CIMA F3 Course Notes Chapter 11 Company valuations Personal use only - not licensed for use on courses 144
1. Company valuations There are several methods of valuing the equity of a company. The simplest and most accurate method would be the value of a company s share price as listed on the stock exchange. However not all companies have their stocks listed on the stock market and so we have to use a range of other methods to value the company: Asset based valuations PE ratio method Earnings based Dividend valuation model It should be noted that the valuation from each method can be quite different, and that valuing a company is not an exact science. The range of answers from different methods can be used to create an estimate of the valuation, but ultimately the best test of the value of any business is what someone is willing to pay for it. 2. Asset based Asset-based approaches Asset based valuations depend on the addition the sum of all the individual assets of the business. This might be represented by the net assets on the balance sheet, or an updated version of that e.g. using current market values. The asset approach to business valuation is based on the principle that in investor would not pay more for the business assets than the cost of procuring similar assets themselves. Use of asset-based valuations Asset based valuations tend to be used less than other valuation methods because of the difficulty in accurately valuing assets, particularly intangible assets such as brands, and the fact that much of the value of a business lies in aspects other than their assets such as reputation, quality and processes market position and dominance, staff skill and knowledge and so on. Asset based valuations therefore work best in capital intensive businesses such as property development, where the value of the business depends largely on the value of the underlying assets and far less well for service businesses such as an accounting firm where the value of the business lies in its people, processes and reputation. Asset based valuations can also work well if the company has been poorly performing and there is little value in the company other than it s Personal use only - not licensed for use on courses 145
underlying assets. Companies which are being liquidated are likely to be valued using an asset based approach. Methods of valuing assets Historic cost: The original cost of the asset investment. This is known and correct, and often easily found as the net assets figure on the balance sheet. However, it only represents past amounts spent, which may be outdated, and depends on the accuracy of depreciation policies which may over or undervalue assets in the real world. Replacement cost: The cost of replacing the assets can be used. This updates historic costs with current prices, but may overvalue older assets. Net realisable value: This is the value if assets if sold on the open market. This might be useful to value companies going into liquidation, or where a good estimate of market value can be made, such as property companies. 3. Earnings based approaches Earnings based methods use known market valuations of similar listed companies to estimate a value of the business. PE ratio method The value of the business = Earnings x PE ratio(of a similar listed business) If the businesses being valued is not (and will not be) listed, the value of the company is reduced, typically by multiplying by 2/3; unlisted shares do not have an open market (i.e. they are illiquid) and it is likely that a lower value would have to be accepted if shares in the company were sold. Value of unlisted business = Earnings x PE ratio x 2 3 Personal use only - not licensed for use on courses 146
Example Eddy Ltd is a successful games software development firm. An asset-based valuation is not appropriate as the value of its key assets (its games and its development team) are not reflected on the balance sheet. A similar listed company has recently floated on the stock market. It has earnings per share of 0.50 and a current share price of 10. Eddy earns profits of 1.2m per annum. Value = 10 x 1.2m = 24m 0. 5 Earnings yield You could be given the earnings yield (earnings/price) as an alternative to the PE ratio. If so simply convert into a PE ratio using: PE ratio = 1. Earnings yield Limitations The limitations of this method are: A comparable listed business must be available to compare against (even if the business is in the same industry it is unlikely to have exactly the same business characteristics) The market value of the listed business is accurate (which it will be if we assume efficient markets as per the efficient market hypothesis) 4. Cashflow based methods Just as we can calculate the value of a project by calculating the discounted cashflows to find the net present value, we can value the how business using the same methodology. The business is valued at the present value of future cashflows of the whole business, discounted at the weighted average cost of capital (WACC). An NPV can be calculated in tabular format, and discounted using normal NPV approach. Personal use only - not licensed for use on courses 147
