Business

valuations

Introduction
In Part F we shall be concentrating on the valuation of businesses. In this
chapter, we will cover the reasons why businesses are valued and the main
methods of valuation.

Exam guide
Business valuations are highly examinable. You might be asked to apply
different valuation methods and discuss their advantages and disadvantages

When valuations are required

Valuations of shares in both public and private companies are needed for
several purposes by investors including:

A. For quoted companies, when there is a takeover bid and the offer price is
an estimated 'fair value' in excess of the current market price of the shares

B. For unquoted companies, when:

I. The company wishes to 'go public' and must fix an issue price for its
shares.
II. There is a scheme of merger with another company.
III. Shares are sold.
IV. Shares need to be valued for the purposes of taxation.
V. Shares are pledged as collateral for a loan and the bank wants to put a
value to the collateral.
VI. Another company is proposing to take over the unquoted company by
making an offer to buy all its shares.

C. For a subsidiary company, when the group’s holding company is

negotiating the sale of subsidiary to a management buyout team or to an
external buyer

Approaches to valuations
The three main approaches are:
 Asset based – based on the tangible assets owned by the company.
 Income/earnings based – based on the returns earned by the company.
 Cash flow based – based on the cash flows of the company

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Asset valuation bases
Net assets method of share valuation
Using this method of valuation, the value of an equity share is equal to the net
tangible assets divided by the number of shares.

Net tangible assets are the value in the statement of financial position of the
tangible non-current assets (net of depreciation) plus current assets, minus all
liabilities.

Intangible assets (including goodwill) should be excluded unless they have

market value (for example patents & copyrights, which could be sold)

Choice of valuation basis

1. Historical cost or book value basis
Book value – this will normally be a meaningless figure, as it will be based
on historical costs. However with fair value accounting the book value of
many assets and liabilities will be the fair value and therefore will be
relevant for valuation purposes.

2. Realisable basis or break up value

Breakup value – The NRV method estimates the liquidation value of the
business. This may represent the minimum price that might be acceptable
to the present owner of the business, in other words this amount would
represent what should be left for shareholders if the assets were sold off
and the liabilities settled.

3. Replacement basis
Replacement cost and deprival value –This approach tries to determine
what it would cost to set up the business if it were being started now. The
value of a successful business using replacement values is likely to be
lower than its true value unless an estimate is made for the value of
goodwill and other intangible assets, such as brands. Furthermore,
estimating the replacement cost of a variety of assets of different ages can
be difficult.

Problems with asset based valuation

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1. Investors do not normally buy a company for its statement of financial
position assets, but for the earning /cash flows that all assets can
produce in the future.
2. Asset based valuation ignores non-statement financial position intangible
assets e.g.
 Highly skilled- workforce
 Experienced management team
 Competitive positioning of companies products
 Goodwill
 Brand
 Customer list

When assets based valuations are useful

1. For asset stripping.

Asset valuation models are useful in the unusual situation that a
company is being purchased is broken up and its assets sold off. In a
break-up situation we would value the assets at their realisable value.
NRV might be difficult to calculate and moreover another weakness of
this is that this gives a value for the assets when SOLD not when IN
USE.

2. To identify a minimum price in a takeover.

Shareholders will be reluctant to sell at a price less than the net asset
valuation even if the prospect for income growth is poor.
In a normal going-concern situation we value the assets at their
replacement cost.

3. To value property investment companies.

The market value of investment property has a close link to future cash
flows and share values, i.e. discounted rental income determines the
value of property assets and thus the company.

Note: If we are valuing a profitable quoted company, in reality the

minimum price that shareholders will accept will probably be the market
capitalization plus an acquisition premium and not the net asset
valuation.

Test your understanding 1 – Asset based measures

The following is an abridged version of the statement of financial position of
Grasmere Contractors Co, an unquoted company, as at 30 April X6:
Noncurrent assets (carrying value) $ 450,000
Net current assets $100,000
–––––––
$550,000

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Represented by $1 ordinary shares $200,000
Reserves $250,000
6% loan notes Z1 $100,000
–––––––
$550,000

You ascertain that:

 Loan notes are redeemable at a premium of 2%
 Current market value of freehold property exceeds book value by
$30,000
 All assets, other than property, are estimated to be realisable at their
book value.

