Ch 12 Flashcards
Factors affecting valuation of a business
note: not a scientific process
reported and/or forecasted sales, profits, asset values
type of industry
level of competition
range of products sold
breadth of customer base
perspective - buyer/seller will often have different expectations, thus may value the business differently
Valuation of a quoted company
listed company will have stock market value (market capitalization) - if small numbers of shares are being traded, this share price will be used by traders
however, if one company is trying to take over another by acquiring majority of shares, market cap value will not necessarily give suitable value b/c no incentive for sh/h to sell their shares at market price - premium would be req’d
thus stock market price as starting price for valuation, not ending point
Valuation of an unlisted company
likely less information published to help a prospective buyer assess value (unless there has recently been a private sale of company shares for known value)
estimates made by applying similar valuation teachniques (cost of equity, beta, P/E ratio, etc.) to similar listed companies (“proxies”) - but not always easy to find a similar listed company
thus an overall discount of 25% to 35% may be req’d against proxy value to account for
(1) relative lack of marketability (b/c unlisted),
(2) lower levels of scrutinty (thus risk of poor fin info), and
(3) higher risk of volatility in earnings b/c smaller / less well regarded entity
Three basic valuation methods
ASSET BASED
difficult where high levels of intangible assets, although these too can be valued
EARNINGS BASED
business with high forecasted earnings will attract customers and thus be valued highly
CASH FLOW BASED
theoretically, value should equal PV of future CF discounted at appropriate COC
Overview - Asset Based Valuation
entity viewed as being worth the sum of the value of its assets
if only equity is being acquired = deduct borrowings
if physical assets and related liabilities are being purchased (but no liability for borrowings) = don’t deduct borrowings
most useful when company being broken up > purchased as going concern b/c usually gives low figure due to absence of intangible assets (thus more useful in capital-intensive businesses > services)
Three alternative bases for asset valuation
BOOK VALUE
little used in practice b/c largely a product of dep’n policy, value of assets on B/S will not reflect reality
REPLACEMENT VALUE
may be relevant if assets will be used on ongoing basis OR if bidder wants to estimate min price that would need paying to buy assets and set up similar business from scratch (esp if intangible asset value can be addewd on)
BREAK UP VALUE / NET REALIZABLE VALUE
individual assets valued at best price obtainable based on second-hand market and urgency orf realizing the asset
can be used to set min price for vendors looking to liquidate the business instead of selling shares
tradeable investments including shares and cryptocurrency should be valued at current market price
Strengths of asset based valuation
valuations are fairly readily available
provide a minimum value of the entity
Weaknesses of asset based valuation
ignores future profitability expectations
SOFP valuations driven by a/c conventions <> market valuation
difficult to allow for value of intangibles
Shareholder perspective - asset based valuation
value given will typically far considerably below market cap value (value of all shares)
thus obviously sh//h (or “the market”) don’t value org based on SOFP assets
sh/h are not buying company for ASSETS but for INCOME the assets can produce
INCOME generated by SOFP assets plus intangible assets - skilled workforce, strong mgmt team, competitive positioning of products
thus SOFP assets only one dimension of overall value (in a normal going concern scenario)
Definition - Intangible Assets
intangibles lack physical properties and represent legal rights or competitive advantages developed / acquired by an owner
they should generate some measurable amount of economic benefit in order to have value - e.g. incremental turnover/earnings (pricing, volume); cost savings (process economies); increased market share/visibility
owners can exploit through direct use in business or through indirect use via licensing / royalty fee
Characteristics of intangible assets
IDENTIFIABILITY
can be specifically identified with descriptive names, should see some evidence/manifestation of existence (contract, licence, etc.)
