BB831 Corporate finance

Unit 4
Company valuation
Written by Janette Rutterford

MBA Programme
Contents
Introduction 5
Unit 4 Session 1: Valuing the assets 7
1.1: Determining book value 8
1.2: Adjusting book value 11
Summary 21
Unit 4 Session 2: Market multiples 22
2.1: Market value 22
2.2: Dividend yield 27
2.3: Price-to-book ratio 28
2.4: Price-to-earnings ratio 29
2.5: Price-to-cash-flow ratio 35
2.6: Enterprise value to EBITDA 40
2.7: Specific valuation ratios 43
2.8: Comparison of market multiples 44
Summary 47
Unit 4 Session 3: Discounted cash flow 49
3.1: DCF valuation steps 50
Summary 61
Unit 4 Session 4: Valuation in context 63
4.1: Regulation 64
4.2: New issues 64
4.3: Privatisations 67
4.4: Mergers and acquisitions 69
4.5: Restructuring 74
Summary 76
References 77
Acknowledgements 79
 Introduction

Introduction
This unit looks at company valuation in the context of investment. Investors
in both shares and companies seeking to make acquisitions need to know
how much a company is worth and how much to pay for their investment.
This unit outlines a number of ways of valuing companies, using the
techniques you have come across in earlier units, and will show how
different valuation techniques can be used in different contexts. Company
valuation is a fascinating topic since it requires an understanding of
financial analysis techniques in order to estimate value. For acquisitions, it
also requires the negotiating and tactical skills needed to fix the price to be
paid. This unit should therefore strike a chord with you, whether you enjoy
the number-crunching aspects of finance or whether you prefer a more
intuitive, or even emotional, approach.
Unit 3 considered investing in projects and how project investment
decisions should be taken. Unit 4 looks at investing in whole companies
rather than individual projects. Although the concept is much the
same – that is, you are investing in a stream of future cash flows – the
range of techniques applied is even more varied than for projects. This is
because, for companies, there is often historical information in the form of
accounting data available, whereas for projects there are often no existing
assets or five-year histories to rely on. Also, even if a company is a start-
up, as was the case with Eurotunnel and Euro Disney, or in a relatively new
sector, such as social networking or biotechnology, there are usually
comparable companies which already have share prices and hence valuation
multiples that can be used as a reference point. As the information available
on companies is so much richer, the techniques available for valuing
companies are more varied. As you will see, the techniques range from
looking at the value of the balance sheet through to a fully fledged
discounted cash flow analysis, as well as the application of a simple profit
or asset ratio.
This unit also looks at the valuation decision inherent in any refinancing.
Companies are now bought and sold, taken into private ownership and then
made public again, with the financing structure a key element in their
valuation.

Structure of the unit

This unit has four sessions. The first three sessions discuss the different
valuation approaches that can be applied to estimate company value and the
attractiveness of any company investment decision. The valuation
approaches used can be split into three main types, depending on which
type of data is used as the basis for valuation:

. Session 1: Valuing the assets. This session looks at asset values, which
use balance sheet data to estimate value.

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Unit 4 Company valuation

. Session 2: Market multiples. This session looks at market multiples,

which use share prices to establish comparative benchmarks for value.
. Session 3: Discounted cash flow. This session considers discounted cash
flow valuation techniques, which use forecast data to estimate present
value.
Session 1 begins with the traditional cautious accounting approach of
looking at the value of the assets to be acquired. The role of market
multiples (for example, the commonly used PE ratio) is then considered in
Session 2. In Session 3, cash flow-based techniques of valuation, in
particular cash flow models, which are closer to project appraisal
techniques, are considered. This unit concentrates on Pearson as the main
corporate case study, although the valuation of other companies, public
sector organisations (in the regulatory and privatisation contexts) and
companies not listed on the major stock markets is also considered. You
will also find additional resources on the BB831 website.
You have already covered a number of these techniques in earlier units, so
you should no longer find the mathematics or formulae you come across
daunting. This unit concentrates on the differences in the techniques used
for company valuation from those of financial analysis and of project
appraisal. That is not to say that there are no overlaps. For example, lenders
may be lending long term and hence concerned with the overall viability
and value of an organisation. Managers may be considering a make-or-buy
decision in the sense that they are trying to choose between buying a
company or making that company’s products in-house.
Session 4: Valuation in context. The unit ends by looking at the five main
situations in which company valuations are typically required: regulation,
new issues, privatisations, mergers and acquisitions, and restructuring. As
you will see, different methodologies are normally applied in different
situations. Valuation is an important, but not exclusive, part of the
investment appraisal process. Strategic issues also need to be addressed, as
well as whether appropriate financing is available.

Learning outcomes
By the end of this unit you should be:

. familiar with the three main methods of company valuation – asset

(book) value, market multiples and discounted cash flow
. able to appreciate the merits and disadvantages of each technique
. able to decide on the most appropriate method or methods of valuation
according to the circumstances – regulation, new issues, privatisation,
merger and acquisition or restructuring.

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 Unit 4 Session 1: Valuing the assets

Unit 4 Session 1: Valuing the

assets
Before considering how to value companies, it is necessary to consider
exactly what is meant by the term ‘value’. As the economist John Maynard
Keynes pointed out, value is in the eye of the beholder – and what the
buyer will pay will depend on a number of factors.

Stop and think

Suppose you are buying a second-hand teddy bear at auction. Why might
you be prepared to pay more than you might have to pay for an equivalent
new one?

Suppose now you are considering buying a company which has just one
machine. Why might you be prepared to pay more for the company than the
cost of a machine of equivalent age and condition?

Discussion
In the first case, a number of factors come into play. The teddy bear might
have rarity value – it might have been Marilyn Monroe’s teddy bear, or be a
Steiff bear still in its wrapping, and hence be ‘collectable’. It might have
sentimental value to you (e.g., it belonged to your mother) but not for anyone
else. It might be impossible to make teddy bears of this quality today (e.g., if
it were made from some rare fur no longer available as hunting of the animal
concerned is no longer allowed).

Buying a company is not usually a sentimental act – although the sale of

Cadbury (the chocolate company) to Kraft (the cheese spread company)
caused an emotional outcry in the UK in 2010. The reason you might pay
more than asset value is because you are also buying management skills
and a customer order book, and you might be able to generate synergy
benefits which more than outweigh the premium you might be paying.

Such issues may be relevant to the valuation of an old teddy bear and to the
valuation of a company. Never forget, even when you have determined the
value to you, the difference between the value you have placed and what
you actually end up paying makes valuation an art and not a science – and it
makes negotiating skills paramount. You will do some negotiation in the
residential school which is linked to this module.

Units 2 and 3 considered a number of stakeholders, including suppliers,

lenders and equity investors. Suppliers and lenders have developed a
number of techniques for assessing the credit-worthiness of enterprises,
which may require a full cash flow analysis – for example, when the finance
is specifically linked in with a project. In this unit, the point of view of
investors, primarily equity investors, is considered, although other
stakeholders are looked at in the section on restructuring. Thus, the value to

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Unit 4 Company valuation

existing ordinary shareholders is found by taking the value of the firm or

organisation as a whole and deducting the value of any liabilities to lenders,
minority interests, convertible debt holders and preference shareholders.

1.1: Determining book value

Determining book value is centred around the balance sheet value of a
company as presented in its latest annual report. The book value given in
the balance sheet is first looked at and then different ways of adjusting the
book value are explored in order to get a closer approximation of how much
a buyer might be prepared to pay for the company.

You can access the 2009 Table 4.1.1 shows the consolidated balance sheet for Pearson at the end
and later Pearson annual of 2009. In terms of valuation based on book value, the principle here is
reports, which have the that a company is worth to its ordinary shareholders the value of its assets
notes to the accounts, on
less the value of any liabilities to third parties. This is sometimes referred to
the BB831 website and
Pearson’s investor as net asset value, shareholders’ funds or the book value of the equity.
website (www.pearson.
com).

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 Unit 4 Session 1: Valuing the assets

Table 4.1.1: Pearson’s consolidated balance sheet at 31 December 2009

(All figures in £ millions) Notes 2009 2008
Assets
Non-current assets
Property, plant and equipment 10 388 423
Intangible assets 11 5,129 5,353
Investments in joint ventures and associates 12 30 23
Deferred income tax assets 13 387 372
Financial assets – Derivative financial instruments 16 112 181
Retirement benefit assets 25 - 49
Other financial assets 15 62 63
Other receivables 22 112 152
6,220 6,616
Current assets
Intangible assets – Pre-publication 20 650 695
Inventories 21 445 501
Trade and other receivables 22 1,284 1,342
Financial assets – Derivative financial instruments 16 - 3
Financial assets – Marketable securities 14 63 54
Cash and cash equivalents (excluding overdrafts) 17 750 685
3,192 3,280
Total assets 9,412 9,896
Liabilities
Non-current liabilities
Financial liabilities – Borrowings 18 (1,934) (2,019)
Financial liabilities – Derivative financial instruments 16 (2) (15)
Deferred income tax liabilities 13 (473) (447)
Retirement benefit obligations 25 (339) (167)
Provision for other liabilities and charges 23 (50) (33)
Other liabilities 24 (253) (221)
(3,051) (2,902)
Current liabilities
Trade and other liabilities 24 (1,467) (1,429)
Financial liabilities – Borrowings 18 (74) (344)
Financial liabilities – Derivative financial instruments 16 (7) (5)
Current income tax liabilities (159) (136)
Provisions for other liabilities and charges 23 (18) (56)
(1,725) (1,970)
Total liabilities (4,776) (4,872)
Net assets 4,636 5,024
Equity
Share capital 27 203 202
Share premium 27 2,512 2,505
Treasury shares 28 (226) (222)
Translation reserve 227 586
Retained earnings 1,629 1,679
Total equity attributable to equity holders of the company 4,345 4,750
Minority interest 291 274
Total equity 4,636 5,024

From Table 4.1.1, you can see that shareholders’ funds available for
Pearson’s equity shareholders were £4,345m at 31 December 2009. Note 27
to the 2009 accounts reports that at the year end there were 810,799,000
fully paid shares in issue, giving a book value per share of £4,345m/

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Unit 4 Company valuation

810.799m = £5.36 or 536p per share. This compares with a price of 890p at
The net asset value at 31 December 2009.
the end of 2009 was
£4,636m. Of that, £291m
belonged to minority
interests. This left
£4,345m of book value
available to shareholders.

The Financial Times – one of Pearson’s assets

Stop and think

What does the book value of a company represent? Does it represent:

. the liquidation value of the assets less the liabilities?

. the replacement cost of the assets less the liabilities?
. the market value of the assets less the liabilities?
The economic value of a . the value of the business as a going concern – that is, the economic
business is its value as a value of the assets less the liabilities?
going concern.
. the value of the business to a potential purchaser – that is, including
synergy benefits?
. the sunk cost – that is, how much has already been invested in the
company?

A sunk cost?

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 Unit 4 Session 1: Valuing the assets

Discussion
Book value represents a mixture of these, rather than a single one of them.
It includes some assets at historic cost, some written down to liquidation
value, some written up to current value (e.g., property), some based on
forecast cash flows (such as intangible assets) and some written down over
their estimated useful lives using an arbitrary depreciation method.
Depending on the accounting jurisdiction and on the type and age of assets
held by each company, the book value will be somewhere along the
spectrum between historic cost and current market value. However, the book
value will not be an estimate of economic value, since not all assets are
valued using the present value of forecast future cash flows.

For example, in the case of Pearson, the tangible assets owned by Pearson
group were around £1bn, and these will be in the accounts at depreciated
cost. However, intangibles are mostly goodwill due to acquisitions. This
goodwill has been tested for impairment using a discounted cash flow
valuation methodology to allow for future cash flows and future growth.
Intangible assets are therefore more likely to be in the accounts at close to
market value. Pearson’s share price of 890p at the end of December 2009
was still higher than the book value per share of 536p.

1.2: Adjusting book value

This section looks at how asset values in the accounts can be adjusted to
offer a closer estimate of economic value than the conventional book value
or net asset value of the company does.

Tangible assets
Tangible fixed assets are typically depreciated according to accounting
estimates of their expected useful lives. Land and buildings may be
depreciated over a period of, say, 40 years whereas plant and equipment
may be written off over five or ten years. If the market value or realisable
value of the assets is lower than the depreciated book value, tangible assets
are typically included in the balance sheet at this lower market value. Book
values of assets therefore give some clue to current values, but not an
accurate one as they do not, for example, fully take account of inflation or
obsolescence. If the analyst has more detailed information on the type and
age of assets than is available from the accounts, it is possible to adjust
book values of fixed and, indeed, current assets to a closer estimate of
current value. It is easier to do this for a small company actively seeking a
purchaser than for a large quoted company fending off a hostile takeover
bid where access to the company will not be allowed before it is bought.

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Unit 4 Company valuation
IFRS is the shorthand
for International
Financial Reporting
Standards.
Fair value is the value
of an asset or liability in
an arms-length
transaction between
unrelated, willing and
knowledgeable parties.
The concept of fair value
is used in many
accounting standards.
Impairment is a fall in
the value of fixed assets.
12
What value do obsolete computers have?
Under IFRS rules, property assets (i.e., land and buildings) may be carried
on the balance sheet either at historic cost or fair value, and this choice can
radically affect book value. Most large companies operating under IFRS
rules prefer the fair value approach. Under this rule, property owned by
companies is often revalued on a regular basis to fair value. Downward
movements during the year are included as impairments and upward
movements are accounted for as reversals of impairments. Tesco, the UK
supermarket chain, does this, differentiating between properties being
operated as stores and so-called investment properties. Properties being used
as stores are valued ‘in use’ with expectations of cash flows generated by
the stores redone every year to estimate whether there has been impairment
or not. Changes to expectations are driven by whether a store has performed
better or worse than expected during the year in question.
Example of how Tesco plc amends tangible asset
values
The impairment losses relate to [shopping] malls whose recoverable
amounts do not exceed the asset carrying values. In all cases,
impairment losses arose due to the malls performing below forecasted
trading levels.
The reversal of previous impairment losses arose principally due to
improvements in the performance of malls over the last year, which
increased the net present value of cash flows.
The estimated fair value of the Group’s investment property is £2.8bn
(2009 – £3.2bn). This fair value has been determined by applying an
 Unit 4 Session 1: Valuing the assets

appropriate rental yield to the rentals earned by the investment

property. A valuation has not been performed by an independent valuer.
(Source: Tesco plc Annual Report and Financial Statements, 2010, Note 12)

Where properties are valued by surveyors or the firms themselves using

estimates of rental income, they can be considered to be included at
economic value (the present value of future income generated) rather than
historic cost.

Prior to adopting IFRS, French and German companies, for example, valued
property at historic cost but UK companies have valued property at close to
current value for a long time. The impetus in the UK for the inclusion of Sometimes, acquirers
property at current value was market driven. Many acquisitions in the UK’s over-estimated the value
takeover boom of the early 1970s were made by would-be asset strippers of assets they were
acquiring! It is rumoured
who felt that company share prices and balance sheets did not fully reflect
that when Ford acquired
the value of the underlying assets. They made hostile bids for the Jaguar after a hostile
companies and then stripped out and sold the assets whose value had been takeover battle, Ford
hidden from view. To protect their company from such asset strippers, management had a shock
managers sought to spell out to the market the true value of their property when entering the Jaguar
assets by including them not at historic cost, but at recent market value. car factory. ‘We thought
we were back in
Revaluation also meant that companies could appear to offer more security
Victorian times’, they
to their bankers for loans, although this proved not to be the case when are reputed to have said!
commercial property prices crashed in 2008–9. Revaluation of assets also
has the effect of reducing one of the performance measures applied to
companies, return on assets (or return on capital employed (ROCE)). As a
result, some companies choose to rent rather than own the properties they
use, as does, for example, Ted Baker, the fashion retailer.

Intangible assets
In the 1980s, another balance sheet item came under scrutiny by the asset
strippers, in this case intangible assets. Examples of intangible assets
include expenditure on research and development (R&D), brand values,
intellectual capital and goodwill.
R&D expenditure does not buy a tangible asset, such as a ship or factory,
but represents cash spent on a knowledge base which may generate future
revenues. It can be argued, however, that R&D does create an intangible
asset whose life is more than one year and, as a result, should be capitalised
on the balance sheet and depreciated over its expected life of, say, five
years. Most countries do not allow or encourage the capitalisation of R&D
although, under IFRS for example, development activities (rather than pure
R&D) can be capitalised if future economic benefits can be linked to them.
These development activities will then be amortised (depreciated) in the
income statement over their expected economic life.
There is also some argument for capitalising spending on other forms of
knowledge, as in database systems within consultancy firms or expertise
provided by professional employees in investment banks. This is known as
intellectual capital and firms such as Scandia, a Swedish insurance

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Unit 4 Company valuation

company, have pioneered approaches to the valuation of intellectual capital

for inclusion in the balance sheet. There is, however, always the possibility
that these types of asset can choose to walk away, in contrast to ships or
factories!
Another type of intangible asset over which there has been controversy is
brand names – for example, whether or not to capitalise the value of the
Coca Cola brand or the Amazon.com brand on their respective balance
sheets. Some UK companies did do this in the 1980s, with firms such as
Rank Hovis McDougall, a food manufacturer, putting brand values on the
balance sheet. Again, the methods used for valuing brands are linked to
forecast cash flows related to the brands and hence to economic value. So
capitalisation of brands will give a closer approximation to market value
than would the exclusion of the brands. Accounting policy in this area is
somewhat confused. For example, under IFRS, brands can currently [2011]
be capitalised if they have been acquired through the purchase of a
company, but not if they have been built up from scratch. This illustrates
the major difficulty in using book values to compare companies across
countries and sectors – the effect of goodwill.
The intangible asset ‘goodwill’ arises as a result of the fact that book values
of companies typically do not reflect their economic values. Hence the
prices paid for companies, especially high value-added firms such as
advertising agencies and consulting firms, typically far exceed their book
values. The difference between the price paid for a company and its book
value is known as goodwill and may appear on the acquiring company’s
balance sheet. In some cases, the value of goodwill may even exceed the
value of the acquiring company’s shareholders’ funds, if acquisitions have
featured prominently in a company’s strategy.
Under IFRS, goodwill is capitalised in the balance sheet as an intangible
asset. If, as is likely in the case of a brand name, its expected economic life
is more than 20 years, it will not be amortised in the same way as, for
example, development activities. Instead, the company concerned is required
Amortisation is the to conduct an annual impairment test: if the estimated value in use or sale
depreciation of value is below the carrying value in the balance sheet, the balance sheet
intangible assets. Value value must be written down and the difference put through the income
in use is the value of
statement.
assets when being used
in a business. Carrying
value is the value of The main point to note here is that companies which make substantial
assets as given in the acquisitions, particularly in growth businesses, will acquire goodwill which,
balance sheet. if capitalised, will increase book value substantially relative to a company,
in the same sector, that has grown organically.
This is a simple In the case of Pearson, which has made a large number of acquisitions,
explanation of a complex particularly in the USA, goodwill accounted for £5,129m + £650m =
area. For further £5,779m at the end of 2009. Indeed, the book value of the company –
information, see
www.ifrs.org.
excluding intangibles – was (£4,345m – £5,779)/810.799m or a negative
£1.77 per share. The book value of Pearson is made up of goodwill from
acquisitions rather than any tangible fixed assets.