Calculate the value of an 80% holding of ordinary shares, on an asset’s basis.

Test your understanding 2

$’000 $’000

Non-current assets 1,000

Current assets:
Inventory 500
Receivables 300
Cash 400
Total Current assets 1,200

Total Assets 2,200

Represented by $1 ordinary shares 400

Reserves 900
Total equity 1,300

Bonds 400
Current liabilities 500

Total equity and liabilities 2,200

Non-current assets contain land and buildings that are valued $700,000
above their book value, and plant and machinery, which would sell for
$200,000 less than their book value. Inventory would sell for $400,000 and
only $250,000 would be realized from receivables. Closure costs add
$100,000 to liabilities

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Calculate the value of the company based on Historical cost basis and Net
realisable value basis

Test you understanding 3

An independent accountant has produced the following valuations of a private
company.

$m
Historical cost adjusted for changes in general purchasing power 3.2
Piecemeal net realisable value 4.1
Cost of setting up an equivalent venture 5.3
Economic value of the business 5.6
Assuming that the above valuations accord with the expectations and risk
perceptions of the purchaser,

What is the maximum price that should be paid for the private company?

A. $3.2m
B. $4.1m
C. $5.3m
D. $5.6m

Test your understanding 4

Asset‐based business valuations using net realisable values are useful
in which of the following situations?

A. When the company is being bought for the earnings/cash flow that all of its
assets can produce in the future.
B. For asset stripping
C. To identify a maximum price in a takeover
D. When the company has a highly‐skilled workforce

Test your understanding 5 (H.W)

A. Give four circumstances in which the shares of an unquoted company
might need to be valued.
B. Suggest two circumstances in which net assets might be used as a basis
for valuation of a company.

Income based valuation

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P/E ratios may be used to value equity shares when a large block of shares,
or a whole business, is being valued. This method can be problematic when
P/E ratios for quoted companies are used to value unquoted companies.

P/E ratio (earnings) method of valuation

This method relies on finding listed companies in similar businesses to the
company being valued (the target company), and then looking at the
relationship they show between share price and earnings. Using that
relationship as a model, the share price of the target company can be
estimated.

P/E ratio

The P/E ratio is the price per share divided by the earnings per share and It
essentially tells us is how long it would take the earnings to repay the share
price

P/E ratio= Market value

EPS

Then, Market value = P/E ratio * EPS

EPS = Profit or loss attributable to ordinary shareholders

Weighted average number of shares

Significance of high P/E ratio

A high P/E ratio may indicate

1. Expectations that the EPS will grow rapidly

A high price is being paid for future profit prospects. Many small but
successful and fast-growing companies are valued on the stock market
on a high P/E ratio.

2. Security of earnings
A well-established low-risk company would be valued on a higher P/E
ratio than similar company whose earnings are subject to greater
uncertainty.

3. Status

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Quoted company shares will be valued at higher P/E ratio than
unquoted company because quoted company ought to be a low risk
company; but in addition, there is an advantage in having shares which
are quoted on a stock market: the shares can be readily sold.

4. Industry average
When it is in an industry where the normal P/E ratio is higher than in
the industry of the bidder

For examination purposes, you should normally take a figure for the P/E ratio
that is around one-half to two-thirds of the industry average, when valuing an
unquoted company.

Problems with using P/E ratios

However, using the P/E ratios of quoted companies to value unquoted
companies may be problematic. This is because a P/E ratio must be guessed
at, using the P/E ratios for similar quoted companies as a guide.

1. Finding a quoted company with a similar range of activities may be

difficult. Quoted companies are often diversified.

2. A single year's P/E ratio may not be a good basis if earnings are
volatile, or the quoted company's share price is at an abnormal level,
due for example to the expectation of a takeover bid.

3. If a P/E ratio trend is used, then historical data will be used to value
how the unquoted company will do in the future.

4. The quoted company may have a different capital structure to the

unquoted company.