should have been created at identifiable time/event and be subject to termination at identified time/event
MANNER OF ACQUISITION
purchased externally or developed internally
DETERMINATE/INDETERMINATE LIFE
determinate life usually established by law/contract or by economic behavior, and should have come into existence at identifiable time as a result of identifiable event
TRANSFERABILITY
int assets may be bought, sold, licensed, rented
subject to rights of private ownership, ensuring a legal basis for transfer
Example Intangible Assets
non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts
Definition - Intellectual Capital
often used synonymously with IP, intellectual assets, knowledge assets
inellectual capital includes:
HUMAN RESOURCES - collective skills, experience, knowledge
INTELLECTUAL ASSETS - defined and coded assets (drawings, computer programs, data collection)
INTELLECTUAL PROPERTY - items which can be legally protected (copyrights, patents)
can be regarded as total stock of capital or knowledge-based equity that the entity possesses
intellectual capital can be both the end result of a knowledge transformation process, or the knowledge itself that is transformed into IP/intellectual assets of the form
Brands
IP increasingly assigns property rights to patents, trademarks, copyrights - these are the only intellectual capitals regularly recognized for a/c purposes
A/C based on historical costs often understates value of IP
company cannot recognize internally-generated goodwill in accounts
on acquisition the value of any brand should be estimated and recognized
Examples of digital assets
becoming a major part of many businesses’ intangibles
websites
apps
branding
cryptocurrency
domain names
Regulatory Environment - Digital Assets
relatively new phenomenon thus regulations developing
when buying an entity with multiple digital assets, important to consider how current/future reg environment might affect revenue stream potential
e.g. govt interest in how data use affects consumers and markets
Usage Rights - Digital Assets
digital assets often created in partnership with 3P consultants - vital to consider usage rights if acquiring an entity with digital assets
due diligence req’d to determine who actually has usage rights
e.g. uncertainty over ownership of code created by 3P consultants could cause buyer to pull out of a potential deal
Valuation of Intangible Assets
intangibe assets can be far more valuable than tangibles
may also be of significant importance to sh/h and other st/h, often a key part of IR
basic asset based methods for valuation do not incorporate this value as intangibles are excluded
three basic ways of valuing intangibles:
MARKET approach
COST approach
INCOME approach
Valuing Intangibles - Market Approach
comparing an intangible asset to an identical/very similar one recently traded arms length
very difficult to obtain this info - public information usually reflects market cap of entire business, not individual intangibles
may however be possible to find direct market evidence for intangibles, e.g. carbon emission rights, internet domain names, licenses for radio stations
Valuing Intangibles - Cost Approach
e.g. internally developed software, websites
historic cost could be easy to identify, but replacement cost is most direct and meaningful way of estimating value
problem - this approach ignores amount, timing, duration of future economic benefits as well as risk of performance in a competitive environment
Valuing Intangibles - Income Approach
best used when intangible is income producing / allows an asset to generate CF
converts future benefits to a single discounted amount - usually as a result of increased turnover or cost savings
challenge is identifying those CF which are uniquely related to the intangible asset vs the company as a whole
Relief from Royalty Method
a form of income based approach to valuing intangibles
the cost savings (or income enhancements) from using an intangible such as a trademark/patent are directly estimated
value is thus based on the payment that would have been made to a 3P arms length for employing the asset to earn benefits through them
Calculated Intangible Value Method
developed to estimate the value of company’s intangibles that do not appear in SOFP
used alongside based asset valuation to give a complete valuation or tang and intang assets
CIV method based on comparison of total return that company is producing vs return expected based on industry average returns on TANGIBLE assets
anything extra is assumed to be return on INTANGIBLE assets
the extra is assumed to continue in perpetuity and can be converted to PV of intangibles by discounting at org’s COC - the result is the “Calculated Intangible Value” or “CIV”
