Chapter 15 - Company Analysis & Company Valuation Methods

Question 1

Dividend payout ratio

Answer 1

Measures earnings attributable to equity shareholders that are paid out in the form of dividends
Equity dividend(s) paid in the year ÷ Profit for the year × 100

Question 2

Dividend yield

Answer 2

How much a company pays out in dividends each year relative to the equity share price.
Dividend(s) per share ÷ market price per equity share × 100

Question 3

EPS

Answer 3

The residual profit (or earnings) attributable to each equity shareholder.
Residual profit - profit for the period after charging interest and other finance charges, corporate tax, preference dividends and any transfers to other component of equity. The balance is the profit available for equity shareholders (usually reported as profit after tax or profit for the period/year).

EPS = profit attributable to equity shareholders for the period ÷ weighted average number of outstanding equity shares during the period

Question 4

Overview - interpreting EPS

Answer 4

If revenue indicates how much money is flowing into the company, EPS indicates how much money is ultimately attributable to the equity shareholders. It serves as an indicator of the profitability of the company that tells us how much money the company is making on every individual outstanding equity share.

• The higher the EPS, the more attractive the shares will be to potential investors and higher the stock market value.
• An appreciating EPS trend indicates the growth of a company. Investors can also look at the estimates of future EPS to get an idea of the profits they will earn in future years.
• A high EPS indicates a company in good health, with enough profits available to pay dividends to the equity shareholders or to plough back into the company for future prospects and long-term growth. A company with a reported loss gives a negative EPS which is usually reported as ‘not applicable’.
• EPS is a measure of the management performance. It shows how effectively the available capital and opportunities have been fully utilised in the reporting period.
• It sets an upper limit for dividends, which some consider to be an important determinant of share price – although users should be aware that dividends are sometimes financed from distributable profits from previous years.

Question 5

Diluted EPS

Answer 5

Diluted EPS is the adjusted attributable profit for a period, divided into the outstanding equity
shares and adjusted to include all potential dilution. A diluted EPS assumes that all the convertible securities such as convertible preferred shares, convertible debt, equity options and warrants will be exercised. Diluted EPS is generally less than basic EPS.

Diluted EPS = adjusted profit attributable to equity shareholders for a period ÷ (weighted average number of outstanding equity shares + diluted shares)

Question 6

example of EPS vs diluted EPS

Answer 6

A company has a profit for the year of £6 million and 2 million equity shares also has convertible debt that could be converted to 1 million equity shares.

Basic EPS = £6,000,000 ÷ 2,000,000 = 300p/share.
Diluted EPS = £6,000,000 ÷ (2,000,000 + 1,000,000) = 200p/share

Question 7

Limitations of EPS

Answer 7

• Earnings per share does not represent actual income to the shareholder. It uses earnings, which are not directly linked to the objective of maximising shareholder wealth.
• Companies have the option to buy back their shares. In this case, the number of shares outstanding decreases, increasing the EPS without an actual increase in the profit. Companies can make EPS look better without profit actually improving.
• EPS does not consider the debt element of the company. It may not be an ideal comparison of two companies where one company has debt and the other company does not.
• EPS trend analysis shows the growth of a company in recent years. However, it may not be meaningful to compare EPS of different companies. The figures are dependent on the number of shares and their nominal value, that each company has in issue. Different companies are also likely to have different accounting policies.

Question 8

P/E RATIO

Answer 8

The price/earnings (P/E) ratio, also referred to as the ‘earnings multiple’ of a company, measures the current market
price of the share relative to its EPS. The current market price is driven by the forces of supply and demand along with
overall stock market performance.
P/E ratio = Market price per share ÷ EPS
This ratio indicates the relationship between the market value of equity share capital and the profit for the year. The P/E ratio valuation method is a simple and commonly used method of valuation. This approach uses the price earnings ratio of a similar quoted company to value shares in unquoted companies.
Value of a share = EPS × suitable industry P/E ratio

The P/E ratio applied should be from the same industry, with similar:
* company risk (in the same industry)
* finance risk (a similar level of gearing)
* growth rate

