Chapter 19:

Business Valuations and

Market Efficiency

Presented by:
Margarita Kouloumbri
Chapter Map
1
8 Valuing Business
Types of and Financial
efficiency Assets
2
7 Valuing Shares-
The Efficient The DVM
Market
Hypothesis
(EMH)
Contents
6 3
Market
Asset Based
Efficiency
Valuations
5
Valuation of
debt and 4
preference Income/earnings
shares based models

Busness Valuations and Market Efficiency 2

1 Valuing Business and Financial
Assets
Valuation of shares in quoted and unquoted
companies are needed…..

Busness Valuations and Market Efficiency 3

1 Valuing Business and
Financial Assets
 The 3 main approaches to valuation of businesses
are:
1. DVM: based on the return paid to a shareholder
2. Income/earnings based: based on the returns
earned by the company
3. Asset based: based on the tangible assets owned
by the company.

Busness Valuations and Market Efficiency 4

1 Valuing Business and
Financial Assets

IMPORTANT NOTE!!
 Valuation is an art of science!!
Different valuations will give
different results
Market Capitalization=
 The final figure will be a No of shares x Share
matter for negotiation between Price
the interested parties

VALUATION IS
SUBJECTIVE

Busness Valuations and Market Efficiency 5

1 Valuing Business and
Financial Assets
 Useful Information when valuing a business:
 Financial Statements
 Supporting Listings ( e.g. non current asset
register, ageing of accounts receivable, inventory
summary)
 Details of existing contracts (e.g. leasing)
 Budgets or projections for the future
 Background information on the industry and key
personnel
 Limitations: unrealistic, subjective or
overoptimistic information
Busness Valuations and Market Efficiency 6
2 Valuing Shares- the DVM
The model states
that the value of a
business is the PV
of the expected
future dividends
discounted at the
shareholders’
required rate of
return

Busness Valuations and Market Efficiency 7

0

2 Valuing Shares- the DVM

Assumptions of dividend model
 Investors act rationally and homogeneously – the
model fails to allow for different expectations of
shareholders
 The dividend is representative of the trend in
dividends in the past few years
 The estimates of future dividends and cost of capital
are reasonable
 Investors’ attitudes to receiving different cash flows
at different times can be modeled using discounted
cash flow arithmetic
Busness Valuations and Market Efficiency 8
2 Valuing Shares- the DVM
Assumptions of dividend model(continued)
 Directors use dividends to signal the strength of the company’s
position – however, companies that pay zero dividends do not
have zero share values!
 Dividends either show no growth, or constant growth
 Share prices are only influenced by the company’s dividend
policy
 The company’s earnings will increase sufficiently to maintain
dividend growth levels
 The discount rate used exceeds the dividend growth rate

Busness Valuations and Market Efficiency 9

2 Valuing Shares- the DVM
Example 1: Christian Dior has the following
financial information:
Share Capital in issue: 2m ordinary shares at par
value $1
Current dividend per share (just paid): 18c
Current EPS :25c
Current return earned on assets 20%
Current equity beta: 1.1
Current market return: 12%, risk-free rate: 5%
Find the market capitalization for CD Ltd.
Busness Valuations and Market Efficiency 10
2 Valuing Shares- the DVM
Solution to Example 1:

Busness Valuations and Market Efficiency 11

2 Valuing Shares- the DVM
Solution to Example 1:

Busness Valuations and Market Efficiency 12

3 Asset based valuations
 The net assets valuation method : can be use to set the lower
limit for the value of a company. Unlikely to produce the most
realistic value.

 The value of an ordinary share is equal to the net tangible

assets attributable to ordinary shares, divided by the number
of ordinary shares. Intangible assets like goodwill should be
excluded, unless they have a market value (e.g. patents and
copyrights which can be sold).