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 Unit 4 Session 1: Valuing the assets

Stop and think

What would be the big book value difference between a company such as
Ted Baker which has grown organically and Pearson which has grown
through acquisition? Table 4.1.2 shows the consolidated balance sheet for
Ted Baker for the year to 30 January 2010.

Table 4.1.2: Consolidated balance sheet for Ted Baker at 30 January 2010
Notes Group Company Group Company
30 Jan 2010 30 Jan 2010 31 Jan 2009 31 Jan 2009
£’000 £’000 £’000 £’000
Non-current assets
Intangible assets 10 634 - 673 -
Property, plans and equipment 11 25,508 - 28,701 -
Investments in subsidiary 12 - 16,694 - 16,534
Investment in equity accounted investee 12 171 - 85 -
Deferred tax assets 13 1,598 - 904 -
Prepayments 842 - 961 -
28,753 16,694 31,324 16,534
Current assets
Inventories 14 33,450 - 37,315 -
Trade and other receivables 15 19,698 24,112 20,466 9,152
Amount due from equity accounted 12 261 - 139 -
investee
Derivative financial assets 16 280 - 2,444 -
Cash and cash equivalents 17 13,698 489 4,660 511
67,387 24,601 65,024 9,663
Current liabilities
Trade and other payables 18 (24,779) (12) (29,806) (2)
Income tax payable (3,511) - (3,801) -
Derivative financial liabilities 16 (304) - - -
(28,594) (12) (33,607) (2)

Non-current liabilities
Deferred tax liabilities 13 (1,316) - (575) -
(1,316) - (575) -
Net assets 66,230 41,283 62,166 26,195
Equity
Share capital 19 2,160 2,160 2,160 2,160
Share premium 19 9,137 9,137 9,137 9,137
Other reserves 19 (12) 14,605 1,713 14,445
Translation reserve 19 124 - 1,182 -
Retained earnings 19 54,906 15,381 48,010 453
Total equity attributable to equity 66,135 41,283 62,202 26,195
shareholders of the parent company
Non-controlling interest (85) - (36) -
Total equity 66,230 41,283 62,166 26,195

(Source: Ted Baker Annual Report and Accounts 2009–10)

Discussion
The big difference is in intangibles, which includes goodwill. Pearson has
over £5bn of intangible assets valued using forecast cash flows. Ted Baker

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Unit 4 Company valuation

has no intangibles other than a single lease which has a residual value
which a new lessor would have to pay them.

Off-balance-sheet items
You have seen how fixed assets and intangible assets can be understated or
overstated in the balance sheet. Another possible area where the value of
shareholders’ funds can mislead is the exclusion from the balance sheet of
what are known as off-balance-sheet items. These can be finance-related,
such as leases or off-balance-sheet financing of vehicles; employee-related
pension assets, health liabilities or share option liabilities; and other
contingent liabilities which may be mentioned in the notes to the accounts
(or not, depending on whether managers view them as material at the date
of the accounts).

Sale and leaseback Leasing represents a form of secured lending for asset investment and can
involves selling a be viewed as an alternative to conventional debt. One of the early
property and leasing it as advantages of leases was that assets acquired under lease and the associated
a tenant. The company
leases themselves (since the assets were technically owned by the lessor
still occupies the
property. The different rather than the lessee or user) did not need to be included in the balance
balance sheet treatment sheet. Companies seeking to reduce disclosed levels of debt often chose
of leases was explored in leasing as a means of doing this. In the early 2000s, companies such as
Unit 3. France Telecom did this via sale and leaseback of some of their properties.
While IFRS now requires leases on the balance sheet, US accounting rules
have been slower to catch up.

US hospitals and accounting for leases

Hospitals and health systems won’t be able to lease equipment or
property with contracts that keep such obligations off the balance sheet
under a proposed change to accounting rules expected within months.

The proposal, under development by the Financial Accounting

Standards Board [FASB] since 2006, would get rid of accounting rules
that do not consider operating leases as debt, and therefore do not
require such contracts to be reported on the balance sheet. The
accounting body is expected to release a draft of the rules by the end
of September, and new standards would be final by the end of
June 2011.

Operating leases are widely used in healthcare as off-balance-sheet

financing for photocopiers, telephones and other technology as well as
medical office buildings, and the proposed rules would increase
reported debt and weaken key measures of leverage.

Credit ratings won’t change as a result, analysts said, because

agencies already factor operating leases into calculations of healthcare
borrowers’ financial strength.

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 Unit 4 Session 1: Valuing the assets

But it may put hospitals and health systems afoul of covenants with
banks or bondholders, according to accounting and finance experts.
How much off-balance-sheet financing hospitals and health systems
hold is unclear, they said.

Some health systems have moved to catalogue operating leases ahead

of the proposals to find out how the contracts will affect balance sheets.

‘I don’t imagine it would be insignificant for anybody,’ said Jenny

Barnett, executive vice president of finance for Catholic Health East,
which owns 23 hospitals in nine states.

The system launched an inventory of its off-balance-sheet leases last See Unit 3 Session 5 for
month after finance executives met with auditors in late May for an a description of finance
overview of the proposed accounting change, Barnett said. and operating leases.

The Newtown Square, PA-based system reported roughly $279m in

expected operating lease payments in the footnotes of 2009 financial
statements, where they must be reported under current accounting
rules.
(Source: Evans, 2010)

Pension fund surpluses or deficits, the difference between the present value
of the pension fund’s assets and the present value of the pension fund’s
liabilities, can be substantial relative to corporate profits. For example, on
31 December 2010, it was estimated that the aggregate deficit of Europe’s
top 50 companies alone was €4,287m. Under International Accounting
Standard (IAS) 19, companies are required to disclose pension fund IAS is the abbreviation
actuarial gains and losses. They can do this immediately – and avoid having for International
to put them through the income statement, disclosing them instead in the Accounting Standards.
Statement of Comprehensive Income. Alternatively, they can defer some of
the gains or losses, but must do so via the income statement. Given the size
and volatility of actuarial gains and losses relative to income, net pension
fund assets or liabilities must be taken into account in any estimate of book
value. The following example shows how the UK government does not as
yet include pension liabilities and other liabilities on its own balance sheet.

The UK’s off-balance-sheet items

The true scale of Britain’s national indebtedness was laid bare by the
Office for National Statistics yesterday: almost £4 trillion, or £4,000bn,
about four times higher than previously acknowledged.

It quantifies the burden that will be placed on future generations, and it

is the ONS’s [Office for National Statistics] first attempt to draw together
the ‘off-balance-sheet’ liabilities that have been accumulated by the
state. The figures imply a huge ‘intergenerational transfer’ – broadly in
favour of today’s ‘baby boomer’ generation at the expense of younger
people and future generations.

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Unit 4 Company valuation
Here, trn is used as an
abbreviation for trillion
rather than the more
usual T.
Other assets or liabilities which may be off-balance sheet can include
liabilities that must be paid to employees, such as healthcare benefits in the
18
The debt primarily consists of the cost of public sector and state
pensions, and of payments promised to private contractors under
private finance initiatives. It far exceeds any of the figures so far
published for the national debt, the largest current estimate for which is
£903bn. That is projected to rise to £1.3trn by 2015.
If the current generation of taxpayers wanted to remove the higher bills
facing their children and grandchildren, they would now be paying
around 30% more in tax.
The ONS data strengthens the Government’s hand in its attempt to pull
down state spending.
The ONS itemised the public sector’s main liabilities as:
. future payments for the state old age pension: £1.1trn to £1.4trn
. unfunded public sector pensions for teachers, NHS staff and civil
servants: £770bn to £1.2trn
. payments under private finance initiative contracts: £200bn
. contingent liabilities (e.g., bank deposit guarantees): £500bn
. nuclear power plant decommissioning: £45bn
. impact of financial sector interventions: £1trn to £1.5trn.
Leaving aside the possibility of another financial meltdown that would
leave the taxpayer with the liabilities of a substantial part of the banking
system, the figures suggest that the realistic total liabilities of the public
sector could be as much as £3.8trn (£3,800,000,000,000).
The ONS says that although much work remains to be done in
constructing a comprehensive public sector ‘balance sheet’ of assets
and liabilities, it is clear that the current figure usually quoted – ‘public
sector net debt’, colloquially called ‘the national debt’ – is ‘selective’ and
incomplete. […]
However, the public sector is still solvent, to the tune of £317bn in
2008, according to the ONS, which is the difference between its
liabilities and its assets, everything from foreign exchange reserves to
shiny new hospitals.
Joe Grice, chief economist at the ONS, said that the public sector’s net
worth has fallen in 2008 for the first time since 1999, and that the figure
for 2009 would probably be lower as well, given the scale of public
borrowing. He added that ‘whole government accounting’, a balance
sheet for the public sector which has never previously been attempted,
would be published from next year, analogous to a company’s balance
sheet. The figures would be prepared according to international
accounting guidelines.
(Source: O’Grady, 2010)
 Unit 4 Session 1: Valuing the assets

USA, the granting of shares to directors or staff below cost and redundancy
payments to directors and employees which may need to be made in the
event of a restructuring or takeover.
Contingent (possible) liabilities which are off-balance sheet can also include
pollution costs or likely lawsuit costs, such as those incurred by BP after its
US oil spillage in 2010, or the costs to financial institutions of rectifying
the mistakes they made when selling mortgage payment protection
insurance in the UK during the 2000s.

‘However, under another accounting procedure ...’

Table 4.1.3 gives an example of how an adjusted book value might be

determined – in this case adjusting fixed asset, pension fund and intangible
asset valuations.

Table 4.1.3: Salt and Pepper plc balance sheet and adjusted book value
(year ended 31 December)
£m
Non-current assets
Property, plant and equipment 135.3
Intangibles 63.1
Other assets 24.8
Total non-current assets 223.2
Current assets
Cash and marketable securities 17.4
Accounts receivable 70.4
Inventory 38.1
Other current assets 16.1
Total current assets 142.0
Total assets 365.2
Long-term liabilities
Debt 115.2
Creditors 13.4
Total non-current liabilities 128.6
Current liabilities
Accounts payable 48.3
Other current liabilities 32.3
Total current liabilities 80.6
Total liabilities 209.2
Net assets 156.0

Book value of total assets 365.2

+ Adjustment for replacement cost on inventory, plant 50.0
and equipment
+ Overfunding of pension fund 4.8

19
Unit 4 Company valuation

+ Undervaluation of intangibles 50.0

= Adjusted book value of total assets 470.0
– Current liabilities (80.6)
– Non-current liabilities (128.6)
– Contingent legal liabilities (24.0)
Adjusted book value of equity 236.8

FASB is shorthand for As accounting regulations have tightened up, and with IFRS and FASB (the
the US’s Financial two global sets of accounting standards) being adopted by a growing
Accounting Standards number of companies across the world, fewer items are off-balance sheet,
Board.
and more items are closer to economic value than historic cost than in the
past. However, as the behaviour of banks in the period preceding the 2008–
9 global financial crisis showed, the search for off-balance-sheet
opportunities continues.

Stop and think

Look at the consolidated balance sheet of Pearson Group shown in
Table 4.1.1. Note how many of the items which were once off-balance sheet
are now on-balance sheet.

Discussion
The main items are pensions (mentioned as retirement assets and liabilities),
goodwill (under intangibles), and treasury shares (held – at cost though –
against future share option scheme liabilities). US corporations were forced
to put healthcare liabilities on-balance sheet in 2006. This makes valuing
book value easier but also has economic effects. British companies have
closed their defined-benefit schemes to reduce volatility in their balance
sheets. US firms have capped retiree healthcare benefits too and transferred
them to trade unions, again to remove them from their balance sheets!

Up to now, there has been some vagueness about exactly which value
should be determined. Book value needs to be adjusted to obtain a closer
estimate of economic value. In certain circumstances, however, economic
value can be less than book value or net realisable value. Figure 4.1.1 helps
to put the alternative definitions of value in context: when buying a
business, the buyer is seeking what economists such as Coase (1937) termed
‘opportunity value’.

20
 Unit 4 Session 1: Valuing the assets

Value to the business

= lower of

Replacement cost and Recoverable amount

= higher of

Value in use and Net

realisable
value

Figure 4.1.1: Definitions of value (Source: adapted from Gregory, 2001)

This figure gives a

ranking for the possible
value of an asset to a
business.
Stop and think
Why do companies try to make their balance sheets or income statements
more ‘attractive’?

Discussion
They must believe that investors are irrational in the sense that they use
valuation methodologies blindly without looking for adjustments which flatter
the ratios. For example, the banks, prior to the 2008–9 global financial crisis,
tried to reduce their capital base by shifting assets and associated liabilities
off-balance sheet, as well as improving returns through leverage. When
investors measured return on equity, they were happy with the high numbers
achieved, without asking themselves why banks were suddenly able to
generate much higher return on equity than in the past.

Summary
This session has looked at the book value of a company from the
perspective of the value of the balance sheet to equity shareholders. Book
value might be adjusted to take into account:

. more recent valuations for current and fixed assets

. intangible assets, including R&D, intellectual capital, brand names and
goodwill
. off-balance-sheet items, such as leases, healthcare liabilities, pension
funds and contingent legal liabilities.

21
Unit 4 Company valuation

Unit 4 Session 2: Market multiples

This session considers the main ratios that are applied to a company’s book
value, profits or cash flows in order to estimate its value. The ratios looked
at are dividend yield, price-to-book, price-to-earnings (or PE), price-to-cash-
flow, and enterprise value to EBITDA. The attraction of using simple
multiples to value a company is clear – the mathematics is easy and
multiples can be compared across companies, sectors and countries. It is
reassuring to know that you have paid ten times profit when your
competitor paid eleven times, or that you have sold a company for twice its
book value when the going rate is 1.8 times.
If a company is already quoted, there may be no need to apply a multiple
from another company. The market value of the company’s shares gives a
clear statement of value. If a company is unlisted and has no share price, or
A private company is is a private company, the market multiple for a similar quoted company can
one where shares cannot be used. Unlisted or private companies being valued using a market
be transferred without multiple normally have a discount applied to the multiple, unless the whole
the permission of other
company is being acquired, to reflect the lack of likely buyers of the stake
shareholders, of whom
there must be (in the in the future.
case of the UK) less
than 50.
Further information on
historical prices paid for
2.1: Market value
private companies is
available from www.bdo. The starting point for determining market multiples (or ratios) is the market
uk.com/library/pcpi- values of companies whose shares are listed and hence quoted on a stock
private-company-price- market. A publicly listed company, one with shares listed on a stock
index. exchange, has its share price quoted by market makers whose job it is to
provide a market in shares. This gives an instant picture of a company’s
value. As you know, the market value of a company may be derived by
Market makers earn a
multiplying the share price by the number of shares in issue. Pearson, at 31
living by buying and
selling shares, making December 2009, had a share price of 890p and 810.799m shares in issue;
their profit from the this gave a market capitalisation or market value of £8.90 ´ 810.799m =
difference between the £7,216.11m or £7.216bn. For large companies traded on the major
bid price (the price at exchanges the share price will represent a price at which the shares were
which they buy from very recently traded and will therefore give an up-to-date valuation. For less
you) and the – higher –
frequently traded shares, in closely held companies or shares traded on
ask or offer price (the
price at which they offer emerging stock markets, the price may be somewhat out of date or may not
the shares to you). You be realistic for a larger than average trade. Less liquid stocks will have
came across bid and ask wider spreads between the bid and offer prices to reflect their lack of
prices in Unit 1 liquidity – making it more difficult for traders or market makers to sell on
Session 2. or buy back the shares.
It is important to note the warning of stock exchange authorities about their
role in reporting market prices. The following is the London Stock
Exchange’s version:

We desire to state authoritatively that Stock Exchange quotations are

not related directly to the value of a company’s assets, or to the
amount of its profits, and consequently these quotations, no matter

22
 Unit 4 Session 2: Market multiples

what date may be chosen for references, cannot form a fair and
equitable basis for compensation.
The Stock Exchange may be likened to a scientific recording
instrument which registers, not its own actions and opinions, but the
actions and opinions of private and institutional investors all over the
country and, indeed, the world. These actions and opinions are the
result of hope, fear, guesswork, intelligence or otherwise, good or bad
investment policy, and many other considerations. The quotations that
result definitely do not represent a valuation of a company by
reference to its asset and earning potential.
(London Stock Exchange)

The London Stock Exchange

With this caution in mind, some additional comments about the term ‘price’
are useful since it is important to understand which price is relevant in the
context of share value.
First, the London Stock Exchange’s caution is essentially warning us that
the share price given may not be a ‘fair market price’. A fair market price
implies at least a semi-strong form of efficient market, where prices reflect The semi-strong form of
all publicly available information about a company and where the price market efficiency was
quickly adjusts to any new relevant information. Possible sources of discussed in Unit 1
Session 3.
inefficiency are manifold. One example already mentioned in Unit 4
Session 1 is that balance sheets may hide undervalued or overvalued assets
or liabilities, not all of which will necessarily be clear to equity analysts.
Enron, when it filed for bankruptcy in 2001, was seen after the event to
have a low book value due to the existence of substantial off-balance-sheet
liabilities. This was also the case for the bank, Northern Rock, which was
nationalised by the UK government in 2008. Although some of these
liabilities could have been deduced from a study of the accounts, this was
apparently not done before the company failed. Another example of
inefficiency is where someone has prior information, say, on a takeover bid
for a company, which is not publicly available. One of the risks of investing

23
Unit 4 Company valuation
in emerging markets is that the quality of publicly available information
may be poor and there may well be relevant inside information not available
to, say, overseas investors.
The mission of the US
Securities and
Exchange Commission
(SEC) is to protect
investors, maintain fair,
orderly and efficient
markets, and facilitate
capital formation.
24
Probe unlikely to change [US] insider trading rules
An insider trading investigation is causing confusion for some investors
and disrupting the fast-growing ‘expert network’ industry, even though
securities lawyers and law professors say the probe is unlikely to
change the rules investors must follow when researching stocks. … US
Attorney General Eric Holder said the Justice Dept. is pursuing a ‘very
serious’ criminal investigation of illegal trading activities on Wall Street.
Investigators haven’t detailed what they’re examining, but the probe has
had an immediate impact on Wall Street research practices, says
Michael W. Mayhew, founder of Integrity Research Associates, which
tracks trends in investment research.
‘Expert networks’ – firms that, for a fee, connect knowledgeable people
with investors and others seeking expertise – have grown into an
industry with $450m to $500m in sales in the past year, Mayhew
estimates. The FBI [Federal Bureau of Investigation] searched the
offices of three hedge funds … part of an investigation begun by federal
prosecutors in Manhattan. The investigation … has caused much of the
expert networks’ business to disappear, Mayhew says. ‘Use of their
services has been suspended or stopped, because their clients are
concerned,’ he said.
In the stock market, modest but crucial pieces of information can reap
big rewards for investors who find them first. The growth of expert
networks – from eight firms a decade ago to 40 today – is part of a
drive by hedge funds and other investors to be more aggressive about
gathering information. Expert networks match investors examining a
particular company or industry with customers, clients, suppliers,
competitors, professors, or anyone who, for a fee, can offer valuable
information or insights on that topic. ... Asked to comment on whether
the definition of insider trading is evolving, SEC spokesman John
Nester said, in a brief email: ‘Illegal insider trading is the act of trading,
or causing someone to trade, on the basis of material non-public
information in violation of a duty.’
That’s the traditional definition, and securities experts say that, in recent
cases, the key phrase is the last one – ‘in violation of a duty.’ The
rumour mills of Wall Street or Silicon Valley – or even company holiday
parties – have always been places to glean juicy information on public
companies. Such information is illegal to trade on when it comes from
someone who had a duty to keep it secret.
Thus, the problem is not when research analysts talk to a company’s
competitors or industry experts, or when they survey hundreds of
customers, Robertson and other legal experts say. Legal trouble comes
when they get information from people – current or former employees,
attorneys or consultants – who are obliged to remain quiet. Research
 Unit 4 Session 2: Market multiples

networks routinely have a policy against connecting investors with

employees of public companies if clients are looking to invest in them,
Mayhew says, although he notes that networks can’t be sure their
clients are being honest about their intentions.

