Market-based Valuations

Question 1

DETERMINING SUSTAINABLE EARNINGS: Starting Point (6)

Answer 1

• Historic earnings
• Both past profit history and industry knowledge
• A review of past years’ income statements
• – A steady trend in both revenue and earnings would indicate that the current year’s earnings are probably representative of the earnings figure that could be sustained into the future.
• – Where profits are erratic you should establish whether this is due to erratic revenue, or erratic margins.
• If budgets and forecasts are available, these should also be considered when determining a suitable earnings figure.

Question 2

DETERMINING SUSTAINABLE EARNINGS: Adjustments to the starting point (7)

Answer 2

• EXTRAORDINARY ITEMS
• PROFIT OR LOSS FROM SALE OF PROPERTY, PLANT &EQUIPMENT
• IMPAIRMENTS OR AN INVENTORY WRITE-DOWN TO NRV
• CHANGE IN MARGINS (NOTE!)
• NOTIONAL OR INADEQUATE AMOUNTS
• GEARING
• PREFERENCE DIVIDENDS

Question 3

DETERMINING AN APPROPRIATE P/E RATIO: Adjustments (10)

Answer 3

 FUTURE GROWTH PROSPECTS
 DIFFERENCE IN MARGINS (percentages and/or trends)
 THE MARKETABILITY OF THE SECURITY
 SOVEREIGN (COUNTRY SPECIFIC) RISK
 CAPITAL STRUCTURE
 OPERATING ACTIVITIES and DIVERSIFICATION
 SIZE
 EXTENT OF SHAREHOLDING BEING VALUED
 DEPTH OF MANAGEMENT
 LEVEL OF INVESTMENT (WORKING CAPITAL, ETC)

Question 4

Shortcomings (9)

Answer 4

▪ Consistency of comparatives (both earnings and P/E). Cyclical industry problematic in this regard (especially where at a peak/trough).
▪ Lumpy cash flows (in both comparative firm and target company)
▪ Abnormal earnings of comparative firms in base year (high, low, negative) – especially important if not driven by industry factors
▪ Difficulty in finding comparable firms (same industry sector, similar capital structure, similar margins, returns, age of assets, growth prospects)
▪ Similar accounting policies required (eg depreciation).
▪ The P/E ratio depends on earnings which are subject to accounting manipulation.
▪ A high P/E ratio may reflect either an expectation of high growth in the future or it may reflect the fact that earnings are very low in a particular year.
▪ Adjustments can tend towards being subjective for many factors.
▪ General over/under pricing of industry sector.

Question 5

Typical Adjustments: 10-35% (5)

Answer 5

• country risk 10%-25%
• control premium applied to market value if holdings are:
• • 51%-74% –> 16% premium
• • 75%-100% –> 21%
• • joint control 8%
• size 10%-30%
• start up premium 6% (but varies a lot)
• minority discount on mv of equity if holdings are
• • 1-24% –> 18%
• • 25-49% –> 13%