thus total value of entity = value of tangible assets + CIV
Drawbacks of Calculated Intangible Value Method
as for basic asset valuation model, based on historical figures
CIV assumes that future growth in income from intangibles will be constant at the COC
CIV based on profit > CF
CIV based on industry average return, may not be representative of the company being valued
Overview - Earnings Based Valuation
earnings of the org are forecasted and an “earnings multiple” is applied
multiple could be a negotiated number (e.g. 3x earnings) or a perpetuity factor based on a suitable COC - effectively a discounted CF approach
most commonly used approach is to take a suitable P/E ratio as the earnings multiple
P/E Valuation Method
simple method which values the equity of a business by applying a suitable P/E ratio to the business’s earnings (profit after tax)
Value of company equity = total post-tax earnings * P/E Ratio
Value per share = EPS * P/E ratio
P/E Valuation Formula - Post-tax earnings
easily found from the published accounts
however, published figures are historical, earnings need to be expected future figure
thus, one-off items should be adjusted before performing the valuation:
- one-offs which won’t happen again (debt write-offs)
- director salaries which may be adjusted after a takeover is completed
- synergies made as part of a takeover
P/E Valuation Formula - P/E Ratio
simple measure of company’s share price divided by EPS
indicates the market’s perception of the company’s current position and future prospects - high P/E suggests good growth prospects
unlisted companies have no market share price so a proxy P/E ratio from a similar listed company often used
P/E Valuation Formula - Proxy P/E Ratios
proxy ratios also sometimes used when valuing a listed company - if its own P/E ratio were applied to its own earnings, the calculation would simply give the existing share price
Strengths of P/E Method Valuations
commonly used and well understood
relevant for valuing a controlling interest in an entity
Weaknesses of P/E method valuations
based on accounting profits > CF
difficult to identify a suitable P/E ratio, esp when valuing shares of an unlisted entity
difficult to establish relevant level of sustainable earnings
Earnings Yield Method
form of earnings based valuation
earnings yield = reciprocal of P/E ratio
thus
Value of Company = Total Earnings / Earnings Yield
Value per Share = EPS / Earning Yield
Interpretation of Earnings Yield
stability of Earnings Yield often as important as growth - the market is absorbing new information to try to assess a sustainable EPS level on which to base future growth
effective growth depends on a stable base, thus trend of Earnings Yield over time is a reflection of this factor
acquirer intentions regarding target - if target entity is to be partially demerged, share price valuation may be higher than if whole target entity were to be retained
however, in this case, potential reduction in goodwill value of acq’n due to break-up considerations, may even damage the acquiring entity itself
Dividend Valuation Model
DVM theory = value of company/share is PV of expected future dividends, discounted at sh/h required ROR
if we assume all CF to equity are paid out as dividends, DVM therefore gives the same result as valuing a company by discounting CF to equity at cost of equity
DVM Formula
g = forecast future growth rate in dividends, and:
P0 = Value of company, when d0 = Total dividends
P0 = Value per share, when d0 = Dividends per share
Dividend Yield Formula
(Dividend/Share price) × 100%
Overview - Gordon’s Growth Model
developed by economist Myron Gordon
attempts to derive a future growth rate rather than simply extrapolating historical growth rate
Gordon argued that more investment by an org leads to higher future dividends - thus two key elements to determine future div growth are
(1) rate of reinvestment by org and
(2) return generated by investments
Formula - Gordon’s Growth Model
g = r * b
r = return on invested funds
b = proportion of funds retained
Assumptions underpinning Gordon’s Growth Model
entity must be enitrely equity financed
retained profits are the only source of additional investment
constant proportion of each yera’s earnings is retained for reinvestment
projects financed from R/E earn a constant ROR
Strengths of dividend-based valuations
Value is based on PV of future div income stream = sound theoretical basis
div-based valuations are useful for valuing minority sh/holdings where sh/h only receives divs from entity over which he has no control
Weaknesses of using DVM
forecasting dividends and div growth is very difficult, especially in perpetuity
- how can we predict there will be sufficient worthwhile projects to invest in for ever?
