Chapter 12

Valuation
BUSINESS VALUATION

Reasons for valuation

(a) For quoted companies, when there is a takeover bid and the offer price is an estimated ‘fair value’ i excess of the current
market price of the shares.

A takeover is the acquisition by a company of a controlling interest in the voting share capital of another company, usually
achieved by the purchase of a majority of the voting shares.

(b) For unquoted companies, when:

1. The company wishes to ‘go public’ and must fix an issue price for its shares
2. There is a scheme for a major with another company
3. Shares are sold
4. Shares need to be valued for the purposes of taxation
5. Shares are pledged as collateral for a loan and the bank wants to put a value to the collateral
6. Another company is proposing to take over the unquoted company by making an offer to buy all its shares.

(c) For subsidiary companies, when the group’s holding company is negotiating the sale of the subsidiary to a management
buyout team or to an external buyer.

(d) For any company, where a shareholder wishes to dispose of his or her holding.

Approaches
The three main approaches are:
 Dividend valuation model
 Income / earnings basis
 Asset basis

Information requirements for a valuation

There is a wide range of information that can be used to value a business.
 Financial statements: statements of financial position and profit and loss, statements of changes in financial position and
statements of shareholders equity for the past five years
 Summary of non-current assets and depreciation schedule
 Aged accounts receivable schedule
 Aged accounts payable schedule
 List of marketable securities
 Inventory summary
 Details of any existing contracts: eg leases, supplier agreements
 List of shareholders with number of shares held by each
 Budgets or projections, for a minimum of five years
 Information about the company’s industry and economic environment
 List of major customers by sales
 Organisation chart and management roles and responsibilities
 Profit forecasts or budgets

Market capitalisation
Market capitalisation is the market value of a company’s shares. This is the share price multiplied by the number of issued shares.

VALUING SHARES
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Asset based valuation
The net asset valuation method can be used as one of the many valuation methods, or to provide a lower limit for the company. By itself it is
unlikely to produce the most realistic value.

Types of asset based measures

Net assets methods of share valuation

Using this method of valuation, the value of an equity share is equal to the net tangible assets divided by the number of shares.

Net tangible assets are the value of the statement of financial position of the tangible non-current assets (net of depreciation) plus current assets,
minus all liabilities.

Intangible assets (including goodwill) should be excluded, unless they have a market value (eg patents and copyrights, which are sold).

a) Goodwill, if shown in the financial statements, is unlikely to be shown at a true figure for purposes of valuation, and the value of goodwill
should be reflected in another method of valuation (eg the earnings basis)
b) Development expenditure, if shown in the financial statements, would also have a value which is related to future profits rather than to the
worth of the company’s physical assets.

Book value
There is never a circumstance where book value is an appropriate valuation base. It may however be used as a stepping stone
towards identifying another measure.

Net realisable value

Only used to establish a minimum value for an asset, it may be difficult to find an appropriate value over the short term. Used for
the company when being broken up or asset stripped.

Replacement cost
May be used to find the maximum value for an asset. Used for a company as a going concern.

Question 1
Below is a balance sheet for Fagan Ltd,
$
Non-current assets (carrying value) 625,000
Net current assets 160,000
785,000
Represented by
50c ordinary shares 300,000
Reserves 285,000
6% loan notes 200,000
785,000
Notes:
 Loan notes are redeemable at a premium of 5%
 The premises has a market value that is $50,000 higher than the book value
 All other assets are estimated to be realisable at their book value.
Required:
Value a 60% holding of ordinary shares on an asset basis.

Question 2 – net assets method of share valuation

The summary statement of financial position of Cactus is as follows.
Assets $
Non-current assets
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
Goodwill 20,000
280,000
Current assets
Inventory 80,000
Receivables 60,000
Short-term investments 15,000
Cash 5,000

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 160,000
Total assets 440,000
Equity and liabilities
Ordinary shares of $1 80,000
Reserves 140,000
Total equity 220,000
Non-current liabilities
12% bonds 60,000
Deferred taxation 10,000
4.9% redeemable preference shares of $1 50,000
120,000
Current liabilities
Payables 60,000
Taxation 20,000
Declared ordinary dividend 20,000
100,000
Total liabilities 220,000
Total equity and liabilities 440,000

Required
What is the value of an ordinary share using the asset basis of valuation?