...

With so much firepower aimed at getting better information to investors,

there may be an inevitable temptation for some to push research to its
legal limits. ‘If your whole job is to get an edge on information,’ Orts
says, ‘there are a lot of people tempted to step over that line.’
(Source: Steverman, 2010)

Second, the term ‘market price’ refers to the publicly quoted price of a
share. This implies that the share is marketable and that an investor can
always be found who is willing to buy the share at the quoted asking or
offer price, or sell it at the quoted bid price. It also refers to the price for a
relatively small number of shares. Anyone wishing to acquire a large or
controlling stake might well have to pay a premium over the quoted share
price. Similarly, anyone wishing to sell a large stake might have to sell at a
discount.
Third, there is a time element affecting share prices. The share price is
quoted at a single point in time, for a specific transaction with a specific
market maker. The next minute, when faced with a different trade, this
market maker – or another – may quote a different price. The essentially
temporary nature of quoted market prices makes market valuation rather
volatile. For example, the price of a large firm such as Pearson can vary by
5% in a day and, indeed, shares do so quite regularly. Prices of shares of
small companies or companies in a volatile sector, such as biotechnology or
social networking, can easily move by 20% or 30% in a single day. This
may be to do with new information, which is fundamental to the company,
or simply to do with supply and demand considerations for this particular
share or company. While such shares can ‘easily’ be moved by 30% in a
day if the new information is important enough, this does not mean such
large movements are commonplace.
Table 4.2.1 shows the price movements of the most volatile shares on the
morning of 19 January 2011 at 10:20 a.m. and you can see that Pearson,
since the previous day’s close, had moved in price (upwards) by 5.47%.
Figure 4.2.1 shows the intraday movements in Pearson shares for the period
16–21 January 2011, including 19 January in the centre of the graph. The
vertical white lines show the price movements each hour, with two small
horizontal white marks showing the high and the low each hour.

Table 4.2.1: Largest daily share price movements up and down of shares in
the FTSE 350 Index at 10:20 a.m. on 19 January 2011
FTSE 350 Risers
Name Price (p) % change
William Hill 190.20 7.64
JD Wetherspoon 468.10 5.98
Pearson 1,061.00 5.47

25
Unit 4 Company valuation

Ladbrokes 137.60 4.16

Soco International 378.10 3.59
Tate & Lyle 556.50 3.44
Lancashire Holdings 597.50 3.37
BTG 232.00 2.29
Hochschild Mining 539.50 1.98
Unilever 1,924.00 1.80

FTSE 350 Fallers

Name Price (p) % change
Kesa Electricals 141.10 –6.43
St. Modwen Property 173.20 –3.62
Persimmon 443.40 –3.42
Taylor Wimpey 36.89 –3.18
Imperial Tobacco 1,874.00 –2.70
Redrow 128.40 –2.65
Bellway 662.50 –2.57
Keller Group 663.00 –2.43
Jardine Lloyd Thompson 619.50 –2.29
Barratt Developments 98.80 –2.18

(Source: quoted by Barclays Stockbrokers, 2011)

Figure 4.2.1: Intra-day volatility of Pearson shares on and around 19/1/11

Notice how the price of (Source: used with permission of Bloomberg Financial L.P.)
Pearson shares jumped
between the close on 18
Finally, there may be factors other than the future prospects of a company
January and the opening
on 19 January; the that affect the relationship between price and economic value. Specific
market makers examples include:
positioned the price
higher due perhaps to . Shareholder loyalty – for example, ownership of shares in a football
movements in the US club such as Everton may be more to do with emotion than the likely
stock markets overnight expected return.
or to a company
announcement before . Additional benefits to shareholders – for example, discount vouchers are
opening hours. sent annually to M&S shareholders to be used in their shops and

26
 Unit 4 Session 2: Market multiples

National Grid, a utility company, invites shareholders to a two-day

networking programme.
. Employee loyalty – an example is the protests by employees of the
chocolate company Cadbury against the £11.5bn hostile bid by the US
food company Kraft in 2009. As part of the offer, Kraft had tried to
mollify employees by promising not to shut down a plant in the UK,
although Kraft did so after it took over Cadbury in early 2010.
. A premium for control – for example, Forte (now swallowed up by
Granada) paid a substantial premium for the small number of voting
shares in the Savoy Hotel Group (compared with the price paid for the
non-voting shares) in order to acquire control.
. Fashion in types of shares – for example, a preference for banking
shares before the 2008–9 global financial crisis rather than ‘old
economy’ firms such as Unilever or Nestlé.
Despite these caveats, it would be foolish to ignore the share price as an
estimate of value. Given the number of analysts studying publicly-quoted
shares as a full-time occupation, surely their combined expertise must
enable them to get close to the economic value of a particular firm? Indeed,
analysts do publish what they call price targets for individual shares, albeit
with no particular time frame over which this is to be achieved, nor with
any adjustment made for what is likely to happen to the market as a whole.
Also, as you will see later, complexities arise when there are differences of
opinion on the appropriate valuation method and when there is a takeover in
the offing, implying a possible premium for control.
A number of ratios which can be applied to a company to obtain an
estimate of its value are now considered. One reason for so doing might be
that the company is not publicly quoted and so has no share price to
provide an indicator of value. Alternatively, ratios can be used to compare
companies in the same sector or to compare stock markets in different
countries. This is called relative valuation. Company A may be seen to be
cheap relative to Company B or Market C expensive relative to Market D.
Note that ratios or multiples can be applied to individual shares or to the
company as a whole.

2.2: Dividend yield

The first market multiple, dividend yield, is a measure of the income yield
from a share. It is the dividend per share divided by the share price.
This is typically calculated as:
dividend per share
Dividend yield =
market price of the share
The dividend yield is the historic or most recent annualised dividend
divided by the share price. Pearson paid 35.5p dividend in 2009 and at the
end of 2009 its share price was 890p. The dividend yield at that time was
therefore 4.0% (35.5/890 = 4.0%), slightly higher than the average dividend
yield for the UK market as a whole of 3.2%, as measured by the yield on

27
Unit 4 Company valuation

the FTSE All-Share Index. In the UK, the dividend yield is what is called a
net yield, as tax is deducted by the company before the dividends are paid
to investors and the tax cannot be reclaimed by investors.
Traditionally, investors were interested in the dividend yield for tax and
income purposes – high-rate taxpayers preferred low dividend-paying shares
The bird-in-the-hand and income seekers preferred high dividend-paying shares. Also, the ‘bird-
theory relating to in-the-hand theory’ supports investing in high dividend-yield shares. BP was
dividend policy was relied on by institutional and individual investors alike to provide a steady
discussed in Unit 2
dividend. Given managers’ reluctance to cut dividends, high dividend-yield
Session 5.
shares are considered a safe haven in a volatile stock market.

2.3: Price-to-book ratio

The price-to-book ratio is simply the ratio of the share price to the book
value per share, or, at the company level, the ratio of the market value of
the equity to the book value of shareholders’ funds. As a formula, this can
be written as:
market price of the share
Price-to-book ratio =
book value per share
or
market capitalisation
Price-to-book ratio =
book value shareholders' funds
For example, in the case of Pearson, using the 31 December 2009 share
price of 890p per share and given a book value of 536p per share, gives a
price-to-book ratio of 890/536 = 1.66. This implies that investors were at
The book value per that time willing to pay 1.66 times the book value for Pearson’s
share was found in shares because of the growth potential which went with them.
Session 1 of this unit by
taking net assets What does ‘1.66 times the book value’ actually mean? Well it is
available to equity meaningless on its own. What it can be used for is to compare Pearson with
shareholders at 31 similar UK companies, or with the sector in which Pearson operates (media
December 2009
publishing) and with comparable companies from other countries – with
(£4,345m) and dividing
this by the number of many caveats relating to the difficulties of comparing book values of
shares in issue companies operating under different accounting regimes (or even choosing
(810,799,000). different methods of accounting within the same accounting regime). It can
also be compared with Pearson’s price-to-book ratio over time. A year
earlier, for example, the price-to-book ratio was 1.09 compared with 1.66.

Exercise
Check the calculation of the book value per share and the price-to-book ratio
for Pearson at end-2008 given that the share price on 31 December 2008
was 641p. Comment on the difference between the end-2008 and end-2009
ratios.

28
 Unit 4 Session 2: Market multiples

Answer
The 2009 consolidated balance sheet gives the figures for 2008 as well. The
net assets attributable to equity shareholders totalled £4,750m. Note 27 to
the accounts gives the number of shares in issue on 1 January 2008 as
808,028,000. Dividing the book value by the number of shares in issue gives
£4,750/808.028 = £5.88 or 588p per share. The book value fell by 52p
during 2009.

The price-to-book ratio is share price at end 2008 divided by the book value
per share. You have been told that the end 2008 share price was 641p and
so the price-to-book ratio at end 2008 was 641/588 = 1.09x. This means that
Pearson shares were more highly rated relative to book value at the end of
2009 (1.66x) compared to end 2008 (1.09x), despite the fall in book value ‘x’ stands for ‘times’.
per share.

The change in price-to-book ratio implies what is known as a ‘re-rating’ of

Pearson. Was this a general phenomenon across all shares? For example,
did the price-to-book ratio for the FTSE All-Share Index or FTSE 100
Share Index (of which Pearson is a constituent) increase as much, or was
this a re-rating of Pearson relative to the market or to the media publishing
sector? Further investigation would be needed. So although the price-to-
book ratio is difficult to interpret – just saying that investors are prepared to
pay over 1.6 times book value is insufficient – making a comparison with
history, with other companies, with the sector and with the market provides
a framework for discussing Pearson’s value.
The price-to-book ratio can also be applied to media publishing companies
that do not have a market price. For example, suppose a company in the
same sector as Pearson had shareholders’ funds (book value) of £100m.
Applying the Pearson price-to-book ratio would give it a valuation of
£166m. This may not be the best estimate of opportunity value, but it is at
least a starting point. Remember that adjustments could be made to book
values to make the two companies’ book values comparable – by, say,
dealing in a consistent way with properties and goodwill. For example, if
the company to be valued had made fewer acquisitions than Pearson, and
had a much lower intangibles figure, it is likely that a higher price-to-book
ratio should be applied.

2.4: Price-to-earnings ratio

The most popular multiple for valuing companies whether at the share,
PE ratio is sometimes
company or market level is the price-to-earnings ratio or PE ratio. written as P/E ratio.
This is simply:
share price Earnings per share is
PE ratio = earnings for equity
earnings per share
shareholders divided by
market capitalisation
PE ratio = the average number of
earnings for shareholders shares in issue.

29
Unit 4 Company valuation

Table 4.2.2: Pearson’s consolidated income statement for 2009

(All figures in £ millions) Notes 2009 2008
Continuing operations
Sales 2 5,624 4,811
Cost of goods sold 4 (2,539) (2,174)
Gross profit 3,085 2,637
Operating expenses 4 (2,360) (1,986)
Share of results of joint ventures and 12 30 25
associates
Operating profit 2 755 676
Finance costs 6 (122) (136)
Finance income 6 27 45
Profit before tax 660 585
Income tax 7 (198) (172)
Profit for the year from continuing 462 413
operations
Loss for the year from discontinued 3 - (90)
operations
Profit for the year 462 323
Attributable to:
Equity holders of the company 425 292
Minority interest 37 31
Earnings per share for profit from
continuing and discontinued operations
attributable to the equity holders of the
company during the year (expressed in
pence per share)
- basic 8 53.2p 36.6p
You will notice in the - diluted 8 53.1p 36.6p
consolidated income Earnings per share for profit from
statement that there are continuing operations attributable to the
two types of earnings equity holders of the company during the
per share: basic and year (expressed in pence per share)
diluted. Diluted - basic 8 53.2p 47.9p
earnings per share are - diluted 8 53.1p 47.9p
calculated after including
the exercise of any (Source: Pearson plc, Annual Report and Accounts, 2009)
options which have been
issued – such as
executive share options You can see from Table 4.2.2 that Pearson’s earnings per share for 2009
or options embedded in was 53.2p. Using a share price on 31 December 2009 of 890p gives a PE
convertible bonds.
ratio of 890/53.2 = 16.7.
Earnings per share from
continuing operations are In this way, any company can be valued by multiplying its earnings by the
relevant when trying to appropriate PE multiple. As for the price-to-book ratio, but more so, PE
forecast future earnings
ratios are calculated for companies, sectors, markets and over time, often
per share, ignoring
businesses which have with little attention being paid to the accounting differences which distort
been sold. For this earnings and hence PE ratios.
example, we use basic
earnings per share. The attraction of the PE ratio is that it uses historical and current data to
say something about the future. The higher the PE ratio, the more the
investor is prepared to pay and hence the more bullish they must be about
PE ratios are not
calculated for companies the company’s future. For example, the higher the expected growth rate in
with negative earnings. earnings, the higher the PE ratio. However, the PE ratio is also affected by
You will therefore never what is known rather poetically as the ‘quality of earnings’. The riskier or
see a negative PE ratio! more volatile the expected future earnings stream, the less the investor will

30
 Unit 4 Session 2: Market multiples

be prepared to pay, and hence the lower the PE ratio. A classic example of
this is the banking sector in the UK and in other countries. In the UK, in
1990, the FTSE Actuaries industry sector PE for banking was 6.24, much
lower than the average PE ratio for non-financial shares of 10.77, a discount
of 42%. By June 2005, banks were doing relatively better, trading on a PE
ratio of 12.34 compared with a non-financial PE ratio of 15.73, a discount
of 22%. They had effectively been re-rated, with earnings viewed as less
volatile than in the past. The market was to be proved badly wrong in
2008–9.

Table 4.2.3: UK sector PE ratios on 31 December 2010

£Stg Day’s Euro £Stg £Stg Year Div P/E
Dec 31 Chge Index Dec 30 Dec 29 ago yield Cover ratio
% %
FTSE 100 (100) 5899.9 -1.2 5335.2 5971.0 5996.4 5412.9 3.00 2.75 12.14
FTSE 250 (250) 11558.8 -0.1 10452.3 11569.4 11628.9 9306.9 2.21 2.37 19.14
FTSE 250 ex Inv Co (204) 12156.6 -0.1 10992.9 12169.6 12226.2 9718.2 2.33 2.41 17.82
FTSE 350 (350) 3129.0 -1.0 2829.5 3162.1 3175.9 2823.7 2.90 2.71 12.76
FTSE 350 ex Inv Co (303) 3114.1 -1.1 2816.0 3147.7 3161.2 2814.1 2.92 2.72 12.59
FTSE 350 Higher Yield 3055.8 -1.0 2763.3 3085.9 3101.3 3008.4 4.27 2.30 10.17
(110)
FTSE 350 Lower Yield 2897.4 -1.1 2620.0 2930.0 2941.0 2435.7 1.63 3.68 16.68
(240)
FTSE SmallCap (270) 3228.6 +0.1 2919.55 3226.75 3219.02 2776.92 2.57 1.64 23.77
FTSE SmallCap ex inv Co 2631.5 +0.1 2379.58 2629.10 2621.62 2327.93 3.11 1.70 18.97
(164)
FTSE All-Share (620) 3062.9 -1.0 2769.66 3094.41 3107.41 2760.80 2.89 2.68 12.90
FTSE All Share ex Inv Co 3039.9 -1.1 2748.88 3072.16 3085.02 2745.98 2.93 2.70 12.65
(467)
FTSE All-Share ex - - - - - - - - -
Multinationals (554)
FTSE Fledgling (154) 4789.7 +0.6 4331.20 4762.62 4753.96 4037.17 3.30 ‡ ‡
FTSE Fledgling ex Inv Co 5692.4 +0.8 5147.50 5646.41 5633.05 4784.10 4.13 ‡ ‡
(99)
FTSE All-Small (424) 2224.6 +0.1 2011.66 2222.29 2217.09 1909.33 2.64 1.23 30.78
FTSE All-Small ex Inv Co 1948.5 +0.2 1761.95 1945.43 1939.98 1714.49 3.20 1.16 26.95
(263)
FTSE AIM All-Share (823) 933.6 +0.7 844.3 927.2 920.9 654.2 0.55 ‡ ‡

FTSE Sector Indices

Oil & Gas (25) 8812.1 -1.1 7968.60 8905.75 8929.82 8636.09 2.74 4.13 8.85
Oil & Gas Producers (17) 8308.6 -1.1 7513.28 8398.84 8422.85 8257.15 2.81 4.14 8.60
Oil Equipment Services (6) 24971.1 -0.5 22580.74 25091.07 25050.71 15978.34 1.01 3.75 26.46
Basic Materials (32) 8514.3 -1.7 7699.25 8664.88 8639.81 6597.47 1.15 7.12 12.16
Chemicals (7) 7718.0 +0.2 6979.16 7705.56 7762.95 4763.45 1.64 2.63 23.23
Forestry & Paper (1) 6035.4 -0.9 5457.70 6088.33 6129.47 3937.43 1.70 4.83 12.19
Industrial Metals & Mining 9271.7 -1.3 8384.22 9392.54 9383.18 5646.86 0.38 8.56 30.93
(3)
Mining (21) 26838.3 -1.8 24269.21 27336.72 27244.23 21016.59 1.14 7.41 11.87
Industrials (113) 3059.8 -0.5 2766.87 3075.94 3094.38 2447.54 2.42 2.11 19.51
Construction & Materials 3899.0 -0.4 3525.73 3914.75 3934.04 3363.69 4.07 2.25 10.94
(10)
Aerospace & Defense (10) 3434.0 -0.9 3105.32 3464.25 3500.07 3187.79 3.28 1.54 19.84

