Topic 2 VALUATION CONCEPTS

Introduction
In this topic we shall highlight valuation concepts. The topic will cover: the concepts of time
value of money, future value and present value, the application of time value of money concept
and valuation of long-term assets.

Time Value of Money

Time value of money refers to fact that investors and other decision makers in finance prefer to
receive a sum of money earlier than later if given a choice. This is because of the following
three reasons, namely:
1) The potential for earning interest/cost of finance.
2) The impact of inflation.
3) The effect of risk.

The Potential for Earning Interest

If a capital investment is to be justified, it needs to earn at least a minimum amount of profit,
so that the return compensates the investor for both the amount invested and also for the length
of time before the profits are made. For example, if a company invests Shs 80 million now to
earn revenue of Shs 82 million in one month’s time, a profit of Shs 2 million in 30 days would
be a very good return. However, if it takes four years to earn the money, the return would be
very low.

Therefore, money has a time value. It can be invested to earn interest or profits, so it’s better to
have Shs 1 now than in one year’s time. This is because Shs 1 now can be invested for the next
year to earn a return, whereas Shs 1 in one year’s time cannot. Put in another way, Shs 1 in
two years’ time is worth less than Shs 1 now.

The Impact of Inflation

In most countries, in most years prices rise as a result of inflation. Therefore, funds received
today will buy more than the same amount a year later, as prices will have risen in the
meantime. The funds are subject to a loss of purchasing power over time.

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Risk
The earlier cash flows are due to be received, the more certain they are - there’s is less chance
that events will prevent payment. Earlier cash flows are therefore considered to be more
valuable.

The Concept of Future Value

Future value refers to the value of present cash flows on an investment when compounded
using an appropriate discount rate. Compounding is the process of calculating the future or
terminal value of a given sum invested today for a number of years. The future or terminal
value therefore is the value in n years’ time of a sum invested now, at an interest rate of r%.

To compound a sum, the figure is increased by the amount of interest it would earn over the
period.

Example 1: Compounding
An investment project of Shs 10 million is to be made today. What is the value of the
investment after 2 years if the interest rate is 10%?

Solution
Particulars Shs
Value after 1 year: 10,000,000 X 1.1 = 11,000,000
Value after 2 years: 11,000,000 X 1.1 = 12,100,000

The Shs 10 million will be worth Shs 12.1 million in two years at an interest rate of 10%. This
is a fairly straight forward calculation. However, if the question asked for the value of the
investment after 10 years, it would take a lot longer.

To speed up the process, we can use a formula to calculate the future value of the sum invested
now. The formula is:
F = P (1+ r) n

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 Where F = Future value after n periods.
P = Present or initial value
r = Rate of interest per period
n = Number of periods

Example 2: Future Value (Compounding) of a Single Sum

You have Shs 5 million to invest now for six years at an interest rate of 5% pa. What will be
the value of the investment after six years?

Solution
F = Shs 5,000,000 (1 + 0.05)6
= 5,000,000 x 1.3401
= Shs 6,700,500

Multi-Period Compounding
This is a situation where interest is compounded several times in a year’. The formula to use is
as follows:
F = P (1+ r/m)nm
Where: F is future value, P is principal or present value today, m = number of times
compounded, r is interest rate, and n is total number of compounding periods.

Thus, if compounding is done semi-annually, m = 2; for quarterly compounding, m = 4, if

compounding is done after every four months, m = 3; for monthly compounding, m = 12; for
weekly compounding, m = 52; and for daily compounding, m = 365.

Compounding Uneven Cash Flow or Mixed streams

Two basic types of cash flow streams are possible: the annuity and the mixed stream. An
annuity is a constant annual cash flow for a number of years and a mixed stream is a stream of
unequal periodic cash flows that reflect no particular pattern.

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Determining the future value of a mixed stream of cash flows is straight forward. We
determine the future value of each cash flow at the specified future date and then add all the
individual future values to find the total future value.

Example 3: Compounding Mixed Streams

Furniture Mat Industries, a cabinet manufacturer, expects to receive the following mixed
stream of cash flows over the next five years from one of its small customers.
End of Year Cash flow
1 Shs 11,500,000
2 14,000,000
3 12,900,000
4 16,000,000
5 18,000,000
If the firm expects to earn 8% on its investments, how much will it accumulate by the end of
year 5 if it immediately invests these cash flows when they are received?

Solution
Year Cash flow No. of years earning FVIF8%, na Future value
(Shs) interest (n) [(1) x (3)]
(3)
(1) (2) (4)
1 11,500,000 5–1=4 1.360 Shs 15,640,000
2 14,000,000 5–2=3 1.260 17,640,000
3 12,900,000 5–3=2 1.166 15,041,400
4 16,000,000 5–4=1 1.080 17,280,000
5 18,000,000 5–5=0 1.000 18,000,000
Future Value of Mixed Stream = Shs 83,601,400
a FVIF at 8%
b The future value of the end of year 5 deposit at the end of year 5 is its present value
because it earns interest for zero years and (1 + 0.08)0 = 1.000.