Busness Valuations and Market Efficiency 13

3 Asset based valuations
 The values of the assets included in this method of valuation
should be as realistic as possible, but this may vary
considerably depending on the assumptions we make when
valuing them:
 is the company operating as a going concern? (net
replacement cost basis)
 is the business being broken-up? (net realizable value basis)
 does the company’s Balance Sheet reflect its true state of
affairs? (historic basis – this is unlikely to give a realistic
value as it depends on the company’s depreciation and
amortization policy)

Busness Valuations and Market Efficiency 14

3 Asset based valuations
Weaknesses 
•Investors do not normally buy a company for its balance
sheet assets but for the earnings/cash flows that all of its
assets can produce in the future
•We should value what is being purchased i.e. the future
income/cash flows
•Ignores non balance sheet intangible assets (workforce,
strong management team, market share)

When asset valuations are useful?

For asset striping
To identify a minimum price in a takeover

Busness Valuations and Market Efficiency 15

3 Asset based valuations

Busness Valuations and Market Efficiency 16

3 Asset based valuations
Example 2:
The following is an arbitrage version of the statement
of financial position of Chanel Ltd, an unquoted
company as at 30th April X6.

Busness Valuations and Market Efficiency 17

3 Asset based valuations

Busness Valuations and Market Efficiency 18

3 Asset based valuations
Solution to Example 2:

Busness Valuations and Market Efficiency 19

3 Asset based valuations
Solution to Example 2:

Busness Valuations and Market Efficiency 20

4 Income earnings based methods
 Very useful when measuring a majority
shareholding:
 Ownership has additional benefits that are not reflected
in the DVM model
 Majority Shareholders can influence the Dividend
Policy so they are interested in earnings.
 P/E Ratio:If the P/E ratio is MV
EPS then
MV = EPS x P/E ratio

Busness Valuations and Market Efficiency 21

4 Income earnings based methods
What is the significance of the P/E ratio?
 expectations that the EPS will grow rapidly – that is a high
price is being paid now for future profit prospects.

 security of earnings (lower business risk)

 status – a quoted company is always taken to be a lower-risk

company, and in addition its shares are more marketable, since
there is a ready market for them to be sold in (the P/E ratio of
an unquoted company’s shares might be around 50%-60% of
the P/E ratio of a similar public company with a full Stock
Exchange listing).
Busness Valuations and Market Efficiency 22
4 Income earnings based methods
Problems with using P/E ratios

 it is difficult to find a quoted company with a similar range of

activities with an unquoted company – quoted companies are
often diversified
 a P/E ratio is a single year indicator, and it may not be a good
basis if the earnings of the company are volatile, or if the
current year has not been a ‘normal’ year
 if a P/E ratio trend is use, then historical data will be used to
value how the unquoted company will do in the future!
 the quoted company may have a different capital structure to
the unquoted company
Busness Valuations and Market Efficiency 23
4 Income earnings based methods

Busness Valuations and Market Efficiency 24

4 Income earnings based methods
HIGH P/E LOW P/E
RATIO
RATIO: •Losses
•Growth Stock( share
expected
price is high because high
growth rates of earnings •Share price is
are expected) low
•No growth Stock
•Takeover bid
•High security price

Busness Valuations and Market Efficiency 25

4 Income earnings based methods
Example 3:
You are given the following information
regarding Estee Lauder, an unquoted company.
You are required to value 200,000 shares in Estee
Lauder on a PE ratio basis.

Busness Valuations and Market Efficiency 26

4 Income earnings based methods

Busness Valuations and Market Efficiency 27

4 Income earnings based methods
Solution to Example 3:

Busness Valuations and Market Efficiency 28

4 Income earnings based methods
Earnings Yield

Busness Valuations and Market Efficiency 29

4 Income earnings based methods
Example 4:
Clinique Ltd has earnings of $300,000. A similar
listed company has an earnings yield of 12.5%.
L Oreal has earnings of $420,500. A similar listed
company has a PE ratio of 7.
Calculate the Value of each company.