Test your understanding 6

Peter plc has made an offer of one of its shares for every three of Baker plc.
Synergistic benefits from the merger would result in an increase in after tax
earnings of $4m per annum. Extracts from the latest accounts of both
companies are as follows:

Peter Plc Baker plc

Profit after tax $120m $35m
Number of shares 400 million 90 million
Market price of shares 250p 120p

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Assume that the price of Peter plc.’s shares rise by 50c after the merger and
that Peter issues new shares as consideration.
What will be the price‐earnings ratio of the group?

Test your understanding 7

The following information relates to two companies, Alpha plc and Beta plc.

Alpha plc Beta plc

Earnings after tax $210,000 $900,000
P/E ratio 16 21

Beta plc’s management estimate that if they were to acquire Alpha plc they
could save $100,000 annually after tax on administrative costs in running the
new joint company. Additionally, they estimate that the P/E ratio of the new
company would be 18.

On the basis of these estimates, what is the maximum that the

shareholders of Beta plc should pay for the entire share capital of Alpha
plc?

Test your understanding 8

The shares of Fencer plc are currently valued on a P/E ratio of 8. The
company is considering a takeover bid for Seed Limited, but the shareholders
of Seed have indicated that they would not accept an offer unless it values
their shares on a P/E multiple of at least 10. Which of the following is not a
reason which might justify an offer by Fencer plc for the shares of Seed on a
higher P/E multiple?

A. Seed has better growth prospects than Fencer

B. Seed has better‐quality assets than Fencer

C. Seed has a higher gearing ratio than Fencer

D. Seed is in a different country from Fencer, where average P/E ratios are
higher

Test your understanding 9

Phobis Co is considering a bid for Danoca Co. Both companies are stock
market listed and are in the same business sector. Financial information on
Danoca Co, which is shortly to pay its annual dividend, is as follows:

Number of ordinary shares 5 million

Ordinary share price (ex div basis) $3·30
Earnings per share 40·0c
Proposed payout ratio 60%

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Dividend per share one year ago 23·3c
Dividend per share two years ago 22·0c
Equity beta 1·4

Other relevant financial information

Average sector price/earnings ratio 10
Risk-free rate of return 4·6%
Return on the market 10·6%

Required:

Calculate the value of Danoca Co using the price/earnings ratio method.

Earnings yield valuation method

Another income-based model is earning yield method

In practice, however, investors may sometimes value equity based on the

present value of future earnings, discounted at the earnings yield. Arguably
this approach could be justified, particularly in the valuation of zero-dividend
firms.

Market value = Earnings

EY

We can incorporate earnings growth into this method

Market value = Earnings * (1+g)

EY-g

Test your understanding 10 – Earnings yield

Company A has earnings of $300,000, growing at 3% pa. A similar listed

company has an earnings yield of 12.5%.

Company B has earnings of $420,500. A similar listed company has a PE

ratio of 7.

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Estimate the value of each company.

Cash flow based valuation models

Cash flow based valuation models include the dividend valuation model, the
dividend growth model and valuation on a discounted cash flow basis.

Dividend valuation model

The dividend valuation model is based on the theory that an equilibrium price
for any share (or bond) on a stock market is:
 The future expected stream of income from the security
 Discounted at a suitable cost of capital

Equilibrium market price is thus a present value of a future expected income

stream. The annual income stream for a share is the expected dividend every
year in perpetuity.

The basic dividend-based formula for the market value of shares is expressed
in the dividend valuation model as follows.

MV = D
Ke

Or

The dividend growth model

MV = D0 (1+g)
Ke - g

D0 = Current year's dividend

g = Growth rate in earnings and dividends

D0 (1+g) = Expected dividend in one year's time (D1)

Ke = Shareholders' required rate of return

P0 = Market value excluding any dividend current

Test your understanding 11

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Target paid a dividend of $250,000 this year. The current return to
shareholders of companies in the same industry as Target is 12%, although it
is expected that an additional risk premium of 2% will be applicable to Target,
being a smaller and unquoted company. Compute the expected valuation of
Target, if:

a) The current level of dividend is expected to continue into the foreseeable

future.
b) The dividend is expected to grow at a rate of 4% pa into the foreseeable
future.
c) The dividend is expected to grow at a 3% rate for 3 years and 2%
afterwards ( H.W )

Test your understanding 12– Valuing shares: the DVM

A company has the following financial information available:
Share capital in issue: 4 million ordinary shares at a par value of 50c.

