Chapter 8 Flashcards
What is organic growth, its advantages and disadvantages ?
Organic growth: involves the retention of profits and or the raising of new finance to fund INTERNALLY generated profits.
Adv:
Costs are spread (as opposed to paying upfront for acquisition) however the costs may be higher
Less disruption (as the need to integrate staff and new systems will be avoided)
Disadvantages:
More risky (higher risk of failure in a new market)
Process may be too slow
May be barriers to entries to new markets
What are the four reasons a business may combine?
Synergy:
combination of two businesses is worth more than the separate business on a stand alone basis. May make administrative savings, economies of scale (greater purchasing power), use of common investment in marketing, new technologies, leaner management structures, access to under utilised assets(target has fantastic technology that they are not using to its full potential)
Risk reduction: specific risk is not reduced for shareholders through diversification, but the reduction of specific risk for the business may lead to cheaper borrowing
Reduced competition
Vertical integration: acquire a key supplier to safeguard the position of the business
What are the two downsides of acquisition?
Bidding company shareholder often lose out due to over paying, high transaction fees and synergies being overestimated
Takeovers are often in the interests of the directors rather than the shareholders
What are the seven reasons we may get business valuations?
To establish merger/takeover terms
To be able to make share purchase/sale decisions
To value companies listing on stock exchange
To value shares sold in a private company
For tax purposes
For divorce settlements
To value subsidiaries for disposals
What are the three types of asset valuations and what are the three general points about them?
Historic costs:
-balance sheet value of equity
- meaningless because historic cost doesn’t equal market value
NRV:
- NRV of assets less liabilities
-minimum acceptable value to owners determined to sell
-ignored goodwill
Replacement cost:
- cost of setting up an identical business from scratch
Maximum price for a buyer
-problems: estimating replacement costs is difficult, ignored goodwill or it is difficult to value.
General points:
- assets are more certain than income. Income is generated only if assets are well managed which is by no means certain
- asset valuations useful for asset strippers
-service business often have very few tangible assets so asset methods would place very little value on the business. Most of their value resides on goodwill
What is the price/earnings ratio?
What does a high earnings ratio mean?
How can you estimate the valuation of the business using current earnings?
PE Ratio = total MV equity/ earnings
= share price / earnings per share
Means:
Carry low risks
Is large/stable/mature
Have excellent cash flow generation
Have a good growth potential
Total MV equity = P/E ratio x current earnings
What are four important points to note regarding the P/E ratio? What are the four problems with the P/E method?
- if valuing a private company, will neee to use P/E ratio of similar listed company
- ratio used will then need to be adjusted to reflect any differences in likely growth
- it will need to be adjusted down to reflect the fact that the listed company are more desirable than a private company
- earnings figure should be the sustainable earnings available to the ordinary shareholders. If PAT has been volatile in recent years, consider using an average
Disadvantages:
- estimating maintainable future earnings
-accounting policies can distort earning figures
-selecting a suitable P/E ratio to value unquoted companies - finding a similar quoted company is difficult
What is the enterprise value (EBITDA)
What is EBITDA
Enterprise value:
- measure of total value of the company (valuing the ordinary shares, debt and preference shares)
-calculation: MV equity + MV pref shares + minority interests -cash
EBITDA:
a way of looking at a company’s performance without factoring in financial decisions, accounting decisions or the tax environment.
Calculation: PBIT + depreciation * amortisation
What is the enterprise value multiple? What do you do with private companies?
Enterprise value/ EBITDA = enterprise value multiple
Can be used to value company, estimate growth, and is an alternative to the P/E ratio
For private companies take EVM of public company and then adjust down for differences between the companies
What are the advantages and disadvantages of EBITDA/EV?
Adv:
- unaffected by financing /cap spend/accounting decisions and tax. Enables comparison of two companies which may differ in these areas
- EBITDA is a key measure used by many investors
Disadvantages:
- simplistic and reflect a point in time
- comparing capital spend and tax management of two companies may be important
What is the dividend valuation model?
What are the advantages and disadvantages?
P0 = D0(1+g)/(ke-g)
Used to value a future dividend stream
Adv:
- based valuation on future dividend stream
- useful for valuing minority shareholdings in private companies
Disadv:
- assumes constant dividend growth which is unlikely
- Ke must be esultate
-assumes constant gearing - hard to use if company has deliberately low dividend policy in the short term
- growth based on historic data
- formula breaks down if g>ke
- estimated growth can be distorted by inflation
- if using ke of quoted company to value private company, must adjust down for non-marketability
What is the dividend yield?
What are two important points to note?
Advantages and disadvanges?
Dividend per share/ share price
This can be used to value a company:
- mv of all shares: dividends/dividend yield
- share price: dividend per share/ dividend yield
- dividend yield are only available for quoted companies. Will have to use div yield of a similar listed company if valuing a private company
- then need to make adjustments for in marketability
Adv:
It values company based on current market values of similar companies
Disadv:
- need to find comparable listed company
- valuation based on historic dividends - need to ensure these are sustainable
- you will need to adjust downwards for non marketability
- will undervalue companies who are profitable but have deliberately low dividend pay out
What are the 4 problems with the SVA method?
Constant percentage assumptions used in valuation may be unrealistic
Input data may not be easily available
May be difficult to establish the length of the competitive advantage period
For many valuations, a large proportion of the value is made up of the terminal value which is an unreliable estimate
What do you do if an exam question asks you to comment on a range of valuations?
Set out in a table the different valuations that you have calculated as a summary of your workings
Provide a commentary on each individual valuation. Refer to pros and cons of each and relate these to the scenario, use data where possible.
Conclude by suggesting a suitable range of values based on two or three that you have calculated that appear to be the most relevant and sensible given the question scenario
How do you value debt?
MV of debt can be calculated by present valuing the future cash flows at the pre tax cost of debt (redemption yield)