- a company with no dividend history would receive a zero score but may actually be worth something
difficult to estimate cost of equity, esp for unlisted companies
for unlisted companies, a consistent dividend policy with constant growth rate is unlikely
Uneven Growth Rates
DVM cannot be used directly when annual growth rate is expected to change
in this case the entity lifespan should be segmented into the periods for which varying rates apply, and each valued separately
Example - DVM Model
org has just paid 250k div, has 2m shares in issue
current industry-wide return to sh/h is 12%, org has addnl 2% risk premium as is unlisted
calculate expected valuation of org if dividends stay constant for 3 years and then grow at 4% per year
Years 1-3
250,000 * AF 1-3 (14%) = 250k * 2.322 = 0.580m
Year 4+
DVM Formula, then adjust for start in year 4, not year 1
[(250*1.04)/0(.14-0.04)] * DF3 (14%) = 1.755m
Total value = 1.755m + 0.580m = 2.335m
per share = EUR 1.17
Summary on DVM
demonstrates underlying principle that company is worth the sum of its discounted future CF
however, based on a very simplistic model
does however provide a useful analytical tool for investors to evaluate different assumptions about growth and future prospects
challenge is to make the model as applicable to reality as possible, thus using the most reliable assumptions available
Overview - Discounted Cash Flow Method
value for the equity of an entity derived by estimating future annual post-tax CF of entity and then discounting at an appropriate COC
theoretically the best way of valuing a business, since the discounted value of future CF represents sh/h wealth
COC used to discount CF should reflect the systematic risk of the CF
Cash Flows to Equity
ideally, cash flows to equity should be used in DCF valuations > post-tax post-fin CF
CF to equity similar to post-tax post-fin CF, except that they include average sustainable levels of net CF investments in capital and working cap over the longer term rather than this year’s figures
post-tax post-fin CF often used as approximation for CF to equity, but CF2E should be used wherever information permits it to be computed
Concept of Free Cash Flow
cash generated by the business that is “freely” available for distribution to investors after having met all immediate obligations and investment in working cap and NCA required to sustain ongoing operations
Definition - Cash Flow to Equity
CF generated by the company after tax, reinvestment needs, and debt-related CF
thus CF attributable to equity investors
Definition - CF to all investors
CF generated by company after tax and reinvestment needs but before debt-related CF
thus, CF attributable to all investors = debt and equity investors
Definition - Free Cash Flow
Free Cash Flow to Equity
sustainable CF to equity
Free Cash Flow to all investors
sustainable CF to all investors
Use of CF to equity
value of sh/h stake/equity in an entity is the sum of future CF to equity discounted at COE
note - if we assume that org pays out all CF2E as divident, the DCF company valuation method (CF2E discounted at COE) will give exactly same result as DVM method
Valuation of businesses using Discount Cashflow Method
harder to quantify and identify CF generated b/c there are so many and the necessary information does not exist in the public domain
thus, for business valuation, we hve to estimate CF using readily-available a/c info
Step-by-step - calculating Cash Flow to Equity from profit data
(1) start with PBIT
(2) deduct tax for year* and interest, to give profit for the year
(3) adjust for non-cash items (e.g. add back dep’n)
(4) adjust for cash items such as capex/NCA disposal; changes in working cap; new debt raised/debt repaid
* tax calculated as
(PBIT - interest) x tax rate
if tax dep’n allowances differ from dep’n:
(PBIT + dep’n - tax dep’n allowance - interest) x tax rate
Step-by-step - calculating Cash Flow to all investors from profit data
(1) start with PBIT
(2) deduct tax for the year, excluding tax relief on interest*
(3) adjust for non-cash (dep’n)
(4) adjust for cash items such as capex/NCA disaposal; working cap changes
* tax calculated as
PBIT x tax rate
if tax dep’n allowances differ from dep’n, tax is
(PBIT + dep’n - tax dep’n allowances) x tax rate
Determining an appropriate cost of capital
USE OF COST OF EQUITY as discount rate
COE can be used to discount CF TO EQUITY (i.e post-tax cash flows after financing charges) in order to value the equity in a company directly
USE OF WACC as discount rate
WACC can be used to discount CF TO ALL INVESTORS (i.e. post-tax CF BEFORE financing charges) when valuing debt+equity value or project or entity
USE OF PROXY COMPANY
when COC info not given or difficult to derive
Summary Diagram - entity value and selection of COC
Strengths of cash-based valuation
theoretically the based method
can be used to place a max value on entity
considers the time value of money
Weaknesses of cash-based valuations
difficult to forecast CF accurately
difficult to determine an appropriate discount rate
what time period should be evaluated in detail, and how is org’s worth valued beyond this point?
