bid
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
To value property investment companies
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.
If we are valuing a profitable quoted company, in reality the
minimum price that shareholders will accept will probably be the
market capitalisation plus an acquisition premium and not the net asset valuation
Book (nominal / carrying) value
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
Break-up value
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
Replacement cost and deprival value
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.
Income/earnings-based methods
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
PE ratio method
PE ratios are quoted for all listed companies and calculated as:
Price per share/Earnings per share (EPS)
Value of company =
Total earnings × PE ratio
Value per share =
EPS × PE ratio
Arbitrary rule:
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.
For example a high PE ratio may indicate:
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
Similarly a low PE ratio may indicate:
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.
Earnings yield
EPS/price per share
Value of company =
Total earnings × 1/
earnings yield
Value per share =
EPS × 1
/earnings yield
Value of company =
earnings × (1 + g) /
(earnings yield – g)
Valuing shares using the dividend valuation model (DVM
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
Discounted cash flow basis
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
DCF - The maximum value of the business is:
PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used
