Valuation model using capital asset pricing model (CAPM) Flashcards
Worked Example 15.4
The shares of Calmen plc are currently paying a return of 9%. Assume the following for Calmen plc’s shares:
- ß: 1.3
- RFR: 12%
- RM: 18%
Using CAPM, calculate the minimum required return from the shares.
Explain how you calculate the price you would pay for these shares
Solution:
The minimum required return is calculated using the formula.
RADR = RFR + ß(RM – RFR)
Where
- RFR = Risk-free rate
- RM = return on stock market portfolio
- ß = measure of a stock’s risk (volatility)
12% + 1.3(18% – 12%) = 19.8%
The minimum return required from the share is 19.8%. Note that the share is actually paying a return of 9%, well below the minimum return required calculated by CAPM.
The rate calculated using CAPM can be used to discount an investment’s or a share’s future cash flows to their present value to determine the fair price of an investment or a share.
Assuming that the CAPM is correct, an investment or share is correctly priced when its market price is the same as the present value of its future cash flows, discounted at the rate suggested by CAPM.
If the market price is lower, the share is considered to be undervalued. If the market price is higher than the price calculated using CAPM rate, it is considered to be overvalued.
Shareholder value analysis (SVA)
Shareholder value analysis
Value creation
Shareholder value analysis (SVA) was developed in the 1980s.
It is a management strategy that focuses on the creation of economic value or wealth for shareholders.
Wealth creation is a dominant company objective and occupies a central place in planning and analysis.
The basic assumption of SVA is that a company is worth its ability to create value for shareholders, which is measured as the net present value of its future cash flows, discounted at the appropriate cost of capital.
The value of a share is typically the amount the shareholders are willing to pay, dependent on two factors:
- the expected dividends to be earned
- the expected returns from the share
Free cash flow?
Free cash flow
Free cash flow (FCF) is central to SVA.
Projects undertaken by the company can either have a positive NPV or a
negative NPV.
A positive NPV indicates that the cost of the project would be completely recovered.
Free cash flow is the surplus cash available after recovering all the costs needed to fund all projects that have positive NPVs.
It also indicates the amounts free to be distributed to equity shareholders.
Companies do not always distribute all the remaining surplus cash: some is retained for the following reasons:
- to make new investments
- to retain flexibility in decision making and such other powers within the company
- to absorb losses in times of economic downturn, thus avoiding administration or liquidation.
See page 280 of book
Value drivers?
Value drivers
Value drivers are factors that drive a company, which in turn creates value in a company. These factors impact a company’s future cash flow and its NPV.
Managers use these value drivers to make approximate estimates of future cash flows that could have an impact on the calculation of the NPV.
Key financial value drivers include:
- growth in sales revenue
- improvement of profit margins
- investment in non-current assets and other capital expenditure
- investment in working capital
- cost of capital
- corporate tax rate(s)
Strengths of SVA?
Strengths of SVA
- Shareholder value analysis uses accounting values and is easy to understand, apply and interpret. It does not
involve any complex calculations. - The reliability of the valuation is established by the use of universally accepted techniques such as NPV and DCF
measures. - Shareholder value analysis allows management to focus on the value drivers to make useful managerial decisions.
- Value drivers can also be used to benchmark the company against its competition
Weaknesses of SVA?
Weaknesses of SVA:
- The DCF flow technique uses a fixed rate for all future years, whereas companies go through ups and downs and generate different rates of returns.
- Value drivers are also assumed to grow at a constant rate which might not be the case in reality.
- Calculations depend on accounting figures including sales revenue and profits. In reality, it is almost impossible to
predict the share value, irrespective of the approaches and accuracy levels, beyond a certain period of time.
Test yourself 15.2
Test yourself 15.2
ABC plc generated sales revenue of £200 million during the year with an operating profit margin of 15%.
The company pays tax at a rate of 20%. The incremental investment in working capital was £13 million and the incremental investment in non-current assets was £6 million.
- Calculate the free cash flow for the year.
£ million Sales 200
Less: operating costs 170
Net operating profit 30
(200 x 15 / 100 = 30)
Less: tax 6
(30 x 20 /100 = 6)
Less: incremental investment in working capital 13
Less: incremental investment in non-current assets 6
= Free cash flow from operations 5
What is the significance of identifying value drivers in SVA?
Value drivers are factors that drive a business, which in return creates value in a company.
These factors impact a company’s future cash flow and the value of its NPV.
Shareholder value analysis helps the management to focus on factors which create value to the shareholders, rather than on short-term profitability.
