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Valuation of equity is important to both

individuals and businesses in Hong Kong
because of the numerous market participants.
According to a research
performed by the
Hong Kong Exchanges and Clearing Limited
in 2009, 35.1% of the Hong Kong adult
population (or 2,069,000 individuals) were
retail investors in stocks. On the other hand,
the strong economic growth in China has led
to unprecedented numbers of mergers and
acquisitions of listed companies in recent
One of the objectives of business valuations
is simple, the search for undervalued shares.
If a share is trading under its intrinsic value,
an ordinary investor would make a buy
decision with the hope that the currently
undervalued shares would reflect its real
value sometime in the future.
Unfortunately, valuation of equity is not an
exact science. It is instead an art because
it is an exercise of incorporating not only
factual data but also personal judgements.
For example, when the dot-com bubble swept
Hong Kong in 2002, a blue-chip company,
with HK$7.7 billion loss in the year ended
31 Dec 2002, had attained its peak share
price at HK$140 in February 2002 but then
decreased to around HK$2 in December
2009. Why were some investors willing to
pay HK$140 to buy the shares which then
had more than 98% fall in share price? What
made the investors judge that HK$140 was
a fair price in 2002? The reason was in large
extent due to the unexplainable judgement.
Some investors were too optimistic that they
paid too much for the overvalued shares. The
personal judgements are seriously affected
by the market atmosphere, personality of
investors, bargaining skills of the acquirer
and the acquiree, etc.
Practically, there are 3 types of valuation
methods: Market-based methods, cash-based
methods and asset-based methods.
This method uses price-earnings ratio (PE
method), market capitalisation, etc.
PE method may be the most commonly
used valuation technique for listed shares in
reality because the information needed in the
PE method (i.e. prices and earnings) is easily
obtainable. In additions, the calculations are
easy as shown in Example 1.
For unlisted companies, the use of PE may
be difficult because information about share
prices is not readily available due to low
marketability of the shares.
PE Ratio =
Price per Share Earnings per Share
Value of Equity =
Profit after Tax x Suitable PE Ratio
Even different companies in the same
industry do not have the same PE ratio
because those companies are different in
growth potential, management efficiency, etc.
A high PE ratio means investors are willing
to pay high amounts to acquire its share with
compared to other companies which have
the same amount of earnings.
Example 1
ABC Co is considering to make a bid for the entire equity capital of XYZ Co, a firm
which has a PE ratio of 9 and earnings of $390m.
ABC Co has a PE of 13 and earnings of $693m, and it is thought that $125m
of synergistic savings will be made as a consequence of the takeover. The PE of the
combined company is expected to be 12.
In this case, the minimum value acceptable to XYZs shareholders:
= 9 x $390m = $3,510m
The maximum amount which ABC is willing to pay:
= Value of the combined entity Value of ABC
= [12 x ($390m + $693m + $125m)] (13 x $693m) = $5,487m
The final acquisition consideration will be somewhere between $3,510m and
$5,487m depending on the negotiation results of ABC and XYZ.
From Example 1, we can see that the
calculation of equity values using PE ratio
is easy, but this method does have some
theoretical weaknesses:
It is based on accounting earnings
which are subject to manipulation and
affected by the choices of accounting
policies. In additions, some non-recurring
extraordinary transactions may distort the
PE ratio.
The estimation of the combined PE ratio
is highly subjective. Why is it 12? Why
cant it be 11, 13, or anything else?
Adjustments to PE ratio is also a
subjective exercise. For example, a
private company should have lower PE
ratio compared to a listed competitor of
similar size and growth because of its
worse marketability. However, there is no
universal rule regarding the exact discount
to be applied to the private company.
PE ratio is not applicable to loss making
PE ratio is a volatile measure. For
example, the PE ratio of Hang Seng Index
in Hong Kong could be as low as 6.83