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Continuous Compounding
Continuous compounding involves compounding over every microsecond – the smallest time
period ever imaginable. In this case the formula to use is:
F = PV x (e)rn
Where: PV is present value, e = 2.7183 is the Euler constant or exponential constant, r is
interest rate, and n is total number of compounding periods

Compounding Annuities
There are two basic types of annuities, that is, an ordinary or regular annuity and an annuity
due. For an ordinary annuity, the cash flows occur at the end of each period and for an annuity
due, the cash flows occur at the beginning of each period. In order to compound an ordinary or
regular annuity (the most common) the following formula is used:
FVAn = PMT x (FVIFAr, n)
Where: FVAn is the future value of an n, year annuity, PMT is the amount to be deposited
annually at the end of each year, and FVIFAr, n is the future value interest factor for the
ordinary annuity compounded at r per cent for n years.

The Concept of Present Value

The process of finding present values is often referred to as discounting cash flows. In a
potential investment project, cash flows will arise at many different points in time. To make a
useful comparison of the different flows, they must all be converted to a common point in
time, usually the present day, that is, the cash flows are discounted.

Years 0 1 2 3 4
Discounting FV

Discounting a Single Sum

The PV is the cash equivalent now of money receivable or payable at some future date. The
PV of a future sum can be calculated using the formula:

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 P= F = F (1+ r)-n

The 5-year DF at 10%

Formula or Tables
(Given in the examination)
1 = 0.621 You can simply find the DF from the
5
(1.10) PV table by locating the DF at the
10% column and the 5-year, i.e.0.621

Example 4: Discounting a Single Sum

What is the PV of Shs 115 million receivable in nine years’ time if r = 6%? Show your answer
using both the formula and the DF tables.

Solution
ThisPis= just
F a re-arrangement
= 115,000,000/ of 0.06)9 = Shs 68,068,323 (using the formula)
(1 +the formula
(1+r) n

P = Shs 115,000,000 x 0.592 = 68,080,000 (using tables)

The difference between the two answers is caused by rounding.

Discounting Annuities
An annuity is a constant annual cash flow for a number of years. There are two basic types of
annuities, that is, an ordinary annuity and an annuity due. For an ordinary annuity, the cash
flows occur at the end of each period and for an annuity due, the cash flows occur at the
beginning of each period.

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Example 5: Discounting Annuities
A payment of Shs 1 million is to be made every year for six years, the first payment occurring
in one year’s time. The interest rate is 10%. What is the PV of the annuity?

Solution
The PV of an annuity could be found by adding the PVs of each payment separately.
Year Payment PV
Shs DF @ 10% (from tables) Shs
1 1,000,000 0.909 909,000
2 1,000,000 0.826 826,000
3 1,000,000 0.751 751,000
4 1,000,000 0.683 683,000
5 1,000,000 0.621 621,000
6 1,000,000 0.564 564,000
4.354 4,354,000
However, you can see that the sum of all the DFs is 4.354. Therefore, the PV can be found
more quickly as follows: Shs 1,000,000 x 4.354 = Shs 4,354,000

The annuity factor (AF) is the name given to the sum of the individual DF. The PV of an
annuity can be found quickly using the formula:
PV = Annual cash flow x AF

Like with calculating a DF, the annuity factor can be found using an annuity formula or
annuity tables. The formula is:

AF = 1 - (1 + r)-n
R

For example, for a six-year annuity at 10%:

The AF

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 Formula or Tables
(Given in the examination)
1 – (1+r)-n You can simply find the AF from the annuity
r table by locating the DF at the 10% column
= 1 – (1.1)-6 = 4.335 and the six-year row, i.e. 4.355
0.1
Note that there might be a small difference due to rounding’s.

Discounting Perpetuities
A perpetuity is an annual cash flow that occurs forever or an annuity with an infinite life. It is
often described by examiners as a cash flow continuing for the foreseeable future. The PV of
a perpetuity is found using the following formula:
PV = Cash flow
r

or

PV = Cash flow x 1
R

1/r is known as the perpetuity factor

The use of annuity factors and perpetuity factors both assume that the first cash flow will be
occurring in one year’s time.

Application of Annuities: Sinking Funds

When a specified amount of money is needed at a specified future date, it is a good practice to
accumulate systematically a fund by means of equal periodic deposits. Such a fund is called a
sinking fund. Formally defined a sinking fund is an account earning compound interest into
which you make periodic deposits in a bid to accumulate a future sum after a specific period.

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Sinking funds are used to pay off debts, to redeem bond issues, to replace assets after useful life
and to redeem preference shares, among other things.