Question 9

Interpreting a company’s P/E ratio

Answer 9

The P/E ratio gives a stock market view of the quality of the underlying earnings. Generally, a high P/E ratio
indicates that investors anticipate higher earnings and higher growth in the future. The average market P/E ratio
has often been stated at 20–25 times earnings. In reality, different markets at different times may have averages
well above or well below this range. A P/E ratio is most useful when compared with a benchmark: for example, the
average P/E ratio for a specific sector of a market.
* A loss-making company does not have a P/E ratio.
* A company with a high P/E ratio can indicate that the equity shares are being overvalued. If a company has a high
P/E, investors are paying a higher price for shares compared to its earnings.
* A company with a low P/E may indicate undervalued shares. This can make a company with a low P/E a good value
investment with potential opportunity to be profitable, but it can also simply indicate that investors are not confident
about the company’s future prospects.
* The P/E ratio shows the number of years it would take for the company to pay back the amount an investor paid for
the share. In other words, the number of multiples over one year’s earnings an investor is willing to pay for a share.

Question 10

Limitations of P/E ratio

Answer 10

• The P/E ratio is applied to earnings based on accounting policies, which are more subjective than cash flows. A company can inflate their earnings to make them look better.
• The P/E ratio simply assumes that the market is valuing earnings and ignores many important variables in an equity share’s worth: dividends, earnings growth, risk and so on.
• The P/E ratio assumes that the market accurately values equity shares.
• The P/E ratio is actually a backward-looking indicator, providing little help where economic conditions have changed significantly.
• It does not consider debt. Companies with high debt levels are higher risk investments and the market price of an equity share is not always a good indicator of fair value.
• The P/E ratio is a useful valuation method used by investors, but it should never be used as the sole reason for investing in a company.

Question 11

What is the relative value method

Answer 11

Relative value is a method of determining an asset’s value that takes into account the value of similar assets of competing companies in the same industry. This is in contrast with other valuation methods, which look only at an asset’s intrinsic value and do not compare it to other assets. It is based on the approach that the investors are not just interested in the absolute figures on the financial statements, but also in the valuation of the asset in relation to its peers.

The investor measures share value (or the attractiveness measured in terms of risk, liquidity and return) in relation to a comparable share of another company.

Question 12

Steps in relative value analysis

Answer 12

1. Identify comparable companies. Revenue and market capitalisation are the widely used parameters.
2. Calculate price multiples such as P/E ratio, equity share price to sales revenue and equity share price to operating cash flow.
3. Compare these ratios with those of peers and the industry average. This will help in understanding whether the security is overvalued or undervalued.

Question 13

Calculating market capitalisation

Answer 13

Market capitalisation = equity share price x number of equity shares outstanding

Question 14

DVM

Answer 14

• The dividend valuation model (DVM) – also known as the dividend discount model (DDM) – is based on the principle that the current value of an equity share is the discounted value of all expected dividend payments that the share is expected to yield in future years. The NPV is calculated using an appropriate risk-adjusted rate that discounts the value of future cash flows to today’s date. This discount rate (see Chapter 12) is also referred to as the cost of capital for equity and the cost of capitalisation. It is the rate of return expected by the equity shareholders as compensation for the risk of owning and holding the shares.
• Future cash flows would include dividends and the selling price of the share when sold. For shares that do not pay dividends, the future cash flows would be equal to the intrinsic value of the selling price of the share.
• Current intrinsic value of an equity share = sum of present value of all future cash flows
• Sum of present value of all future cash flows = sum of present value of future dividends + present value of the share price

Question 15

Assumptions of DVM

Answer 15

• The future income stream is the dividends paid out by the company.
• Dividends will be paid in perpetuity.
• Dividends will be constant or growing at a fixed rate.

Question 16

Variable growth rate model

Answer 16

In a real-life scenario, dividends paid by companies do not remain constant over a number of years. The variable growth model – also known as the dividend growth model – divides the dividend growth into three phases:
* an initial phase of fast growth;
* a slower transition phase; and
* a sustainable ‘long run’ lower growth rate.

This model is a refinement of the DVM, but the basic principles remain the same. The capitalisation factor (the required rate of return) and the dividend growth rate might vary in these three phases. The intrinsic value of the share is the PV of each of these stages added together.

Different investors and analysts might have different predictions about the company’s future dividends, which might lead to different growth rates and required rates of returns. The exact intrinsic value of the share is indeterminable in most cases.

