Chapter 4 Business and securities valuation Flashcards
2.1 Business valuation general principles – use of listed company data to value unquoted firms
The models shown below often value unquoted firms using data derived from proxy quoted companies, it can therefore be difficult to find a similar quoted company. The final answer may have to be discounted to account for:
- Relative lack of marketability of unquoted shares
- Lower levels of scrutiny
- Higher risk
2.2 Distortions in accounting figures
Professional scepticism needs to be applied. When reviewing data for a valuation, distortions in accounting figures should be identified. It may be necessary to product normalised earnings figure that represents expected earnings once the company has been bought.
2.3 Valuation of a company making a loss
Normal models are more difficult to apply, as they are likely to generate a negative value and there may be more uncertainty around the data used. Consideration of why the company is loss making is important, if only temporary then normalised earnings could be calculated and used for a valuation. Possible approaches include:
- Fair value of net assets, although due diligence will be required to determine fair value.
- If the losses have been incurred by one-off items, such as impairments, then it may be that we can predict future profits and use an earnings-based approach.
- A company that is loss making may still be generating a positive cash flow and therefore a discounted FCF method could be appropriate.
2.4 Valuation of a start-up company
Valuation of a start-up company has a new set of issues.
- Often revenue is growing, but there is little track record to determine an ongoing trend.
- Revenues and costs may be increasing at different rates as new customers can be gained before any efficiency savings are made.
- It could have a negative cash flow or be making losses in the first few years.
- It will not have an established customer base, or market presence.
The approach is discounted cash flow. Identify the drivers of value in the business, determine the time horizon, usually needs to be long-term (more than 7 years) to give revenue growth and cost savings a chance to stabilise. Determine the expected growth, in comparison to market expectations. Discount revenue and costs separately if they are expected to grow at different rates.
Market based valuation: compare to a similar company at a similar stage that has already been sold.
3.1 Discounting delayed perpetuities
When using discounting techniques to value companies, the assumption is cash flows go on forever. Hence most DCF valuations involve a perpetuity calculation. The general formula is:
PV of whole CF stream = CF (at start of the delayed perpetuity) x PF (either with or without growth) x DF (for the period before the delayed perpetuity starts).
- PF without growth: PF = 1/r
- PF with growth: 1/r-g
4.1 Business valuation – income-based measures
This method is very commonly used in practice.
- P/E ratio = Share price / EPS, or
- P/E ratio = market capitalisation / total earnings, or
- P/E ratio = 1/ Ke
If the market is efficient, assets with similar risk and growth prospects should trade a similar multiple of earnings. MV equity = P/E ratio x earnings (earnings = PAT less preference dividends).
This valuation will need to be adjusted downwards if listed company data is used to value an unquoted company. For controlling interests, the valuation may need to be adjusted upwards to reflect the value of synergies. The EPS should be adjusted to reflects the sustainable earnings of the company.
4.2 Dividend valuation model
Generally, used for minority shareholdings. In theory, the share price should be equal to the PV of future dividends, discounted at the cost of equity. The approach is to provide the DVM formula:
P0 = D0(1+g) / Ke-g or (D1 / Ke – g)
4.3 Discounted earnings
The PV of future earnings discounted at the shareholders required rate of return. The approach is to take the earnings figure from the scenario. If requested, you should adjust the earnings figure used to reflect the sustainable earnings of the company. Discount the cost of equity and the resulting PV = MV of equity.
The aim is not to make the earnings figure a better approximation of cash flows but simply to make it more representative of future sustainable earnings. Adjustments may include:
- Additional depreciation of FV of assets
- Adjusting directors’ salaries to reflect the market rate.
- Removal of one-off items
- Stripping out the impact of aggressive revenue recognition/estimates
5.1 Free cash flow method
This method of business valuation is similar to both discounted earnings approach and NPV of project appraisal. In theory, the free cash flow equals the total free cash flow which is available to reward all of the investors. Hence FCF is the total CF remaining after capital expenditure and tax, but before interest and dividend payments. The PV of future FCF discounted at the WACC equals the enterprise value (MV of debt plus equity).
The approach to estimate FCF is to obtain earnings before interest and tax, less tax, then add back non-cash items less any capital expenditure and working capital investment to equal the estimated FCF.