Busness Valuations and Market Efficiency 30

4 Income earnings based methods
Solution to example 4:

Busness Valuations and Market Efficiency 31

4 Income earnings based methods

Busness Valuations and Market Efficiency 32

4 Income earnings based methods
Example 5:
Lancôme Ltd:
 Sales: $200m, Cost of sales: $110m

 Admin and Distribution Expenses: $20m

 Tax allowable depreciation: $40m

 Annual Capital Spending: $50m

 Tax: 30%, Current Value of debt: $17m

 WACC: 14,4%, Inflation: 4%

 These cash flows are expected to continue every year for the
foreseeable future
Calculate the value of equity
Busness Valuations and Market Efficiency 33
4 Income earnings based methods
Solution to Example 5:

Busness Valuations and Market Efficiency 34

4 Income earnings based methods
Solution to Example 5:

Busness Valuations and Market Efficiency 35

4 Income earnings based methods

Busness Valuations and Market Efficiency 36

5 Valuation of debt and preference
shares

RECAP
FROM
CHAPTER
18!!

Busness Valuations and Market Efficiency 37

5 Valuation of debt and
preference shares
Example 6: Valuation of Convertible Debt
Yves Saint Laurent Ltd has in issue convertible loan
notes with a coupon rate of 12%. Each $100 loan note
may be converted into 20 ordinary shares at any time
until the expiry and any remaining loan notes will be
redeemed at $100. The loan notes have 5 years left to
run. Investors will normally require a return of 8%pa
on a five year debt security.
Should the investors convert if the current share price
is: (a) $4.00 (b) $5.00 ( c ) $6.00

Busness Valuations and Market Efficiency 38

5 Valuation of debt and preference
shares

Solution to Example 6:

Busness Valuations and Market Efficiency 39

5 Valuation of debt and preference
shares

Solution to Example 6:

Busness Valuations and Market Efficiency 40

 5 Valuation of debt and
preference shares
 Example 7: Convertible Debt Calculations
Maxfactor Co has in issue 8% bonds which are redeemable at their par
value of $100 in three years time. Alternatively, each bond may be
converted on that date into 30 ordinary shares of the company.
The current ordinary share price of Maxfactor is $3.30 and this is
expected to grow at 5% per year for the foreseeable future.
Maxfactor has a cost of debt of 6% per year.
Required:
Calculate the following current values for each $100 convertible bond:
(i) Market Value
(ii) Floor Value

(iii) Conversion Premium

Busness Valuations and Market Efficiency 41

5 Valuation of debt and preference
shares

Solution to Example 7:

Busness Valuations and Market Efficiency 42

5 Valuation of debt and preference
shares

Solution to Example 7:

Busness Valuations and Market Efficiency 43

5 Valuation post take over
 It may be necessary to estimate the value of a company
following a take over.
 When estimating the effect of the take over on the total value
of the company and on the value per share we should consider:
1. Synergy- any synergy arising from the takeover would
be expected to increase the value of the company

2.The method of financing the take over. If cash used to

finance the takeover the value of the company will be
expected to fall by the amount of cash needed. If shares
are used to finance the takeover then the extra shares
issued need to be taken into account when calculating the
value per share.
Busness Valuations and Market Efficiency 44
5 Valuation post take over
Example 8:

Busness Valuations and Market Efficiency 45

5 Valuation of debt and preference
shares

Solution to Example 8:

Busness Valuations and Market Efficiency 46

5 Valuation of debt and preference
shares

Solution to Example 8:

Busness Valuations and Market Efficiency 47

6 Market Efficiency
THE
CONCEPT!!!

Busness Valuations and Market Efficiency 48

6 Market Efficiency

Busness Valuations and Market Efficiency 49

7 The Efficient Market
Hypothesis

Money and Capital Markets and Market 50

Efficiency
7 The Efficient Market
Hypothesis
In an efficient market:
 The prices of securities bought and sold reflect all the relevant
information which is available to buyers and sellers. Share
prices change quickly to reflect all new information about
future prospects.
 No individual dominates the market.
 Transactions costs of buying and selling are not so high as to
discourage trading significantly.
NOTE: IF THE STOCK MARKET IS EFFICIENT,
SHARE PRICES WILL REFLECT ALL AVAILABLE
INFORMATION!!!!