Weaknesses
 Investors do not normally buy a company for the book value of its assets, but for the earnings / cash flows that the sum of its assets can
produce in the future

 It ignores intangible assets. It is very possible that intangible assets are more valuable than the balance sheet assets.

Uses of asset based valuation

 A measure of the ‘security’ in share value. A share might be valued using an earnings basis. This valuation might be higher or lower
than the net asset value per share. If the earnings basis is higher, then if the company went into liquidation, the investor could not
expect to receive the full value of his shares when the underlying assets were realised.
 The asset backing for shares thus provides a measure of the possible loss if the company fails to make the expected earnings or
dividend payments.
 As a measure of comparison in a merger.
 A merger is essentially a business combination of two or more companies, of which none obtains control over any other.
 For example, if company A, which has a low asset backing, is planning a merger with company B, which has a high asset backing, the
shareholders backing, the shareholders of B might consider that their shares’ value ought to reflect this. It might therefore be agreed
that a something should be added to value of the company B shares to allow for this difference in asset backing.

 As a ‘floor value’ for a business that is up for sale – shareholders will be reluctant to sell for less than the NAV. However, if the sale is
essential for cash flow purposes or to re-align with corporate strategy, even the asset value may not be realised.

 Asset stripping
 If the assets are predominantly tangible assets.
Income / earning based methods
Of particular use when valuing a majority share holding:
1. As majority shareholders, the owners can influence the future earnings of the company.
2. The dividend policy of a company is less of an issue when control is held; the level of dividends can be manipulated to what
you want.

PE method
PE ratios are quoted for all listed companies and calculated as:

PE ratio = Price per share

EPS

This can then be used to value shares in unquoted companies as:

Value per share = EPS x P/E ratio
Value of company = Total earnings x P/E ratio

Using an adjusted P/E multiple from a similar quoted company (or industry average).

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The EPS could be a historical EPS or a prospective future EPS. For a given EPS figure, a higher P/E ratio will result in a higher
price.

Significance of a higher P/E ratio

A high P/E ratio may indicate:
(a) Expectations that the EPS will grow rapidly
A high price is being paid for future profit prospects. Many small but successful and fast growing companies are valued on
the stock market on a high P/E ratio.

(b) Security of earnings

A well-established low-risk company would be valued on a higher P/E ratio than a similar company whose earnings are
subject to greater uncertainty.

(c) Status
If a quoted company (the bidder) made a share for share takeover bid for an unquoted company (the target), it would normally
expect its own shares to be valued on a higher P/E ratio than the target company’s shares. The P/E ratio of an unquoted
company’s shares might be around 50% to 60% of the P/E ratio of a similar public company with a full stock market listing.

Problems with using P/E ratio

Using P/E ratios of quoted companies to value unquoted companies may problematic. This is because a P/E ratio must be guessed
at, using the P/E ratios for similar quoted companies as a guide.

 Finding a quoted company with a similar range of activities may be difficult. Quoted companies are often diversified.

 A single year’s P/E ratio may not be a good basis, if earnings are volatile, or the quoted company’s share price is at an
abnormal level, due for example to an expectation of a takeover bid.

 If a P/E ratio trend is used, then historical data will be being 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.

Question 3
Flycatcher wishes to make a takeover bid for the shares of an unquoted company, Mayfly. The earnings of Mayfly over the past
five years have been as follows.

20X0 $50,000
20X1 $72,000
20X2 $68,000
20X3 $71,000
20X4 $75,000

The average P/E ratio of quoted companies in the industry in which Mayfly operates is 10. Quoted companies which are similar in
many respects to Mayfly are:

(a) Bumblebee, which has a P/E ratio of 15, but is a company with very good growth prospects
(b) Wasp, which has had a poor profit, record for several years, and has a P/E ratio of 7

Required:
What would be a suitable range of valuations for the shares of Mayfly?

