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FM - Financial Management > Chapter 20 - Business valuations and market efficiency > Flashcards

Chapter 20 - Business valuations and market efficiency Flashcards

1
Q

Valuations of share in both public and private companies are needed for several purposes including what?

A
  • to establish terms of takeovers and mergers
  • to be able to make ‘buy and hold’ decisions
  • to value companies entering the stock market
  • establish values of shares held by retiring directors, which the articles of the company specify must be sold
  • for fiscal purposes (CGT, Inheritance tax)
  • divorce settlements
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2
Q

How do we calculate the market capitalisation of public companies?

A

current share price x no. of shares in issue

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3
Q

The real worth of a company will be known when?

A

once a purchase has been made after negotiation between the two parties

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4
Q

The accounting equation states what?

A

Total assets = shareholders’ equity + liabilities
Therefore follows that:
Shareholders’ equity = total assets - liabilities

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5
Q

What are the 3 alternative asset valuation bases?

A
  • Book value
  • Replacement
  • Breakup value/ NRV
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6
Q

What is the book value bases?

A
  • value is largely a function of depreciation policy
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7
Q

What is the replacement value bases?

A

Useful for the buyer. If the buyer wants to estimate the minimum price that would have to be paid to buy the assets and set up a similar business from scratch

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8
Q

What is the breakup value/NRV?

A

Useful for the seller. Considers the amount they would receive if they were to liquidate the business as an alternative to selling the shares.
Useful for a buyer if their intention is to strip the assets and sell them

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9
Q

What are some problems of asset-based valuations?

A
  • asset based valuations do not value what is being purchased, i.e., the right to future earnings/cash flows of the company
  • asset based valuations ignore intangible assets, such as goodwill
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10
Q

What are advantages with asset-based valuations?

A
  • the valuations are fairly readily available
  • they provide a minimum value of the entity
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11
Q

When are income/earnings based valuation methods particularly useful?

A

when valuing a majority shareholding

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12
Q

What do income/earnings based valuation methods reflect?

A

that the investor has additional benefits of control, which means they have access to the earnings of the business, not just the dividends (as they can influence dividend policy)

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13
Q

What is the PE ratio calculation?

A

Value per share = EPS x P/E ratio
Total value of equity = Total earnings x P/E ratio

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14
Q

What are some disadvantages of the PE ratio valuation method?

A
  • they are based on accounting profits rather than cash flows
  • it is difficult to establish the relevant level of sustainable earnings
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15
Q

What are some advantages of the PE ratio valuation method?

A
  • They are commonly used and are well understood
  • they are relevant for valuing a controlling interest in an entity
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16
Q

What is the earnings yield method?

A

inverse of the PE ratio

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17
Q

What is the calculation for the earnings yield method?

A

value per share = EPS / earnings yield
total value of equity = total earnings / earnings yield

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18
Q

When incorporating constant growth in earnings what is the calculation?

A

Total value of equity = (earnings x (1-g)) / (earnings yield -g)

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19
Q

What is the dividend valuation model used for?

A

used for valuing a minority shareholding in a company

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20
Q

If dividends are growing what calculation will be used?

A

Po = Do (1+g) / (re -g)

21
Q

If dividends are constant what calculation will be used?

A

Po = D / re

22
Q

What are some strengths and weaknesses of the DVM?

A
  • problems estimating a suture growth rate
  • growth assumed to be zero or at a constant rate
  • high sensitivity to changes in the assumptions used
  • few advantages over earnings based methods for controlling interests
23
Q

What is the growth caluclation?

A

g = (Do / Dn) ^(1/n) - 1

24
Q

The value of equity is derived by what?

A

estimating the future annual free cash flows of the entity, and discounting these cash flows at an appropriate cost of capital

25
Q

What are free cash flows?

A
  • operating cash flows excluding financing flows
  • deduct tax cash flows
  • add revenue from sales of assets
  • add cash flow benefit of synergies from the manager
  • deduct the cash flow for ongoing asset expenditure
26
Q

What are the steps for valuation?