31
Unit 4 Company valuation
General industrials (6)
Electronic & Electrical
Equipment (12)
Industrial Engineering (13)
Industrial Transportation (9)
Support Services (53)
Consumer Goods (35)
Automobiles & Parts (1)
Beverages (4)
Food Producers (12)
Household Goods & Home
Construction (11)
Leisure Goods (2)
Personal Goods (3)
Tobacco (2)
Health Care (18)
Health Care Equipment &
Services (5)
Pharmaceuticals &
Biotechnology (13)
Consumer Service (94)
Food & Drug Retailers (8)
General Retailers (27)
Media (25)
Travel & Leisure (34)
Telecommunications (9)
Fixed Line Telecom (7)
Mobile Telecom (2)
Utilities (9)
Electricity (3)
Gas Water & Multiutilities (6) 5961.6 -1.3 5390.95 6042.40 6071.70 5523.84 5.29 1.66 11.39
Financials (255)
Banks (5)
Nonlife Insurance (12)
Life Insurance/Assurance
(10)
Real Estate Investment &
Services (27)
Real Estate Investment
Trusts (17)
Financial Services (31)
Equity Investment
instruments (153)
Non Financials (365)
Technology (30)
Software & Computer
Services (20)
Technology Hardware &
Equipment (10)
(Source: adapted from FT Actuaries Share Indices, 2010)
Stop and think
Look at Table 4.2.3 which shows sector PE ratios and find the industrial or
commercial sectors with the three highest and the three lowest PE ratios. Try
32
2471.8 -0.6 2235.14 2486.42 2496.48 1803.45 2.52 2.44 16.28
3433.8 -0.1 3105.12 3437.16 3451.84 1807.85 1.97 2.09 24.18
7170.9 +0.4 6484.49 7139.19 7170.52 4103.11 2.05 2.31 21.11
3294.1 +0.2 2978.77 3286.56 3293.28 2735.03 3.74 1.60 16.68
4298.3 -0.7 3886.88 4326.71 4347.88 3568.92 1.93 2.52 20.49
10594.2 -1.1 9580.12 10709.20 10781.28 9320.42 3.23 2.03 15.26
5326.1 +0.3 4816.29 5311.75 5268.60 2804.49 0.68 5.55 26.69
9523.5 -1.2 8611.91 9640.60 9731.51 8236.43 2.63 1.78 21.38
5274.9 -0.8 4769.95 5317.93 5337.44 4912.84 3.43 3.24 9.00
5547.8 -1.2 5016.74 5616.33 5683.55 5491.16 2.54 2.36 16.71
3036.9 +0.3 2746.21 3027.73 2988.69 2075.10 3.56 1.38 20.29
16394.8 -0.6 14825.46 16496.41 16645.50 9307.34 1.30 1.88 40.94
28479.7 -1.1 25753.54 28805.93 28926.14 24772.94 4.26 1.54 15.24
6319.0 -1.4 5714.08 6406.96 6425.52 6381.24 4.50 1.70 13.08
3821.8 -0.5 3455.96 3841.70 3827.40 3633.54 1.37 4.08 17.96
8723.5 -1.4 7888.45 8849.33 8878.27 8840.38 4.68 1.66 12.88
3423.0 -0.6 3095.33 3443.34 3463.36 3074.15 2.75 2.60 13.97
5002.5 -0.8 4523.63 5042.88 5104.70 4916.08 3.20 2.12 14.71
1681.1 -0.6 1520.21 1691.37 1700.78 1738.65 3.11 2.80 11.47
4215.7 -0.4 3812.12 4232.65 4239.81 3480.30 2.54 2.32 16.97
4825.9 -0.6 4363.97 4852.79 4869.16 3888.83 2.30 3.43 12.65
2575.4 -0.8 2328.83 2595.47 2623.64 2228.57 4.85 2.51 8.22
2330.3 -1.3 2107.27 2361.55 2384.29 1937.59 3.81 1.73 15.20
3797.7 -0.7 3434.18 3823.01 3865.48 3312.29 5.06 2.63 7.51
6574.5 -1.5 5945.16 6677.98 6696.86 6000.58 5.17 1.87 10.33
7537.1 -2.1 6815.58 7695.94 7680.03 6608.99 4.87 2.44 8.43
3952.0 -0.8 3573.70 3982.23 4005.83 3769.20 2.84 1.86 18.91
4678.5 -1.2 4230.70 4737.56 4764.94 4683.41 2.40 1.77 23.57
1730.5 - 1564.87 1730.13 1738.64 1473.80 4.72 2.06 10.26
4084.5 -0.3 3693.55 4096.24 4139.90 3999.49 4.34 2.84 8.11
1686.3 +0.2 1524.90 1683.18 1688.56 1791.82 3.37 0.13 80.00†
1814.6 -0.2 1640.89 1818.71 1826.19 1770.30 3.94 0.88 28.99
5257.6 -0.4 4754.32 5280.24 5302.19 4384.71 3.58 1.54 18.10
6191.6 - 5598.88 6192.21 6221.59 5186.65 1.64 1.73 35.16
3578.4 -1.1 3235.89 3618.09 3631.47 3170.82 2.90 2.92 11.81
682.1 -0.6 616.79 686.17 690.84 513.35 1.20 3.59 23.26
787.7 -0.3 712.26 790.23 795.88 640.23 1.48 3.38 20.02
785.3 -1.1 710.08 794.35 799.18 476.59 0.63 4.58 34.91
 Unit 4 Session 2: Market multiples

to explain the differences in terms of quality of earnings and earnings growth

potential. What has happened to banks?

Discussion
The sectors with the three highest PE ratios are Real Estate Investment &
Services (80.00), Personal Goods (40.94), and Equity Investment
Instruments (35.16). The first of these high PE ratios is affected by a special
factor (as evidenced by the dagger sign next to the PE ratio) and is probably
affected by a company with almost zero earnings but not insolvent, giving a

very high PE ratio indeed. The second and third highest PE ratio sectors are Glamour stocks typically
two sectors which have high growth prospects within a global market. have high PE ratios. For
example, the luxury
The sectors with the three lowest PE ratios are Mobile Telecommunications brand group, Burberry,
(7.51), Life Insurance/Assurance (8.11) and Electricity (8.43). Life Insurance/ one such share, with a
Assurance and Electricity have relatively low growth prospects, at least in PE ratio of over 26
in 2011.
developed markets. Mobile telecommunications is a highly competitive
industry.

The Banks’ PE ratio is 23.57, compared with Non Financials’ 11.81, a

surprising premium of almost 100%. Note that there are now only five banks
in the UK banking sector compared with ten in 2005. For those banks which
had not ceased trading or been fully nationalised or taken over in 2010, their
historic (2009) earnings had fallen during the 2008–9 global financial crisis.
But these banks were expected to do well with future earnings, in the
artificially low interest rate environment which had been deliberately created
by the UK government to keep the economy – and the banks – going after
the crisis. Hence the relatively high banking sector PE ratio.

PE ratios enable relative comparisons across time, across companies, across

sectors and across countries. A company can be considered cheap or
expensive according to its relative PE ratio. For example, from Table 4.2.3,
you can see that the Media sector’s PE ratio on 31 December 2010 was
16.97. On that date, Pearson was trading at 1008p with a PE ratio, using
2009 earnings of 53.2p, of 18.95, which was above the sector average.
Notice how difficult it is to compare PE ratios when different companies
have year ends at different times. Suppose Pearson’s year end was 31
October. On 31 December 2010, the PE ratio would have used earnings to
31 October 2010 and not the much less recent earnings of 2009 (as done
here). In practice, most financial data providers try to keep earnings up to
date by using interim as well as annual earnings. So, for example, on 31
December 2010, Pearson’s second-half earnings for 2009 and first-half
earnings for 2010 would have been used. Major US companies report
quarterly, making it even easier to keep up to date.

PE ratios in practice
When Rolls-Royce was privatised, the closest comparable company,
British Aerospace, was trading on a PE multiple of 11. Rolls-Royce’s
share price was based on a multiple of 10 times its earnings – to make

33
Unit 4 Company valuation

it relatively cheap compared with British Aerospace. Another example

Consensus earnings
forecasts are the average
forecast earnings of
individual brokers.
could be the pricing of an unquoted company in a takeover where the
sector PE is 15 on average. The exit PE – the PE ratio implied in the
sale price – might be 13, perhaps to reflect lower growth prospects than
the sector average. Or the price paid might reflect prospective earnings
using forecasts. This makes companies look cheaper. For example,
Pearson had a PE of 18.95 on 2009 earnings in 2010, but had a
prospective PE using the same share price using consensus broker
forecast 2012 earnings of 12.7, as earnings were expected to grow.
A number of factors should be taken into account to ensure that the
comparisons of companies are valid. For example:

. the accounting methods used by each company to calculate

earnings might be different – for instance, one company might
record R&D as an expense, while another might capitalise it
. the financial year ends might be different (although in some
countries this is not allowed) so that the earnings of each company
relate to different parts of the seasonal cycle
. one company may have experienced an atypical drop in earnings,
which would have the effect of artificially boosting the PE ratio.

Stop and think

Why do you think corporate financiers prefer to use prospective earnings
rather than historic earnings in their valuation?

Discussion
If floating a company, it will look cheaper (have a lower PE ratio) if
prospective earnings are higher than historic earnings. Prospective earnings
may also be a better indicator of the future.

Exercise
Using a Weir Group share price at the end 2010 of £17.80 and earnings per
share in the year to 31 January 2010 of 58.3p, calculate the PE ratio for
Weir Group. Compare your result with the sector PE ratio for Industrial
Engineering in Table 4.2.3. Comment on what you find.

Answer
The PE ratio for Weir Group at end 2010 was 1780/58.3 = 30.53. The
Industrial Engineering sector PE ratio from Table 4.2.3 was 21.11. This
implies that Weir Group is relatively highly rated by investors, with high
growth in earnings expected. Note also that the earnings were for 2009, a
recessionary year, not expected to be repeated.

34
 Unit 4 Session 2: Market multiples

2.5: Price-to-cash-flow ratio

Another ratio that can be used to determine value is the price-to-cash-flow
ratio. This ratio is problematic in that there are many different definitions of
cash flow, depending on whether cash flow is before or after tax, before or
after interest payments, and relates to operating cash flows only or to all
cash flows. If, however, you are using the ratio in the context of the share
price (which is the numerator in this ratio), the cash flow figure in the
denominator should be the cash flow available to shareholders. This cash
flow is called the free cash flow to equity as opposed to the free cash flow
to the firm, which is available to all providers of capital (e.g. bondholders,
banks and shareholders).
Thus, the price-to-cash-flow ratio can be defined as:
share price
Price-to-cash-flow ratio =
cash flow per share
market capitalisation
Price-to-cash-flow ratio =
cash flow
The free cash flow to equity in the demoninator can be defined in two ways
and the alternatives are described below.

Definition 1
Cash flow available to shareholders is made up of operating cash flow, net
interest received and other income net of taxation. It can be written as
follows:

Free cash flow to equity providers =

operating cash flow + interest received − interest payable − taxation
− net capital expenditure + new debt − debt repayment
These figures can be obtained from the consolidated cash flow statement of
a company in its annual report.
If, however, there is no consolidated cash flow statement, but only a

consolidated income statement, the cash flow for shareholders starting cash Why the emphasis on
flow can be calculated starting from accounting profit. Accounting profit is consolidated accounts?
then adjusted for cash flow rather than accounting elements. So, for This is because most
companies are groups of
example, accounting depreciation would be added back and the actual cash
companies, and it is the
spent on equipment, so-called capital expenditure, subtracted. Changes in overall group which is
working capital which affect operating cash flow but not accounting profit being valued. The
would also be deducted. company accounts which
are also provided in the
This means that cash flow for shareholders can now be defined in terms of Annual Report are for
operating profit by substituting for operating cash flow in definition 1 of the the holding company in
cash flow equation. This leads to definition 2. the group and do not
reflect the whole group
at all.

35
Unit 4 Company valuation

Definition 2

Cash flow for shareholders = net income + depreciation – net capital

expenditure – changes in working capital – net interest payable + new
debt – debt repayment.

A full calculation of this slightly simplified formula can be found in Note

31 (‘Cash generated from operations’) of Pearson’s 2009 annual report.
However, public companies following globally recognised accounting
standards do have consolidated cash flow statements, making cash flow for
shareholders easy to find using definition 1. To find the cash flow to equity,
all cash flows under the headings ‘Cash flows from operating activities’,
‘Cash flows from investing activities’ and ‘Cash flows from financing
activities’ in a standard consolidated cash flow statement, such as Pearson’s,
need to be summed up with the exception of cash flows to shareholders
such as new shares issued, treasury stocks acquired or dividends paid.
Table 4.2.4 gives Pearson’s consolidated cash flow statement for the two
years 2008 and 2009. Estimate Pearson’s cash flow using definition 1.

Table 4.2.4: Extract from Pearson’s consolidated cash flow statement for
the years ended 31 December 2008 and 2009
(All figures in £ millions) Notes 2009 2008
Cash flows from operating activities
Net cash generated from operations 31 1,012 894
Interest Paid (90) (87)
Tax paid (103) (89)
Net cash generated from operating 819 718
activities
Cash flows from investing activities
Acquisition of subsidiaries, net cash acquired 29 (208) (395)
Acquisition of joint ventures and associates (14) (5)
Purchase of investments (10) (1)
Purchase of property, plant & equipment (62) (75)
(PPE)
Proceeds from sale of investments - 5
Proceeds from sale of PPE 31 1 2
Purchase of intangible assets (58) (45)
Disposal of subsidiaries, net of cash 30 14 111
disposed
Interest received 3 11
Dividends received from joint ventures and 22 23
associates
Net cash used in investing activities (312) (369)
Cash flows from financing activities
Proceeds from issue of ordinary shares 27 8 6
Purchase of treasury shares (33) (47)
Proceeds from borrowings 296 455
Liquid resources acquired (13) -
Repayment of borrowings (343) (275)
Finance lease principal payments (2) (3)
Dividends paid to company’s shareholders 9 (273) (257)
Dividends paid to minority interest (20) (28)
Net cash used in financing activities (380) (149)

36
 Unit 4 Session 2: Market multiples

Effects of exchange rate changes on cash (36) (103)

and cash equivalents
Net increase in cash and cash equivalents 91 97
Cash and cash equivalents at beginning of 589 492
year
Cash and cash equivalents at end of year 17 680 589

(Source: Pearson plc, Annual Report and Accounts for the year ended 31
December 2009)

The following values were in the 2009 consolidated cash flow statement: The –£315m is the
–£312m of net cash used
£m in investing activities net
Operating cash flow 1,012 of the +£3m interest
received.
Interest received +3
Interest paid –90
Tax paid –103
Net capital expenditure –315
New debt 296
Repayment of borrowings –343
Liquid resources acquired –13
Finance lease principal payments –2
Dividends paid to minority interest –20
Free cash flow to equity 425

Thus, the cash flow for shareholders using definition 1 is: £425m.
Dividends to minority shareholders need to be subtracted if the goal is to
compare the resulting cash flow to the share price of the parent company.
Cash flow is thus adjusted in the same way as profits attributable to
shareholders of the parent company when a price-to-earnings ratio is
calculated. Coincidentally, the cash flow to equity just calculated is the
same as the profit attributable to shareholders of the parent in the
consolidated income statement for 2009 on p. 79 of the annual report.
Cash flow for shareholders
= operating cash flow + other income + interest received − interest payable − taxation
= 1, 012 − 315 + 3 − 90 − 103
= £ 507m
An alternative, and sometimes simpler, way of finding the 2009 cash flow
for Pearson shareholders is to take:
Net cash from operations + net cash used in investing activities + net cash
used in financing activities − cash flows to shareholders of the parent
= 1,012 − 312 − 380 + 273 − 8 + 33 = 425.
From Note 8 of the 2009 Pearson annual report and accounts, the weighted
average number of shares in issue in 2009 was 799.3m. We need to use the
average number of shares over a time period here because the cash flow in
the numerator refers to the same time period, not a point in time. The share
price on 31 December 2009 was 890p. The market capitalisation at end
2009 was thus:

37
Unit 4 Company valuation

Market capitalisation = average number of shares in issue × share price

= 799.3 m × £8.90
= £7, 113.77m
market capitalisation
Price−to−cash−flow ratio =
cash flow to equity
£7, 113.77
=
£425
= 16.74

Exercise
Using Table 4.2.4, calculate the price-to-cash-flow ratio for end-2008 for
Pearson when the average number of shares in issue was 797.0m and the
share price was 641p.

Answer
Cash flow for Pearson shareholders
= net cash generated from operations − net cash used in investing activities
= 718 − 369
= £ 349m
Cash flow for Pearson shareholders:

£m
Operating cash flow 894
Interest received 11
Interest paid –87
Tax paid –89
Net capital expenditure –380
New debt 455
Repayment of borrowings –275
Liquid resources acquired 0
Finance lease principal payments –3
Dividends paid to minority interest –28
Free cash flow to equity 498

The net capital expenditure of –£380m has been obtained by subtracting the
interest received of £11m from the net capital expenditure shown in the
annual report.

Market capitalisation = average number of shares in issue × share price

= 797.0m × £6.41
= £5, 108.77m
market capitalisation
Price − to − cash − flow ratio =
cash flow to equity
£5, 108.77
=
£498
= 10.26
Although relatively easy to calculate, there are problems in using a price-to-
cash-flow multiple as a valuation measure. Cash flow after taxes, interest
and capital expenditure may vary widely from year to year and hence give
misleading valuations for companies. In contrast, earnings are smoother than
cash flows, because accounting rules require standard depreciation policies

38
 Unit 4 Session 2: Market multiples

and the matching of revenues and costs as far as possible. This makes the
PE multiple more stable over time than the price-to-cash-flow multiple. Cash
flow ratios can be important, however, in the context of takeovers, especially
leveraged buy-outs. In such situations, though, it is likely to be operating
cash flow that is important, because the leverage (and thus interest payable
and taxable profits) will be significantly different after a buy-out than before.

The main conclusion on price-to-cash-flow ratios seems to be: beware!

Check your definitions. This module uses the definitions recommended in the
Financial Times and outlined in the following box. The hope is that, over
time, analysts, managers, accountants and investors will come to agree a
standard set of definitions making everyone’s life much easier.

Cash flow
‘Cash is King’. Though the phrase is a cliché, the notion that investors
ought to be looking at a company’s cash flow rather than merely its
accounting profits is valid. The only snag is that defining cash flow is
slippery. Different companies’ stockbrokers and consultants calculate it
in different ways.

Some semantic tidying-up is needed. The starting point should be

recognition that there is no correct definition of cash flow, just as there
is no single measure of profit. But just as investors distinguish between
operating profit, pre-tax profit and earnings, it is important to be precise
about which sort of cash flow one is talking about. Below are the
definitions Lex proposes to use.

EBITDA: earnings before interest, tax, depreciation and amortisation The term ‘amortisation’,
has caught on as a valuation tool, especially for judging the relative as used here, relates to
attractiveness of companies in the same industries across borders – for the depreciation of
intangibles.
example, European telephone companies. Typically, ratios of sales or
enterprise value (market capitalisation plus debt) to EBITDA are
calculated. The appeal is that these measures strip out the different
depreciation, capital structures and tax regimes in different countries.

Closely allied to EBITDA is operating cash flow. The only difference is

that adjustments are made for changes in working capital. Operating
cash flow is the top line of UK cash flow statements, where it is
described as ‘cash flow from operations’. While working capital changes
can be important in any single year, they tend to even out over time. So
for trend analysis, EBITDA is normally a better measure.

