Business Valuations & market effeciency

Question 1

What are the reasons for valuing businesses and financial assets?

And what information is generally used to carry these out?

Answer 1

• To establish terms of takeovers and mergers.
• 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 the company specify must be sold.
• For Fiscal purposes (capital gains, inheritance tax)
• Divorce settlements act.

Information used to carry out a valuation may include:

• Financial statements - most recent and potentially up to 5 years past.
• Supporting Schedules - FAR, Aged debtors and creditors act.
• Details of existing contracts (liabilities)
• Budgets or projects for the future, up to 5 years.
• Background info on the industry and key personnel.

Question 2

What are the three main approaches to valuations?

Answer 2

Assets 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.

These three methods will give varying results, and it will be in the interests of the parties involved to argue that a high or low figure is appropriate.

Primarily though what ever method is used it is really a starting point from which the final figure will be negotiated.

Question 3

What is market capitalisation and how is it calculated?

Answer 3

Market Capitalisation - a companies current share price x number of shares in issue.

Important to bear in mind:

Share prices fluctuate, sometimes rapidly, which will impact market capitalisation.

Share price does not necessarily reflect business value.

Question 4

What are the types of asset based valuations, where are they useful and what are the disadvantages?

Answer 4

Book Values - Easy to obtain values but are based on historic cost less Dep’n. Is fairer if at fair value.

Net realisable value - Minimum value acceptable to owners, but can be a problem if looking for a quick sale. Asset stripping so probably assumes business is not going concern.

Replacement cost (going concern) - Max to be paid by the buyers, valuation can be difficult if similar assets are not available for comparison, ignore goodwill.

This type of valuation is useful in the following situations:

• Asset stripping - the business is being broken up.
• To identify Min price for a take over - as a starting point for negotiation.
• Value property investment companies - value of company closely linked to market value of property which is driven by potential rental income.

Weaknesses to bear in mind:

• Investors will be buying for earnings/cashflow not the companies assets.
• It ignore intangible assets such as skilled work force, market position of the company act.

Question 5

What is the PE method of valuation, when is it relevant and what are the advantages/disadvantages?

Answer 5

These methods are useful when valuing a majority shareholding because:

• Ownership bestows additional benefits of control not reflected by DVM
• Majority shareholders can influence dividend policy so are more interested in earnings.

PE (Price/Earnings) Ratio - Price per share/Earnings per share.

Value of company = Total earnings (after tax)x PE ratio

Value of a share = EPS x PE ratio.

These ratios are quoted for all listed companies, an adjusted ratio from a similar company can be used to value an unquoted company.

Adjust by 10% per reason - less liquid, more risky, higher growth.

Question 6

What is the earnings/yield valuation method, how is it applied and what are the limitations?

Answer 6

Earnings/ Yield can be used in the same situations as PE ratios.

Calculated as - EPS/Price per share.

Value of company = Total earnings x (1/earnings yield) or with growth

Total earnings x(1+g)/ earnings yield - g

Value per share = EPS x (1/earnings yield)

Question 7

What are the two cash flow based methods of valuing a company?

Answer 7

Dividend Valuation Model - use for valuing minority shareholdings as based on dividends paid which cannot be influenced by minority share holders.

Discounted cash flow basis - Use for valuing a majority shareholding as buyer is obtaining a stream of future operating cash flows.

Question 8

How is DVM used in cash flow based business valuations?

Answer 8

The value of the company/share is the PV of the expected future dividends at the shareholders required rate of return.

Without growth - P₀ (value of company) = Dividend/Rate of return.

or

With Growth - P₀ = D₀(1+g)/r_e-g

This assumes constant growth in dividends.

Weaknesses:

• Estimating future growth rate may be difficult.
• Changes in assumptions will have significant impact on the model.
• Assumes growth rate is lower than Re

note - this calculates the Ex dividend price.

Watch out in questions - Current return earned on assets is another way of saying required return for the growth model.

Question 9

How is the discounted cash flow basis applied to business valuations?

Answer 9

Max value of a business = PV of future cash flows.

1. Identify Free cash flows (exclude financing flows) inc Operating flows, sales of assets, Tax, ongoing CapEx and synergies from mergers.
2. Identify suitable time horizon.
3. Calculate PV over this horizon - gives value to all providers of finance.
4. Deduct value of Debt to leave equity

Pros - Theoretically best method and can be used to value part of a company.

Weaknesses:

• Uses estimates of cash flows and discount rates, may be unreliable.
• Difficult to choose a time horizon.
• Difficult to value a companies worth beyond that period.
• Assumes Discount rate, Tax and inflation rates are constant through period.

If cash flow is a perpetuity use real (inflated) cash flow and real discount rate.

Question 10

What other considerations must be made when valuing a business post take over?

Answer 10

Synergy - this would be expected to increase the value of the company.

Method of Financing - Cash - business value would fall by amount of cash needed. Share issue - extra shares issued must be taken in to account when calculating per share price.

Question 11

What additional values may be asked for in relation to convertible debt?

Answer 11

Floor Value - Market value without the conversion option.

also, PV of future interest and redemption value discounted at debt holders required return.

Conversion Premium - Market value - Current Conversion value. remember this is at current values.

Market value of convertible bond = Present value of interest payments + present value of conversion option.

Question 12

What is Market efficiency?

Answer 12

An efficient market is one where securities prices fully reflect all available information.

Where all available information is incorporated in to share prices rapidly and without bias.

Benefits of an efficient market

• Ensures investor confidence - paying and receiving fair price for share transactions.
• Motivation and control of directors - giving prompt feed back through changes in share price on the directors decisions.

Question 13

What are the three levels of market efficiency?

Answer 13

• Weak Form - share prices reflect all past price movements.
  
  • No patterns or trends.
  • Prices rise/fall based on the next piece of news.
  • Prior change is not useful for predicting future change.
• Semi Strong form efficient - share price incorporates all past and publicly available information.
  
  • Share prices react quickly to new information.
• Strong form efficient - Share price incorporates all information.
  
  • Basically this would include insider trading so is hypothetical.