Current dividend per share (just paid) 24c.

Dividend four years ago 15.25c.

Current equity beta 0.8.

You also have the following market information:

Current market return 15%.
Riskfree rate 8%.

Find the market capitalisation of the company.

Test your understanding 13

A company has the following financial information available:

Share capital in issue: 2 million ordinary shares at a par value of $1.

Current dividend per share (just paid) 18c.

Current EPS 25c.
Current return earned on assets 20%.
Current equity beta 1.1.

You also have the following market information:

Current market return 12%.
Risk free rate 5%

Find the market capitalisation of the company

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Assumptions in the dividend valuation model
The dividend valuation model is underpinned by a number of assumptions
that you should bear in mind.

a) Investors act rationally and homogenously. The model fails to take into
account the different expectations of shareholders, or how much they are
motivated by a preference for dividends over future capital appreciation on
their shares.

b) The current year's dividend (D0 figure) does not vary significantly from
the trend of dividends. If D0 does appear to be a rogue figure, it may be
better to use an adjusted trend figure, calculated on the basis of the past
few years' dividends.

c) The estimates of future dividends and prices used and also the cost of
capital are reasonable. As with other methods, it may be difficult to make
a confident estimate of the cost of capital. Dividend estimates may be
made from historical trends that may not be a good guide for a future, or
derived from uncertain forecasts about future earnings.

d) Directors use dividends to signal the strength of the company's position.

(However, companies that pay zero dividends do not have zero share
values.)

e) Dividends either show no growth or constant growth. If the growth rate

is estimated using Gordon's growth approximation (g = br), then the model
assumes that the percentage of profits retained in the business and the
return on those retained profits, b and r, are constant values.

f) The company's earnings will increase sufficiently to maintain dividend

growth levels.

g) The discount rate used exceeds the dividend growth rate.

Test your understanding 14

Chad Co is a stock-market-listed company which has managed to increase
earnings over the last year. As a result, the board of directors has increased
the dividend payout ratio from 40·0% for the year to March 2014 to 41·4% for
the year to March 2015. Chad Co has a cost of equity of 12·5%. The following
information is also available:

Year to March 2014 2015

$000 $000
Earnings 13,200 13,840
Ordinary shares 8,000 8,000

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The nominal value of the ordinary shares of Chad Co is $0·50 per share.
Listed companies similar to Chad Co have an earnings yield of 8·2%.

Required:
a) Calculate the equity market value of Chad Co using the dividend
growth model. (3 marks)

b) Calculate the equity market value of Chad Co using the earnings

yield method. (2 marks)

c) Discuss the relative merits of the dividend growth model and the
earnings yield method as a way of valuing Chad Co.

Discounted cash flow basis of valuation

A DCF method of share valuation may be appropriate when one company
intends to buy the assets of another company and to make further
investments in order to improve cash flows in the future.
The steps in this method of valuation are

Method:
1. Identify relevant ‘free’ cash flows (i.e.excluding financing flows)
– operating flows
– revenue from sale of assets
– tax
– synergies arising from any merger.

2. Select a suitable time horizon.

3. Calculate the PV over this horizon.This gives the value to all providers of
finance, i.e. equity + debt.
4. Deduct the value of debt to leave the value of equity.

Test your understanding 15 (H.W)

The following information has been taken from the statement of profit or loss
and statement of financial position of B Co:

Revenue $350m

Production expenses $210m

Administrative expenses $24m
Tax allowable depreciation $31m
Capital investment in year $48m

Corporate debt $14m trading at 130%

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Corporation tax is 30%.
The WACC is 16.6%. Inflation is 6%.

These cash flows are expected to continue every year for the foreseeable
future.

Required:
Calculate the value of equity.

