Chapter 12 Flashcards
Factors affecting value of a business
Reported sales, profits and asset value
Forecast sales, profits and asset value
Type of industry
Level of competition
Range of products sold
Breadth of customer base
Perspective
What should be used as a starting point when valuing a quoted company?
Stock market share price
Three basic valuation methods
Asset based valuation
Earnings based valuation
Cash flow based valuation
Asset based valuation
Business net assets form the basis for the valuation
Earnings based valuation
Projected future earnings for a business will give an indication of the value of that business
Cash flow based valuation
Business value should be equal to the PV of its future cash flows, discounted at an appropriate cost of capital
Alternative asset valuation bases
Book Value
Replacement Value
Breakup value/Net reliasable value
Strengths of asset based valuation
Valuations are generally readily available
Provide a minimum value for an unlisted company
Particularly relevant for valuing businesses in liquidation
CIV Method
Compares the total return that the company generating against the return that would be expected based on industry average returns on tangible assets
Earnings based valuation starting point and adjustments
Start: The current post-tax earnings, or EPS
Adjust for:
One off items which will not recur
Director salaries
Strengths of the P/E valuation method
Commonly used and are well understood
Relevant for valuing a controlling interest in an entity
Weaknesses of the P/E valuation method
Based on accounting profits rather than cash flows
Difficult to identify a suitable P/E ratio, particularly when valuing the shares of an unquoted entity
Difficult to establish the relevant levels of sustainable earnings
DVM theory
Value of share is present value of the expected future dividends, discounted at the shareholders rate of return
Strengths of DVM
Sound theoretical baiss
Useful for valuing minority shareholdings where the shareholder only receives dividends from the entity, over which he, she or they have no control
Weaknesses of DVM
Very difficult to forecast dividends and dividend growth, especially in perpetuity
Particularly for unquoted companies, it can be difficult to estimate the cost of equity
For unquoted companies, a consistent dividend policy with constant growth rate is unlikely
Free cash flows to entity
Similar to post tax, post financing cash flows, except they include average sustainable levels of capital and working capital net cash flow investments over the long term rather than this year figures
Use of cost of equity as a discount rate in free cash flows
Cost of equity can be used in order to value the equity in a company directly
Use of WACC as a discount rate in free cash flows
WACC can be used when valuing a project or an entity.
Discounting forecast free cash flows to equity
Use cost of equity
Discounting forecast free cash flows to all investors
Discount using WACC
Deduct value of debt
Strengths of discounted cash flow method
Theoretically the best method
Used to place a maximum value on the entity
Considers time value of money
Weaknesses of discounted cash flow method
Difficult to forecast cash flows accurately
Difficult to determine an appropriate discount rate
Model assumes that the discount rate and tax rates are constant in the period
CAPM
Enables us to calculate the required return from an investment given the level of risk associated with the investment
2 types of risk
Systematic risk
Unsystematic risk
Systematic risk
Caused by general macro-economic factors
Unsystematic risk
Caused by factors specific to the company or industry
CAPM criticisms
Single period method
Beta values are calculated based on historic data
Risk free rate may change over time
CAPM assumes an efficient market where it is possible to diversify away unsystematic risk, and no transaction costs
Beta factor
Measure of systematic risk of an entity relative to the market
How is beta factor measured?
Comparing the volatility of an entity’s share price to the volatility of the market as a whole
Four very important implications of beta
Company’s equity beta will always be greater than its asset beta UNLESS
if it is all equity financed when its equity beta and asset beta will be the same
Companies in the same ‘area of business’ will have the same asset beta, BUT
Companies in the same area of business will not have the same equity ebta unless they also happen to have the same capital structure
When is asset based method suitable?
Most appropriate when valuing capital intensive businesses with plenty of tangible assets
When is DVM most appropriate?
Suitable when valuing a minority shareholding
When is P/E method and DCF appropriate?
Methods are based on forecasts of the future, and often use proxy information.
For service businesses, these methods are generally preferred to asset based methods
Efficient market
One in which security prices fully reflect all available information
New information is rapidly and rationally incorporated into share prices in an unbiased way
Three forms of efficiency
Weak
Semi Strong
Strong
Weak efficieny
Past share price movements
Semi strong efficiency
All public information
Strong efficiency
All information (public and private)
