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Business Valuations: Exam Guide
Business Valuations: Exam Guide
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
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
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.
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.
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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
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Represented by $1 ordinary shares $200,000
Reserves $250,000
6% loan notes Z1 $100,000
–––––––
$550,000
Current assets:
Inventory 500
Receivables 300
Cash 400
Total Current assets 1,200
Bonds 400
Current liabilities 500
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
$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
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
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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
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
EPS
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.
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.
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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?
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.
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?
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Dividend per share one year ago 23·3c
Dividend per share two years ago 22·0c
Equity beta 1·4
Required:
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Estimate the value of each company.
The basic dividend-based formula for the market value of shares is expressed
in the dividend valuation model as follows.
MV = D
Ke
Or
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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:
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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.
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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)
c) Discuss the relative merits of the dividend growth model and the
earnings yield method as a way of valuing Chad Co.
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.
Revenue $350m
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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.
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
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The following scenario relates to questions
$m $m
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.
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?
A. 1 and 2 only
B. 3 and 4 only
C. 1,3 and 4 only
D. 1, 2, 3 and 4
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:
12,100 12,700
Earnings
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.
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