Question 4
Houllier Ltd, an unlisted company:
Ordinary share capital is 200,000 50c shares
Extract from income statement for the year ended 31 December 20X7:
$ $
Profit before taxation 430,000
Less: corporation tax 110,000
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Profit after taxation 320,000
Less: Preference dividend 130,000
Ordinary dividend 120,000
(250,000)

Retained profit for the year 70,000

PE ratio applicable to a similar type of business is 10.

Required:
Value 200,000 shares in Houllier Ltd on a PE Basis.

Earnings yield
The earnings yield is the inverse of the PE ratio.

Earnings yield = EPS .

Price per share

It therefore is used to value the shares or market capitalisation of a company in exactly the same way as the PE ratio:

Value of company = Total earnings

Earnings yield

Question 5
A company has the following results.
20X1 20X2 20X3 20X4
$m $m $m $m
Profit after tax 6.0 6.2 6.3 6.3
The company’s earnings yield is 12%.
Required:
Calculate the value of the company based on present value of expected earnings.

Question 6
Company A has earnings of $300,000. A similar listed company has a dividend yield of 12.5%.
Required:
Find the market capitalisation of each company.

Question 7
Company B has earnings of $420,500. A similar listed company has a PE ratio of 7.
Required:
Find the market capitalisation of each company.

The dividend valuation model

The value of the company / share is the present value of the expected future dividends discounted at the cost of equity.

Either: Po = do (1 + g) FORMULA GIVEN

Ke – g

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Can either be used to calculate the total MV of a company or the value of a share?

Assumptions in the dividend valuation model

The dividend valuation model is underpinned by a number of assumptions that you should bear in mind.
(a) Investors act rationally and homogeneously. The model fails to take into account the different expectations of shareholders,
or how much they are motivated by a preference for dividends over future capital appreciation on their shares.

(b) The current year’s dividend does not vary significantly from the trend of dividends. If this does not appear to be a rogue
figure, it may be better to use an adjusted trend figure, calculated on the basis of the past few years’ dividends

(c) The estimates of future dividends and prices used, and also the cost of capital are reasonable. It may be difficult to make a
confident estimate of the cost of capital. Dividend estimates may make from historical trends that may not be a good guide for
a future or derived from uncertain forecasts about future earnings.

(d) Investors’ attitudes to receiving different cash flows at different cash flows at different times can be modelled using
discounted cash flow arithmetic

(e) Directors use dividends to signal the strength of the company’s position. However, companies that pay zero dividends do not
have zero share values.

(f) Dividends either show no growth or constant growth. If the growth rate is estimated using Gordon’s growth approximation
(g = br), then the model assumes that the percentage of profits retained in the business and the return on those retained profits,
b and r, are constant values.

(g) Other influences on share price are ignored

(h) The company’s earnings will increase sufficiently to maintain dividend growth levels.
(i) The discount rate used exceeds the dividend growth rate.

Advantages
1. Considers the time value of money and has an acceptable theoretical basis.
2. Particularly useful when valuing a minority stake of a business.

Disadvantages
1. Difficulty in estimating an appropriate growth rate.
2. The model is sensitive to key variables.
3. The growth rate is unlikely to be constant in practice.

Note

Total MV = Share price x Total number of shares

Question 8
A company has the following information:
Share capital in issue is 2m ordinary shares (25c)
Current dividend per share (ex div) – 4c
Dividend five years ago – 2.5c
Current equity beta 0.6
Market information:
Current market returns 17%
Risk – free rate 6%

Required:
What is the market value of the company?

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Question 9
A company has the following information:
Ordinary share capital (1m par value 50c)
Current dividend (ex div) – 16c
Current EPS 20c
Current return earned on assets – 20%
Current equity beta 0.9
Current market returns 11%
Risk – free rate 6%
Required:
What is the market capitalisation of the company?