in November 2008 and then increased
to 16.58
in October 2010. It highly
depends on the market atmosphere!
A more practical weakness of PE ratio
is that there is no universal decision rule
under the method of PE ratio. A low PE
ratio indicates a cheap share, but it does
Example 2
Today is 1 Jan 2010. DEF Ltd has
earned $1 per share. Its policy is to
retain 75% of its profits for future
expansion. The return on equity is 20%.
What is the theoretical value per share
if the dividend will stay constant for the
next 5 years and then grow by 5% p.a.
to perpetuity?
D0= $1 x (1 75%) = $0.25
Present value of dividends for the next
5 years = $0.25 x 2.991
= $0.748
Present value of dividends from Year 6
and onwards
_____________________________________________________________________________________________________________________________________________________________________________________ ______________________________________________________________________________________________________________________________
$0.25 (1+5%) 1
20% - 5% (1+20%)
= $0.703
The theoretical share price
= $0.748 + $0.703
= $1.451
From Example 2, we can see that the
amount of equity values highly depend on the
assumptions which are subjective.
Other weaknesses of this model are as
Even a minor change in investors
expectation of growth rates can cause a
major change in share price.
It is almost not possible to estimate the
growth rate of the dividends in perpetuity.
Some investors use the long term average
growth rate of dividend, but this is only
applicable to those well established
companies with historically stable
dividend policy.
Some companies never pay dividends.
Cost of equity is usually calculated by
the Capital Asset Pricing Model (CAPM)
which does not give a perfectly correct
cost of equity.
The traditional asset based valuation
method is to take as a starting point the value
of all the firms assets less any liabilities.
Asset values used can be:
Book value the book value of assets
can easily be found from the financial
statements. However, it is unlikely
that book values (which are based on
historical cost accounting principles) will
be a reliable indicator of current market
Replacement cost The buyer of
a business will be interested in the
replacement cost, since this represents
the alternative cost of setting up a similar
business from scratch (organic growth
versus acquisition). This in theory is a
very suitable value for asset, but it is not
easy to identify such assets in practice.
Net realisable value the seller of
a business will usually see the net
realisable value of assets as the minimum
acceptable price in negotiations.
2.991 is extracted from the annuity table
not necessarily lead to a buy decision. Here
is a recent example. From 2003 to 2007
when Hong Kong enjoyed a very bullish
ride in the stock market, some international
banks listed in Hong Kong were trading at
very low PE ratios. Many people purchased
their seemingly cheap shares because,
according to the belief of value investing,
those international banks with low PE ratios
will finally enjoy high PE ratios when the
market discovered their real values. Sadly,
the whole bullish boom was over and those
banks had only increased for less than the
market average. Finally, the financial tsunami
due to sub-prime mortgages in the US swept
the world in 2008 and those international
banks, being hard hit by the problem, had
their shares fallen much more serious than
the market average.
This story tells us that a low PE ratio
comes with reasons. This may be due to a
team of poor management. Similarly, there
may be some hidden problems known to
a small portion of investors but not yet
commonly covered in the media and agreed
by the public. When the hidden problems
become obvious, those cheap shares can
become even cheaper.
In conclusion, the investor merely using PE
ratio as an evaluation tool for investing very
often falls into value traps. It is worth using a
comprehensive list of tools in order to assess
whether a particular company is a real cheap
deal. In reality, finding a undervalued share
takes a lot more work than just reviewing its
PE ratio.
A very simple idea behind the
cash-based valuation is that the
value of a share is the present value of
the expected future dividends discounted
at the shareholders required rate of return.
In theory, it sounds sensible.
A very common formula is as follows:

P =
Do (1+g)
Ke - g
P = Value of the shares
D0 = Dividend per share today
g = growth rate of dividend
Ke = Cost of equity
From example 3, we can see that the
current share price is trading at a premium of
$0.305 to its theoretical value.
Why is that?
A major flaw with this valuation method
Example 3
The following is the statement of
financial position of Happy Ltd as at
31 Dec 2009
Non-current asset
(carrying value) 450,000
Net current asset 100,000
Share capital ($0.5 par) 200,000
Retained earnings 250,000
6% loan note 100,000
You also notice that:
Loan note are redeemable at a
premium of 2%.
Current market value of freehold
property exceeds book value by
All assets, other than property, are
estimated to be realisable at their
book values.
The current market share price of the
company is $1.5.
What is the theoretical value of the
share price of Happy Ltd as at 31 Dec
Net asset value
= $550,000 + $30,000
$100,000 x (1 + 2%)
= $478,000
Theoretical value per share
= $478,000 400,000 shares
= $1.195
is that it does not take account of intangible
assets which are defined as the assets
that have no physical substance like, for
example, goodwill, brand name, a competent
management team, etc. Intangible assets,
though not easily observable and measurable,
affect values of shares in a positive way.
If these items were not considered in the
valuation, the values of shares would become
understated. As a result, this method is not
well applicable to companies in, for example,
the retail industry of luxurious brands where
the intangible brand names account for a big
deal of its success. It is not surprising to see
their shares are trading at high premium to
the net asset values.
Some investors purchase shares which are
trading at discount to its net asset values
in an attempt to wait for the true net asset
values being reflected in the share price.
Similar to a low PE ratio, a discount to net
asset values comes with reasons. Unless you
can change the operations of the companies,
the true net asset values may never be
incorporated into the share price. As a result,
individual investors do not find this valuation
method useful.
However, some institutional investors are
specialised in using this valuation method
to gain unbelievably huge sum of profits.
After they have identified a company with
potentially valuable assets but not efficiently
managed by the current management, they
purchase its shares in secret without pushing
the share prices up. As soon as they have
accumulated enough shares, they will try to
gain management board representation and
force the existing management to implement
strategies that can realise the real values of
the potential assets.
So who should use this valuation method?
If you are confident that you can influence
or change the existing management in order
to take control of the potential asset by
selling or implement your desired strategies,
you should adopt this valuation method.
Of course, the cost of searching for such
companies may be so high that the potential
profit is outweighed.
After the discussions above, it becomes
understandable that why valuation is not
an exact science. It is a highly subjective
exercise in that personal judgements need
to be considered. It is also a comprehensive
process in that it cannot be possibly well
completed with just a few valuation tools.
So what can an investor do to obtain a
more accurate valuation?
In theory, the more information an investor
has, the more he understands about a firm.
As a result, his valuation should lead to a
more accurate result.
Paradoxically, this is not true in practice,
evidenced by the fact that even financial
conglomerate makes wrong investment
From the irregular failures of investment
veteran, it is not odd to conclude that there is
just no simple or best way to obtain accurate
valuations and make correct investment
Ted Chan
Kaplan Hong Kong