Valuation

Question 1

What is valuation?

Answer 1

Present value of future cash flows of an asset

Question 2

What is the discount rate used for valuation?

Answer 2

The required rate of return that the investors requires given the environment in which the investment is made. It can be determined by the return in similar assets trading on the market.

Question 3

How do you value non redeemable debentures and bonds?

Answer 3

Non redeemable debentures = perpetuity

PV= CF1 / I/Y

Question 4

What is yield to maturity?

Answer 4

Implicit return that an investor will earn by holding the bond or debenture until maturity. It is also known as the internal rate of return(IRR).

Question 5

How do you calculate the present value of redeemable debentures?

Answer 5

Two types of cash flows:
- periodic interest
- repayment of capital at redemption date
Therefore, PV of interest + PV capital

Question 6

What is the present value of non redeemable preference shares?

Answer 6

Perpetuity - PV= CF1 / I/Y

Question 7

What is the present value of cumulative preference shares in arrear?

Answer 7

Step1: add all the missed dividends in the year that is will be paid
Step 2: calculate the value do perpetuity of the preference share on the year the arrear dividends will be paid
Step 3: sum up
Step 4: discount it back to present value using the required rate of return

Question 8

What is the present value of non cumulative preference shares with dividend passed?

Answer 8

Step 1: calculate the value of perpetuity of preference shares at the end of the year that the dividend will be received
Step 2: add the dividend for that year
Step 3: discount back to present value using the required rate of return

Question 9

What is the present value of redeemable preference shares?

Answer 9

Similar to redeemable debentures.
Step 1: calculate the PV of dividends
Step 2: calculate the PV of capital
Step 3: sum up 
Or 
Financial calculator

Question 10

What is the valuation of ordinary equity?

Answer 10

Present value of future cash flows (dividends)

Question 11

What are some methods used for valuation of ordinary equity?

Answer 11

1. Dividend discount/growth model and Earnings yield
2. Price multiples ( PE ratio or EY)
3. Free cash flow method
4. Economic value added (EVA)

Question 12

How do you calculate using dividend growth model?

Answer 12

PV = CF1 + growth / I/Y - growth
PV = next dividend / (required rate of return - growth)
PV = (EPS + growth) / (required rate of return - growth)

Question 13

What is downfall of dividend growth model?

Answer 13

1. Assumes growth is constant

2. Applicable only where the required rate of return is higher than the growth rate

Question 14

When do you use the dividend growth model?

Answer 14

When valuing a firm with steady growth, operating in a mature industry sector.

Question 15

How do you value a firm with a non constant growth rate?

Answer 15

Using two stage valuation method

Question 16

How do you perform a two stage valuation?

Answer 16

Step 1: calculate the PV of dividend until the growth rate changes
Step 2: value the growing perpetuity in the date the growth rate changes
Step 3: discount back to present value using the required rate of return
Step 4: sum step 1 and step 3

Question 17

When do you use price multiple?

Answer 17

To determine whether the shares are over or under valued
These are useful for valuing unlisted companies, as you can use PE or EY of a comparable listed company and adjust according to its specific risk factors.

Question 18

What is the PE ratio?

Answer 18

It measures the relationship between the company’s earnings per share and the share price
PE = EPS/ price per share
It shows how may times the investors are prepared to pay for a firm’s earnings per share

Question 19

How do you know using the PE ratio that a share is under or over valued?

Answer 19

Compare the PE of a firm to sector’s average PE
If company’s PE is lower than its undervalued
If company’s PE is higher than it is overvalued

Question 20

When will a company have a high PE ratio?

Answer 20

When it is experiencing high growth rate in earnings

When a company has low financial leverage to reflect the lower risk profile

Question 21

What is earnings yield?

Answer 21

Earnings yield is the inverse of PE ratio
So if PE is 9
EY is 0.09

Question 22

What is market to book ratio?

Answer 22

Also known as the net asset value per share

It is the share price of a company to the company’s book value per share.

Question 23

How do you calculate the market to book ratio?

Answer 23

Share price / book value per share

Book value per share = shareholders equity / number of ordinary shares

Question 24

How do you calculate price to sale ratio?

Answer 24

Price to sale ratio= sales per share / share price

Question 25

List the 10 steps approach to valuation.

Answer 25

1. Purpose of valuation - for whom - for what reason - limitations 2. Date of valuation 3. What is being valued? And size of interest 4. Interested parties - who do you represent? 5. Decide in suitable method - dividends yield - net asset value (liquidation or going concern) - earnings yield - free cash flow 6. Calculate the expected future sustainable earnings or dividends - sustainable income = net income after tax adjust for unusual items 7. Determine reasonable rate of return - use listed company and adjust for risk factor 8. Carry out the valuation 9. Test for reasonability - perform valuation using different method - provide reason if its reasonable 10. Conclusion

Question 26

When do you use the dividend yield method for valuation?

Answer 26

Company shows a reasonable return on their asset and the investment is a majority interest with evidence of growth.

Question 27

When do you use earnings yield?

Answer 27

When the investment has a fluctuation in its annual cash flows with evidence for growth, and the investment is a majority interest

Question 28

When do you use net asset value?

Answer 28

When the value of the company lies in the financial position. If the company is going concern then you would use the going concern basis if its not a going concern then you would use liquidation basis (asset stripping)

Question 29

What are some reasons for adjustment in income to reflect reasonable future sustainable income?

Answer 29

1. Exceptional items which are non recurring 2. Over provision or under provision 3. Changes in accounting policy 4. Transactions that do not occur in the normal course of business 5. Higher or lower reasonable/market compensation to employees or directors 6. Higher or lower finance costs 7. Inflation 8. Profit or loss on sale of assets or investment 9. Changes in statutory tax rate

Question 30

What are some of the adjustment factors for required rate of return?

Answer 30

1. Share of listed co are more easily traded 2. Shareholders agreement limits the transferability of private co 3. Funds are readily available for listed co 4. Shares of listed co are more acceptable as security for financial institutes 5. Nature of product marketed(luxury or necessities) 6. Competence of management 7. Size of company (larger are better cope with economic downturns) 8. Age of the company 9. Financial risk (gearing and ability to raise additional finance) 6.