Question 10
Target paid a dividend of $250,000 this year. The current return to shareholders of companies in the same industry as Target is
12%, although it is expected that an additional risk premium of 2% will be applicable to Target, being a smaller and unquoted
company.

Required:
Compute the expected valuation of Target, if:
(a) The current level of dividend is expected to continue into the foreseeable future.
(b) The dividend is expected to grow at a rate of 4% p.a. into the foreseeable future.
(c) The dividend is expected to grow at a 3% rate for three years and 2% afterwards.

PV of free cash flows

A buyer of the business is obtaining a stream of future operating or ‘free’ cash flows.
The value of the business is:

PV of future cash flows

A discount rate reflecting the systematic risk of the flows should be used.
Method:
1. Identify relevant ‘free’ cash flows.
 Operating cash flows
 Revenue from sale of assets
 Tax payable
 Tax relief
 Synergies from merger (if any)
2. Select a suitable time horizon
3. Identify a suitable discount rate
4. Calculate the present value over the time period

Question 11
Diversification wishes to make a bid for Tadpole. Tadpole makes after-tax profits of $40,000 a year. Diversification believes that
if further money is spent on additional investments, the after-tax cash flows (ignoring the purchase consideration) could be as
follows.

Year Cash flow (net of tax)

$
0 (100,000)
1 (80,000)
2 60,000
3 100,000
4 150,000
5 150,000

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The after-tax cost of capital of Diversification is 15% and the company expects all its investments to pay back, in discounted
terms, within five years.

Required:
(a) What is the maximum price that the company should be willing to pay for the shares of Tadpole?

(b) What is the maximum price that the company should be willing to pay for the shares of Tadpole if it decides to value
the business on the basis of its cash flows in perpetuity, and annual cash flows from year six onwards are expected to
be $120,000?

Question 12
The following information has been taken from the income statement and balance sheet of Paisley Ltd:

Revenue $400m
Production expenses $150m
Administrative expenses $36m
Tax allowable depreciation $28m
Capital investment $60m
Corporate debt $14m trading at 110% of par value.
Corporation tax is 30%
The WACC is 16.6%. inflation is 6%.
These cash flows are expected to continue every year for the foreseeable future.

Required:
Calculate the value of equity.

Advantages
 The best method on a theoretical basis
 May value a part of the company

Disadvantages
 It relies on estimates of both cash flows and discount rates – may be unavailable.
 Difficulty in choosing a time horizon.
 Difficult in valuing a company’s worth beyond this period.
 Assumes that the discount rate and tax rates are constant through the period.

Question 13
PACT provides a tuition service to professional students. This includes courses of lectures provided on their own premises and
provision of study material for home study. Most of the lecturers are qualified professionals with many years’ experience in both
their profession and tuition. Study materials are written and word-processed in-house, but sent out to external printers.

The business was started fifteen years ago, and now employs around 40 full-time lecturers, 10 authors and 20 support staff.
Freelance lecturers and authors are employed from time to time in times of peak demand.

The shareholders of PACT mainly comprise of original founders of the business who would now like to realise their investment.
In order to arrive at an estimate of what they believe the business is worth, they have identified a long-established quoted
company, City Tutors, who have a similar business, although they also publish texts for external sale to universities, colleges etc.

Summary financial statistics for the two companies for the most recent financial year are as follows.
PACT City Tutors
Issued shares (million) 4 10
Net asset values ($m) 7.2 15
Earnings per share (cents) 35 20
Dividend per share (cents) 20 18
Debt: equity ratio 1:7 1:65
Share price (cents) 362

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Expected rate of growth in earnings/dividends 9% pa 7.5 pa

Notes
1. The net assets of PACT are the net book values of tangible non-current assets plus net working capital. However:

 A recent valuation of the buildings was $1.5m above book value.

 Inventory includes past editions of text books which have a realisable value of $100,000 below their cost.

 Due to a dispute with one of their clients, an additional allowance for bad debts of $750,000 could prudently be made.