If the cashflows are the same each year or growing by a consistent amount the following formula can be used: Valuation = Next year s cashflow x 1. Ke-g Ke = cost of capital, g = growth rate Ideally we would calculate the company s future cashflows and use this as the basis of the valuation, but we are often only given details of their earnings which is often used as an estimate of cashflow. 5. Example As part of the company s expansion plans BQ a construction company have been seeking opportunities to acquire other construction companies in new markets. Details of one target company based in Australia, taken from the latest accounts are as follows: 2010 2009 Aus$m Aus$m Turnover 1,032 998 Cost of sales 999 967 Gross profit 33 31 Administrative, financing 22 21 expenses, and tax Profit 11 10 They believe that based on a strong current order book and improved economic conditions in the future that profitability, and hence cashflows, will increase by approximately 3% per annum for the foreseeable future. They also believe that synergies between the two firms will increase profits by about 20% per annum. What is the valuation using the NPV method and a cost of capital of 10%. Solution Valuation = Next year s cashflow x 1. Ke-g Ke = cost of capital, g = growth rate = 13.60 (W1) x 1. 0.1-0.03 = Aus$ 194.29 Personal use only - not licensed for use on courses 148
(W1) Next years cashflow = Profit x 120% (synergies) x 3% growth = 13.60 6. Dividend Growth Model and Dividend Yield Dividend growth model The dividend growth model is a way of valuing a company, finding its share price or working out the cost of equity capital based on the theory that a share is worth the discounted sum of all of its future dividend payments. We are used to calculating the Net Present Value of an investment to understand the value of the investment. This is simply a way to value shares using the same approach, instead valuing the share based on the net present value of the future dividends. The equation used is called Gordon s growth model, named after Myron Gordon who originally published it in 1959. P 0 d 1 = k e g P 0 g k e d 1 is the current share price is the growth rate expected for the dividends is the cost of equity is the value of the next year's dividend If dividends are expected to remain constant then g is 0 and the formula becomes d P = 1 0 k e This equation can also be used to calculate the cost of capital by rearranging it to: d1 P 0 = + g P 0 Personal use only - not licensed for use on courses 149
d 1 can often be calculated using the current years dividend if next year s dividend is not available, as it is simply this year s dividend with one year of growth or d 1 = do (1+g) ( + g) d k e = 1 0 + g P 0 Example questions share prices Investors require a return of 12%, and the current dividend was 20p per share. It typically rises at 5% per annum. What is the expected share price? P 0 d 1 = k e g = 0.2 (1 + 0.05) 0.12 0.05 = 3.00 7. Cost of capital to use for valuations In mergers and acquisitions, there are many instances when companies acquire targets from another industry. In such cases, if the acquirer were to use the weighted cost of capital (WACC) of its current capital structure, it would be incorrect. This is because the current WACC represents the current level of risk that the shareholders have to undertake to gain the current rate of return. However in most cases, especially when acquiring a company from a different industry, the capital structure of the company would undergo a change after the acquisition. Hence the current WACC of the company would be incorrect. The company therefore needs to recalculate the WACC based on the future or proposed capital structure. Example Wayne Ltd a textile company is looking to diversify into the beverages industry, away from its main line of business. This project requires a capital investment of $500,000. The company is expecting to generate a post-tax annual cash flow of $75,000 per year into perpetuity. The management expects to finance 40% of the initial capital expenditure through debt. The loan will be irredeemable and carry an annual interest rate of 10%. The remaining capital expenditure would be covered through an equity placement (assuming no flotation or issue cost on this placement). Personal use only - not licensed for use on courses 150