Growth rate (g) = r × b

       r	=	annual	rate	of	return	from	investing
      b	=	the	proportion	of	annual	earnings	retained

Question 17

What is the CAPM

Answer 17

• The capital asset pricing model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly shares.
• Capital asset pricing is widely used for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating the cost of equity
• The capital asset pricing model provides a rate of return that is proportional to an asset’s systematic risk and the expected excess return to the market. The rate calculated using CAPM can be used to discount an investment’s future cash flows to their present value, which helps to determine the fair price of an investment.
• The calculated fair value of an asset can be compared to its market price.
• Assuming that CAPM is correct, an investment is considered to be correctly priced when its market price is the same as the present value of its future cash flows, discounted at the rate suggested by CAPM.
• If the market price is lower than the fair value arrived using CAPM valuation, the investment is considered to be undervalued (a bargain).
• If the market price is above the price calculated using CAPM rate, it is considered to be
• overvalued.

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Question 18

How is cost of equity calculated under the CAPM

Answer 18

Ke = Risk-free rate + (beta coefficient × market risk premium)

Where the market risk premium (also called equity risk premium) = market return – risk free rate of return, or:

RADR = RFR + (ß (RM – RFR))
* RADR = risk-adjusted discount rate
* RFR = Risk-free rate of return
* RM = return on stock market portfolio
* ß = a measure of a stock’s risk (volatility) in relation to its market, where 1.0 is the market level

Question 19

What is Shareholder valuation model - what is value creation

Answer 19

• Shareholder value analysis (SVA) was developed in the 1980s. It is a management strategy that focuses on the creation of economic value or wealth for shareholders. Wealth creation is a dominant company objective and occupies a central place in planning and analysis.
• The basic assumption of SVA is that a company is worth its ability to create value for shareholders, which is measured as the net present value of its future cash flows, discounted at the appropriate cost of capital.
• The value of a share is typically the amount the shareholders are willing to pay, dependent on two factors:
• the expected dividends to be earned
• the expected returns from the share

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Net present value and IRR are the most common standardised approaches for estimating a company’s future cash flows and finding its present value. They are also the most popular techniques in capital investment appraisal that measure wealth creation for shareholders. Net present value is the difference between the present value of cash inflows and cash
outflows over a period of time. It indicates whether the cash inflows are sufficient to cover the outflows. It also estimates the number of years it will take to break even (when NPV equals 0). A high NPV indicates that a company is able to generate sufficient cash flows to cover all costs incurred in a project and pay higher dividends with its surplus. The market price of a share increases with the expectation of higher dividends.

Question 20

6 Value drivers

Answer 20

• growth in sales revenue
• improvement of profit margins
• investment in non-current assets and other capital expenditure
• investment in working capital
• cost of capital
• corporate tax rate(s)

Question 21

RE SVA - what is free cash flow (FCF)

Answer 21

Free cash flow (FCF) is central to SVA. Projects undertaken by the company can either have a positive NPV or a negative NPV.
A positive NPV indicates that the cost of the project would be completely recovered. Free cash flow is the surplus cash available after recovering all the costs needed to fund all projects that have positive NPVs. It also indicates the amounts free to be distributed to equity shareholders. Companies do not always distribute all the remaining surplus
cash: some is retained for the following reasons:
* to make new investments
* to retain flexibility in decision making and such other powers within the company
* to absorb losses in times of economic downturn, thus avoiding administration or liquidation

Question 22

How is FCF calculated (SVA)

Answer 22

CALCULATION OF FREE CASH FLOW

Sales revenue – operating costs  =  operating profit
	             (CT)
	             (Incremental investment in working capital)
	             (Incremental investment in non-current assets)
	             = FREE CASH FLOW FROM OPERATIONS

Question 23

How is shareholder value calculated (SVA)

Answer 23

1) Calculate FCF using value drivers as base. Calculated for period of planning horizon
2) Calculate NPV of the FCF
3) Estimate value attributable for period beyond planning horizon – terminal/residual period
a. Worked out by calculating value of perpetuity over last year of planning period
b. PV of a perpetuity is done using DF method
4) As assumed indefinite cash flows – sales rev and OP of the last yr taken as a base
5) Application of above steps leads to corporate value
6) Total shareholder value = deduct market value of long-term borrowings

Question 24

Strengths & Weaknesses of SVA

Answer 24

Strengths
* Shareholder value analysis uses accounting values and is easy to understand, apply and interpret. It does not involve any complex calculations.
* The reliability of the valuation is established by the use of universally accepted techniques such as NPV and DCF measures.
* Shareholder value analysis allows management to focus on the value drivers to make useful managerial decisions.
* Value drivers can also be used to benchmark the company against its competition.