Since the amount needed in the sinking fund, the time the amount is needed and the interest rate
that the fund earns are known, we have an annuity problem in which the size of the payment in
the sinking-fund deposit, is to be determined. A schedule showing how a sinking fund
accumulates to the desired amount is called a sinking-fund schedule. The sinking fund formula is
as follows:
Sinking fund annually = Future value
Compound value interest factor of annuity

Capital Recovery and Loan Amortisation

Is an annuity of an investment made today at a given rate for a specific period of time. To
amortise a loan using a fixed periodic instalment to cover interest and principal repayment, we
use the present value interest factor of annuity table. The formula for the annual instalment is
shown, thus:
Annual instalment = Present Value
Present Value Interest Factor of Annuity

Example 6: Capital Recovery and Loan Amortisation

Jerry has borrowed Shs 10,000,000 payable after four years from Bank of Africa at an interest
Interest 10%.

Required: Work out the annual instalment and prepare the amortisation schedule for the loan.

Solution
Annual instalment = PV
PVIFA10%, 4 years

= 10,000,000
3.170

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 = 3,154,574.132

The Amortisation schedule is as follows:

Year Beginning Instalment Interest Principal Ending Balance
Balance [(1 x 0.10)] [(2) – (3)] [(1) – (4)]
(1) (2) (3) (4) (5)
(Shs) (Shs) (Shs) (Shs) (Shs)
0 10,000,000.000
1 10,000,000.000 3,154,574.132 1,000,000.000 2,154,574.132 7,845,426.868
2 7,845,426.868 3,154,574.132 784,542.587 2,370,031.545 5,475,395.323
3 5,475,395.323 3,154,574.132 547,739.532 2,606,834.600 2,868,560.723
4 2,868,560.723 3,154,574.132 286,856.072 2,867,718.060 842.663
Note: The small difference of Shs 842.663 is due to rounding off.

Valuation of Long-Term Assets

Valuation is the process that links risks and return to determine the worth of an asset. It is a
relatively simple process that can be applied to expected streams of benefits from bonds, stocks,
income properties, oil wells, and so on.

Why Value Business and Financial Assets

There are several reasons why valuation of shares or the value of an entire company (equity plus
debt) in both public and private companies might be required.

For quoted companies the main reason for making a business valuation is when there is a
takeover bid. In a takeover bid, the bidder always offers more for the shares in the target
company than their current market price. A valuation might therefore be made by the bidder in
order to establish a fair price or a maximum price that he will bid for the shares in the target
company.
For unquoted companies, a business valuation may be carried out for any of the following
reasons:

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 1) The company might be converted into a public limited company with the intention of
launching it on to the stock market. When a company comes to the stock market for the
first time, an issue price for the shares has to be decided.
2) When shares in an unquoted company are sold privately, the buyer and seller have to
agree a price. The buyer has to decide the minimum price he is willing to accept and the
seller has to decide the maximum price he is willing to pay.
3) When there is a merger involving unquoted companies, a valuation is needed as a basis
for deciding on the terms of the merger.
4) When a shareholder in an unquoted company retires or dies, a valuation is needed for the
purpose of establishing the tax liability on his estate.

Approaches to Valuation
The three main approaches are:
1) The dividend valuation model (DVM) - based on the return paid to a shareholder.
2) Income/earnings based methods - based on the returns earned by the company.
3) Asset based valuation models - based on the tangible assets owned by the company.

Valuing Shares: The DVM

The DVM is based on the theory that an equilibrium price for any share (or bond) on a stock
market is the future expected stream of income from the security discounted at a suitable cost of
capital. That is to say, either:
Po = D
re
Or
Po = Do (1+g)
re - g
Assuming: a constant dividend or constant growth in dividends.
re = shareholders’ required return, expressed as a decimal
g = annual growth rate
Po = value of company, when D = total dividend.

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Example 7: The DVM
Uganda Clays Ltd has the following financial information available:
Share capital in issue: 4 million ordinary shares at a par value of Shs 50.
Current dividend per share (just paid) Shs 24.
Dividend four years ago Shs 15.25.
Current equity beta 0.8

You also have the following market information:

Current market return 15%.
Risk-free rate of return is 8%

Required: Find the market capitalisation of the company.

Solution
The formula Po = Do (1+g) will provide the value of a single share. The market
re - g
capitalisation can then be found by multiplying its current share price by the number of
shares in issue.
Do = Shs 24.
g can be found by extrapolating from past dividends as follows:
g = n√ Do -1
Dividend n years ago

g = 4√ 24 -1 = 24 1/4
- 1 = 12%
15.5 15.5

re can be found using the capital asset pricing model (CAPM) as follows:
re = Rf + β (Rm – Rf)
= 8 + 0.8(15 – 8)
= 13.6%

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 Therefore
Po = 24 (1+ 0.12) = Shs 1,680
0.136 – 0.12
The market capitalisation is therefore Shs 6,720,000,000 (4,000,000 x 1,680).