But, EBITDA is not a Holy Grail, precisely because it is calculated

before many of the costs business has to bear. Most important is
capital expenditure. Without investment, companies would wither on the
vine. The snag is that for most companies, only a portion of the CAPEX CAPEX is shorthand for
is required to maintain the business while the rest is used for capital expenditure.
expansion. Ideally, companies would give a breakdown; but, in practice,
they do not. That means that estimates of maintenance CAPEX – the

39
Unit 4 Company valuation

investment needed to maintain the value of the company’s assets – is

subjective though not worthless.

Of course tax is also a cost to business and certainly if one wants to

discount cash flows to calculate net present value, one needs to take it
into account. For this purpose the best measure is operating free cash
flow: operating cash flow minus CAPEX and tax (but before interest).
Discounting such cash flows by a company’s cost of capital will give its
enterprise value – from which net debt needs to be deducted to
calculate the value of the equity. Sometimes, though, one is interested
simply in how much cash is left over for shareholders – in which case
interest should also be subtracted.

[…]

At other times it is useful to think of dividends as given and subtract

them to give residual cash flow. This number, which is often negative, is
the cash available for repaying debt and acquisitions. It is not very
useful for valuation purposes, but in judging how much debt and
dividends a company can support, it is invaluable.
(Source: Copeland et al., 1997)

2.6: Enterprise value to EBITDA

As mentioned in the box on cash flow, a ratio that has become popular as a
valuation tool for companies is enterprise value (EV) to EBITDA. This ratio
is different in several respects from PE or price-to-cash-flow ratios. First, it
considers the value of the enterprise as a whole, not merely the equity
element. The profits it measures are the profits before interest and tax and
hence are independent of financing choice. Interest payments are clearly
affected by the amount of debt finance and corporate tax payments are also
affected since debt interest typically attracts corporate tax relief. Profits
before both taxes and interest are not affected by the financing choice. The
second characteristic of the ratio is that the profits considered are also
before depreciation and amortisation. This means that EBITDA is not
equivalent to cash flow, since it is before capital expenditure or its
accounting surrogate, depreciation. Thus, companies with very different
capital expenditure programmes will not be seen to be different using this
ratio. The main advantage of this ratio, however, is its stability – you saw
how volatile the cash flow ratio could be.
EBITDA can be calculated in a number of ways from the consolidated
income statement:

EBITDA = earnings before interest, tax, depreciation and amortisation

EBITDA = earnings before interest and tax (EBIT) + depreciation +
amortisation

40
 Unit 4 Session 2: Market multiples

EBITDA = operating profit + depreciation + amortisation

Enterprise value is typically defined as follows:

EV = market value of the equity + the market value of net debt + the
market value of any preference shares or convertibles + minority
interests

The idea is to include any long-term capital provided by all types of

investors. The equity element is easy to calculate and preference shares may
also have a market price. However, when prices are not available, analysts
often use book value as a proxy for market value. They certainly do this for Minority interests are the
the net debt element of enterprise value. You may be wondering what we rights of outside
mean by ‘net debt’. The idea here is to include only debt that represents shareholders of
subsidiary companies of
long-term capital to the business. Determining the debt element of the
a group to a proportion
enterprise value will involve a decision as to whether any short-term debt of the group’s assets.
should be included and whether cash should be netted off. Many companies
build up cash mountains, as described in the following box, but these tend
to be reinvested in the business or used to make acquisitions.

European companies build cash

mountain
Europe’s largest companies are enjoying their biggest financial boost in
nearly seven years, sitting on a multibillion-dollar cash pile that
experts hope can help maintain economic growth next year.
Some 466 of Europe’s biggest companies – the benchmark Stoxx
Europe 600 Index, minus its financial constituents, many of which
have received distorting government bailouts – are sitting on a $US691
bn ($A720 bn) pile of cash, according to Bloomberg.
This represents a 16% increase on the amount of cash these companies
– which include Vodafone ($US14.3 bn), BP ($US12.8 bn) and
AstraZeneca ($US10 bn) – were sitting on at the end of 2007 as the
financial crisis gained momentum.
….
Despite a sharp decline in demand from pre-credit crunch [2008–9
global financial crisis] levels, Europe’s biggest quoted companies have
managed to build their cash reserves by reducing dividend payments,
scaling down share buy-backs and cutting back on mergers and
acquisitions. They have also slashed costs through redundancies and
reductions in inventories and investment.
The benefit of this accumulated cash is expected to be felt initially by
the companies’ shareholders, before feeding into the economy.
Andrew Goodwin, senior economist at Ernst & Young, said: ‘UK,
European and US firms all have big cash piles and we think the main
way they will spend them is through investment.

41
Unit 4 Company valuation

‘There is evidence that investment in areas such as machinery and

innovation has rebounded a little this year but over the next 12 months
we expect things to pick up considerably and for that to carry into
2012 and 2013.’
…
As well as amassing a cash mountain, companies have also
significantly reduced debt. Furthermore, profits have rebounded
strongly this year.
(Source: The Guardian, 2010)

In the case of Pearson, using the 2009 consolidated balance sheet shown in
Table 4.1.1, and Note 27 to the 2009 accounts for the number of shares in
issue, gives the following calculation for enterprise value (EV) at 31
December 2009:

EV = market value of equity + market value of net debt + market

value of other equity + minority interests

For simplicity, the book value of debt is used instead of market value, and
there is no ‘other equity’. Also, the number of shares used in the calculation
of Pearson’s market capitalisation is taken at the year end. A more exact but
also more complicated procedure would be to use the average number of
shares over the year, which would then correspond to EBITDA; this is also
measured over the period of one year.
So,

EV = 810.799m x £8.90 (market value of equity) + £1,934m long-term

borrowings + £74m short-term borrowings + £291m minority interest
EV = £7,216m + £1,934m + £74m + £291m
EV = £9,515m

Note that, in this example, the £750m cash has not been included in the
enterprise value calculation, because it is assumed that this cash will be
reinvested in the business. Thus, the enterprise value of Pearson at 31
December 2009 was £9,515m.
To find the EBITDA for Pearson from its consolidated income statement for
the financial year ended 31 December 2009, you can use this formula:

EBITDA = operating profit + depreciation + amortisation

For Pearson, it is necessary to identify the total operating profit before tax
and before interest costs and interest income for 2009 of £755, (from
Table 4.2.2) and then add back (using Note 4 on page 99 of the 2009

42
 Unit 4 Session 2: Market multiples

Pearson annual report) £85m of depreciation and £454m of amortisation of

intangibles:
EBITDA = £ 755m + £ 85m + £ 454m
= £ 1, 294m
The EV/EBITDA ratio can now be calculated:
£ 9, 515m
EV / EBITDA =
£ 1, 294m
= 7. 35
For new companies, some analysts look not at profits or cash flow or even
EBITDA but at revenues, and calculate the EV/sales ratio. This ratio can be
useful for new issues such as that of Ocado in 2010, since Ocado had at
that time both negative earnings and negative cash flow. The higher the EV/
sales ratio, the greater the growth expectations for a particular company.
In summary, the main attractions of the EV/EBITDA ratio are its stability
and its independence from capital structure, as well as its freedom from any
distortions due to differences in depreciation policies between companies.
This independence of tax and accounting differences enables comparison of
companies across national boundaries and has been of particular use in the
valuation of privatised utilities worldwide. These utilities have had very
different capital and asset structures, according to their level of modernity
and which government was responsible for privatisation. EV/EBITDA
helped, for example, in the valuation of newly privatised telecoms
companies in Europe, since comparison could be made with quoted
companies in the same sector, such as British Telecom (BT), even though
BT had a different gearing ratio and a different asset base.
EV/EBITDA has also been a key valuation metric for private equity firms
buying listed companies and taking them private, changing the capital
structure in the process. Since EV/EBITDA is a pre-financing metric, unlike
the PE ratio which is calculated after interest payments, EV/EBITDA has
become the most popular ratio for takeovers where capital structure changes
are to be implemented.

2.7: Specific valuation ratios

Finally, there are a number of specific value drivers that are used in certain Value drivers are key
sectors as valuation tools and for comparisons. They are based on the idea factors that affect value,
that profit and cash flow depend on a key driver which can form part of a for example, the number
of bank branches of a
valuation ratio. For example, supermarkets may be valued on a ‘per square
retail bank or the size of
metre’ basis, mobile phone companies on a multiple of the number of funds – both in terms of
subscribers, and fund management companies on a percentage of the value value and the actual
of the funds under management. number – under
management for a fund
management company.

Stop and think

Think of possible value drivers and hence valuation multiples for:

43
Unit 4 Company valuation

. fashion boutiques
. advertising agencies
. airlines.

Discussion
For fashion boutiques, a crucial value driver might be the frontage of the
shop in metres rather than the overall size; for advertising agencies, it might
be the value of billings; for airlines, it could be the number of hubs at
airports.

Examples of valuation multiples would therefore be a multiple of frontage for

boutiques; a multiple of billings for advertising agencies; and a multiple of
revenues from airport hubs.

2.8: Comparison of market multiples

You have seen the key market ratios used in valuation. These were dividend
yield, price-to-book, PE ratio, price-to-cash-flow, EV/EBITDA, EV/sales,
and sector-specific ratios. Table 4.2.5 compares the advantages and
disadvantages of valuation multiples.

Table 4.2.5: Pros and cons of valuation multiples

Valuation Pros Cons
multiple
Net asset . .
Easy to calculate Relies on accounting
value
.
value and not economic
It comes straight from the
value
accounts
. Accounting standards in
. Useful for special
different countries can
situations such as
vary
companies that deal
predominantly in easily . Accounts are often out of
valued fixed assets date and subjective as to
valuation. How much
value in a fire sale? What
about possible tax
payments in a fire sale?

PE ratio . .
Commonly used ratio If earnings are erratic, PE
.
ratio should be normalised
Easy to calculate
. Does not fully take
account of the time value
of money
. Sensitive to accounting
standards
. Investment requirements
are overlooked

44
 Unit 4 Session 2: Market multiples

Price-to-cash- . .
Takes investment into
flow
account
. Represents real cash
belonging to shareholders
EV/EBITDA . .
Commonly used ratio
.
More stable than cash
flow
.
Allows companies with
different financial
structures to be compared
.
Allows international
comparisons
EV/sales . .
Commonly used ratio
especially in countries
where earnings are not
meaningful numbers
. Enables accounting
distortions to be minimised
Sector-specific . .
Commonly used for
ratios
valuation purposes,
especially in acquisitions
. Allows companies whose
earnings may be
meaningless to be
compared
. Gives reference points
within a sector
. Allows concentration on
concept of value drivers
Confusion over definition
of cash flow
. Ignores the time value of
money
. Can be variable over time
Ignores capital
expenditure requirements
. Ignores differences in tax
rates between companies
. In calculating EV, the book
value is often used as a
proxy for the market value
of debt which may distort
comparisons
. Ignores the time value of
money
Ignores value to
shareholders, taxes,
capital structure
. Does not fully take
account of time value of
money
May mask important
differences between
companies
. Does not fully take
account of the time value
of money
. Considers only one value
driver

Stop and think

Go back through this session and collect all the valuation metrics for
Pearson as at 31 December 2009.

Discussion
The following are the ratios for Pearson on 31 December 2009:

2009
Dividend yield (%) 4
Price-to-book ratio 1.7
PE ratio 16.7
Price-to-cash-flow ratio 174.0
EV/EBITDA 7.4

45
Unit 4 Company valuation

But remember that all these numbers are meaningless unless compared over
time or with other companies in the same sector or market.

Each analyst, manager, investor and accountant will use different ratios in
different contexts, which will be discussed in more detail in Session 4. The
results of a survey of UK investment analysts interviewed as to their
preferred valuation metrics are shown in Table 4.2.6.

Table 4.2.6: Valuation module usage (content analysis)

Content analysis is a
summarising, Number of times the models appear as the
quantitative form of dominant one(s)
analysis of interviews or Dominant model(s) Financial Industrial Media Retail Tech Total Rank
written communications. DCF (or FCF) 1 10 15 11 12 49 1
Price/earnings (PE) 15 4 4 15 7 45 2
EV/EBITDA 0 4 4 12 5 25 3
Price-to-book value 9 2 0 0 0 11 4
DDM 10 0 0 0 0 10 5
CFROI 0 0 1 2 6 9 6
EV/sales 0 2 1 1 3 7 7
PEG 0 0 1 0 2 3 8
EVA® 0 0 0 2 1 3 8
Dividend yield (DY) 1 1 0 0 0 2 10
Price-to-cash-flow 1 0 0 0 1 2 10
Price-to-sales 0 0 0 1 0 1 12
EV/BV 0 0 0 0 0 0 13
Total dominant 37 23 26 44 37 167
models
Total reports 17 15 19 26 21 98
analysed

(Source: Imam et al., 2008, p. 514)

From Table 4.2.6 you can see that the most popular valuation method
mentioned by analysts was discounted cash flow, which is described in more
detail in Session 3. The next most popular methods were the PE ratio,
EV/EBITDA and price-to-book value. There are a couple you have not yet
come across – PEG and CFROI. PEG is the PE ratio divided by growth and
is used, if possible, with forecast growth rather than historic growth. If the

There is no reason why PEG is lower than 1, the shares are believed to be cheap. There is no
this should be the case, theoretical underpinning to this ratio. CFROI and EVA® are compromises
for example, from the between cash flow and accounting measures. Cash flow return on investment
DVM. It is just a
(CFROI) is the cash flow equivalent of the accounting rate of return.
‘market myth’.
Economic value added is the added value over and above what would have
been earned on invested capital with the WACC as rate of return.
The following box shows how valuation methods vary even within one
investment analyst department. It all depends on the type of company being
valued.

46
 Unit 4 Session 2: Market multiples

Valuation methods: horses for courses

Media publishing
Our fair value of 1,005p is based on a sum of the parts valuation, ‘Sum of the parts
although the value assigned to assets such as the FT Group is unlikely valuation’ is when a
to be realised in the short-term. Pearson currently trades at a premium company is valued as the
sum of the values of its
relative valuation to its professional publishing peers, based on PE and
constituent operating
EV/EBITDA multiples but we believe it will struggle to outperform this divisions or subsidiaries
year and the premium should reduce. and where different
valuation multiples or
(Pearson plc, 10 December 2009) methods may be applied
to each element.
Food retailing
With the stock trading on a 2012 PE of 12X our revised forecasts, a
discount to the European sector, we feel the current level looks a good
entry point.

(Tesco plc, 22 November 2010)

Food and fashion retailing

Our 325p price target is based on our 10-year DCF. In our DCF, we use
a terminal growth rate of 0.5% and a WACC of 7.6%.

(Marks & Spencer plc, 29 November 2010)

Pharmaceuticals
We value GSK using discounted cash flow analysis with a weighted
average cost of capital of 8.5% (risk-free rate 4.2%, equity risk premium
5% and asset beta 0.9). Beyond our explicit forecast horizon we
assume returns fade to cost of capital in the long run.

(GlaxoSmithKline plc, 16 December 2010)

We value AZN at 3,300p, based on a DCF-valuation with a WACC of

8.85% (risk-free rate 4.35%, equity risk premium 5% and asset beta of
0.9). Beyond our explicit forecast horizon we assume returns fade to
cost of capital in the long run.

(AstraZeneca plc, 24 December 2010)

(Source: Barclays Wealth Research, 2011)

Summary
This session has looked at a number of ratios which compare share prices
with dividends, book value, profit or cash measures, and which allow
comparison of companies across sectors, time and countries. Valuation
ratios can be used to compare companies that are listed on stock markets

47
Unit 4 Company valuation

and also allow the valuation of companies not listed by using the multiple
derived for a comparable listed company.
The main ratios considered were:

. dividend yield – a measure of income

. price/book – a measure of how much more (or less) than book asset
value is being paid
. PE ratio – the most common measure of valuation using a multiple of
accounting earnings
. price-to-cash-flow – a measure of valuation using cash flow, although the
definition of cash flow can vary according to the analyst
. enterprise value to EBITDA – a valuation multiple for the enterprise as
a whole and using a proxy for operating cash flow before tax
. enterprise value to sales – a valuation multiple for the enterprise as a
whole which is unaffected by accounting differences
. sector-specific ratios – valuation multiples based on a value driver for a
specific sector.

48
 Unit 4 Session 3: Discounted cash flow

Unit 4 Session 3: Discounted cash

flow
The attraction of market multiples is their availability and their simplicity. It
is clear, however, that market multiples do not expressly take account of the
time value of money and only crudely allow for differences in growth
prospects at the earnings or cash flow level. You saw in Unit 3 how net
present value (NPV) as a decision-making tool for project appraisal is now
common in major organisations. What is noteworthy is that discounted cash
flow (DCF) has become almost as common in company valuation.

Stop and think

From what you have read in Unit 4 so far, what do you think are the key
differences between using DCF techniques for company valuation and using
them for project appraisal?

Discussion
There are many differences, but two major ones spring to mind. First, if
shares are traded on an efficient stock market, share prices should reflect
the market’s best estimate of their value. Thus, discounting the forecast cash
flows back to a share price should lead to a zero net present value, whereas,
as you saw in Unit 3, managers regularly expect positive net present values
from projects.

Second, the information available on companies (particularly for outside

investors) is often more complex than for projects – and companies can be
viewed as a collection of projects. Valuing companies is therefore more
difficult than valuing projects, which is why a number of simplifying
assumptions are often made.

In essence, the DCF approach to valuing companies is the same as the DCF
approach to projects. There are two levels at which the DCF approach can
be carried out – the equity level and the enterprise level. The enterprise
level is the level most commonly used. These two methods are summarised
in Table 4.3.1.

Table 4.3.1: DCF techniques

Method 1 Valuing the equity Discount the equity cash flows
(dividends) by the cost of equity

Method 2 Valuing the enterprise Discount the after-tax operating cash

flows by the WACC to obtain the overall
value of the enterprise
Value of equity Enterprise value – debt – minority
interests

49
Unit 4 Company valuation

Method 1: Valuing the equity using DCF

The present value of a share can be stated as the discounted present value
of all the future dividends expected on a share. In Unit 2 Session 3, the
special case of constant growth in dividends, called the Gordon growth
model, was used – not as a valuation tool but as a means of determining the
required rate of return on a share, which is also called the cost of equity.
Valuing a company at the equity level, method 1, seems logical for equity
investors who are buying or selling a relatively small number of shares
compared with the total number in issue. Investors have no control over
capital structure (i.e., how much debt and equity management choose to
raise), nor over the dividend policy, even though they may vote on dividend
policy at the annual general meeting. It would seem sensible, therefore, for
the investor to value the cash flows they expect from a likely dividend
policy and from the likely growth rate of dividends.
Although this method has been relatively popular in the past, the more
common approach now is method 2, which is to value companies at the
enterprise level – that is, to value the company as funded by debt providers
and equity providers. When this value is obtained, the part of the company
belonging to debt holders is deducted, to leave the value belonging to the
equity holders.

Method 2: Valuing the enterprise using DCF

The enterprise-value approach to valuing a company consists of forecasting
the future operating cash flows of the company, before financing cash flows
(such as interest payments and dividends), but after taxes. These forecast
cash flows are discounted by the weighted average cost of capital (WACC)
because the enterprise is financed by both debt and equity (and sometimes
minority interests). The figure obtained for the present value is the
enterprise value. To estimate how much the equity holders’ part is worth,
the debt (and minority interests) must be subtracted from the enterprise
value first.

