Valuation

Question 1

When might you need to value equity in a company?

Answer 1

When shares will be bought/sold
Issued on stock market

Question 2

What are some advantages of buying shares from existing shareholders, rather than growing organically?

Answer 2

Faster than organic growth
Synergies
Diversification/ risk reduction
Lower WACC if combined business is lower risk

Question 3

What are some disadvantages of buying shares from existing shareholders, rather than growing organically?

Answer 3

Expensive: sellers want a premium so buyers overpay
Synergies overestimated/ integration issues
Shareholders should already be diversified

Question 4

How does asset valuation measure the value of a company?

Answer 4

SFP carrying amount of fair value of its nets assets

Question 5

How can you easily calculate the net assets of a company?

Answer 5

Ordinary share capital + Retained earnings

Question 6

Advantages of asset valuation methods

Answer 6

Easy to apply
Useful for asset strippers

Question 7

Disadvantages of asset valuation methods

Answer 7

Ignores unrecognised intangibles (brands, patents, goodwill)
Service businesses have few assets:the value I’d in the people/process

Question 8

Advantages of using PV of Future Cash Flows (SVA) value method

Answer 8

Theoretically superior as uses discounted CFs
Uses cash and not accounting profits (accounting affected by accruals and policies)

Question 9

Disadvantages of using PV of Future Cash Flows (SVA) value method

Answer 9

Estimating future cash flows and growth is difficult
Estimating impact on WACC due to lower business risk is difficult
Perpetuity assumption unrealistic

Question 10

What is perpetuity?

Answer 10

Constant cash flow which is assumed to last forever

Question 11

How can you calculate perpetuity?

Answer 11

Cash flow / Return% - Growth %

Question 12

Name 7 ways a PV of future cash flows (value of business) can be increased.

Answer 12

1. Increasing cash inflows (sales)
2. Reducing cost outflows
3. Reducing tax outflows (planning)
4. Reducing asset outflows (cheaper assets)
5. Reducing working capital outflow (cash in receivables/inventory)
6. Reducing cost of capital (investors with lower rate of return)
7. Increasing life of cash flows (extend life of products/services)

Question 13

What does the PE ratio show?

Answer 13

How much an investor is prepared to pay for each £1 of ‘earnings’ (profits)

Question 14

Why might an investor pay more per £1 of earnings?

Answer 14

If they think that future earnings will grow

Question 15

How can the value of a company be calculated using the PE ratio?

Answer 15

P/E ratio x historic earnings (profit after tax)

Question 16

What PE ratio should unquoted companies use?

Answer 16

A PE ratio of a comparable listed company

Question 17

What are advantages of using the P/E ratio for valuing a company?

Answer 17

Easy to obtain input information (share price, EPS, accounting profits)

Question 18

What are disadvantages of using the P/E ratio for valuing a company?

Answer 18

Accounting profits affected by accounting policies
Historic earnings may not be an indicator of future
Hard to find comparable listed company

Question 19

How is the Enterprise Value (EV)/EBITDA Multiple different to the PE ratio?

Answer 19

EV measures the market value of debt and equity rather than the share price(MV of one equity share)

Question 20

Advantages of the EBITDA multiple

Answer 20

Removes depreciation enabling easier comparisons between companies
Take debt into account
By valuing the whole company, the price is less affected by capital structure

Question 21

Disadvantages of the EBITDA multiple

Answer 21

Still uses accounting profits which are affected by accounting policies
Still uses historic earnings which may not be indicator of future
Still hard to find comparable quoted company when valuing unquoted companies

Question 22

What formula can be used to calculate the share price using the Dividend Yield method?

Answer 22

Share Price = Dividend (1+growth) / Dividend Yield (%-growth)

Question 23

Advantages of the Dividend Yield method

Answer 23

Historic dividend information easily available

Question 24

Disadvantages of the Dividend Yield method

Answer 24

Uses historic dividends which may not be an indicator of future
Ignores cash flows which are not paid out as dividends
Estimating growth is difficult
Need to adjust for unquoted shares (reduce by 25%)
Doesn’t consider control premium if investor controls company

Question 25

When may it be suitable/not suitable to use an asset-based method using fair value?

Answer 25

Suitable if purchaser is buying the company to sell all the assets
Not suitable if the business will continue or has unrecognised intangibles

Question 26

When may it not be suitable to use dividend yield?

Answer 26

For controlling shareholdings - interested in profits/cash not dividends
If profits retained for reinvestment rather than paying dividend

Question 27

When may it not be suitable to use accounting-based methods (PE/EBITDA)?

Answer 27

If future earnings will be different from historic

Question 28

When may it not be suitable to use PV of CFs?

Answer 28

Not suitable if growth, perpetuity and WACC assumptions unrealistic