Key value drivers include:
- growth in sales
- improvement of profit margin
- investment in fixed assets or fixed capital
- investment in working capital
- cost of capital
- tax rate
Managers are required to pay attention to decisions influencing the value drivers and its ultimate impact on value creation.
Calculation of shareholder value in SVA?
Shareholder value analysis involves carrying out the following calculations:
- Calculating the free cash flow by using the value drivers as the base.
This FCF is calculated for the period of the
planning horizon.
- Calculating the NPV of the FCF.
- Estimating the value attributable for the period beyond the planning horizon.
This is also known as the terminal
period or residual period.
Its value is worked out by calculating the value of perpetuity over the last year of the
planning period.
The present value of a perpetuity is calculated using the discounting method (covered in Chapter 13).
As it is assumed that the company will generate cash flows indefinitely, the sales revenue and operating profit of the
last year are taken as a base.
The application of all the above steps leads to the ‘corporate value’.
The total shareholder value is worked out by deducting the market value of total long-term borrowings.
£
- NPV of FCF for the planning period
xxx
- Add: present value over the terminal period or value of perpetuity xxx
- Less: market value of total long-term borrowings xxx
- Shareholder value xxx
Economic value added?
Economic value added :
It is a measure of profitability and wealth created for shareholders over and above the cost of invested capital. It is calculated as follows:
EVA = operating profit after tax (OPAT) – (WACC × capital invested)
A positive EVA indicates that a project has recouped its cost of capital, while a negative EVA indicates that the company
has not made sufficient profits to recover its cost of running the company
Worked example 15.6
The details of Mimang plc are below.
Mimang plc is a services company: its profit is high given the amount of capital invested.
Calculate the EVA of the company:
£’000 Operating profit after tax (OPAT) 3,380 Capital invested 10,300 WACC 5.6%
OPAT – (WACC × capital invested) = EVA
3,380,000 - (5.6% × 10,300,000) = 2,803,200
A positive EVA indicates that the company or project has recovered its cost of capital.
The value of the profitability or wealth created for shareholders over and above their cost of capital is £2,803,200.
Test yourself 15.3
Mirak Ltd invested £15 million at the start of the year and has generated after-tax operating profits of £3 million. The
weighted average cost of capital is 12%.
- Calculate the EVA of the firm.
- Calculate the EVA of the firm.
£ million OPAT 3 Capital invested 15 WACC 12% EVA 1.2
EVA = NOPAT – (WACC × capital invested)
= 3 – (12% × 15) = £1.2 million
Step 1. (12 x 15) / 100 = 1.8
Step 2. 3m - 1.8 = 1.2 m
A positive EVA indicates that Mirak Ltd has recovered its cost of capital.
The value of the profitability or wealth created for shareholders over and above their cost of capital is £1.2 million.
Strengths of EVA?
Strengths of EVA
- It uses accounting concepts that are familiar to managers, such as profit and the cost of capital.
- It looks at economic value and presents a better picture of the company based on the idea that a company must cover both the operating costs as well as the capital costs.
- There are no requirements to produce any additional reports or data collection procedures.
- It is best used for asset-rich companies that are stable or mature.
Weaknesses of EVA?
Weaknesses of EVA?
- EVA is restricted to specific or short-term projects as it does not take into account the present value of future cash flows.
- Its reliance on accounting profit makes it subjective in nature.
- Assets such as brand and reputation, which enhance the value of the company but are not recorded in the statement of financial position, are not considered in EVA.
This limits its scope for companies with intangible assets, such as technology companies.
Measuring value creation
Measuring value creation:
- Total shareholder return
Total shareholder return (TSR) is the total amount returned to an investor, equal to the capital gain or loss on a share plus
all dividends received. It is calculated as:
TSR = ((selling price + all dividends received) – purchase price) ÷ purchase price
It measures the performance of different companies’ shares between buying and selling a block of shares
- Market value added
It measures the value of the company as a result of its existence and operation in the market.
It is calculated as follows:
MVA = market value – total amount invested
Market value represents the current value of the company, whereas capital represents the funds invested by the shareholders and long-term debt holders.
It represents the increase in the value above the level of capital invested.
However, it does not consider any loans raised by the company.
- The effects of dividend payments on shareholder wealth
When a company pays a dividend, market value and equity are reduced by the same amount.
The calculation of MVA remains unaffected.
The following changes do happen on payment of an equity dividend:
a. the market value of the share reduces by the amount of dividend paid; and
b. the total equity balance on the statement of financial position, included in the MVA, is also reduced by the amount of dividend.
It can be assumed that dividend payments do not have an impact on MVA or shareholder wealth.