3.1: DCF valuation steps

The steps that need to be determined for the valuation of a company using
method 2 are described in Table 4.3.2. None of these should surprise you,
as you have considered most of them in the context of project appraisal
(Unit 3). The only complexity is to link the accounts with the DCF
forecasting technique, step 6, which most valuation spreadsheets will do
automatically. Step 6, though, can be ignored and the DCF valuation
technique used without regard to the impact on future income statements or
balance sheets. However, estimating future financial statements can prove a
useful check against unrealistic cash flow forecasts.

50
 Unit 4 Session 3: Discounted cash flow

Stop and think

Think why it might be useful to look at the impact of your cash flow forecasts
on financial statements.

Discussion

Most DCF valuations assume that a firm will generate increasing cash. This You may wish to refer
cash either has to be reinvested, paid back to shareholders, or used to keep back to Unit 2 to refresh
the target debt/capital ratio constant, which is an underlying assumption of your memory on how to
estimate the WACC from
using the WACC as discount rate.
the cost of equity and
the cost of debt.

Table 4.3.2: Steps in valuing a company using DCF

Step 1 Determine time horizon for specific forecasts

Look at the economic and business cycle

Consider positive and negative growth

Consider period of comparative advantage

Forecast operating cash flows

Step 2 Determine value drivers

Estimate historic, current and future ratios

Decide how to treat cash

Determine residual value

Step 3 Decide on residual-value methodology

Either estimate growth rate in perpetuity or decide on a valuation multiple to use for
residual value
Estimate WACC

Step 4 Estimate cost of equity

Estimate cost of debt

Estimate cost of other finance if any

Determine target debt/capital ratio

Discount cash flows

Step 5 Determine enterprise value

Deduct debt and minority interests, add back cash and investments (if appropriate) to
determine equity value

Conduct sensitivity analysis

51
Unit 4 Company valuation
The residual value or
terminal value is the
present value in year n
(where year n is usually
year 5 or 10) of all cash
flows occurring in year n
or at any later date. It is
a way of valuing long-
term projects or
companies without
having to forecast
individual years far into
the future. Simplifying
assumptions, such as low
or no growth of cash
flows beyond the
terminal value year, are
usually made.
52
Step 6 Prepare related financial statements (optional)
If future financial statements are to be calculated, determine what
to do with cash flows generated regarding capital structure
and dividend policy
Step 1: Determine time horizon for specific forecasts
Look at the economic and business cycle
Forecasting plays a large part in our lives
Many valuation spreadsheets assume a specific forecasting period (say ten
years). At the end of the forecast period, a residual value or terminal
value is calculated for all cash flows beyond that fixed time horizon. A
residual value is needed to allow for the fact that companies, unlike
projects, are expected to last longer than a single project. A ten-year
detailed forecast period, with a residual value calculation in year 10 is
designed to allow you to include at least one economic cycle in the specific
forecasts. It is all too easy to forecast three to five years of rapid growth
and then assume implicitly in the residual value that things can only get
better!
Consider positive and negative growth
In the run-up to the 2008–9 global financial crisis, many so-called growth
companies were valued using DCF analysis. Part of the reason for the
optimistic valuations derived, and hence the number of deals that
subsequently went sour, was the failure to incorporate negative growth into
the spreadsheet models. Growth was assumed to be both large and positive.
It was assumed that sales could never fall, only go up. During the 2008–9
global financial crisis, these assumptions were proved to be wrong.
Consider period of competitive advantage
Consider how long the company is likely to generate above-average
performance, given any advantage it may have relative to the competition.
For example, pharmaceutical companies can use the life of a patent since
they will be able to charge higher prices over that period before competitors
 Unit 4 Session 3: Discounted cash flow

are allowed to provide substitutes. The choice of the period for specific
forecasts can be linked to the competitive advantage period, with standard
returns thereafter.

Step 2: Forecast operating cash flows

Determine value drivers

Before estimating a stream of future cash flows, analysts need to determine
what the key drivers of those expected cash flows are. Different valuation
software will concentrate on different value drivers, but there is general
consensus that the following forecasts are key to future cash flows:

. future sales
. operating profits
. capital expenditure
. working capital needs
. taxes.
Future sales can be estimated in detail, looking at the likely volume and
price of each product over time, as well as taking ‘industry analysis’ into
account. It is assumed that, before attempting a valuation, you will have
carried out this kind of strategic analysis and are aware, for example, of
likely future inflation rates, economic growth rates, forecasts for the sector
and company-specific issues such as quality of product, operating capacity,
and so on.
Alternatively, instead of forecasting absolute numbers directly to feed into
the cash flow forecasts, ratios can be used to compare previous ratios and
current ratios for the company and make a subjective decision as to whether
to extrapolate a historical average, accept that the status quo will be
maintained, or input other growth rates based on specific expectations for
the future.
Value drivers commonly used include:

. change in sales (%)

. operating profit/sales (%) or operating profit margin
. working capital (excluding cash)/sales (%) (any excess cash can be dealt
with as an investment)
. sales/net property, plant and equipment and depreciation/net property,
plant and equipment which will drive the capital expenditure
assumption, in that the greater the sales, the more capital expenditure is
needed, and the higher the depreciation rate, the more quickly the plant
will require replacement
. taxes/net operating profit (or taxes/net profit before tax). This ratio is
simply the corporate tax rate unless the company has a different rate,
say due to overseas allowances.

53
Unit 4 Company valuation

Estimate historic, current and future ratios

Having determined a suitable set of value drivers, the historic ratios for the
past five years can be used to derive an estimate for the five or ten years up
to residual value. Of course, for a new company, there are no historical
ratios to choose from, but ratios from a comparable company or from the
sector can be used.

Decide how to treat cash

It is a good idea to separate the financial elements of working capital from
the operating elements, in order to get a better picture of the enterprise in
question. In most DCF valuation models for companies, it is usual to
estimate future working capital needs as one line, excluding overdrafts and
cash which are taken account of in the capital structure.
If there is substantial and persistent short-term debt, one option is to include
it as part of debt in the capital structure and to include it in the debt-capital
estimate for WACC.
If there is short-term cash in excess of operating requirements, should this
be included in investments that are dealt with separately or treated as an
asset that generates income in the form of interest received?

Stop and think

What is the role of cash in the biotech companies discussed in the box
below?

Biotech research

The biotech dilemma: cash-rich, product-poor

‘I’m an absolute idiot,’ says David Ebsworth, chief executive of Oxford
Glycosciences. ‘I’m destroying value and it would be better if we closed
the company and put our money in the bank. That’s what the market’s
telling me. Of course, I don’t think that’s true.’

54
 Unit 4 Session 3: Discounted cash flow

For companies like Oxford Glycosciences (OGS), trading for less than
the cash they have on hand, that is indeed the message.

And the market’s deep-seated scepticism over biotechnology

companies’ ability to come up with products is creating opportunities for
a new generation of corporate raiders.

A wave of consolidation is hitting the biotech sector as buyers fight over

the spoils of the late 1990s investment boom that left many young
companies flush with cash. Two bidders – Cambridge Antibody
Technology and Celltech – are now battling it out for OGS’s $244m.

Last week, Dendreon said it would acquire Corvas for $73m, slightly
more than the amount Corvas has in the bank. ‘We saw some value in
its pre-clinical programmes,’ said Mitch Gold, Dendreon chief executive.
‘So you could say it was partly strategic.’

Other groups adhere to a pure ‘take the money and run’ philosophy.
Exelixis bought Genomica last year at a discount to its cash levels for
$110m. After completing the acquisition, the company shut down
Genomica’s research operations.

Hyseq last year bought Variagenics to get its hands on the company’s
bank account. The newly formed company from the merger, Nuvelo,
has halted development of all Variagenics’ drug candidates.

Hype surrounding the sequencing of the human genome lifted the stock
of many companies to unsustainable heights in the late 1990s. When
shares began to tumble, much of the sector was brought financially to
its knees. Extreme difficulty in raising public funds has created
challenges for groups with no commercial products on the market – that
is, most of the industry.

Initially, analysts predicted that hard times would encourage bargain

hunters in the pharmaceuticals and biotech industries to pick up
interesting technology on the cheap.

Companies with insufficient cash to finance research were considered

most vulnerable. Few predicted that the cash-rich would be in danger of
liquidation as well.

The latest twist in the saga – which values companies’ cash more
highly than their knowledge – shows just how low the odds have been
set on many groups’ chances for clinical success. Once hot names are
now trading below cash: Celera Genomics, Transkaryotic Therapies,
Incyte Genomics, Sequenom and Curagen.

‘Between 10 and 20 per cent of public biotech companies are trading

near or below cash levels,’ reckons Eric Schmidt, analyst at SG Cowen.
‘Some will survive to see a better day, but others will be purchased.’
Fear of takeover has led some groups to adopt ‘poison pill’ strategies.

‘I wouldn’t put any company with high cash levels out of the running,
but some are trying to stay independent by using dilution provisions and
other poison pills,’ says Mr Gold. Not all acquisitions in the biotech

55
Unit 4 Company valuation

sector will be to access cash reserves. A selected few are valued for
their technology.

In February, Johnson & Johnson agreed to pay $2.4bn for biotech

group Scios for its arthritis drug candidate. And NPS Pharma said it
would buy Enzon for $1.6bn to gain access to its experimental hepatitis
treatment.

But until the public regains its enthusiasm for the sector, more
consolidation – for whatever reason – is probably on the cards.
(Source: Griffith, 2003)

Discussion
The role of cash in the biotech companies is, in theory, for investment in
positive net present value projects. However, in practice, the number of such
projects which are available is limited, so that there is no use for the cash
internally. The value of these companies is a small amount for current or
future projects plus the cash at book value, with no premium for its use in
future projects which might add value.

The same phenomenon happens with closed end investment companies

which raise, say, £1bn to invest in an emerging market but find only £400m
of investments.

In both cases, managers should return the cash to shareholders, or risk

takeover.

Step 3: Determine residual value

The aim here is to estimate the present value of a stream of cash flows from
the year after the specific time horizon to perpetuity. The difference between
projects and companies is that projects typically have finite lives and most
companies do not, because it is assumed that companies will invest in new
projects in the future. Thus, what is sometimes known as the present value
of future growth opportunities has to be estimated through the mechanism
of the residual value. This is an extremely important part of DCF valuation
since, particularly for growth companies such as Ted Baker or Google, the
residual value often makes up a substantial element of present value.

Decide on residual-value methodology

There are a number of ways in which the residual value can be estimated,
deriving mostly from the valuation methods considered in Sessions 1 and 2
of this unit. For example, a pessimistic view might be that the residual
value was equal to the liquidation value – making the assumption that there
are no future growth opportunities and that, once the specific value has been
added, the company will be disbanded. Not surprisingly, this approach to
residual value is not popular, because most companies expect to continue at
least at current levels rather than close down.

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 Unit 4 Session 3: Discounted cash flow

The most common approach is to value the company at the end of the
forecasting time horizon by some appropriate market multiple, most often
the EV/EBITDA ratio. Current levels of EV/EBITDA can be considered for
the sector or for the economy, but the analyst must take into account the
fact that the company may be valued on a very different multiple in ten
years’ time, perhaps due to lower growth forecasts, but also perhaps due to
different economic fundamentals.

Estimate growth rate in perpetuity

Instead of using a market EV/EBITDA multiple, the analyst may wish to
make a specific forecast for growth. This is rather difficult to do in practice
since 10% per annum growth in perpetuity, for example, is clearly
unrealistic. The convention is to assume a low growth rate, from 0% to 4%,
and care must be taken to allow for an appropriate inflation rate in the
growth-rate assumption. For example, a growth rate of 3% in perpetuity in
an environment of 3% per annum forecast inflation would effectively
assume zero real growth.

Step 4: Estimate WACC How to estimate the

WACC was covered in
detail in Unit 2 and you
Determine target debt/capital ratio should review that unit if
necessary.
For this, analysts should assume a debt/capital ratio that is likely to be
maintained over time. Some companies disclose their target gearing
levels – for example, at the oil company BP, senior managers make
company presentations to analysts at which they disclose five-year targets
for gearing. For others, you will have to look over time and see what has
been achieved and what is likely to be achieved. Do not forget, within
sensible limits, that the higher the target debt/capital ratio, the lower the
WACC and hence the higher the valuation you will get. Target debt/capital
ratios should not be so high that tax relief on interest is not available.
Notice also that the forecast cash flows and residual value ignore any flows
to do with debt – the choice of capital structure, including the amount of
debt, is left to be input into the WACC.

Step 5: Discount cash flows

Determine enterprise value

Most valuation spreadsheets calculate the present value of the cash flows
for you. The present value is equal to the value of the enterprise, which
belongs to all providers of long-term capital. In most cases, these are
considered to be long-term debt providers, equity investors and preference
and convertible shareholders. Minority interests can be included if
significant. Enterprise value will include any investments such as cash
mountains that you have deemed appropriate to treat separately as
investments from the operating cash flows.

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Unit 4 Company valuation

Determine equity value

Equity value can be estimated provided you input the amount of debt, other
non-equity capital and minority interests. Equity value is calculated as

Enterprise value was enterprise value less total debt, minority interests and other equity, such as
defined in Session 2 of preference shares, if there are any. Dividing the equity value by the number
this unit. of shares in issue gives the value per share, which can be compared with
the current share price. You can then decide whether the market value is too
high or too low compared with your own valuation.
One sensible check on your calculations is to compare the share price
obtained from DCF with the current share price and with market multiples.
It is a good idea to estimate the implied PE ratio, implied price-to-book
ratio and implied EV/EBITDA ratio. These multiples allow you to compare
the valuation result with other companies, sectors and markets and help to
place the DCF valuation in context.

Conduct sensitivity analysis

Any valuation exercise should include a sensitivity analysis. This is vital (as
was also emphasised for project appraisal) in order to identify which
variables or value drivers affect value most. Is it, for example, the profit
margin, the capital expenditure, the residual-value assumption or the choice
of WACC? No analyst should offer just one value without discussion. The
point of valuing companies using the DCF approach is to identify the
important numbers and assumptions and then to consider what happens if
the forecasts are wrong – either way. By changing inputs to the estimates
for cash flow and WACC, you can study the effect of the changes on your
estimated value.

Step 6: Prepare related financial statements (optional)

Commercial valuation software packages typically include future balance
sheets and income statements based on the cash flow forecasts as part of the
output on valuation. To do this, however, assumptions have to be made
concerning the future cash flows generated. For example, in order to be
consistent with the assumed constant target debt/capital ratio embedded in
the WACC calculation, the software may assume a constant debt/capital
ratio over time. If there is insufficient cash in any one period, the model
will assume that debt or equity finance is raised according to the debt/
capital ratio constraint. Excess cash, on the other hand, is assumed to be
paid out as dividends (or share repurchases).
It is important to think about the future cash flow, capital structure and
dividend policy that is likely to occur in the future.

DCF modelling in practice

In order to assess whether intangible assets have been impaired during
a financial year which would require an amortisation write down,
companies are required to value operations which are in the balance

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 Unit 4 Session 3: Discounted cash flow

sheet as having goodwill or intangible value. In order to get a value

which reflects goodwill, companies use a DCF approach to valuation,
exactly as in steps 1 to 6 above. There is a certain irony in that
companies are being valued using estimates of the discount rate,
perpetuity and cash flow growth rates which may be different from
those used by the company being valued! See the following box for an
example of this paradox using Pearson.

Extract from Note 11 of Pearson Annual Report 2009

Key assumptions
The value in use calculations use cash flow projections based on
financial budgets approved by management covering a five-year period.
The key assumptions used by management in the value in use
calculations were:

Discount rate

The discount rate is based on the risk-free rate for government bonds,
adjusted for a risk premium to reflect the increased risk in investing in
equities. The risk premium adjustment is assessed for each specific
CGU.
CGU is shorthand for
The average pre-tax discount rates used are in the range of 10.9% to cash-generating unit.
11.8% for the Pearson Education businesses (2008: 10.2% to 11.7%),
12.7% to 18.1% for the FT Group businesses (2008: 10.8% to 20.5%)
and 9.5% to 11.4% for the Penguin businesses (2008: 8.8% to 10.4%).

Perpetuity growth rates

The cash flows subsequent to the approved budget period are based
on the long-term historic growth rates of the underlying territories in
which the CGU operates and reflect the long-term growth prospects of
the sectors in which the CGU operates. A perpetuity growth rate of
2.0% was used for all CGUs in 2009 (2008: 2.0%). The perpetuity
growth rates are consistent with appropriate external sources for the
relevant markets.

Cash flow growth rates

The cash flow growth rates are derived from management’s latest
forecast of sales taking into consideration past experience of operating
margins achieved in the CGU. Historically, such forecasts have been
reasonably accurate.

Sensitivities
The Group’s impairment review is sensitive to a change in assumptions
used, most notably the discount rates, the perpetuity growth rates and
expected future cash flows. Based on the Group’s sensitivity analysis, a
reasonably possible change in the discount rate or perpetuity growth
rate could cause an impairment in the US School Curriculum CGU.
Following a restructuring during 2009, the Penguin UK CGU is no
longer considered sensitive to impairment.

The fair value of US School Curriculum is 6%, or approximately £59m,

above its carrying value, but an increase of 0.4 percentage points in the

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Unit 4 Company valuation

discount rate or a reduction of 0.5 percentage points in the perpetuity

growth rate would have caused the value in use to fall below the
carrying value.
(Source: Note 11 of the Notes to the Financial Statements in the Pearson plc
Annual Report and Accounts for the year ended 31 December 2009)

The DCF valuation method is widely used by companies and their advisers
when making acquisition or divestment decisions; by venture capitalists and,
increasingly, by equity analysts. Although theoretically more accurate than
simple multiples or adjusted book value, DCF estimation is, however, only
as good as the numbers put into the spreadsheet. It is difficult, when faced
with a set of rising cash flows over time, to be clear where you are making
assumptions that are unrealistic (say, in strategic or economic terms) and
where you are being pessimistic.
As an analyst, you will need to have a good sense for the numbers and the
behaviour of revenues and costs for the sector, company or country you are
examining. This means studying a sector closely – as equity analysts
do – and using your common sense.

Stop and think

You have been asked to value a start-up cable company which is expected
to have heavy capital expenditure over the next five years and not to make a
profit before year 10. Think of at least three possible pitfalls in valuing this
company using a traditional DCF approach.

Discussion
There are many possible pitfalls including the following:

. It is likely that all the positive present value will come from the residual-
value calculation if you restrict the forecasted time horizon to ten years,
making estimation errors very likely.
. The company is not going to be paying tax for at least ten years and
probably longer. Using an after-tax cost of debt in the WACC or after-tax
cost flows for years 1 to 10 would be wrong.
. It is unlikely that the company will use debt finance in the early years, but
will do so later. It is unlikely to have a stable debt/capital ratio.

As you saw in Unit 3, IRR is often used to decide whether or not a project
is worth doing. Some companies, such as start-ups, are essentially single
projects themselves. Firms considering investing in such start-ups, which
typically involve several rounds of financing as the company grows, use
IRR. Just as with projects, there are pitfalls in using IRR, as the following
box shows.