basic NPV method does not evaluate existence of further options - although can be modified using decision trees/probabilities to assess sensitivity of results to potential CF variations
basic model assumes constant discount rates and tax rates - again this can be overcome using sensitivity analysis / other ways of analyzing risk (probs, decision trees)
Overview - Capital Asset Pricing Model
CAPM enables us to calculate required return from an investment given level of associated risk measured by beta-factor
gives a req’d ROR for a given risk level (measured by beta factor)
if we can estimate level of risk associated with an entity (beta of the entity) CAPM can be used to give a required return to sh/h
this required return is essentially the COE, which can then be used to derive an appropriate WACC for the entity
Definition - systematic and unsystematic risk
UNSYSTEMATIC / SPECIFIC
risk of company CF being affected by specific factors
strikes, R&D success, systems failure
can be eliminated by DIVERSIFICATION
SYSTEMATIC / MARKET
risk of company CF being somehow affected by general macroeconomic factors
tax rates, unemployment, interest rates
cannot be eliminated
CAPM - impact of diversification
holding a portfolio of approximately 25 shares enables an investor to diversify away the unsystematic risk while the systematic risk will remain
CAPM enables calculation of required return for well-diversified investor not subject to unsystematic risk
if we can measure the systematic risk of a company/investment, CAPM will enable calculation of level of required return
CAPM - ß (beta) factor
method adopted by CAPM to measure SYSTEMATIC/market risk
ß (beta) factor is measure of share’s volatility in terms of market risk
beta-factor of market as a whole is 1 - it is a yardstick against which risk of other investments can be measured
CAPM - interpretation of beta-values
ß > 1
shares have MORE systematic risk than stock market average
ß = 1
SAME systematic risk
ß < 1
LESS
ß = 0
NO RISK
ß = 1.25
25% MORE RISK
etc
CAPM - Security Market Line (SML)
gives the relationship between systematic risk and return - two relationships:
(1) RISK FREE SECURITY
no risk, no systematic risk, thus ß of zero
Rf on graph
(2) MARKET PORTFOLIO
ultimate in diversification, thus contains only systematic risk, ß of 1
Rm on graph
higher systematic risk = higher rate of return required
CAPM - Security Market Line formula
ke = Rf + [Rm – Rf] ß
where
ke = required return from individual security
ß = beta factor of individual security
Rf = risk-free rate of interest
Rm = return on market portfolio
MARKET PREMIUM = diff between Rf and Rm
CAPM - Calculating Beta Factors
calculated statistically from past observed returns
is it reasonable to use a history-based beta factor to make decisions about the future? are beta factors stable over time?
highly diversified shares (e.g. investment trusts) => stable beta value b/c companies carry on same areas of business in long term
longer period of data => higher quality calculation
CAPM - Alpha Values
say CAPM states we should expect average annual return of 16.5%
this does not means shares will produce a return (dividend yield plus capital gain) of 16.5% each year
shares are a risky investment and returns are not certain
thus an 18% return is a +ve “abnormal” return of 1.5%
the alpha value of a share is its average abnormal return - e.g. alpha of +2% means an average return of 18.5% in recent past
alpha values reflect that world isn’t perfect and actual returns don’t always match those indicated by CAPM
Criticisms of CAPM
(1) single period model - values calculated are only valid for a finite period and need recalculating or updating regularly
(2) CAPM assumes no tx costs associated with trading securities
(3) any beta value calculated is based on past information, may no longer be appropriate (esp if company has changed type of business or capital structure)
(4) risk free rate may change considerably over short periods of time
(5) CAPM assumes an efficient investment market where possible to diversify away risk - not necessarily possible, thus some unsystematic risk may remain
(6) idea that all unsystematic risk can be diversified away does not hold true if stocks change in terms of volatility
(7) CAPM assumes all stocks relate to going concerns, this may not be the case
CAPM - Asset Betas, Equity Betas, Debt Betas
BETA FACTOR
measure of systematic risk of an entity relative to the market
this will depend on level of business risk and financial risk (gearing) associated with an entity
thus, beta factor for a geared company > equivalent ungeared company
Formula - beta factors for geared/ungeared companies
ßg = the equity (geared) beta measures the systematic business risk and the systematic financial risk of a company’s shares
ßu = the asset (ungeared) beta measures the systematic business risk only
ßd = the debt beta measures the risk associated with the debt finance. Usually we assume that debt is risk free and hence the debt beta is zero
CAPM - Systematic Risk - more info
Shareholders only interested in systematic risk because they all have well-diversified portfolios
An entity’s systematic risk is measured by its BETA
Shareholders in a geared company suffer two types of systematic risk - business risk, financial risk
Business risk = risk to operating CF
Financial risk = increased volatility of dividend payment to shareholders as gearing increases
CAPM - Systematic Risk - Modigliani & Miller
