Approaches to Company Valuation
Author: Yousif Eltom SUN: 061413353
MEng Chemical Engineering
ABSTRACT The different approaches to valuing a business are identified, and the main approached are income approach, asset approach and market approach. The asset approach estimates the equity of a business by identifying the assets and liabilities of the company being valued. The methods include the super profits method, and net assets basis. The income approach values a company based on its expected cash flows, and includes the earnings based method, discounted cash flow method, discounted dividend yield method, accounting rate of return and capital asset pricing method.
INTRODUCTION The approach taken by businesses when valuing a prospective company, or even valuing themselves is critical these days. Various methods exist whereby valuations may be achieved, however these methods yield different values therefore companies and directors must be able to identify the options which are most feasible for them, therefore employ systematic approach to arriving at their valuations.
This paper will identify the various methods available to value a prospective project, and identify any key advantages or shortcomings which may influence the valuations attained.
According to Lonergan (2003, pg14) valuations of share are required for different reasons, and based on these circumstances different methodologies will be adapted. Some of the reasons for share valuations are:
To assist a seller at which price to sell To assist a management buyout proposal To assist a purchaser in deciding how much to consider paying To determine a value according to a contractual agreement
Once identified, the adopted method may be further modified to tailor it to the specific circumstance of valuation, thus providing a more accurate valuation.
VALUATION METHODS There are three known valuation methods when it comes to valuation of a company and its shares, these are:
o Asset Approach o Income Approach o Market approach
Within the methods listed, there are more specialist methods which can be applied when valuing a company, there are broken down as below:
o Asset Approach o Super Profits Method o Net assets valuation o Income Approach o Earnings based method o Discounted Cash Flow Method o Discounted Dividend Yield Method o Accounting Rate of Return o Capital Asset Pricing Method
SUPER PROFITS METHOD According to Kapoor et Bhushan(1996 pg 185) the super profits method denotes the profit’s accrued by a firm above the normal profits earned by other firms in the same industry.
ctual rofits- ormal rofits
Here the normal profits are calculated by multiplying the rate of return by the capital invested and dividing by 100.
rate of return
NET ASSETS VALUATION The net assets valuation approach is a method used to value the equity of a business. Sometimes referred to the adjusted book value approach, according to Rezaee(2001,pg.206) this approach adjusts the tangible assets of a company from book value to market value by valuing intangible assets such as goodwill and subtracting liabilities. For companies with exceptionally high income, or may have endured years or loss, this method is particularly useful.
Goodwill is a type of intangible asset, which takes measure when the overall value of a business is greater than that of its tangible and identifiable intangible assets. During a merger or acquisition, the goodwill value can be determined by the difference between the price paid for the acquisition, and the market value of the assets less the liabilities.
umber of ears urchase
EARNING BASED METHOD The earnings based method is a commonly used method and according to Reuvid et al(2007, p145) the earnings based method works by ascribing a value to the business being assessed by comparing it with a similar business. The basis of this method is to identify the maintainable earnings of a business and then applying a price multiple. Although it may seem straightforward, the difficulties lie in determining the underlying maintainable value of a business, and the multiple factor to be applied.
The underlying value is essentially the net earnings accrued by the company, and usually measured according to shares, earnings per share (EPS). This is deduced by dividing the amount of earnings reported by a company by the outstanding shares. arnings eported utstanding hares
The multiple factor to be used, also known as the price/earnings(p/e) ratio takes a company’s stock price and divides it by the company’s last four quarters earnings.
ompany s stock price per share ompany s last four quarters earnings per share
Since the basis of this model is around the market in which the business is operating in, it can provide a good indication on company valuation bases on a ‘going concern’ basis, in which the company is not at threat of liquidation.
Although this method is widely used, obtaining the p/e ratio is not always accurate, therefore the p/e ratio of sector average is a reliable source to start. Adjustments can also be made to this multiple by considering the circumstances of the business
DISCOUNTED CASH FLOW METHOD The discounted cash flow method, according to Damodaran (2002,pg12) is a method by which the value of an asset is related to the present value of the future cash flows associated with that asset. The fundamental correlation for this method is :
here resent alue
ash low in period t
r discount rate This model can be modified depending on what is being valued. Equity Valuation The value of equity is obtained by discounting the expected cash flows to equity against the actual cost of equity.