Now the beverages industry has an average geared equity beta of 1.368 and a debt : equity ratio of 1 : 5. As per Wayne Ltd s current capital structure, its current geared equity is 1.5 and debt comprises of 20% of total capital structure and the cost of debt is 5%. The current risk free rate in the market is 5% and the market s rate of return is 10%. For the purpose of calculation corporate tax can be assumed to be at 20%. Now based on this information, we can calculate Wayne Ltd s WACC- WACC = k d (1 - t) V d + k e V e (previously explained in Chp 5) V e + V d V e + V d Where; k e = r f + β e (r m - r f ) k d = cost of debt = 5% k e = cost of equity (calculate using formula) V e = value of equity (80% of total value is equity) V d = value of debt (20% of total value is debt) t = tax (20%) β e = equity s beta = 1.5 r f = risk-free rate of return = 5% r m = market s rate of return = 10% WACC = 0.05 (1-0.20) [0.20] + (0.05 + 1.5 (0.10 0.05)) [0.80] = 0.80% + 11.00% = 11.80% However 11.80% is the WACC for Wayne Ltd as per its current capital structure, which would be ideal if it was assessing a project in the textile industry. But in this case, Wayne Ltd is considering whether to enter the beverages industry for which the capital structure and the WACC would be different. Taking this into perspective, we need to find a WACC which is in line with shareholders expectations with regards to the new risk of the beverages industry. Since this is the company s first time into this industry, we would need to consider a proxy figure based on the beverage industry s beta. There are two methods you need to know Method 1 Adjusted WACC using beta The first method adjusts the WACC using betas. You may like to remind yourself of use of betas for cost of capital in the cost of capital chapter before reviewing this section. Personal use only - not licensed for use on courses 151
Step 1 Un-gear the geared industry beta In order to un-gear the geared beta of the beverage industry we use the following: β = ug β g V e Ve + Vd ( 1 t) where β ug = un-geared beta β g = geared beta distribution industry = 1.368 V e = value of equity (Ratio 5:1 = 5/6=83%) V d = value of debt (Ration 1:5 = 1/6 = 17%) t = tax = 20% β ug 0.83 = 1.368 0.83 + 0.17(1 0.2) = 1.368 [0.859] = 1.18 Step 2 Re-gear the ungeared beta using company s debt Remember, the un-geared beta means the figure without any debt in the capital structure. That s not going to be suitable for Wayne Ltd though as they do have debt, so we now need to find the beta which includes the debt (the geared beta). We should calculate the geared beta under the new capital structure i.e. debt:equity of 40:60. This ratio is based on the new financial arrangements. We can rearrange the B ug formula above to make one for B g and then use this to work out what the new beta will be: β g = V e β ug V e + Vd ( 1 t) where β ug = un-geared beta = 1.18 (step 1) β g = geared beta V e = value of equity (60%) V d = value of debt (40%) t = tax (20%) Personal use only - not licensed for use on courses 152
1.18 β g = = 1.81 0.6 0.6 + 0.4(1 0.2) Step 3 Calculate the new cost of equity This geared beta can now be used to calculated the new cost of equity using the CAPM k e = r f + β e (r m - r f ) where k e = value of equity β e = equity s beta r f = risk-free rate of return r m = market s rate of return k e = 5% + 1.81 (10% - 5%) = 14.05% Step 4 - Calculate the new WACC for the project WACC = k d (1 - t) V d + k e V e V e + V d V e + V d WACC = 5% (1-0.2) x 0.40 + (14.05% x 0.60) + = 10.03% Step 5 - Calculate the project s NPV Based on this WACC, the project s NPV is as follows NPV = [ PAT (before financing charges) WACC ] Cash outflow NPV = [75,000 10.03%] 500,000 = 247,756 Note that while calculating NPV, we should always consider the post-tax annual earnings before financing charges because these charges are already included in the WACC calculation. Method 2 - Adjusted present value (APV) An alterative method is to use the adjusted present value technique from the investment appraisal chapter. You might like to remind yourself of this first before reviewing this section. Step 1 as above Personal use only - not licensed for use on courses 153
Step 2 Calculate the new WACC Under this method we assume that Wayne Ltd. is an all equity firm and use the un-geared beta to calculate the cost of equity capital k e = r f + β e (r m - r f ) k e = 5% + 1.18 (10% - 5%) => 5% + 5.90% = 10.90% Step 3 Calculate a base case This cost of equity is used to calculate a base case NPV = [ PAT (before financing charges) WACC ] Cash outflow NPV = [75,000 10.90%] 500,000 => 688,073 500,000 = 188,073 Step 4 Calculate the present value Now, we apply the financing side-effects, by calculating the present value of the debt interest using the pre-tax cost of debt as a discount rate. Debt interest = 5% x (40% x 500,000) = 10,000 Tax relief = 10,000 x 20% = 2,000 PV of the tax relief = 2,000 5% = 40,000 Therefore APV of the beverages industry = 40,000 + 188,073 = 228,073 Which method? The two methods have given different answers 247,906 and 228,073. This is because the APV method considers 40% of (500,000) as the amount of debt while the adjusted WACC method considers the tax benefit on the additional debt capacity. The risk adjusted WACC is advantageous as it is easier to calculate and has only one hurdle rate to calculate. While the APV method is more flexible as it takes it account other side effects like subsidies on the loan. APV method is also useful when recalculation is to be done when there is a change in the capital structure. Personal use only - not licensed for use on courses 154