a share’s systematic risk can be further subdivided:
Systematic BUSINESS risk
arises out of risky nature of company’s business caused by revenue sensitivity, proportion of fixed to variable prod’n costs
Systematic FINANCIAL risk
how the company has financed itself - gearing/capital structure
Use of the beta formula
ABC company has gearing ratio (D:E) of 1:2, shares beta value 1.45, corp tax rate 30%
beta value/systematic risk exposure is 1.45
attached formula gives betaU (systematic business risk only) of 1.074
thus 1.45-1.074 = 0.376 arises out of financial risk caused by company’s capital structure
Implications of using the beta formula
a company’s equity beta ßg (systematic business + financial risk) will always exceed its asset beta ßu (systematic business risk only)
unless entity is all equity financed - thus no debt - thus the two are the same
companies in the same area of business have the same business risk thus the same asset beta
companies in the same area of business will have different equity betas unless they also happen to share capital structures
Gearing/Degearing Formula - Application to business valuation
two ways to use the formula to derive COE and/or WACC for use in business valution
both methods assume you have been given an equity beta for a proxy company
METHOD ONE
use the formula to derive proxy’s ungeared beta factor
assume this beta factor also reflects business risk of entity X being valued
regear this ungeared beta factor with X’s actual capital structure
then use CAPM to derive COE for X and use this ke to find WACC (if required)
METHOD TWO
use formula to derive proxy’s ungeared beta factor
use CAPM to find ungeared COE (keu) for proxy
assuming proxy’s keu as keu of X (same business risk), use M&M’s WACC formula to calculate WACC of entity being valued
Definition - Effecient Market Hypothesis
level of efficiency in market is important when considering value of business
EMH says that the share price is a sum of all known information aout the company - thus always “fair” and a true valuation - never under or over valued
thus, without additional information not currently wrapped into share price, an investor can never beat the market
higher returns are thus only possible by investing in higher risk investments (higher beta factor)
Efficient Market Hypothesis - Weak Form of Efficiency
WEAK FORM OF EFFICIENCY
share price reflects any/all information that can be discerned from past trends in share prices
day traders trying to speculate / predict future mvmts based on past trends are wasting their time
e.g. a speculator buying shares that are going to increase in price will push up the price
Efficient Market Hypothesis - Semi-Strong Form of Efficiency
SEMI-STRONG FORM OF EFFICIENCY
share price reflects all information publicly available
analysts studying financial reporting to identify mispriced shares are wasting their time
could however be possible to benefit from ability to follow news real-time and respond to events before they become public knowledge
investors generally subscribe to info sources which povide news before broadcast
their responses will enable tmarket to update itself - e.g. flurry of sales by major investors signalling that “bad” news has become available
Efficient Market Hypothesis - Strong Form of Efficiency
STRONG FORM OF EFFICIENCY
share price reflects all information, even that not made publicly available
does not seem credible - but info may have been leaked due to insider trading
market may not know why blocks of shares are being traded, but trading activity suggests someone knows something and prices may respond accordingly
Efficient Market Hypothesis (EMH) - Impact on Business Valuation
EMH does not mean it is wrong to pay a premium over market price to acquire control
bidder is usually hoping to benefit from exploitable strategy
however, EMH suggests that markets will take possibility of a future bid into account in seting prices
Summary - Efficient Market Hypothesis (EMH)
WEAK FORM OF EFFICIENCY
suggests that patterns of past trades can be a sign of a future bid
SEMI-STRONG EFFICIENCY
suggests that any information suggesting possibility of a bid will affect the price (e.g. loss-making company that requires support only obtainable from being incorporated into a larger group)
STRONG FORM EFFICIENCY
suggests that share prices could rise because a dishonest employee could signal possibility of positive news by buying up shares in target company
Valuation Methods - which are most useful when?
ASSET BASED METHODS
when valuing capital intensive businesses with plenty of tangible assets
service businesses will be significantly undervalued (unless work put in to value intangibles)
however, in times of uncertainty, asset based if favored as avoids the needs to forecast future earnings/CFs
DIVIDEND VALUATION MODEL (DVM)
valuing a minority sh/holding - b/c a minority owner’s dividends represent forecast income from investor, which will impact wealth
in majority stake scenario - more relevant to consider overall company CF or asset values as basis for valuation
P/E METHOD AND DISCOUNTED CF METHOD
both based on future forecasts and often using proxy information - difficult to identify in practice
providing accuracy of forecasts, these methods value a business based on future prospects and thus automatically include a measure of associated goodwill/intangibles
for this reason, generally preferred by service businesses vs asset based methods