Note the tax figure from the P+L should not be used, as this includes a tax saving on interest which is already reflected in the discount rate. Hence, tax should be calculated before adding back depreciation to ensure the tax saving on depreciation/Cas is correctly included.
When discounting FCFs, the approach is to discount at WACC. The resulting PV equals the enterprise value, then less the MV of debt to obtain the MV of equity.
5.2 Business valuation – free cash flow method
Similar to discounted earnings approach, except earnings are adjusted to make them more like CFs. The PV of future CFs attributable to equity shareholders discounted at the shareholders required rate of return equals the market value of equity.
The approach is to calculate forecast PAT from the scenario. Estimate FCFs to equity from PAT figures, adjusting for adding back depreciation and deducting actual capital expenditure and incremental working capital investment. Then discount FCFs to equity at Ke to obtain the MV of equity.
5.3 Adjusted present value approach
APV is the base case NPV plus the PV of the tax shield. The APV is modified NPV calculation and a modified version of the discounted FCF approach.
APV is based on M&M’s with tax theory which states, the value of the leveraged firm equals the value of the unleveraged firm plus the PV of the tax shield.
The company is valued in two parts:
- The base case PV total (total FCFs discounted at the unleveraged cost of equity)
- The PV of the tax shield (tax saving on interest discounted at the pre-tax cost of debt)
APV separates the calculation of the asset values from the effects of the financing. The advantage over WACC based FCF valuation approach is that it is better suited to valuing a company where the target capital structure is expected to change over time.
The approach is:
- Estimate the FCFs
- Discount estimated FCFs at the unleveraged cost of equity. This equals the base case PV.
- Forecast the tax savings on future interest payments on the target company’s debt.
- Discount these future tax savings at pre-tax cost of debt. This equals the PV of the tax shield.
- APV = Base case PV + PV of tax shield = the enterprise value (MV of equity plus MV of debt)
- Then less the MV of debt to get the MV of equity.
5.4 Value based methods – shareholder value analysis
These methods align the strategic, operational and management processes to focus management decision-making on what activities create value. value is only achieved when returns are in excess of the cost of capital.
Shareholder value analysis is the present value of future cash flows, but presented using the seven value drivers:
- Increase sales growth.
- Extend the competitive advantage period.
- Increase operating margins.
- Reduce the cost of finance.
- Reduce working capital investment.
- Reduce the cost of capital investment.
- Use tax planning, to reduce the tax paid.
This method is the free cash flow method, with a presentational difference and the approach is the same as the free cash flow method.
- Calculate the PV of future cash flows.
- Add back short-term investments.
- Deduct the market value of the debt to get the market value of equity.
5.5 Value based methods – economic value added
This is an estimate of the amount of shareholder value created year by year. It is calculated as:
Net operating profit after tax – (WACC x Capital employed)
EVA can be used as the basis of a business valuation method as follows:
- Estimate NOPAT and capital employed for each year in the future.
- Use the NOPAT and capital employed estimates to calculate the EVA for each year.
- Discount the EVA figures to present value using the WACC.
- The PV of future EVA plus the opening invested capital (book value of debt plus equity on the valuation date) which equals the enterprise value.
- Enterprise value less the value of debt equals the market value of equity.
5.6 Value based methods – market value added
MVA is the present value of the future EVA of the business. It shows how much value the management have created, above the value of the capital invested by the finance providers.
6.1 Business valuation – asset-based measures (Net assets approach)
Starting point for an asset valuation is the NBV of the company’s net assets. Advantages of the approach include:
- It may be used as a floor value when selling a company, or a measure of the asset backing security in a share value. the asset backing for shares provides a measure of the possible loss.
- However, this is unlikely to represent the acquisition value of the company as NBV is historic cost and does not reflect market values and many intangibles are not recognised on the SFP.
Ideally the NBV of equity should be adjusted to reflect the fair value of the net assets.
The approach is taking the NBV of equity from the SFP. Then adjust this figure to reflect fair values, often uplifting land and buildings to fair value is the only adjustment required. Concerns include:
- The valuation of many intangible assets is subjective.
- Financial liabilities recorded using amortised cost basis may not be reflective of fair value.
- The valuation of pension assets/liabilities are highly sensitive to changes in the underlying assumptions.