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 Unit 4 Session 3: Discounted cash flow

Internal rate of return

Imagine an investment that requires a payment of $5,000 in year 1 and
then produces positive cash flows of $3,000 in years 2 to 10. At a 10%
discount rate, this project will have a positive net present value of
$11,161 and an internal rate of return of 59%.

Now assume the investor can sell out at a fair value in year 3, receiving
$14,605 (the NPV of the cash flows in years 4 to 10). The project’s
overall NPV remains exactly the same. But the IRR more than doubles
to 120% even though no extra value has been created.

This is hardly news. But all too often, it creeps into practice: IRR is the
private equity industry’s main yardstick for judging performance, raising
funds and rewarding managers. Indeed, the sector makes much of its
superior, 25% returns. Yet as the example shows, such IRR-based
numbers can be artificially boosted by extracting cash early through
trade sales, listings or recapitalisations. Indeed, the theoretical investor
could accept as little as $5,000 in year 3, thereby destroying
considerable shareholder value, and still trumpet an IRR of over 59%.

IRR calculations implicitly assume that interim cash flows are reinvested
at the original IRR. It would be more realistic to assume, as NPV does,
reinvestment at the cost of capital. Because it is intuitive and easy to
calculate, IRR will remain popular. But it should not be used in isolation
and investors should recognise its flaws.

NPV vs IRR during an early exit.

Scenarios:

Investment Years Sale Years NPV IRR

2–3 Year 3 4–10
1 Hold −$5,000 $3,000pa No $3,000pa $11,161 59%
2 Sale at ‘fair −$5,000 $3,000pa $14,605 0 $11,161 120%
value’
3 Sale below ‘fair −$5,000 $3,000pa $5,000 0 $3,944 60%
value’

(Source: Ogier et al., 2004)

Summary
In this session, you have seen how companies, as well as projects, can be
valued using discounted cash flow (DCF) techniques, either at the equity
level (by discounting expected dividends by the cost of equity) or at the
enterprise level (discounting after-tax operating cash flows by the WACC).
The six steps in discounted cash flow valuation were outlined:

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Unit 4 Company valuation

. determine time horizon for specific forecasts

. forecast operating cash flows
. determine residual value
. estimate WACC
. discount cash flows
. prepare related financial statements.

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 Unit 4 Session 4: Valuation in context

Unit 4 Session 4: Valuation in

context
This session looks at the context of valuation. As you will have gathered by
now, after having looked at a number of valuation methods, the value you
get will partly depend on the method you use and partly on the numbers
you use. Another factor, though, is the purpose for which you are valuing a
company. For example, are you a buyer or a seller? You will not be
surprised to learn that sellers typically arrive at larger valuations for the
same company than do buyers. Perhaps you are in the process of making a
competitive tender for a company? Your bid will have to take account of
the likely bids of the competition as well as on the value you have derived.
The value of a company may be very different to two different bidders, for
two reasons.
First, one bidder may be intending to change the financial structure – reduce
the WACC – whereas the other is not. Lowering the WACC will increase
the value. In recent years, leveraged buy-out specialists and private equity
bidders have used aggressive debt levels to outbid the competition. Another
reason why you might attach more value to a company than someone else is
because of the benefits of synergy. This means that the combination of your
company with the company you are bidding for is expected to create greater
cost savings, higher sales or lower inventories than would be the case for
other bidders.
The valuation context will be examined in a number of specific
circumstances:

. regulation
. new issues
. privatisations
. mergers and acquisitions
. restructuring.

Stop and think

Eastern Electricity was created as part of the nationalised British electricity
industry in 1948. It was privatised (floated on the London Stock Exchange) in
1990 and renamed the Energy Group. Hanson Group, a conglomerate,
gained control in 1995 but floated the Energy Group on the LSE again
in 1997. The Energy Group was acquired by a US utility company, Texas
Utilities, renamed TXU, in 1998 and the European assets were renamed
TXU Europe. These European businesses were sold to the British utility,
Powergen, in 2002 with their distribution rights being sold separately to the
French company, EDF Energy, at the same time.

How many times do you think Eastern Electricity has been valued in its
lifetime?

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Unit 4 Company valuation

Discussion
The answer is at least six times: as a nationalised industry for regulatory
purposes; on flotation; when it was acquired by Hanson; when it was
refloated; when it was sold to TXU; and when it was sold to Powergen and
EDF Energy. It is likely that a different methodology was used each time. We
also do not know how many times potential bidders have valued Eastern
Electricity as a potential takeover target.

4.1: Regulation
Eastern Electricity was originally part of the UK’s state-owned electricity
industry and, as such, was regulated as a monopoly. Since the state-owned
sector was the sole provider of electricity in the UK, in theory it could
charge what it wanted, subject to competition from other nationalised
industries such as gas. Utilities such as Eastern Electricity are regulated all
over the world, regardless of whether they form part of the public or state-
owned sector or they are owned by private investors. The traditional way
for UK nationalised utilities to be regulated was for their return on assets to
be monitored, with assets defined in terms of current costs. This meant that
the fact that certain assets went up in value as a result of inflation would be
taken into account in determining notional book value. However, allowance
was also made for depreciation of assets that, although long-lived, did not
necessarily last forever. Return on assets was a key performance measure
and book value was a key valuation input into that.
Utilities such as Eastern Electricity and British Telecom (BT) are still
regulated now that they are, or form part of, listed companies. Although the
regulatory emphasis, in the UK at least, has shifted towards controlling
prices charged and away from return on assets or return on capital
employed, these ratios are still important. For example, BT and its regulator
OFCOM have clashed on whether development expenditure should be
treated as an intangible asset and capitalised on the balance sheet, thus
allowing BT a larger capital base on which to earn a return, or simply
deducted from profits as an expense.

4.2: New issues

When a company comes to the stock market for the first time, such a new
issue is called a flotation or a primary issue or an initial public offering
(IPO). Any subsequent equity issue is called a secondary equity offering
(SEO). The traditional way in which new issues were managed in the UK
was that the shares were offered at a fixed price based on a valuation of the
company as a going concern. Under this system, however, the issue price
was typically below the valuation in order to ensure that the new issue was
a success. The level of success was judged by how much the new issue was
oversubscribed – that is, by how much demand exceeded supply. The price
was agreed between the issuing company, the bank(s) underwriting

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 Unit 4 Session 4: Valuation in context

(guaranteeing) the success of the issue, and the broker(s) to the issue who
advised on market sentiment.
In recent years, US practices have become the norm for new issues in most
countries. Under the US system, prices are not fixed in advance of the issue
date. Instead, banks managing the issue obtain indications of interest from
investors, called book building or book running (and for big issues this
can be on a global basis), and fix the price at the last minute according to
demand. It is argued that this method is better for the issuing company
since shares are issued at a higher price and fewer shares have to be issued
in order to obtain the same proceeds from the sale. However, the book
building system relies heavily on marketing and the typical total charges,
including marketing commissions, for even a large issue worth hundreds of
millions of dollars, amount to at least 5% of the gross proceeds. Each stock
market has certain criteria, which companies have to satisfy before they can
be listed. Listing typically entails additional requirements on companies,
over and above those embodied in legislation. For example, companies
listed on the London Stock Exchange are required to issue interim reports
(for the first six months of the financial year) in addition to the annual
report, whereas unlisted companies are required only to file annual
accounts. In the US, companies listed on the New York Stock Exchange are
required to report results quarterly – this requirement can be off-putting for
those companies whose management and financial accounting systems are
not up to it!
Other listing requirements are concerned with the size and profitability of
companies and with their track record. They may also require at least a
minimum percentage of the equity to be held outside owner–managers’
hands in order to be sure of sufficient trading and hence liquidity in the
shares. Major stock exchanges may require five years of audited accounts
showing profits before they will allow a listing. In recent years, however,
many stock exchanges have developed special markets or deliberately
encouraged start-up companies to list on their exchanges. Thus,
biotechnology companies, for example, with no profits and little in the way
of assets have been able to issue shares on markets such as NASDAQ in the
US or AIM in the UK which have less onerous listing requirements.
Although new shares are often issued at a discount to the value at which
they subsequently trade, one of the more interesting areas of finance
research is what is known as the ‘new equity puzzle’ or the ‘long-run
underperformance’ phenomenon (e.g., see Ritter and Welch, 2002). These
authors found that new issues in the US between 1980 and 2001 – a long
period encompassing both bull and bear markets – had been poor long-term
investments. This applied to both primary (IPO) and secondary (SEO)
issues of shares. They calculated that investors would have earned 23% less Note that the returns are
over a three-year period when investing in an IPO or an SEO compared calculated from the end
with investing in a US stock index and 5.1% less compared with investing of day one of issue,
excluding any new issue
in seasoned companies of the same size and price-to-book ratio.
underpricing.
More recently, this result has been linked to broker research on new issues,
which has been found to be over-optimistic. Analysts then, over the next
few years after a new issue, revise these over-optimistic forecasts down to
more realistic levels. Indeed, in 2002, Merrill Lynch paid a fine of $100m

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Unit 4 Company valuation

in compensation for having published buy recommendations during the

stock market bubble of the late 1990s. Their ‘buy’ recommendations were
for issues promoted by Merrill Lynch which their own analysts privately
believed were worthless (Walter, 2006). There is even more recent evidence
of overpricing of new issues, as shown in the following box.

Investors’ anger rises at poor IPO returns

Investors’ anger over the performance of stock market listings this year
[2010] is rising after the fall of shares in a number of high-profile
offerings below their sale price.

More than half the big initial public offerings in Europe this year are
trading below their issue price, according to data from Dealogic,
prompting claims from institutional investors that companies are being
sold at unrealistic valuations.

Institutional investors complain that investment bankers are siding too

closely with corporate clients on IPOs, advising companies to price
shares at levels that are too high.

While such tensions are a traditional feature of the IPO market and
equity markets in general have slumped this year, the poor record of
some prominent deals in 2010 has been such that it has triggered a
backlash from investors.

‘Investors are sick to the back teeth of being treated like idiots,’ said
Dan Nickols, head of mid- and small-cap equities at Old Mutual Asset
Managers. ‘Companies have been too greedy or misunderstood what
the right price for their float is.’

David Lis, head of UK equities at Aviva Investors, added: ‘Until

investment bankers realise that instead of lining their pockets and those
of their corporate clients, they need to consider what is a fair valuation
for the eventual buyer of their overpriced IPOs, then it is unlikely that
the new issue market can function.’

...

Some bankers worry that the European IPO market will continue to
stutter, given the extent of investor scepticism and concerns about the
economy.

Of the 31 European IPOs this year that have raised more than $100m
(£64.7m), 16 were trading below their issue price by the close of trading
last Friday, according to Dealogic data.

....

The average gain of the shares of all the 31 IPOs this year is 3.76 per
cent.

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 Unit 4 Session 4: Valuation in context

In comparison, the pan-European FTSE Eurofirst 300 index is down 1.9

per cent this year, while the FTSE 100 Index has dropped 3.9 per cent.
(Source: Johnson and Sakoui, 2010)

4.3: Privatisations
A major source of new issues has come from the privatisation of state-
owned companies and the demutualisation of companies previously owned
by their members (e.g., building societies). Privatisation is the transfer of ‘Building societies’ is
state-owned assets or enterprises from governmental to private ownership the UK term for
and control. One of the main reasons for the UK government’s privatisation mortgage banks, or what
Americans call ‘savings
programme was that many UK utilities needed to replace an ageing
and loans’.
infrastructure. Privatisation has the advantage of effectively reducing public
sector debt and at the same time allowing utilities to raise both debt and
equity finance to fund capital expenditure.
Valuation of these utilities depends very much on the terms on which they
were privatised – that is, on the regulatory regime in which they were
required to operate in the private sector. Valuation also depends on utilities’
opportunities to cut costs and increase revenues in changing technological
environments. For example, the restrictions imposed on several utilities
included price rises capped at the rate of inflation less a percentage figure
determined by the state regulator, which in the case of BT was the
telecommunications regulator, OFTEL. This encouraged utilities, such as
BT, to cut costs since there were, in general, no clawbacks of any profits
made by increased efficiencies.
The new-issue valuations applied to the early UK privatisations were based
on the political need to be seen as successes and on their sheer size. They
also reflected the fact that there was little experience in the UK of valuing
utilities, as, until the 1980s-privatisation programme, utilities had not been
listed on the stock exchange since before the Second World War. For these
reasons, the traditional fixed-price flotation method was adopted in most
cases, leading to substantial underpricing of the shares on issue. This could
be seen when the share prices rose within a day of listing to premiums of
sometimes more than 100% over the issue prices.
Banks selling newly
Some other UK privatisations were simply the sale of shares in companies issued Rolls-Royce
that had previously been quoted, but had been rescued by past governments shares approached
Middle Eastern investors
for economic or strategic reasons. An example of this was the privatisation
and were happy to find a
of Rolls-Royce (the aero-engine manufacturer, not the car builder). In such substantial number of
cases, the valuation methods used could reflect the fact that the company people keen to buy the
had previously been run on a commercial, profit-making basis and could shares. It was only later
therefore be compared with similar companies trading on the stock market. that the investors
realised that they were
From the 1990s onwards, there was a move towards privatisation in many investing in aero-engines
countries around the world, encouraged by international bodies such as the and not luxury cars.
International Monetary Fund (IMF). Different governments have chosen What price sophisticated
valuation techniques!
different means of moving their state-owned departments or organisations

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Unit 4 Company valuation

into the private sector, not all of them involving new issues. For example,
after the reunification of Germany, East German companies were privatised
by means of trade sale to other companies, often with an auction process
involving two rounds of sealed bids. This preference for trade sale was
because many companies were not profitable and needed capital investment
and management skills that could only be provided by other companies and
not by a diffuse body of shareholders. The Czech government chose to give
vouchers to its taxpayers, which they either used to buy shares in specific
companies or gave to specially created investment companies to choose and
manage the investments on their behalf. This privatisation route was chosen
because many of the companies for sale were too small to warrant
individual privatisation. The New Zealand government sold some of its
enterprises to foreign-based companies which had expertise in overseas
investment.
Privatised companies have included telecommunications, electricity and road
companies and have been sold to investors around the world. One of the
major consequences of this globalisation of equity issues has been a trend
towards standard methods of valuation, notably market multiples such as
EV/EBITDA and also discounted cash flow. Privatisation is still taking
place in a number of countries. For example, the following box discusses
the Australian government’s U-turn on privatisation of toll roads, partly
driven by the need to improve the government’s credit rating. It highlights
some of the complex issues that arise when considering the value of the
privatisation to taxpayers.

Bligh backs away from toll road sell-off

The Bligh government has backed out of the second-biggest tranche of
its privatisation program, citing a soft market for its toll roads.

Premier Anna Bligh and Treasurer Andrew Fraser yesterday said

Queensland Motorways (QML) would no longer be sold on the open
market, but would be transferred to the government-owned Queensland
Investment Corporation (QIC).

The decision comes three days after the successful stockmarket launch
of Queensland Rail, whose privatisation netted the government $4.6bn.

Mr Fraser said the government had withdrawn Queensland Motorways

from the market because toll-road investment was ‘soft’, despite
approaches by parties interested in buying the toll roads.

The government and QIC will now enter talks to establish a sale price,
after an initial Treasury valuation for Queensland Motorways – which
consists of two motorways that link the Gold and Sunshine coasts and
skirt the eastern suburbs of Brisbane – of $3bn.

Ms Bligh called the deal a ‘win-win situation for Queensland taxpayers’.

She said it would maintain the government’s asset sales program,

designed to reduce debt, and provide a good acquisition for the QIC,
owned by the Queensland government.

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 Unit 4 Session 4: Valuation in context

‘It means the motorways will stay in public hands while at the same
time working towards our goal of regaining the AAA credit rating as
soon as we can,’ the Premier said.

The main purpose of the privatisation program is to reduce debt and

allow the state to regain its triple-A credit rating, and Mr Fraser said he
was confident ratings agencies would approve the decision.

The privatisation of QR National – Queensland Rail’s coal-carting

division – was the biggest asset for sale under the program.

Standard & Poor’s analyst Anna Hughes said the ‘dust needs to settle’
on the privatisation program before any moves to revalue Queensland’s
credit rating.

QML was to be the final asset sold in the privatisation program, and
was due to be placed on the market next year and sold before the next
Queensland election, which is due before March 2012.
(Source: Fraser, 2010)

4.4: Mergers and acquisitions

A merger is the result of two or more companies (or indeed other
economic entities, such as trade unions, housing associations, charities, etc.)
of similar scale coming together to form a single entity. Mergers require the
consent of all the entities concerned since they cease to exist as separate
entities on merger, becoming, instead, a single merged entity.
An acquisition is the result of the assumption of the assets or the business
of an economic entity by another, where the acquired entity usually survives
as a separate operation, perhaps a fully owned subsidiary of the acquirer.
Takeover is simply another word for acquisition. Note that, unlike mergers,
acquisitions do not always have to be accepted by managers. If there are
voting shareholders, for a listed company, or voting policyholders, for a
mutual insurance company, the company or entity can be sold over the
heads of the existing management. Managers may fight off a takeover bid,
even though it represents value for shareholders, because they are reluctant
to lose control.
Until recently, the most common form of combination for companies was
the full or partial takeover of one company by another. Although the term
mergers and acquisitions (often shortened to M&A) had been used for
decades, many people had never seen a true corporate merger. The late
1990s, however, changed all that with huge mergers, such as those between
two Swiss pharmaceutical companies, Sandoz and Ciba-Geigy, to form
Novartis; between two accounting partnerships, Coopers & Lybrand and
Price Waterhouse, to form PricewaterhouseCoopers; and the $166bn merger
of Citibank and Travelers Group to form Citigroup, a financial services
company with 100 million corporate and retail customers in over 100
countries. The common theme behind all these mergers was that, as markets

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Unit 4 Company valuation

have become global, so companies need to have sufficient size to operate in

this larger marketplace. The less publicised rationale was cost savings from
removal of duplication in a number of product areas, countries and central
services operations. However, the trend towards conglomerates is not always
viewed with equanimity.

Korean firms expand like ‘octopus tentacles’

The number of 30 conglomerates’ affiliates broke the 1,000 mark for the
first time last year, an online portal reported on Monday.

There are escalating concerns over the conglomerates’ wayward

expansion in areas that have nothing to do with their core businesses.

According to Chaebul.com, an online portal that specializes in

information concerning large businesses and family-owned
conglomerates, the number of affiliates owned by the nation’s top 30
companies by assets reached 1,069 as of the end of last year, up 78
from the previous year.

The number of their units stood at 702 in 2005, followed by

764 in 2006, 847 in 2007 and 969 in 2008 before recording
991 in 2009, meaning that the number gained 50% in the five-year
period.

The nation’s top 10 conglomerates, to no surprise, led the increase, as

they accounted for 51.2% of the surge after their affiliates grew from
350 to 538 in the cited period.

