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)
How do you value debt?
MV of debt can be calculated by present valuing the future cash flows at pre tax cost of debt (redemption yield)
If given post tax yield, can calculate pre tax by dividing by (1-t)
Pre tax cash flows to present value will include annual interest (if the annuity is redeemable) and the redemption cash flow (a single cash flow at maturity of the debt)
Can use PV spreadsheet function
= pv(rate, number of periods, payment, future value.
No periods: in months or six month periods
Payment is payment in cash in each period
Future value is redemption value
Why is the valuation of tech companies difficult?
Often loss making
Have unknown competition
Difficulties associated with valuing digital assets
Periodic swings in stock market sentiment
What are the three methods of payment for shares, and their pros and cons for buyer and seller?
Cash
Pros buyer: most attractive to seller. Get a better price?
Pros seller: certain amount received
Cons buyer: causes liquidity problems
Cons seller: immediate tax issues, no ongoing stake in buisiness
Share:
Pros buyer: preserves liquidity, ensure corporation of the seller in ongoing business
Pros seller: no immediate tax issues as gain deferred
Cons buyer: dilution of control of existing shareholder
Cons seller: uncertain value received, transaction costs to sell shares
Loan stock;
Pros buyer: avoids dilution of control for existing shareholders, preserves immediate liquidity
Pros seller: lower risk than shares
Cons buyer: increases gearing
Cons seller: may prefer higher returns of equity
What are the five reasons to divest?
Avoid conglomerate discount (tendency for market to undervalue larger companies)
Due to a bad fit with your other operations
Business is too time intensive
Due to poor results
Due to a need for liquidity
What are the six methods of divestments
Management buy out: existing management buy out owners in order to greater control and financial reward
Management buy in: as for an MBO but external managers buy shares
Spin off (demerger) holding companies gives shares in subsidiaries to its shareholders
Trade sale: the trade and assets are sold to third party
Repurchase of own shares: to enhance share price (reduce supply) give exit route for shareholders or increase gearing
Liquidation: company is wound up with assets sold, creditors paid and amounts left returned to shareholders
How do you forecast future income statements and balance sheets?
Forecast income statement first
Make sure to calculate retained profits for the year (added to reserves on balance sheet)
Calculate balance sheet lines that you can
Leave cash as balancing figure
Remember for share issuances that. You need to credit share capital with nominal value and then share premium with excess ossuance
What is a cash budget?
What do they estimate and what does this allow you to do?
Is a detailed budget of estimated cash flows incorporating both revenue and capital items
Provides an early warning of liquidity problems:
How much cash is required
When it is required
How long it is required
Whether it will be available from anticipated sources
What does cash forecasts based on the balance sheet tell us?
When forecasting the balance sheet cash is left as balancing figure
Able to identify either a cash surplus or funding shortfall at balance date
Surplus of share capital and reserves over net assets (assets minus liabilities) we have a cash surplus
Surplus of net assets over share capital and reserves we will be forecasting a funding deficit
What are the responses for forecasting a cash deficit or funding surplus ?
Deficit:
Issue shares
Borrow
Sell surplus assets
Lag on supplier payments/incentivise clients to pay earlier.
Cash surplus;
Use to increase sales by better credit terms
Reduce short term borrowing
Put on deposit in money markets
