Chapter 12 - Intro to valuation methods

Question 1

The Efficient Market Hypothesis

Answer 1

• Hypothesis which proposes that markets are efficient, so a company’s share price reflects all current info and is therefore a reliable indication of its true value.

Question 2

Impact of efficiency on share prices:

Answer 2

• If the stock market is efficient, the share prices should vary in a rational way
• If a company makes an investment with a positive NPV, shareholders will know about it and the market price of shares will rise in anticipation of future dividend increases
• Is a company makes a bad investment, shareholders will find out and share prices will fall
• If interest rates rise, shareholders will want a higher return so market prices will fall

Question 3

Varying degrees of efficiency:

Answer 3

1. Weak Form:
   * Share prices reflect all historical info (recurring patterns of past share price changes)
   * Investor’s can’t make excess profits by analysing charts of past price changes (random walk theory)
2. Semi Strong Form:
   * Share prices also reflect all publicly available info
   * Investors can’t beat the market in the long-term unless they know something that the market doesn’t
3. Strong Form:
   * Share prices ALSO reflect info held privately by directors

Question 4

Implications of a semi-strong efficient market:

Answer 4

• Share price is best basis for takeover bid = company should only pay more than market price if there are synergies
• Directors should take the correct investment, financing, risk management decisions and make this info public (press release, annual accounts)

Question 5

Valuation of quoted companies

Answer 5

1. Already valued by the stock market and market makers commit to buying shares at prices they are quoting
2. Price of shares are continually adjusted to reflect changing pattern of supply & demand for these shares and should be good indication of value unless:
   * Shares are not regularly traded – case for small companies trading on junior markets
   * Behavioural factors are distorting the share price
   * Behavioural finance = assumption that share prices are determined by psychological factors

Question 6

Valuation of unquoted companies

Answer 6

1. Companies may impose restrictions in their articles of association on the ability of shareholders to sell shares
2. Where this does not exist, is should be possible to sell shares either:
   * To entrepreneurial investors through private sales
   * Via a market for small company shares = no market price at which market maker will guarantee to buy shares, instead shares are sold by auction to highest bidder

Question 7

Range of Values:

Answer 7

• Range of techniques will create a bidding range within which negotiation will take place, E.g:
• Maximum value = cash flow or earnings valuation
• In between = dividend valuation
• Minimum value = asset valuation

Question 8

Asset Valuation Methods

Answer 8

• Involves estimating a minimum value for a company that is in financial difficulties or difficult to sell – owners may be prepared to accept a minimum bid that matched the value they get from a liquidation

Question 9

Assessing the break-up value of a company:

Answer 9

1. Historic net book value = value of net assets from SOFP (little use in practise as assets may be very old or fully written off)
2. Realisable value = individual assets are valued at disposal value (used to set a minimum price)

*If a company can assess the replacement value of a company it can estimate the cost of setting up the company from scratch – difficult to calculate in reality because it is hard to estimate the expenditure to replicate the intangible assets (asset-based approach – does not give a minimum value)

Question 10

Use of Asset Basis:

Answer 10

1. As a floor value for a business that is for sale
   * Shareholders will be reluctant to sell for below the net asset value but if sale is essential for cash flow purposes or to realign the corporate strategy, even the asset value may not be realised
2. As a measure of the security in a share value
   * Asset backing for shares provides a measure of the possible loss if the company fails to make expected earnings or dividend payments
   * Valuable tangible assets may be a good reason for acquiring a company, especially freehold property which may increase in value over time

Question 11

Strengths of Asset Valuation methods:

Answer 11

• Info is readily available

* Provides a minimum value

Question 12

Weaknesses of Asset Valuation methods:

Answer 12

• Ignores future profitability
• Excludes most intangible assets
• Is dependent on the company’s accounting policies

Question 13

Valuation of Intangibles:

Answer 13

• Asset based valuation method excludes most intangible assets from its computation – this rendered the method unsuitable for valuing most established businesses (especially service industry)
• Knowledge plays an expanding role in achieving competitive advantage – employees are extremely valuable to a business and should therefore be included in the full asset-based valuation (employee knowledge = intellectual capital)

Question 14

Definition of Intangible assets

Answer 14

identifiable non-monetary assets without physical substance which must be controlled by the entity as a result of past events and from which the entity expects a flow of future economic benefits

Question 15

Definition of intellectual capital

Answer 15

Knowledge which can be used to create value and includes:

1. Human resources = collective skills, experience and knowledge of employees
2. Intellectual assets = knowledge which is defined and codified such as a drawing, computer program or collection of data
3. Intellectual property = intellectual assets which can be legally protected, such as patents and copyrights

Question 16

Valuing intangibles can:

Answer 16

• Highlight importance of investing to create intangibles
• Benchmarking
• Adjust the asset basis of valuation

Question 17

Market to book values:

Answer 17

1. M2BV = the value of the firm’s intellectual capital is represented by the difference between the book values of the company’s tangible assets and the market value.
2. The simplicity of this method serves to indicate that it fails to take account of real world complexities:
   * may be imperfections in the market valuation
   * book values are subject to accounting std’s (reflects historic cost and amortization policies rather than true market value of tangible NCA)

Question 18

Valuing the intangible assets - Calculated intangible value (CIV) method:

Answer 18

1. CIV method estimates the value of the company’s intellectual capital by assessing whether a company is making an above avg return on its intangible assets compared to an industry average
2. Additional return is assumed to be the return on intangible assets
3. Additional return is assumed to continue into perpetuity and therefore discounted using the cost of capital
4. Value of intangible assets are added to tangible assets to arrive at a total value

