Chapter18 Flashcards
Reasons for business valuation
To determine the value of a private company (e.g. for a management buy out (“MBO”)).
To determine the maximum price to pay when acquiring a listed company (e.g. in a merger or takeover). The quoted share price is only relevant for taking a minority shareholding.
To aid in decisions on buying/selling shares in private companies.
To place a value on companies entering the stock market (i.e. for an IPO).
To value subsidiaries/divisions for possible disposal.
Majority and minority shareholders
ecause minority shareholders have little power and no control, a 20% share of a company should have less than 20% share of its total value. On the other hand, because of the power and control that majority shareholders have, an 80% share should be worth more than 80% of the total value of the company. Majority shareholders should therefore be prepared to pay a premium for control.
Net Book Value as a method of business valuation
The balance sheet equation: Equity = assets - liabilities
Problems with Net Book Value
Balance sheet (i.e. “carrying”) values are often based on historical cost rather than market values.
Net book value of non-current assets depends on depreciation/amortisation policies.
Significant assets may not be recorded in the statement of financial position
Will a valuation based on NBV be likely in any circumstance ?
No
Net Realisable Value (NRV)
NRV method estimates the liquidation value of the business:
Equity = Estimated net realisable value of assets − liabilities
This represents what should be left for shareholders if the assets were sold off and the liabilities settled and may represent the minimum price that might be acceptable to the present owner of the business as it ignores unrecorded assets (e.g. internally-generated goodwill).
In addition, it is also difficult to estimate the NRV of assets for which there is no active market (e.g. a specialist item of equipment).
Net replacement cost
s the cost of setting up an identical business “from scratch”:
Equity = Estimated depreciated replacement cost of net assets
This may represent the maximum price a buyer might be prepared to pay.
Problems and weaknesses of this method include:
Technological change means it is often difficult to determine comparable assets for the purposes of valuation.
It ignores unrecorded assets (e.g. goodwill).
Price/Earnings ratio
P/E ratio of a quoted company takes into account the expected growth rate of that company (i.e. it reflects the market’s expectations for the business).
Using published P/E ratios as a basis for valuing unquoted companies may indicate an acceptable price to the seller of the shares.
Earnings yield
Earnings yield is simply the reciprocal of the P/E ratio (and therefore has the same problems and weaknesses).
Earnings yield equals EPS over Market price per share × 100
Formula for ordinary share price
Eps x. P/E ratio
Value of a company
P/E ratio x profit after tax and preference dividends
Problems with valuing shares with P/E ratio
A suitable “proxy” may not exist (i.e. no similar company listed on the stock market).
Even if a proxy exists it may be under/over-valued by the stock market.
The earnings of the unquoted company may be intentionally inflated.
The earnings may not be a fair representation of future earnings even if they have not been deliberately distorted. Information asymmetry means that the seller will know more about the company and potentially the industry than the buyer.
The P/E ratios might not be appropriate. Share prices can sometimes vary dramatically.
A valuation based on earnings is less appropriate for purchases of minority shareholdings.
If the unquoted company being valued is loss-making, the P/E ratio method results in a (meaningless) negative value for its equity