A
  • identify free cash flows
  • select a suitable time horizon
  • calculate the PV over this time period
  • if valuing equity only, deduct the value of the debt to give the equity value
27
Q

what are some advantages of the discounted cash flows basis?

A
  • theoretically the best method
  • can be used to value all or part of a company
28
Q

what are some disadvantages of the discounted cash flows basis?

A
  • relies on estimates of cash flows and discount rates
  • difficulty in choosing a time horizon
  • difficult in valuing a company’s worth beyond this time horizon
  • assumes that discount rates, tax and inflation rates are constant over the period
29
Q

What is the calculation for preference shares Po?

A

D/Kp

30
Q

What is the calculation for irredeemable debt MV?

A

I/kd

31
Q

What is the calculation for redeemable debt MV?

A

PV of future interest and redemption receipts discounted at investors required return rate

32
Q

What is the floor value?

A

the market value as calculated if you ignore the conversion option and use only the interest and redemption cash flows

33
Q

What is the conversion premium?

A

this is the difference between the current market value of the loan note and the current market value of the shares that the loan note could eventually be converted into

34
Q

What is the floor value equal to?

A

market value without the conversion option

35
Q

What is the conversion premium equal to?

A

market value of loan note - current conversion value of shares

36
Q

What is an efficient market?

A

one in which security prices fully reflect all available information. New information is rapidly and rationally incorporated into share prices in an unbiased way

37
Q

Fairly priced shares ensure what?

A

investor confidence and reflect director performance

38
Q

What are the 3 forms of efficiency?

A
  • Weak
  • Semi strong
  • strong
39
Q

What is weak form efficiency?

A
  • share prices reflect information about all past price movements. Past movements do not help investors in identifying positive NPV trading strategies
40
Q

What is the evidence for a weak form efficiency?

A

Share prices follow a random walk:
- no patterns or trends
- prices rise or fall depending on whether the next piece of news is good or bad
- very little of a share price movement on one day can be predicted from knowledge of the change on the previous day

41
Q

What is the conclusion for the stock market in regards to a weak form efficiency?

A
  • future price movements cannot be predicted from past price movements
  • chartism/technical analysis cannot help make consistent gains on the market
42
Q

What is a semi-strong form efficiency?

A
  • share prices incorporate all past info and all publicly-available info. Incorporates weak form market efficiency
43
Q

What evidence is there for a semi-strong form efficiency?

A

Share prices react within 5-10 minutes of any new info being released:
- rising in response to good news
- falling in response to bad news

44
Q

What is the conclusion for the stock market that is semi-strong form efficient?

A
  • fundamental analysis - examining publicly-available info will not provide opportunities to consistently beat the market
  • only those trading in the first few minutes after the new breaks can beat the market
45
Q

What is a strong form efficiency?

A

share prices incorporate all info, whether public or private, including which is as yet unpublished

46
Q

What evidence is there of a strong form efficiency?

A
  • insiders (directors e.g.,) have access to unpublished info.
  • share prices would not move with breaking news, as they would have already reacted before the news became public
  • there would be no need to ban ‘insider dealings’ as insiders would not be able to beat the market
47
Q

What is the conclusion for strong form efficiency?

A
  • not strong form efficient; therefore max level of efficiency is semi-strong
  • insider dealing is banned
  • the stock exchange encourages the release of new info quickly preventing insider dealing opps
  • insiders are forbidden from dealing in their shares at crucial times
48
Q

Why do investors make seemingly irrational decisions when buying and selling?

A
  • market paradox
  • herding
  • stock market bubble
  • noise traders
  • loss aversion
  • momentum effect
49
Q

What are the practical considerations associated with valuing a company?

A
  • marketability and liquidity of shares
  • available info
  • equilibrium prices

FM - Financial Management (19 decks)

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