Test your understanding 16

Diversification wishes to make a bid for Tadpole. Tadpole makes after-tax
profits of $40,000 a year. Diversification believes that if further money is spent
on additional investments, the after-tax cash flows (ignoring the purchase
consideration) could be as follows.

Year Cash flow (net of tax)

$
0 (100,000)
1 (80,000)
2 60,000
3 100,000
4 150,000
5 150,000

The after-tax cost of capital of Diversification is 15% and the company expects
all its investments to pay back, in discounted terms, within five years.
a) What is the maximum price that the company should be willing to pay for
the shares of Tadpole?

b) What is the maximum price that the company should be willing to pay for
the shares of Tadpole if it decides to value the business on the basis of its
cash flows in perpetuity, and annual cash flows from Year 6 onwards are
expected to be $120,000?

Valuation of debt

1. Irredeemable debt (previous lessons)

2. Redeemable debt (previous lessons)
3. Convertible bonds (previous lessons)
4. Preference shares

Test your understanding 17 (H.W)

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The following scenario relates to questions

Mathilda Co is a listed company, which is seen as a potential target for

acquisition by financial analysts. The value of the company has therefore
been a matter of public debate in recent weeks and the following financial
information is available:

Year 20X4 20X3 20X2 20X1

Profit after tax ($m) 25.3 24.3 22.3 21.3

Total dividends ($m) 15.0 14.0 13.0 12.5

Statement of financial position information for 20X4

$m $m

Non-current assets 227.5

Current assets
Inventory 9.5
Trade receivables 11.3 20.8
Total assets 248.3

Equity finance
Ordinary shares 50.0
Reserves 118.0 168.0

Non-current liabilities
8% bonds 62.5
Current liabilities 17.8
Total liabilities 248.3

The shares of Mathilda Co have a nominal value of 50c per share and a
market value of $10.00 per share. The business sector of Mathilda Co has an
average price/earnings ratio of 16 times.
The expected net realisable values of the non-current assets and the
inventory are $215.0m and $10.5m, respectively. In the event of liquidation,
only 90% of the trade receivables are expected to be collectible.

1. What is the value of Mathilda Co using market capitalisation (equity market

value)?

2. What is the value of Mathilda Co using the net asset value (liquidation
basis)?

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W
hat is the value of Mathilda Co using the price/earnings ratio method
(business sector average price/earnings ratio)?

4. What is the average historic dividend growth rate for Mathilda Co?

5. Which of the following statements are problems in using the price/earnings

ratio to value a company?
1) It can be difficult to find a quoted company with a similar range of
activities.
2) A single year’s P/E ratio may not be representative
3) It is the reciprocal of the earnings yield
4) It combines stock market information with corporate information

A. 1 and 2 only
B. 3 and 4 only
C. 1,3 and 4 only
D. 1, 2, 3 and 4

Test your understanding 18 (H.W)

Daisy Co is listed on the stock market and has increased earnings over the
last year. As a result, the board of directors has increased the dividend payout
ratio from 36% for the year to June 20X4 to 37.1% for the year to June 20X5.
Daisy Co has a cost of equity of 13%. The following information is also
available:

Year to June 20X4 20X5

$’000 $’000

12,100 12,700
Earnings

Ordinary shares 7,000 7,000

The nominal value of the ordinary shares of Daisy Co is $0.50 per share.
Listed companies similar to Daisy Co have an earnings yield of 9.2%

1. What is the equity market value of Daisy Co using the dividend growth
model?

2. What is the equity market value of Daisy Co using the earnings yield
method?

3. The following statements relate to the dividend growth model (DGM) and
the earnings yield method (EYM).

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1) The EYM uses profit (rather than cash) so is the preferable method for
Daisy Co.
2) In an acquisition context, the EYM is used to value a minority
shareholding in a target company.

Are the statements true or false?

A. Both statements are true

B. Both statements are false
C. Statement 1 is true and statement 2 is false
D. Statement 2 is true and statement 1 is false

4. How is the net assets method of share valuation calculated?

A. Net current assets number of shares

B. Net tangible assets number of shares
C. Total net assets number of shares
D. Tangible assets less current liabilities number of shares

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