8. Comparison of valuation methods When a company (acquirer) is bidding to take over another company (target), there are various ways in which it can calculate the value of said target company. These methods are: Asset based approach Price earnings (P/E) approach Dividend valuation method Discounted cash flows approach Using all the three methods can provide a range of different valuations of the target company. This would provide the acquirer with a rangemaximum, minimum and average value. These methods have been discussed in detail earlier. In this section we would be discussing the advantages and disadvantages of each method. This would explain the circumstances under which each method could be used. Asset based approach Advantages This method provides the minimum value of the business. If the seller were to liquidate the business at a particular moment it would either get the balance sheet value or net realisable value of the company whichever is less. It can be useful as a minimum value for a seller when bargaining the price. Disadvantages This method does not consider intangible assets and goodwill. It does not consider the future earnings of the company, which is what a potential buyer would be most interested in. It would be difficult to find a free market which would provide the net realisable value for each asset on the balance sheet. Personal use only - not licensed for use on courses 155
Price earnings (P/E) approach Advantages This method provides an industry average of where the target company is valued in respect with its peers in the same industry. It gives a figure based on current fair market prices on the stock market. Disadvantages It will be very difficult to find an accurate P/E ratio for the company especially since every company is unique in its own way. The earnings considered could vary a lot if there are any one-off incomes or expenses in the year of acquisition. The discounted PE for unlisted companies (usually 2/3 of a listed PE) is a pure estimate. It could be ¾ or just ½ depending on people s perceptions. Dividend valuation method Advantages This can be very useful when acquiring an all equity firm with predictable dividend streams. Disadvantages Under this method dividend growth rate needs to be estimated. This can be very difficult and tricky. This method assumes that dividend growth rate and growth rate of the company is constant. In reality that is never true. This method cannot be used in case of companies that provide returns to their shareholders through increased capital gains. For example Microsoft did not distribute dividends during its initial years but its investors gained returns on the significant increase in share price. The nature of the calculation can mean high growth companies can be given negative valuations, if g > Ke, which is obviously incorrect. Personal use only - not licensed for use on courses 156
Discounted cash flow approach Advantages It calculates the present value of all future earnings using the cost of capital that is most appropriate to the company, giving a theoretically robust valuation. This method considers the future earning power of the target company. It is this advantage that the acquirer would be most interested in. This method ignores historical results which are not necessarily reflective of the future. Disadvantages The cash flows predicted under this method are uncertain and can be very unreliable, as predicting the future growth prospects of company and the industry can be very difficult. It is dependent on many uncertain underlying assumptions. 9. Valuing intangible assets Intangibles are assets which don t have a physical presence but still add value to the company. They can be brands, patents, goodwill, skill and knowledge of a company s workforce, a company s corporate strategy etc. They generally tend to be unique to a company and its business. The measurement of these assets can be difficult, especially since they are hard to recognise and find a similar substitute in the market. The value of intangibles also tends to rapidly change with time and circumstances of the company. There are three methods of valuation. Market capitalisation and tangible asset value The market capitalisation of a company represents the total value of tangible and intangible assets. The book value of the company represents the tangible net assets as per financial statements. The difference between market capitalisation and the book value should be equal to the value of the intangible assets of the company. Intangible assets = Market Capitalisation Value of Tangible Assets Personal use only - not licensed for use on courses 157
