Topic 1.2 Equity Valuation

Question 1

Why is Equity Value needed for unquoted companies? (5 answers)

Answer 1

No market price is available
- Going public - fixing an issue price
- When shares are sold
- Tax purposes (capital gains)
- Security for loans.
- Death / Divorce

Question 2

Why is Equity Value needed for quoted companies? (3 answers)

Answer 2

• For takeovers or mergers (calculation of offer price, bidder looks at their own valuation
• Sale of subsidiary (no price available)
• Management buyout (possibly only a segment or old business is in new hands).

Question 3

What is the real worth of equity?

Answer 3

Depends on the viewpoints of various parties, or the price someone is willing to pay.
Different valuation methods often give widely different values.

Question 4

What is Asset-Based Valuation (NAV)?

Answer 4

Book value.
Total Assets - Total Liabilities.

Question 5

Advantages of Asset-Based Valuation (NAV)? (2 answers)

Answer 5

Objective, as based on balance sheet values.
Easy to calculate.

Question 6

Disadvantages of Asset-Based Valuation (NAV)? (5 answers)

Answer 6

• Not as objective as one may think (creative accounting).
• Many non-quantifiable assets are not included as not on the balance sheet (i.e. goodwill)
• Some liabilities are not included on the balance sheet (i.e. Litigation)
• Based on historic values
• Rarely agrees with the stock market valuation.

Question 7

When is Asset-Based Valuation (NAV) useful? (4 answers)

Answer 7

• To establish a minimum takeover price.
• When the firm is in difficulty.
• When a firm is being asset stripped.
• Certain industries where assets are largely the valuation of the company and not many assets not hitting the balance sheet (i.e. extractive industries such as mining) complement this valuation model.

Question 8

When is Asset-Based Valuation (NAV) not useful? (2 answers)

Answer 8

• Usually, a firm is bought for the earnings/cash flow potential of assets, not the assets themselves.
• Should value what is being purchased (earnings/cash flow)

Question 9

What is Dividend-Based Valuation (DVM)?

Answer 9

Share price (P0) is the PV of all future CF streams from a share discounted at Ke.
I.e. Income from dividends and capital gains.
CF = D1 + D2 + D3 + … + Dn + Pn
However, the future price is the constant future cash flow stream, so P0 is treated like a perpetuity.
Simplified: P0 = div/Ke

Question 10

Formula for DVM with constant growth?

Answer 10

P0 = D1 / (Ke - g)

D1 = D0 * (1-g) next years dividend

Question 11

What are the strengths of DVM? (2 answers)

Answer 11

• Simple to calculate
• Okay for valuing a non-controlling interest

Question 12

What are the weaknesses of DVM (3 answers)

Answer 12

• Some companies don’t pay dividends
• How can you estimate future growth rates
• For controlling interests, other earnings-based valuation models are better.

Question 13

What is the formula for calculating growth rate (DVM)?

Answer 13

g = (dn / d0)^1/n - 1

Question 14

What are the steps for calculating non-constant DVM?

Answer 14

1. Work out the PV of each year’s CF’s up until the time of constant growth.
2. Add those PV’s the a constant DVM from year n.

Question 15

What is Earnings-Based Valuation (Price-Earnings Ratio)?

Answer 15

Share price = Estimated PER ratio x Estimated EPS

Question 16

Formula for PER ratio

Answer 16

Share Price / EPS

Question 17

Problems with using a proxy

Answer 17

• Difficult to find a similar company with growth prospects.
• Adjustments may be required (liquidity, risk, growth levels, tax position)

Question 18

Positives of Earnings-Based Valuation

Answer 18

• Chief driver of investment value
• PE ratio is widely recognised and used by investors
• Differences in PE ratio may be due to differences in long-run average returns on investments.

Question 19

Negatives of Earnings-Based Valuation

Answer 19

• EPS can be zero, negative or insignificantly low.
• Managers can distort EPS

Question 20

Advantages of Cash Flow Valuations

Answer 20

• Based upon asset fundamentals, should be less exposed to market moods and perceptions.
• Cash flow is the correct way of thinking for investors.
• Forces an investor to think about the underlying characteristics of a firm, and understand its business.

Question 21

Disadvantages of Cash Flow Valuations

Answer 21

• It requires a lot of input and information to be accurate, simplified models may not be enough.
• Information inputted may be noisy, and subject to manipulation
• Can be over-simplified and unrealistic.
• Data availability can affect accuracy/

Question 22

Cash flow valuation formula

Answer 22

[CF0 * (1 + g)] /( K0 - g)
Similar to DVM

Question 23

CF0 formula (for CFV)

Answer 23

Current:
PBIT + non-cash expenses - actual investment in assets - tax on PBIT

Question 24

What is Shareholder Value Analysis (SVA)

Answer 24

A more sophisticated CFV

Question 25

SVA Working order

Answer 25

Sales
Profit
Tax
————
Profits net of tax
ICI
IWCI
—————
Free Cash Flows
Discount Factor
——————
PV

Question 26

SVA steps of working

Answer 26

1. Highlight Value Drivers
2. List out SVA workings
3. Fill in until end of planning horizon
4. In the year after the planning horizon, use total cash flow prior and divide by cost of capital (perpetuity), and discount by prior years discount value.
5. Calculate share value from order.

Question 27

SVA Share value order

Answer 27

PV of residual value
PV of free cash flows
—————————-
Business Value
Plus Marketable Securities
————————
Corporate Value
Less Debt
——————-
Shareholder Value (Mrkt Cap)