Strengths and Weaknesses of the DVM

The model is theoretically sound and good for valuing a non-controlling interest but:
1) There may be problems estimating a future growth rate.
2) It assumes that growth will be constant in the future; this is not true of most companies.
3) The model is highly sensitive to change in its assumptions.

Asset Based Valuation

In this valuation method the firm's assets form the basis for the company's valuation. The
traditional asset based valuation method is to take as a starting point the value of the entire firm’s
statement of financial position assets less any liabilities.

Asset values used can be:

1) Book values. This can easily be found from the financial statements. However, it is
unlikely that book values (which are based on historic cost accounting principles) will be
a reliable indicator of current market values.
2) Replacement cost. The buyer of a business will be interested in the replacement cost,
since this represents the alternative cost of setting up a similar business from scratch.
3) Net realisable value. The seller of a business will usually see the realisable value of assets
as the minimum acceptable price in negotiations.

Problems with asset based valuation methods

The fundamental weakness of asset based valuation methods is that investors do not normally
buy a company for its statement of financial position assets, but for the earnings/cash flows that
all of its assets can produce in the future. On this basis we should therefore value what is being
purchased, i.e. the future income/cash flows.

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The subsidiary weaknesses of asset-based approach is that it ignores non-statement of financial
position intangible ‘assets’ e.g. highly-skilled workforce, strong management team and
competitive positioning of the company’s products.

When asset-based valuations are useful

For Asset Stripping
Asset valuation models are useful in the unusual situation that a company going to be purchased
is to be broken up and its assets sold off. In a break-up situation we would value the assets at
their realisable value.

To Identify a Minimum Price in a Takeover

Shareholders will be reluctant to sell at a price less than the net asset valuation even if the
prospect for income growth is poor. A standard defensive tactic in a takeover battle is to revalue
statement of financial position assets to encourage a higher price.

To Value Property Investment Companies

The market value of investment property has a close link to future cash flows and share values
i.e. discounted rental income determines the value of property assets and thus the company.

Example 8: Asset Based Measures

The following is an abridged version of the statement of financial position of Dott Services Ltd
an unquoted company as at 30 April, 2013:
Shs’000
Non-current assets (carrying value) 450,000
Net current assets 100,000
550,000
Represented by:
Shs 1,000 ordinary shares 200,000
Reserves 250,000
6% loan notes 100,000

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 550,000
You ascertain that:
Loan notes are redeemable at a premium of 2%.
Current market value of freehold property exceeds book value by Shs 30,000,000.
All assets, other than property, are estimated to be realisable at their book value.

Required: Calculate the value of an 80% holding of ordinary shares, on an assets basis.

Solution
Shs’000
Non-current assets as per statement of financial position 450,000
Add: Undervalued freehold property 30,000
Adjusted value of non-current assets 480,000
Net current assets 100,000
Net assets 580,000
Less: Payable to loan note holders on redemption (102,000)
478,000
Valuation of 80% holding = 80 /100 x Shs 478,000,000 382,400

Income/Earnings Based Methods

Income based methods of valuation are of particular use when valuing a majority shareholding
because ownership bestows additional benefits of control not reflected in the DVM model and
majority shareholders can influence dividend policy and therefore are more interested in
earnings. There are two main methods used here, namely: the price earnings (PE) method and
earnings per share (EPS).

PE ratio method
The PE method is a very simple method of valuation. It is the most commonly used method in
practice. The PE ratios are quoted for all listed companies and calculated as:
PE = Price per share/ Earnings per share (EPS)

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This can then be used to value shares in unquoted companies as:
Value of company = Total earnings x PE ratio
Value per share = EPS x PE ratio

Problems with the PE Ratio Valuation

It may be necessary to make an adjustment to the PE ratio of the similar company to make it
more suitable, e.g. if the company being valued is a private company as its shares may be less
liquid, is a more risky company – fewer controls, management knowledge, etc.

Earnings yield
The earnings yield is simply the inverse of the PE ratio:
EPS
Price per share

It can therefore be 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 x 1
Earnings yield

Value per share = EPS x 1

Earnings yield
Example 9: Earnings yield
Company A has earnings of Shs 300,000,000 A similar listed company has an earnings yield of
12.5%. Company B has earnings of Shs 420,000, 000. A similar listed company has a PE ratio
of 7.

Required: Estimate the value of each company.

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Solution
Value of company = Total earnings x 1
Earnings yield

Value of company A = Shs 300,000,000 x 1 = Shs 2,400,000,000

0.125
Value of company B = Shs 420,000,000 x 7 = Shs 2,940,000,000

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