Observers attribute the sharp jump to a flurry of mergers and

acquisitions (M&As) on the back of President Lee Myung-bak’s
business-friendly policy after the government abolished regulations that
prevented major firms from expanding their operations into some
business fields in 2009.
(Source: Kang Seung-woo, 2011)

The economic rationale for a merger or acquisition is that A and B

combined will be worth more than A on its own and B on its own. There
are a number of possible reasons for this phenomenon, known as synergy,
which can come from benefits derived from vertical integration, horizontal
integration, technology, process or brand capture, improved management,
cost savings through economies of scale, critical mass, and so on. A further
motive for mergers, popular in the 1970s and 1980s, was the opposite
reason to synergy – diversification. This was the time when tobacco
companies diversified into food manufacturing and car companies went into
insurance. What was not appreciated at the time was that, since shareholders
can diversify by buying shares in different sectors, there is no need for
companies to do it for them.
Financial motives for mergers and acquisitions are also relevant. In the
1980s, acquirers attempted to enhance earnings per share by acquiring

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 Unit 4 Session 4: Valuation in context

companies with lower PE ratios. Provided investors applied the same PE

ratio to the larger entity as they had to the acquirer – in other words,
provided that they were fooled – value was added as if by magic! In the
1990s, a main motive for takeovers was to add value through increasing the
debt/capital ratio and thereby reducing the WACC. The same cash flows,
discounted by a lower WACC, became worth more. As a result, there was a
boom in what were then known as ‘leveraged buy-outs’. Private investment
vehicles, using bank loans or bonds to provide the debt, took publicly listed
companies private. In the 21st century, the trend is for private equity and
venture capital funds to acquire companies and enhance value through
better management and more cost-effective financing.
If there are synergy benefits to a merger or takeover, whether economic,
strategic, or purely financial, these should be quantified and included in the
valuation. For example, cost savings of £100m a year for five years can be
discounted using the WACC to provide a net present value. Alternatively, if
the acquirer has access to a lower WACC, the acquiree will be worth more,
even if there are no cost savings. The value of a company as a standalone
concern is likely to be different from its value as a subsidiary or merged
entity. In addition, the bidding process for a company will also affect the
price.
For example, a company may be put up for sale because a large company
had decided that it no longer wants to be in the business of a subsidiary.
The advisers to the selling company will put together an offering
memorandum, giving financial and other details on the company to be sold.
Potential bidders can then put in a non-binding bid. This first-stage process
will identify serious purchasers and eliminate the rest. The second stage
gives potential bidders access to more information, but they then have to
put in sealed bids. This part of the process requires bidders to think not
only of the standalone value of the target company and of the value to
them, but also of the value to the competing bidders. Competitive bids such
as these and also hostile bids via the stock market should be just high
enough to see off the competition, but not so high as to give the seller all
the synergy benefits. Once a bid has been accepted, the buyer signs a letter
of intent to purchase, subject to what is known as ‘due diligence’, which is
where financial advisers, such as accountants, go into the target company
and check that there are no hidden problems. The final contract signed
between buyer and seller will try to deal with any problems, such as
contingent liabilities, unpaid debts, and so on. The purchase price may even
be in several elements, with later payments linked to performance.
An alternative valuation process takes place when companies are acquired
on the stock market. Bids can either be agreed or hostile. If agreed, this
means that the directors of the target company have approved both the
potential acquirer and the price to be paid for the shares. If hostile, the
would-be acquirers make a direct approach to shareholders, bypassing the
directors. It is unusual for directors to agree to a bid immediately, since
directors have a duty to extract the best possible price for shareholders,
even if they believe that the company should be sold. They may try to
encourage a second bidder to raise the value of the offer. Directors do not
always manage to do this though. And sometimes mergers just do not

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happen, denting the reputations of the CEOs involved, as with BHP Billiton
and Rio Tinto described in the following box.

Not a surprise
Rio Tinto’s proposed joint venture with rival BHP Billiton has finally
crumpled, to the surprise of almost no one. The deal, which would have
combined the two-biggest iron producers in Western Australia’s Pilbara
region, fell foul of regulators. After more than a year of uncertainty, Tom
Albanese, Rio’s chief executive, may be relieved. But the drama has
not helped his credibility.

Mr Albanese first agreed to enter a tie-up with BHP when his company
was laden with heavy debts in June 2009. Rio was on the defensive,
and the terms of the proposed venture showed that. Rio, which had
previously rejected a merger proposal from BHP, even gave its rival the
right to nominate the venture’s first chief executive.

While Rio publicly stood by the plan, the company’s shareholders seem
to have lost faith a while ago. In the hours after the deal was formally
terminated, the combined market capitalization of Rio and BHP fell by
around $4bn, far less than the $10bn in savings the companies
expected to make. The amount that investors in Australia wiped off
BHP’s market value after the news was five times greater than the loss
suffered by Rio, suggesting that they felt the joint venture would have
done much less for Rio than for BHP.

Moreover, antitrust watchdogs flatly rejected Rio’s claims that the deal
would not harm competition. Mr Albanese had argued that the deal
structure meant that the two sides would be unable to collude on the
price of iron ore. Regulators in Korea, Europe, Japan and even
Australia disagreed.

Shareholders have plenty to give them solace. Rio’s growth prospects

look strong. Questions remain over projects in Mongolia and the
Simandou iron ore deposit in Guinea. Still, if these projects do
materialize, Rio should have even more momentum.

That should be enough to keep Mr Albanese in his role. But he has

botched three big deals since his tenure began: an overpriced merger
with Alcan of Canada, an abortive attempt to sell shares to the Chinese
mining company Chinalco, and now the terminated BHP tie-up. So he
might do well to stick to the basics for a while.
(Source: Currie et al., 2010)

Valuing a target company

In a hostile bid, making an appropriate valuation is more difficult than in
competitive tendering. Although the target has a share price which, in an
efficient market, should reflect its value as a standalone company, rumours

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 Unit 4 Session 4: Valuation in context

of potential takeovers may already be in the price and these will have to be
excluded. In contrast, the synergy benefits can be added to the share price
to give the maximum amount the bidder can afford to pay.
Therefore:

Maximum price to be paid = current share price – any bid premium

already in share price + synergy benefits

A bidder has to take account of whether the bid is likely to be immediately

successful or not. If the initial bid is too low, this could draw in other
bidders and may lose the target. If it is too high, the synergy benefits will
be wasted. One thing is certain: the bidder will have to pay a premium to
the current share price to tempt shareholders to accept. Bid premiums can
go as high as 50% or more in a bull market. The M&A business involves
negotiation skills as well as valuation skills. The median bid premium paid Remember that a median
for listed European companies between 1990–2009 has, apart from a spike premium means that
in 1992 and again in the dotcom boom of the late 1990s, been steady at 50% of deals will have
been at a premium less
between 20% and 30%. So, the economic benefits have to be greater than
than the median and
this for the acquisition or merger to be worthwhile. Many firms, such as 50% of deals at a
RBS when it bid for ABN Amro, are over-optimistic about the synergy premium more than the
benefits; this explains why over 50% of acquisitions do not make money for median.
the acquirers. One possible argument is that the acquirer would have lost
more had they not made the acquisition!
An additional factor to consider is the method of payment. Paying equity
for a company is, given the cost of equity, an expensive means of payment.
It also has the effect of transferring some of the synergy benefits to the
selling shareholders. They, too, will benefit in any future growth. The use of
debt is now more common, for a number of reasons. First, interest rates
have been very low, which, with the tax advantage of debt, leads to a very
low WACC and hence high valuation. Second, debt has the advantage that it
can be secured on the assets of the business to be acquired and secured debt
is even cheaper than unsecured debt. Third, buying and selling companies
has become easier. This has led to an increase in private equity and venture
capital firms, using money raised from institutional or large private
investors, seeking high returns from leveraged deals. These firms do not
usually have listed shares that can be used as payment for companies.
Instead, they use their own funds, plus bank debt, to buy the companies
they intend to sell at a profit in a few years’ time.

Does M&A add value?

There is a substantial academic literature on whether or not mergers and
acquisitions add value for the shareholders concerned. A large number of
studies have been carried out in a wide range of countries and the overall
results are that there are synergy benefits – in other words A plus B is
worth more than A and B alone. However, the shareholders who benefit are
more likely to be the selling shareholders than those of the acquirers.
Given the weight of evidence against the benefits of takeovers, why do
companies persist in making acquisitions? There is some evidence (see, for
example, Shleifer and Vishny, 2003; Savor and Lu, 2009) of the existence

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Unit 4 Company valuation

of merger waves or cycles. In this pattern, companies grow because of

economic booms and market expansion. A point is then reached where
growth expectations of investors can no longer be met solely from the
organic growth of products or services. Companies may also be benefiting
from strong cash flows at this stage of the cycle and further investment in
projects may not yield the required rate of return. At this point, companies
consider either a major expansion in the same sector, or a new one, and
adopt the merger or acquisition route. Once started, the size of the
acquisitions or mergers has to increase continually in order to satisfy
investors’ required rates of return. The company then reaches a size and
diversity of businesses which makes both analysis and cost savings difficult
to achieve. It then becomes a break-up candidate, until the merger wave
begins all over again. Merger waves are therefore fuelled by easy debt (if
funded by debt), rising equity markets (making the acquirer’s equity stretch
further) and periods of economic growth. They are also fuelled by stock
market inefficiency and possibly the lack of good alternatives.

4.5: Restructuring
This section looks at valuation in the more general context of restructuring.
Behind such moves lies the idea of releasing value back to shareholders.
For example, as you saw in Unit 2 Session 4, share repurchases and altering
the debt/capital ratio could affect value. There are, however, ways in which
altering the ownership of companies can add value. For example,
conglomerates, as you have already seen in this session, may have difficulty
in maximising shareholder value. This can be because different elements of
a company will be valued differently (owing to different growth prospects
and levels of profitability). Shareholder value may be maximised by
spinning off an undervalued subsidiary or breaking up the conglomerate
altogether.
An alternative to companies restructuring is for financiers to do it for them.
Leveraged buy-outs first became popular in the 1980s. A bank, or specialist
company, uses its own finance, plus bank debt, or bond finance, to fund the
buy-out and then refinance the deal or sell on the company to realise a
profit. Today, equity funds and the financing expertise for such deals are
provided by venture capital firms (for start-ups) or private equity firms (for
existing companies). Private equity firms such as Blackstone and Advent
International are proactive. They analyse sectors and companies looking for
suitable restructuring candidates. No company is safe, however large.
Capital structure is behind another reason for restructuring. After the 2008–
9 global financial crisis, many companies – especially banks – found that
A fire sale is a they had too much debt and were forced into a fire sale of some of their
picturesque term for a subsidiaries in order to pay back debt. One such example is Terra Firma, the
forced sale. private equity group, which paid a high price for EMI but lost control of the
music group to its major creditor, Citigroup, in 2011. Citigroup then began
a fire sale of EMI’s assets. Another example is the fire sale of Bear Stearns,
which was one of the first US banks to suffer in the 2008–9 global financial
crisis, to JP Morgan, the US investment bank, encouraged by the US

74
 Unit 4 Session 4: Valuation in context

government. In the UK, Lloyds, encouraged by the Prime Minister, took

over the ailing bank HBOS in January 2009.

Stop and think

What do you think is the impact of a fire sale on valuation?

Discussion
In practice, announcing that you wish to sell subsidiaries because you are in
financial difficulties gives the buyers the upper hand when it comes to how
much they are prepared to offer. Barclays made such a mistake when it sold
off its asset management (fund management) subsidiary in 2009 to
BlackRock to form BlackRock Global Investors.

Management buy-outs (MBO)

Another form of restructuring is that of a management buy-out, when the
management of a subsidiary offers to buy the subsidiary from the group. In
such cases, the deals are highly leveraged because managers do not have
substantial assets. An existing management team purchasing an entity is
known as a management buy-out (MBO), a new team coming in with
financial backing is a management buy-in (MBI).
MBOs and their related transactions are generated by such circumstances
as:

. a chief executive who owns a private company and wishes to retire

. a listed company that is underperforming
. a company put into liquidation with the receivers selling it to the
managers
. a group seeking to divest itself of an underperforming operation or of a
subsidiary no longer deemed an appropriate business to be in after a
strategic appraisal.
Often the management will not have sufficient personal wealth to buy the
entity from their own resources, so they will seek the assistance of venture
capitalists, or specialist buy-out fund managers. In return for a share in the
company, these providers of funds will put up the greater part of the money
for the purchase, while holding a lower portion of the equity. This allows
the management to have an incentive to generate positive results while
sharing in the rewards as enhanced equity holders. The managers are
encouraged to put in as much as they can afford, often borrowing
substantially in a personal capacity to increase their individual
shareholdings. They are highly motivated to see that the operation succeeds,
even though in the scale of things they may be the smallest investors. In
valuation terms, however, there may be a conflict of interest. For example,
if managers have formed part of a large group and have been aware of the

75
Unit 4 Company valuation

possibility of making an MBO, they may well be tempted to make the

accounting numbers look poor before approaching the board with an offer.
Just as there is a paramount need for a robust financial plan in merger and
acquisition activity, so too in MBO activity, the plan should be tested to
ensure all possibilities are considered. Very often, MBOs focus on cost-
cutting as a source of improved performance, but experienced investors will
know that there is a balance to be struck between the cost paring and
reinvestment needs. Many celebrated MBOs that ran into trouble did so
because investment was underestimated, due to a lack of foresight
concerning industry changes.
After a buy-out, a company is not listed on a stock exchange. This means
that financiers, with a time horizon of no more than, say, five years to
getting a return, will look to a flotation or a trade sale to crystallise their
expected profit.
Private equity firms have taken over from management in taking companies
private. They may give management a financial incentive to stay on and
grow the business but private equity firms have the advantage of sources of
finance and expertise across a number of deals as to how best to manage the
process.

Summary
This session looked in more detail at different situations in which company
valuation plays a major role. These were:

. regulation
. new issues
. privatisations
. mergers and acquisitions
. restructuring.
The aim was to show how valuation is carried out in practice. In the section
on regulation, you saw how book value was a major input in estimating
return on capital employed for regulated sectors. In the sections on new
issues and privatisations, you saw how market multiples played a major role
and how global privatisations, managed by US investment banks, have
introduced new multiples based on enterprise value and on cash flow. The
section on mergers and acquisitions showed that discounted cash flow was
the major valuation approach, although it would appear that any cash flows
generated from synergies are paid to the sellers rather than retained by the
bidders. Finally, the pressures on companies to restructure and to add value
through divestments such as management buy-outs were considered.

76
 References

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78
 Acknowledgements

Acknowledgements
Grateful acknowledgement is made to the following sources:

Cover
Cover image: Speedometer with Red Dashboard-Vehicle
© iStockphoto.com © teekid.

Figures
Figure 4.1.1: Gregory, A. (1992) ‘Definitions of value’, Valuing
Companies: Analysing Business Worth, Woodhead-Faulkner.
Figure 4.2.1: Bloomberg LP (2011) ‘Bloomberg GIP graph to show intra-
day volatility’, Bloomberg Financial LP. Used with permission of
Bloomberg Finance LP.

Illustrations
Page 10: Financial newspaper series. © iStockphoto.com. Pali Rao.
Page 10: Gross, S. (1990) A sunk cost? With kind permission of Sam
Gross.
Page 19: ‘However, under another accounting procedure...’ Dana Fradon.
Page 33: Burberry – model on the catwalk. © Rex Features.
Page 52: Global Warming Images. Alamy.
Page 54: Tray of test tubes. © John Smith/Corbis.
Page 58: Photo of cash mountain e.g. piles of coins. © PhotoDisc.

Tables
Table 4.1.1: Pearson (2009) ‘Consolidated balance sheet’, Annual Reports
and Accounts 2009. Pearson PLC. With kind permission.
Table 4.1.2: Ted Baker London (2010) ‘Consolidated balance sheet as at 30
January 2010’, Reports and Accounts 2009–2010, Ted Baker PLC.
Table 4.2.2: Pearson plc (2009) ‘Annual report and accounts 2009’, Pearson
plc. With kind permission.
Table 4.2.3: Financial Times (2010) ‘United Kingdom Sector PE Ratios’,
FT Actuaries Share Indices, 31 December. © Thomson Reuters. All rights
reserved. Republication or redistribution of Thomson Reuters content,
including by framing or similar means, is expressly prohibited without the
prior written consent of Thomson Reuters. Thomson Reuters and its logo
are registered trademarks or trademarks of the Thomson Reuters group of
companies around the world. © Thomson Reuters 2010.
Table 4.2.4: Pearson plc (2009) ‘Annual report and accounts 2009’, Pearson
plc. With kind permission.
Table 4.2.6: Imam, S., Barker, R. and Clubb, C. (2008) ‘The use of
valuation models by UK investment analysts’, European Accounting
Review. Copyright © European Accounting Association reprinted by
permission of (Taylor & Francis Ltd, http://www.tandfonline.com) on behalf
of European Accounting Association.

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Unit 4 Company valuation

Text
Pages 16–7: Evans, M. (2010) ‘Putting it on the books: Proposed rules
wouldn’t allow hospitals to keep leases off balance sheets’, Modern
Healthcare, July 12, Crain Communications Inc. (MI). Reprinted with
permission, Modern Healthcare 2010. © Crain Communications, Inc.
Pages 17–8: O’Grady, S. (2010) ‘Britain’s heavy burden of off-balance-
sheet liabilities is revealed’, The Independent, 14 July 2010. © The
Independent.
Pages 24–5: Steverman, B. (2010) ‘Probe unlikely to change insider trading
rules’, Businessweek.com. Bloomberg.
Pages 39–40: Copeland, T., Koller, T. and Murrin, J. (1997) ‘Cash is King
(Cash Flow)’, Financial Times, 27 December 1997. From the Financial
Times © [The Financial Times Limited 1997]. All Rights Reserved.
Pages 41–2: Bawden, T. (2010) ‘Europe’s biggest companies sitting on
£445bn cash’, The Guardian, November 30. Copyright Guardian News &
Media Ltd 2010.
Pages 54–6: Griffith, V. (2003) ‘The biotech dilemma: cash-rich product-
poor’, Financial Times, 4 March 2003. From the Financial Times © [The
Financial Times Limited 2003]. All Rights Reserved.
Pages 58–60: Pearson plc (2009) ‘Annual report and accounts 2009’,
Pearson plc. With kind permission.
Pages 61: Ogier, R. and Rugman, J. (2000) ‘Internal rate of return’, The
Financial Times, 1 June 2000. From the Financial Times © [The Financial
Times Limited 2000]. All Rights Reserved.
Page 66–7: Johnson, M. and Sakoui, A. (2010) ‘Investors’ anger rises at
poor IPO returns’, Financial Times, 30 August 2010. From the Financial
Times © [The Financial Times Limited 2010]. All Rights Reserved.
Pages 68–9: Fraser, A. (2010) ‘Bligh backs away from toll road sell-off’,
The Australian, 26 November. News Limited.
Page 70: Seung-woo, K. (2011) ‘Some big firms expand like “octopus
tentacles”’, Korea Times, 17 January 2011. Korea Times.
Page 72: Currie, A., Foley, J. and Galani, U. (2010) ‘Citi’s good news
proves reassuring’, The New York Times, October 18. © Thomson Reuters.
All rights reserved. Republication or redistribution of Thomson Reuters
content, including by framing or similar means, is expressly prohibited
without the prior written consent of Thomson Reuters. Thomson Reuters
and its logo are registered trademarks or trademarks of the Thomson
Reuters group of companies around the world. © Thomson Reuters 2010.
Every effort has been made to contact copyright holders. If any have been
inadvertently overlooked the publishers will be pleased to make the
necessary arrangements at the first opportunity.

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