2. Growth rates should be assumed to be constant per annum; PACT’s earnings growth rate estimate was provided by the
marketing manager, based on expected growth in sales adjusted by normal profit margins. City Tutor’s growth rates were
gleaned from press reports.

3. PACT uses a discount rate of 15% to appraise its investments, and has done for many years.

Required
(a) Compute a range of valuations for the business of PACT, using the information available and stating any assumptions made.
10 marks

(b) Comment upon the strengths and weaknesses of the methods you used in (a) and their suitability for valuing PACT.
15 marks
Total marks = 25

VALUATION OF DEBT
When valuing debt we assume that

Market = The discounted cash flows of the debt

Price

Note
a) The debt is normally valued gross of debt because we do not know how the tax position of each investor.

b) Debt is always quoted in $100 nominal units, or blocks: always use $100 nominal value s as the basis to your calculations

c) Debt can be quoted in % or as a value, eg 97% or $97. Both mean that $100 nominal value of debt is worth $97 market value.

d) Interest on debt is stated as a percentage of nominal value. This is known as the coupon rate. It is not the same as the
redemption yield on debt or the cost of debt.

e) The examiner sometimes quotes an interest yield, defined as coupon/market price

f) Always use ex-interest prices in any calculations

Irredeemable debt
The company does not intend to repay the principal but to pay interest forever; the interest is paid in perpetuity.

The formula for valuing a debenture is therefore:

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 MV = I.
‘r
Where
I = annual interest starting in one year’s time
MV = market price of the debenture now (year 0)
‘r = debt holder’s required return, expressed as a decimal

If instead of r you are given the company’s cost of debt the formula becomes:

MV = I (1 – T)
Kd
Where
Kd = company’s cost of debt, expressed as a decimal

Question 14
A company has issued irredeemable loan notes with a coupon rate of 9%. The required return of investors in this category of debt
is 6%.

Required:
The current market value of the debt?

Redeemable debt
The market value is the present value of future cash flows, these normally include:
1. Interest payments for the years in issue.
2. Redemption value

Value of debt = (interest earnings x annuity factor) + (redemption value x Discounted cash flow factor)

Question 15
A company has 10% debt redeemable in 5 years. Redemption will be at par value. The investors required a return of 8%.

Required:
The market value of the debt?

A company has in issue 9% redeemable debt with 10 years to redemption. Redemption will be at par. The investors
require a return of 16%. What is the market value of the debt?

Question 16
Furry has in issue 12% bonds with par value of $100,000 and redemption value $110,000, with interest payable quarterly. The
cost of debt on the bonds is 8% annually and 2% quarterly. The bonds are redeemable on 30 June 20X4 and it is now 31
December 20X0.

Required:
Calculate the market value of the bonds

Question 17
A company has issued some 9% bonds, which are now redeemable at par in three years’ time. Investors now require a redemption
yield of 10%.

Required:
What will be the current market value of each $100 of bond?

Convertible debt
The value of a convertible debt is the higher of its value as debt and its converted value. This is known as the formula value.

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Question 18
Elliot plc has convertible loan notes with a coupon rate of 10%. Each $100 loan note may be converted into 25 ordinary shares at
any time until the date of expiry and any remaining loan note will be redeemed at $100.

The debenture has four years to redemption. Investors require a rate of return of 6% per annum.

Required:
Should we convert if the current share price is:
(a) $4.00
(b) $5.00
(c) $6.00?

Question 19
What is the value of a 9% bond if it can be converted in five years time into 35 ordinary shares or redeemed at par on the same
date? An investor’s required return is 10% and the current market price of the underlying share is $2.50 which is expected to grow
by 4% per annum.

Preference shares
Similar to irredeemable debt, the income stream is the fixed percentage dividend received in perpetuity.

The formula is therefore: Po = D/Kp

Where:
D = the constant annual preference dividend
Po = ex-div market price of the share
Kp = cost of the preference share.

Question 20
A firm has in issue $1 11% preference shares. The required return of preference shareholders is 12%.

Required:
What is the value of a preference share?

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