alue of quity
to equityt k
here to equityt k cost of equity xpected cash flow to equity, at time t
This model takes into consideration the residual cash flows after meeting all expenditures, and is adopted in the discounted dividend model whereby the value of equity is modelled as the present value of future dividends. Company Valuation The value of a company can also be obtained by discounting the expected cash flows to the company against the weighted average cost of capital (WACC). The WACC is the cost of the different components of financing used by the company, and weighted using their proportion of the market value. to firmt
alue of ompany
here to firmt xpected cash flow to the company, at period t
eighted average cost of capital
The weighted average cost of capital can be summarised simply using the below correlation:
ndividual costs of capital arket values of individual sources equity,debt,stocks etc. otal market value of company
DISCOUNTED DIVIDEND YIELD METHOD Discounted dividend models are an agglomeration of valuation models based on the distribution of dividends to shareholders where dividend can be described as ‘cash flow’. Fundamentally, the purpose of this model is to value a stock, and there are a variety of models which could be applied to model the distribution of future company dividend payments. Pinto et al(2010, pg 85) state that the forecasting of dividends in the indefinite future is not practical, therefore the approach is simplified by applying growth patterns to the company.
For zero growth, i.e. an assets value is the present value of the future cash flow it generates, we can model the below equation according to pinto et al (2010,pg 85)
= Present Value of assets at t ash flow at time t
ividends iscount rate
The anticipation of zero growth is a very inaccurate observation, and a company would expect growth over a period of time, therefore the equation is adjusted to include growth. When the growth is at a constant known rate, the below can be stated:
here g expected growth rate
g r g r
g r r
g n rn
This model is known as the Gordon growth model, and according to Pinto et all(2010, pg 97), was developed by Gordon and Shapiro in 1956, and adopted further by Gordon (1962) whereby the assumption that dividends grow at a constant rate is applied. For many companies, it is more desirable to view dividends and earnings as a function of multiple stages of growth since they will undergo different economic cycles throughout the years and will trade shares regularly which will mean they rate of growth will change. For instance, if a company would offer dividends with constant growth for three years after which they continue to offer dividends equal to that given during the three years into perpetuity, the constant growth and perpetuity must be combined. Perpetuity can be presented by the following formulae:
Combined with the Gordon growth model g r r g r g n rn
In this example, the present value of perpetuity discounts back two year, therefore the perpetuity term requires a further three years discount.
arket rice per hare
g r r
ACCOUNTING RATE OF RETURN The accounting rate of return is a method which uses information available on a financial statement to measure an estimated performance of a capital investment. According to Needles et al (pg 1260) this method is an imprecise however easy method to estimate performance of capital investment in which the annual profits are divided by the average investment cost. verage nnual et ncome verage nvestment ost
For projects with time t, the average net income over that period should be taken into consideration to account for fluctuation.
CAPITAL ASSET PRICING MODEL The capital asset pricing model(CAPM) is a model used to estimate the cost of equity capital. Pratt et al(2010, pg104) state that is one of the most widely used models due to its association of market risk in the model. The market risk is measured by a value known as beta, furthermore pratt et al(2010,pg 107) suggest a linear correlation between a security’s equity risk premium and the security’s beta.
xpected rate or return on security i ate of return on a risk-free security
measure of market risk
quity isk remium
The equity risk premium, can be further defined as
m m f
market rate or return isk-free rate of return
CONCLUSION Various methods exist for which a value may be applied to a company. These methods vary in their approach, and the variables involved. The asset approach methods estimates the value of equity held by a business by investigating the assets and liabilities of the business at the time of valuation. The income approach methods, estimate the value of a company by predicting future cash flows, the basis of which is on a discount rate which is also a projection. These methods can be implemented, and factors applied to arrive at more accurate valuations.
REFERENCES Reuvid,J Floating Your Company:The Essential Guide to Going Public (3e) (Kogan Page,2007 )
Barker, R. Determining Value: Valuation Models and financial Statements (1e) (Pearson Education Limited, 2001)
Needles,B &Powers,M & Crosson , S. Principles of Accouting (1e) (Houghton Mifflin Company, 2008)
Damodaran, A. Investment valuation: Tools and techniques for determining the value of any asset (2e) (John Wiley & Sons,Inc, 2002)
Pratt,S. & Grabowski,R. Cost of Capital: Applications and Examples ( 4e) (John Wiley & Sons,Inc, 2010)
Rezaee,Z. Financial Institutions, valuations, mergers, and acquisitions: the fair value approach. (2e) (John Wiley & Sons,Inc, 2001)
Kapoor, N. & Bhushan,B. A Complete Course in ISC Accounting (6e) ( Pitambar Publishing Company,2006)
Lonergan,W. The Valuation of Businesses, Shares and other Equity (4e) (Allen&Unwin:Australia, 2003)
Valuation of Yolanda Ltd
Author: Yousif Eltom SUN: 061413353
MEng Chemical Engineering
FOR THE ATTENTION OF THE CEO OF XAVIER PLC
EXECUTIVE SUMMARY The valuation methods used arrive at values ranging from £366,600 and £1,030,000 which suggest the board of directors of Yolanda ltd will only accept an offer above this. The valuation methods used were with the expected rate of return of 15% however the CAPM method arrived at an expected rate of return of 8%. This suggests that the actual valuation will exceed the £1,030,000 as suggested by the net assets method.
