Chapter 12 - Valuation and market efficiency

Question 1

What are four reasons for Business valuations?

Answer 1

• Listing on the stock market
• Valuing a target company in an acquisition
• Parent company disposes of subsidiary
• Shareholder disposes of investment in privately owned company

Question 2

What is the calculation for the value of all the equity in a company?

Answer 2

(Value of one share) x (number of ordinary shares in issue)

Question 3

What is the term for the market value of the equity in a company that is listed on a stock market?

Answer 3

Market Capitalisation

Question 4

What is the calculation for Market Capitalisation?

Answer 4

The share price x number of ordinary shares in issue

Question 5

What are the three categories of valuation?

Answer 5

• Asset Based Valuation
• Earning/Income Based Valuation
• Cash-flow based Valuations

Question 6

How to calculate Historic Basis (Net Book Value - NBV)?

Answer 6

Take the net book value of all of the assets less all of the liabilities directly from the balance sheet of the company

Question 7

What does Historic Basis (Net Book Value - NBV) represent for the seller?

Answer 7

Minimum price

Question 8

What is the Realisable Basis?

Answer 8

the current values if a business were to sell all of its assets individually today

Question 9

What is the Replacement basis

Answer 9

Current replacement costs of the assets held by the company

Question 10

What does the Replacement basis represent to a buyer?

Answer 10

The maximum price that they would be willing to pay

Question 11

What are the two problems with asset based valuations?

Answer 11

• They ignore intangible assets generated by a company over its lifetime
• Ignores future cash-flows generated by the assets

Question 12

How do you calculate the value of equity in a company using the price/earnings method?

Answer 12

Value of the equity of a company = (Suitable P/E ratio) x (Earnings of the company being valued)

Question 13

How do you calculate the value of one share in a company using the price/earnings method?

Answer 13

Value of share = (Suitable P/E ratio) x (EPS of the company being valued)

Question 14

What is the price/earnings method used to value?

Answer 14

The controlling interest in a company

Question 15

What should the earnings of a company being valued be multiplied by?

Answer 15

A comparison (proxy) company’s P/E ratio or an industry average P/E ratio

Question 16

What two adjustments to the P/E ratio should be considered?

Answer 16

▪ If using the P/E ratio from a listed company to value a privately owned company
▪ If there is an expected change in risk/ key staff

Question 17

What two adjustments to the earnings should be considered?

Answer 17

▪ Earnings are taken as profit after tax and preference dividends
▪ The earnings used must be the future maintainable earnings, and therefore should be adjusted to reflect
this

Question 18

How do you calculate the earnings yield in a company using the earnings yield method?

Answer 18

Inverse of price/earnings method…

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑 = (𝐸𝑃𝑆) ÷ (𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐e)

Question 19

How do you calculate the value of one share in a company using the earnings yield method?

Answer 19

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑛𝑒 𝑠ℎ𝑎𝑟𝑒 = (𝐸𝑃𝑆 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑏𝑒𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒𝑑) ÷ (𝑆𝑢𝑖𝑡𝑎𝑏𝑙𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑)

Question 20

What are the three problems with the earnings based method?

Answer 20

▪ Finding a quoted company with a similar range of activities may be difficult
▪ A single year’s P/E or Earnings Yield may not be a good basis if earnings are volatile
▪ Taking a P/E or earnings yield ratio from a listed company to value a privately owned company

Question 21

What are the four weaknesses with the dividend valuation growth model

Answer 21

▪ It assumes that dividends grow at a constant rate
▪ Future dividend growth is predicted from past results
▪ Cost of Equity may fluctuate in the future
▪ What if Ke is less than the growth rate?

Question 22

What is theoretically the best method of valuation?

Answer 22

The WACC

Question 23

What are the two difficulties with the Discounted cashflow method?

Answer 23

• Estimating future cashflows

- Finding a suitable discount rate

Question 24

What is the investors required rate of return on a bond?

Answer 24

The pre-tax cost of debt or yield

Question 25

What is the value of a bond (Irredeemable debt)?

Answer 25

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑏𝑜𝑛𝑑 = (𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ÷ (𝑃𝑟𝑒 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡)

Question 26

What are the three types of market efficiency?

Answer 26

• Weak form
• Semi-strong form
• Strong form

Question 27

Which type of efficiency states that…

Past information about the company such as sales
volumes, earnings etc. are already reflected in the share price of the company

Answer 27

Weak form

Question 28

Which type of efficiency states that…

There is no point in an analyst looking at historic information and trying to find something useful that will help them predict future movements in the share price

Answer 28

Weak form

Question 29

Which type of efficiency states that…

a share price is considered to reflect all past information and all publicly available information.

Answer 29

Semi-strong form

Question 30

Which type of efficiency states that…

When new information about a company is publicly released the share price instantly reflects this.

Answer 30

Semi-strong form

Question 31

Which type of efficiency states that…

The share price reflects all information whether publicly available or not.

Answer 31

Strong form

Question 32

With which form of efficiency will the share prices appear to follow a ‘random walk’?

Answer 32

Weak form.

Question 33

What does the efficient market hypothesis assume?

Answer 33

That investors behave in a rational way

Question 34

What are three reasons that investors sometimes behave irrationally?

Answer 34

Herding
Loss aversion
Momentum effect

Question 35

What is herding?

Answer 35

Herding, or the herd instinct suggests that investors sometimes decide to buy or sell shares because other
investors are doing so.

Question 36

What can herding lead to in the market?

Answer 36

Bubbles and crashes

Question 37

What is Loss aversion?

Answer 37

Some investors fear making losses. They might therefore choose to invest in companies that make stable low profits rather than high profits in one year and low profits in another

Question 38

What can loss aversion lead to?

Answer 38

Distorting demand for shares and hence affect the share price

Question 39

What is the Momentum effect?

Answer 39

If share prices start to rise significantly many investors become optimistic about the future. They think that prices will continue to rise and invest in companies with high growth prospects. The opposite is also true

Question 40

What can the momentum effect lead to?

Answer 40

Booms and busts lasting longer

Question 41

What is the formula for PE ratio?

Answer 41

P/E ratio = (Share price) ÷ (EPS)

or
Total share value / Total earnings

Question 42

What is the Dividend valuation model?

Answer 42

P0 = (D0*(1+g)) ÷ (Ke - g)