Chapter 20 - Business Valuations And Market Efficiency

Question 1

The real worth of a company

Answer 1

Valuation is described as ‘an art not a science’.

• The various methods of valuation will often give widely differing results.
• It may be in the interests of the investor to argue that either a ‘high’ or ‘low’ value is appropriate.
• The final figure will be a matter for negotiation between the interested parties.

Question 2

Asset based valuations

Answer 2

When asset based methods are useful:

1. Asset stripping
   Asset valuation models are useful in the unusual situation that a company is going to be purchased to be broken up and it’s assets sold off.
   Value the assets at NRV.
2. To set a minimum price in a takeover bid.
   Shareholders will be reluctant to sell at a price less than the net asset valuation.
   A standard tactic is to revalue balance sheet assets to encourage a higher price.
   In a normal going concern situation, we value the assets at their replacement cost.
3. To value property investment companies.
   The market value of investment property has a close link to future cash flows and share values.

Question 3

Income/ earnings-based methods

Answer 3

PE ratio method:-

PE = Price per share/ Earnings per share (EPS)

Value of company = Total earnings x PE ratio

Value per share = EPS x PE ratio

Question 4

Problems with the PE ratio valuation

Answer 4

It may be necessary to make an adjustment to the PE ratio of the similar company to make it more suitable.

Adjustment decrease:-

• Is a private company as its shares may be less liquid.
• Is a more risky company - fewer controls, management knowledge etc.

Adjustment increase:-
- Has a higher protected growth level.

Question 5

Earnings yield

Answer 5

Earnings yield = EPS/ Price per share

Value of company = Total earnings x (1/ Earnings yield)

Value per share = EPS x (1/ Earnings yield)

Question 6

Approaches to valuations

Answer 6

The three main approaches are:

1. Asset based - based on the tangible assets owned by the company.
2. Income/ earnings based - based on the returns earned by the company.
3. Cash flow based - based on the cash flows of the company.

Question 7

Weak form efficiency

Answer 7

Information:-

1. In a weak form efficient market, share price reflects information about all past price movements.
2. Past movements do not help in identifying NPV trading strategies.

Evidence:-
Share prices follow a random walk
1. There are no patterns or trends.
2. Prices rise or fall depending on whether the next piece of news is good or bad.
3. Tests show only 0.1% of a share price on one day can be predicted from knowledge of the change on the previous day.

Conclusion:-
The stock market is weak form efficient and so:
1. Future price movements cannot be predicted from past price movements.
2. Chartism/ technical analysis cannot help make a consistent gain on the market.

Question 8

Semi-strong efficiency

Answer 8

Information:-
1. The share price incorporates all past information and all publicly available information.

Evidence:-

1. Share prices react within 5-10mins of any new information being released and
   - Rise in response to breaking good news.
   - Fall in response to breaking bad news.

Conclusion:-
The stock market is (almost) semi-strong form efficient and so:
1. Fundamental analysis - examining publicly available information will not provide opportunities to consistently beat the market.
2. Only those trading in the first few minutes after the news breaks can beat the market.
3. Since published information includes past share prices, a semi strong form efficient market is also weakly efficient.

Question 9

Strong form efficiency

Answer 9

Information:-
1. The share price incorporates all information, whether public or private including information which is as yet unpublished.

Evidence:-

1. Insiders have access to unpublished information. If the market was strong form,
   - The share price wouldn’t move when e.g. News about a takeover, as it would have moved when the initial decision was made.
   - There would be no need to ban ‘insider dealing’ as insiders couldn’t make money by trading before news became public.

Conclusion:-
The stock market is not strong form efficient and so
1. Insider dealers have been fined and imprisoned for making money trading in shares before the news affecting them went public.
2. The stock exchange encourages quick release of new information to prevent insider trading opportunities.
3. Insiders are forbidden from trading in their shares at crucial times.