Weaknesses
* The DCF flow technique uses a fixed rate for all future years, whereas companies go through ups and downs and generate different rates of returns.
* Value drivers are also assumed to grow at a constant rate which might not be the case in reality.
* Calculations depend on accounting figures including sales revenue and profits. In reality, it is almost impossible to predict the share value, irrespective of the approaches and accuracy levels, beyond a certain period of time.

Question 25

What is economic value added *****

Answer 25

Stern Stewart and Co developed the concept of economic value added (EVA) as an alternative to SVA.
It is a measure of profitability and wealth created for shareholders over and above the cost of invested capital.
It is calculated as follows:
EVA = operating profit after tax (OPAT) – (WACC × capital invested)
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Capital invested comprises equity plus long-term debt at the beginning of the period.
The weighted average cost of capital is the average rate of return a company expects to pay itsinvestors; the weights are derived from a company’s capital structure.
WACC = (proportion of equity × cost of equity) + (proportion of debt × post-tax cost of debt)
<br></br>
If a company is financed by 70% equity with a cost of 10% and 30% debt with after-tax costs of 8%:
WACC = (0.70 × 0.10) + (0.30 × 0.08) = 0.094 = 9.4%

• The rationale behind multiplying the capital invested by WACC is to assess the cost of using the capital invested by the shareholders. It determines whether the company is adding more wealth to shareholder value by earning a higher rate of return on the funds invested than the cost of the funds.
• A positive EVA indicates that a project has recouped its cost of capital, while a negative EVA indicates that the company has not made sufficient profits to recover its cost of running the company.

Question 26

Strengths & weaknesses of EVA

Answer 26

Strengths
* It uses accounting concepts that are familiar to managers, such as profit and the cost of capital.
* It looks at economic value and presents a better picture of the company based on the idea that a company must
cover both the operating costs as well as the capital costs.
* There are no requirements to produce any additional reports or data collection procedures.
* It is best used for asset-rich companies that are stable or mature.

Weaknesses
* EVA is restricted to specific or short-term projects as it does not take into account the present value of future cash flows.
* Its reliance on accounting profit makes it subjective in nature.
* Assets such as brand and reputation, which enhance the value of the company but are not recorded in the statement of financial position, are not considered in EVA. This limits its scope for companies with intangible assets, such as technology companies.

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Question 27

What is total shareholder return?

Answer 27

Total shareholder return (TSR) is the total amount returned to an investor, equal to the capital gain or loss on a share plus all dividends received.
It is calculated as:
TSR = ((selling price + all dividends received) – purchase price) ÷ purchase price
* It measures the performance of different companies’ shares between buying and selling a block of shares.
* Despite the ease of calculation, this method is subject to limitations as it uses market prices as the base. These are subject to market volatility.
* Therefore, it would only be meaningful if the performance is compared between companies in the same sector with same level of risk.

Question 28

Explain the concept of MVA

Answer 28

• The concept of market value added (MVA) was also developed by Stern Stewart and Co. It measures the value of the company as a result of its existence and operation in the market. It is calculated as follows:
  MVA = market value – total amount invested
• Market value represents the current value of the company, whereas capital represents the funds invested by the shareholders and long-term debt holders.
• It represents the increase in the value above the level of capital invested.
• However, it does not consider any loans raised by the company.

Question 29

How do dividend payments effect shareholder wealth?

Answer 29

When a company pays a dividend, market value and equity are reduced by the same amount. The calculation of MVA remains unaffected. The following changes do happen on payment of an equity dividend:
* the market value of the share reduces by the amount of dividend paid; and
* the total equity balance on the statement of financial position, included in the MVA, is also reduced by the amount of dividend.

It can be assumed that dividend payments do not have an impact on MVA or shareholder wealth.

Question 30

OVERVIEW - STOCK MARKET INFLUENCES

Answer 30

• Stock markets are influenced by a variety of factors.
• For any public issue or rights issue to be successful, it is essential that the shareholders are kept informed about how funds are used and the (positive) NPV of any new projects.
• The amount of value increase is not essential, but shareholders should be kept informed about the success of the project.
• Communications to shareholders and the stock exchange are an important part of the proces of maintaining confidence in a company and, therefore, access to capital funds at fair prices.
• The concepts of market efficiency and competitive advantage are relevant.
• Market efficiency is measured by how quickly the markets respond to the news or information that is reflected by an increase or decrease in the share price.
• Competitive advantage is attained by the value created as a result of undertaking the new project or venture.