Question 19

CIV involves 2 steps:

Answer 19

1. Estimate the post-tax profit that would be expected from an entity’s tangible asset base using an industry average expected return
2. Calculate the PV of any excess profits that have been made in the recent past, using the WACC as the discount factor

Question 20

Drawbacks of the CIV approach:

Answer 20

1. Avg industry return is used to calc the excess returns = industry avg may be distorted by extreme values
2. Assumes past profitability is a sound basis for evaluating current value of intangible assets
3. Assumes there will be no growth in excess profits being generated by the intangible assets

Question 21

Dividend Valuation Method

Answer 21

• Simplest cash flow valuation model
• Based on the theory that an equilibrium price for any share is the future expected stream of income from the share discounted at a suitable cost of capital

Question 22

Dividend Valuation Method Formula:

Answer 22

d0= d1/(ke-g)
* Ke = cost of equity of the target

• Formula calculates the value of a share as the PV of a constantly growing future dividend
• Anticipated dividends are based on existing management policies – technique most relevant to minority shareholders who are not able to change these policies

Question 23

Non-constant growth:

Answer 23

1. DVM can be adapted to value dividends where the dividend growth is forecast to go through two phases
2. Growth is forecast at an unusually high/low rate (e.g. 2 years) = use normal NPV approach to calc div in each time period
3. Growth returns to a constant rate:
   a) adapt time periods in normal DVM approach (P2 = d3 / Ke - g)
   b) adjust (a) value by discounting using discount rate in T2

Question 24

Strengths of Dividend valuation Method:

Answer 24

• Based on the PV of future cash flows received by an investor
• Good for valuing a minority interest

Question 25

Weaknesses of Dividend valuation Method:

Answer 25

• Difficult to forecast future dividends and dividend growth
• Difficult to estimate cost of equity for unlisted companies
• Creates zero value for zero dividend companies

Question 26

Earning Valuation Method

Answer 26

1. One of the highest business valuations is calc by valuing the earnings under new ownership
2. Common method to value a controlling interest, where the owners can decide on the dividend and retention policy
3. To value an entire company the P/E ratio is multiplied with the earnings of the target

Question 27

P/E Method of valuation - Formula:

Answer 27

• Market-based value = earnings of target x appropriate P/E ratio
• Earnings of target = shows the current profitability of the company
• P/E ratio = reflects the growth prospects/ risk of a company

Question 28

Problems with P/E method:

Answer 28

1. Choice of which P/E ratio to use
   * The P/E ratio must reflect the business and financial risk of the company being valued – quite difficult to achieve in practice
   * P/E ratio will normally be reduced if the company being valued is unlisted (30-50% lower)– listed companies have a higher value due to greater ease of selling shares
2. Earnings calculation
   * Earnings will have to be adjusted if it includes once-off items or if it is affected by director’s salaries which may be adjusted after a takeover
   * Historic earnings will have to be adjusted for future synergies
   * Latest earnings figures of the target company may have been manipulated upwards if it was seeking to be bought by another company
3. Stock market efficiency
   * Behavioural finance suggests that stock market prices may not not be efficient because they are affected by psychological factors, so P/E ratios may be distorted by swings in market sentiment

Question 29

Strengths of P/E method:

Answer 29

• Straightforward approach and commonly used
• Good for valuing a controlling interest
• P/E ratio incorporates the market’s perception of future growth

Question 30

Weaknesses of P/E method:

Answer 30

• Difficult to identify a suitable P/E ratio
• Difficult to establish sustainable earnings
• Based on accounting profits, not cash flows

Question 31

Earnings Yield Method:

Answer 31

• The earnings yield is the reciprocal of the P/E ratio
• Referred to as capitalising future earnings
• Forward looking measure because it is based on estimated future earnings – but future maintainable earnings can be difficult to estimate

Question 32

Earnings yield Formula:

Answer 32

• Market value = prospective earnings (in one year) x (1÷Ke)
• Can also be calculated as current earnings x 1 ÷ earnings yield
• Earnings yield = earnings / share price

Question 33

Cash Flow Valuation Method

Answer 33

• Method calculates the value of the firm as the discounted value of future cash flows
• It can build in the extra cash flows (synergies) resulting from a change in management control, and when the synergies are expected to be received
• Future cash flows can be difficult to estimate

Question 34

Cash flow to all investors:

Answer 34

• (cash available for payment to shareholders and debt holders)
• PBIT – tax, investment in assets + depreciation, any new capital raised

1. Identify the cash flow to all investors of the target company (before interest)
2. Discount at WACC
3. This calculates the NPV of the cash flows before allowing for interest payments
4. Subtract the value of debt from step 3 to obtain the value of the equity

Question 35

Cash flow to equity:

Answer 35

• (cash available for payment to shareholders only)
• PBIT – interest, tax, debt repayment, investment in assets + depreciation, any new capital raised

1. Identify the cash flow to equity of the target company (after interest)
2. Discount at an appropriate cost of equity, Ke
3. This calculates the NPV of equity

Question 36

Strengths of cash flow valuation methods:

Answer 36

• Based on cash flow
• Good for valuing a controlling interest
• Can incorporate expected synergies

Question 37

Weaknesses of cash flow valuation methods:

Answer 37

• Difficult to forecast future cash flows accurately
• Difficult to estimate synergies that will arise
• Calculating an appropriate discount factor representing risk can be difficult