Further to this, a revaluation of Yolanda ltd may be required using an expected rate of return of 8% however this valuation will arrive at a higher value than those reached by the 15% rate.
Following this, the recommendations to the board of directors of Xavier plc is not to pursue acquisition of Yolanda ltd since the valuation of £1,030,000 is the minimum shareholders of Yolanda ltd are willing to accept, and this valuation does not consider the 8% rate of return.
1.0 VALUATION OF YOLANDA LTD APPLYING THE NET ASSETS METHODS
1.1 SUPER PROFITS APPROACH Yolanda ltd do not present a set fair rate of return on tangible assets, however since investor in Yolanda ltd have received a rate of return on investment of 15% in recent years, and both of Xavier’s hurdle rate and accounting rate of return are set at 15%, it is a rational value to use as the fair rate of return.
olanda ltd’s financial statements show that the company’s net tangible assets are currently valued at £1m.
Fair return on net tangible assets
The current earnings of Yolanda Ltd is £75,000 and for super profits to exist must exceed the fair return on tangible assets, however this is not the case and the current earnings of Yolanda Ltd are half of the fair return on tangible assets. This means the super profits method cannot be applied.
1.2 NET ASSETS METHOD inancial statements of olanda Ltd show that the company’s net tangible assets
are currently valued at £1m, additionally freehold land and buildings have an estimated book value in excess of £150,000. The financial statement also shows that Yolanda Ltd have liabilities in the form of debentures for £100,000 whereby a premium of 20% is applicable upon redemption. Furthermore, the directors of Yolanda Ltd estimate that there is about £100,000 available in goodwill in the business, however since super profits do not exist this estimation can be nullified.
£ Assets Fixed Assets (cost less depreciation) £850,000 Net Current Assets Freehold and Buildings Total Assets Liabilities Debentures Premium on Debentures Total Liabilities Net Asset Value of Equity £100,000 £20,000 £120,000 £1,030,000 £150,000 £150,000 £1,150,000
Based on the information available to Xavier plc regarding
financial statements and the judgement taken with regards to the discarding of the goodwill value applied to Yolanda Ltd by its board of directors, a value of £1,030,000 can be attached to Yolanda Ltd.
2.0 VALUATION OF YOLANDA LTD APPLYING THE INCOME BASED METHODS 2.1 EARNINGS BASED METHOD As a commonly used method, the earnings based method utilises the earning values of preceding years to determine the value of its shares.
The figures presented to Xavier plc regarding the earnings of Yolanda Ltd for the previous five years are:
2005 £47,000 2006 £51,000 2007 £59,000 2008 £68,000 2009 £75,000
Since Yolanda Ltd has authorised share capital of 200,000 ordinary shares at £1 each, the earnings per share ratio can be deduced.
Year 2005 2006 2007 2008 2009 Mean Average
Earnings £47,000 £51,000 £59,000 £68,000 £75,000
Earnings Per Share(EPS)
A price to earnings ratio (p/e) is not listed for Yolanda Ltd therefore a suitable alternative must be sought. Since the p/e ratio of three similar companies is given, a mean average can be deduced.
Company Ashraf plc Bronagh plc Conrad plc Mean average
p/e ratio 15 8 12
This average value can be rounded up to 12, which is also the mean p/e ratio for the industrial sector in which Yolanda Ltd operates in therefore is a plausible value to use. Furthermore, Conrad plc is a company with the same level of gearing as Yolanda Ltd and has a p/e ratio of 12 which reinforces the use of 12 as the p/e ratio. he company’s stock price per share of applying the following equation: ompany s stock price per share p e ratio ompany s last four quarters earnings per share olanda Ltd can now be evaluated by
The introduction of the number of ordinary shares authorised by Yolanda Ltd enables Xavier plc to value all the share capital.
Earnings Per Share(EPS) 2005 Year
Stock Price Per Share
2006 ,000 2007 ,000 2008 ,000 2009 ,000 Mean Average ,000
ADJUSTMENTS TO SHARE CAPITAL
Since Yolanda Ltd is an unlisted company there is inherently a higher risk involved, and according to Corriera et al(2007, page 6-20) a discount for lack of marketability(DLOM) must be applied of between 25% - 45%1.