Money and Capital Markets and Market 51

Efficiency
7 The Efficient Market
Hypothesis
Benefits of an efficient market:
 Ensure investor’s confidence
 Reflect Director’s performance in the share price

There are 3 forms of market efficiency:

Money and Capital Markets and Market 52

Efficiency
8 Types of Efficiency
WEAK FORM

Money and Capital Markets and Market 53

Efficiency
8 Types of Efficiency
WEAK FORM

WEAK FORM
Share Prices only change when
new information about a company
and its profits have become
available. They DO NOT change
in anticipation of new information
being announced.

Money and Capital Markets and Market 54

Efficiency
8 Types of Efficiency
WEAK FORM
 Information: All past price movements are already
incorporated into the share price.
 Evidence: Share prices follow a random walk, there
are no patters or trends, prices fall depending on
whether the new information is good or bad

 Conclusion: FUTURE PRICE MOVEMENTS CAN

NOT BE PREDICTED FROM PAST PRICE
MOVEMENTS!!!

Money and Capital Markets and Market 55

Efficiency
8 Types of Efficiency
SEMI STRONG FORM

Money and Capital Markets and Market 56

Efficiency
8 Types of Efficiency
SEMI STRONG FORM

SEMI STRONG
FORM
Share prices reflect:
all information available
publicly, all information
about past price
movements and their
implications

Money and Capital Markets and Market 57

Efficiency
8 Types of Efficiency
SEMI STRONG FORM
 Information:The share price incorporates all publicly
available information
 Evidence: Share prices react within 5-10 mins of any
new information being released and rise in response
to breaking good news, fall in response to breaking
bad news.
 Conclusion: EXAMINING PUBLICLY
AVAILABLE INFORMATION WILL NOT
PROVIDE OPPORTUNITIES TO BEAT THE
MARKET!!

Money and Capital Markets and Market 58

Efficiency
8 Types of Efficiency
STRONG FORM

Money and Capital Markets and Market 59

Efficiency
8 Types of Efficiency
STRONG FORM

STRONG FORM
Share prices reflect
all information available:
from past price changes,
publicly, form insider
knowledge available to
specialists

Money and Capital Markets and Market 60

Efficiency
8 Types of Efficiency
STRONG FORM
 Information: The share price incorporates ALL information,
whether publicly or private, including information which is yet
unpublished.

 Evidence: Insiders have access to unpublished information

 Conclusion: If the strong form of the efficient market

hypothesis is correct then a company’s real financial positions
will be reflected in its share price. Its REAL financial position
includes both its current position and its expected future
profitability.

Money and Capital Markets and Market 61

Efficiency
8 Types of Efficiency
STRONG FORM
Other factors to take into account when considering
the value of shares:

 Marketability and liquidity of shares

 Available Information

 Equilibrium Prices

Money and Capital Markets and Market 62

Efficiency
8 Types of efficiency

Busness Valuations and Market Efficiency 63

8 Types of efficiency

Busness Valuations and Market Efficiency 64

8 Types of efficiency

Busness Valuations and Market Efficiency 65

8 Types of efficiency- EXAMPLE 9

Busness Valuations and Market Efficiency 66

How is this Chapter Tested?
 Explain:
 the concepts and types of market efficiency. Make sure
you are able to identify the 3 different types from a
scenario
 Calculate and explain the valuation methods,
advantages and disadvantages from a set of FS
 Dec 07 Q1, June 09 Q1, Dec 08 Q1, Dec 2010
Q2(market efficiency) , Dec 2010 Q3 (valuation), Dec
2011 Q 3(valuation)

Busness Valuations and Market Efficiency 67

Business Valuations and
Market Efficiency

Thank you !