Problems with this approach: The book value can be outdated as they are based on historical values. They can be substituted by the replacement costs of the tangible assets. But replacement costs can be hard to find. Market value can be difficult to calculate if the company is not listed. Then it can be calculated using price/earnings method, discounted cash flows approach or dividend valuation method, but as we saw earlier these values are often very varied an inaccurate. Calculated Intangible value (CIV) The CIV method calculates the value of intangible assets based on excess returns the company earns in comparison to its peers. This excess return is calculating by difference between the returns of the company with the expected returns of a similar company. The weakness of this method is that the expected returns of another company would include the intangible assets of that company. As a result, the CIV measures the additional intangible assets the company has over a similar company. Intangible to tangible asset ratio This method calculates ratio of intangible to tangible assets of a similar company or an industry average and applies it to the tangible assets of the company, to calculate the value of intangible assets. This method assumes that similar companies will have similar levels of intangible assets, which in reality is never true. These three methods would provide different answers for each company. The decision on which method to choose would depend upon the circumstances under which the valuation of intangible assets is being done. Personal use only - not licensed for use on courses 158
Example Below are the financial statements of Emerson Co. Carrick ltd. financial position on 31 st December 2012 m Assets Non-current assets Property, plant and equipment (book values) 4,900 Current assets Inventories 160 Receivables 3,750 Cash 288 Total 9,098 Equity and liabilities Equity Share capital and reserves 3,418 Non-current liabilities Loan stock 2,700 Current liabilities 2,980 Total 9,098 Carrick ltd. has 400 million shares currently trading at 25.00 per share Replacement cost as per the current market value for the tangible assets is 5,800 million The pre-tax return on the book value for Carrick ltd s tangible assets 13% while the industry average is 16% The cost of capital for Carrick ltd. is 15% The current tax rate is 30% A similar company s tangible non-current assets have a value of 7,400 million while its intangible assets have a value of 1,540 million Required: Calculate the value of intangible assets as per the 3 methods. Solution Method 1 Carrick ltd s market capitalisation = 400 m x 25 = 10,000 m Book value of net assets (capital & reserves) = 3,418 m Value of intangible assets = 10,000 3418 = 6,582 m Personal use only - not licensed for use on courses 159
Difference between the book value of Carrick ltd s property, plant and equipment and its replacement cost = 5800 4900 = 900 m If we adjust this replacement cost against the cost of intangible assets = 6,582 900 = 5682 m Method 2 Value of Carrick ltd s net tangible assets = 9098 2980 = 6118 m Pre-tax return on net tangibles in excess of the industry average = (16% - 13%) x 6118 = 183.54 m After tax return = 183.54 x (1 30%) = 128.48 m Value of intangible assets= present value of post-tax earnings at Carrick ltd cost of capital = 128.48 15% = 856.52 m Method 3 The ratio of intangible to tangible assets for a similar company = 1540 7400 = 21% Value of intangible assets = 21% x 4900 = 1019.69 mn 10. Efficient Market Hypothesis and valuations The share value of listed companies is available on the stock market on a daily basis. The ability to value a company based on its stock market price depends on the efficiency of the market. The efficient-market hypothesis (EMH) is the theory that financial markets are "informationally efficient". This means that stock prices are fair and reflect all information available about them. Investors and researchers have disputed the efficient-market hypothesis. From experience we know that investors may 'temporarily' move financial prices away from their long term aggregate price 'trends'. Over-reactions may occur so that excessive optimism may drive prices unduly high or excessive pessimism may drive prices unduly low. Economists continue to debate whether financial markets are 'generally' efficient. If markets are truly efficient then the current share price should be correct and reflective of all the information available. Personal use only - not licensed for use on courses 160
If they are not, for instance because of excessive pessimism, the other valuation approaches may offer a more objective perspective on the company s valuation. Personal use only - not licensed for use on courses 161
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