Discount to be applied
Currently the share price for Xavier plc is listed at 320p and the most recent financial statement shows the the earnings per share to be 20p, from this we know that the p/e ratio for Xavier is 16. Since Xavier plc is a well-known UK company, it is foreseeable that Yolanda Ltd can be operated according to the standards set by Xavier plc thus increasing the value of Yolanda plc; this will be by a fraction of 16/12. Just taking into consideration the lowest, highest and mean share capitals the below can be deduced:
Corriera,C & Flynn,D, &Uliana, E, & Wormald,M. Financial Management (Juta and Company,2007)
Stock Price Per Share Capital Share Year Low . p p p 64,000 p , ,000 p , ,000 ,
Share New Share Capital
, , , ,
By applying the earnings based method, a share capital between £366,600 and £780,000 can be justified depending on adjustments.
2.2 DISCOUNTED CASH FLOW METHOD The discounted cash flow method cannot be implemented due to insufficient information. Due to the information presented to Xavier plc regarding the cash flows of Yolanda ltd, and not knowing the rate at which Yolanda ltd is expected to grow means no accurate value can reached using the discounted cash flow method.
2.3 DISCOUNTED DIVIDEND MODEL The board of directors at Yolanda Ltd and Xavier plc hold differing expectations when to comes to the distribution of dividends , however it will be dependent on whether a takeover is successful or not.
Board of directors of Yolanda Ltd profile The board of directors at Yolanda Ltd expect to pay a dividend next year of 80p per share, rising over the following two years at a compound rate of 10% p.a. and remaining constant in perpetuity thereafter.
With 100,000 shares available at 80p per share, the total is £80,000 and with an annual profit of £75,000 for 2009 should be treated cautiously.
In recent years, investors in Yolanda Ltd have received a 15% rate of return on investement.
The perpetuity is calculated and then discounted back,
For 100,000 shares this equates to
Board of directors of Xavier plc profile The board of directors at Xavier plc state that the do not into to pay dividends with the first three year of successful acquisition of Yolanda ltd. Following this period, they intend to pay dividends of 120p per share in year four, with a rise in compound rate of 10% p.a. until year 6 and remaining constant thereafter. Xavier plc currently operate a policy whereby the hurdle rate is 15% when evaluating potential projects. The perpetuity value is calculated as below:
r . . And then discounted as below: . . . .
r . .
r r . . .
With 100,000 ordinary shares available, this amounts to
£615,510 is the present value of the future dividends to Xavier plc.
A minimum valuation of Yolanda, according to the requirements of the Yolanda board of directors is £624,060 and this is the least value shareholders will accept should an approach be made to buy their shares. However, this valuation is only feasible should Yolanda plc manage to generate profits of £80,000 in the next year.
2.4 ACCOUNTING RATE OF RETURN As a simple method to establish the maximum value a company would attach to a prospective company they wish to take over, the accounting rate of return could be applied to value Yolanda ltd.
Companies in the Xavier group are required to yield an accounting rate of return of 15%, and the board of directors of Yolanda ltd estimate that the investment by Xavier plc will lead to Yolanda ltd accruing earnings of £90,000 in the twelve months following the investment. ,
Should the required accounting rate of return be achievable and the projected earnings accurate, the value of £600,000 can be attached to Yolanda ltd.
3.0 ESTIMATION OF EXPECTED RATE OF RETURN 3.1 CAPITAL ASSET PRICING MODEL The capital asset pricing model (CAPM) method is a suitable method to estimate the expected rate of return for the investment.
A suitable beta value is required for Yolanda ltd to be able to estimate the expected rate of return. Conrad plc is a company which operates with the same level of gearing as Yolanda plc, therefore the risk associated is similar and it is feasible to apply the same beta value as Conrad plc.
Currently a risk-free return of 2% is achievable from the UK treasury Gilts, and an average stock market return is estimated at 6%.
Combining the following equations :
i f m
The following equation is deduced.
The CAPM method presents an expected rate of return of 8%, which is significantly lower than the rate of return which investors in Yolanda Ltd have received in recent years of 15%. Furthermore, it is also lower than the 15%
hurdle rate set by the Xavier group when evaluating potential projects.
4.0 CONCLUSION The various methods applied arrived at different valuations of Yolanda ltd, and these are summarised below:
Net Assets Method
Earnings Based Method
Between £366,600 and £780,000
Discounted Dividend Method
Accounting Rate of Return
Yolanda Ltd currently possess assets values at £1,030,000 therefore a valuation below this means the company would be undervalued. Further to this, the CAPM method arrived at an expected rate of return of 8% which is significantly lower than the rate of return investors have been receiving in recent years. Revaluation using the 8% rate of return will yield different values.
Since this is the case, the recommendations to the board of Xavier plc is not to pursue acquisition of Yolanda ltd since the minimum value the shareholders will accept is £1,030,000 and the calculated rate of return is significantly lower than the anticipated expected rate of return, which in turn means the valuation using this rate of return will be exceptionally higher, and although this can possibly yield more profit in the future by eliminating competition, it is not Xavier plc’s interest to acquire Yolanda ltd following these valuations. 13