Chapter Business Valuation

Business valuations
Reasons for business valuation
There are several reasons why a valuation might be required.

Quoted companies
Quoted companies already have a share price valuation: this is the current market price of the shares.
The main reason for making a business valuation for a quoted company 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 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. The valuation placed on a target
company by the bidder can vary substantially, depending on the plans that the bidder has for the
target company after the takeover has been completed.

Unquoted companies
For unquoted companies, a business valuation may be carried out for any of the following reasons:

 The company might be converted into a public limited company with the intention of
launching it on to the stock market.

 When shares in an unquoted company are sold privately, the buyer and seller have to agree a
price.

 When there is a merger involving unquoted companies, a valuation is needed as a basis for
deciding on the terms of the merger.

 When a shareholder in an unquoted company dies, a valuation is needed for the purpose of
establishing the tax liability on his estate.

Valuation models
There are two broad approaches to valuing companies.
 Income-based valuation models which focus on the future earnings or cash flows of the
company.
o P/E ratio method
o Earning yield method
o Dividend valuation model
 DVM – Constant annual dividends
 DVM – Constant rate of growth in annual dividends
 The earnings retention valuation model
o Cash flow valuation method
 Discounted cash flow basis
 Discounting estimated free cash flows and shareholder value analysis

 Asset-based valuation models which focus on the value of the company’s assets.
o Net asset value (Balance Sheet basis)
o Net asset value (Net realizable value)
o Net asset value (Replacement value)
o The valuation of debt and preference shares

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Range of Values
Normally following range of values are calculated using different methods

Max Value of the cash flow or earnings under new ownership

Value of the dividends under the existing management
Min Value of the assets

A Income-Based Valuation Method

1 Price/Earnings (P/E) ratio method

It is the ratio of the market value of a share to the annual earnings per share. For every company
whose shares are traded on a stock market, there is a P/E ratio. For private companies (companies
whose shares are not traded on a stock market) a suitable P/E ratio can be selected and used to derive
a valuation for the shares.

Value = EPS × Estimated P/E ratio

 The EPS might be the EPS in the previous year, an average EPS for a number of recent years
or a forecast of EPS in a future year
 The P/E ratio is selected as a ratio that seems appropriate or suitable. The selected ratio might
be based on the average P/E ratio of a number of similar companies whose shares are traded
on a stock market, for which a current P/E ratio is therefore available.

The main advantage of a P/E ratio valuation is its simplicity.

This provides a useful benchmark valuation for negotiations in a takeover, or for discussing the
flotation price for shares with the company’s investment bank advisers.

2 Earning yield method

With the earnings yield method of valuation, a company’s shares are valued using its annual earnings
and a suitable earnings yield.

Annual Earnings
Earnings yield % =
Market value of share

Using the earnings yield method of valuation, this formula is adapted as follows:

Annual Earnings
Market value of share =
Earnings yield %

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The earnings yield method of valuation is essentially a variation of the P/E ratio method of valuation
and is subject to the same criticisms.

3 Dividend valuation method

a) Constant annual dividend
The dividend valuation model is a more objective and cash-based approach to the valuation of
shares. Like the P/E ratio method and earnings yield method, it is an income-based valuation method.

The basic assumption with the dividend valuation models is that the value of shares to shareholders
is the value of all the future dividends that they expect to receive from those shares in the future.

If the fair value of a share represents the value of all expected future dividends, this value can be
estimated by discounting expected future dividends to a present value at the shareholders’ cost of
capital. All expected future dividends ‘in perpetuity’ are therefore discounted to a present value at
the cost of equity capital.

Without going into the mathematics to prove the valuation model, it can be shown that if it is
assumed that the company will pay a constant annual dividend every year into the foreseeable
future, the present value of those dividends, and so the value of the shares, is:

D
P0 =
ke

Where:
P0 = the current value of the share ex dividend. A share price ex dividend is a price that excludes
the value of the annual dividend in the current year.
D = the amount of the annual cash dividend.
ke = the shareholders’ cost of capital expressed as a proportion (so 9% = 0.09, etc).

b) Constant rate of growth in annual dividends

The dividend growth model assumes that the annual dividend payable by a business will grow at a
constant annual growth rate.

The equation for obtaining a market value, based on a shareholder’s expected rate of return (ke), the
projected growth rate (g) and the company’s dividend (d0) is given below:

D0 (1+g)
P0 =
ke - g

So, for example, if the company’s current dividend is 20 pence per share, its cost of equity is 18 per
cent and it is expecting growth in earnings and dividends of 9 per cent per annum, we would estimate
a share valuation of:

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20 (1.09)
P0 =
0.18 - 0.09

c) The earnings retention valuation model

Dividend growth can be achieved by retaining some profits (retained earnings) for reinvestment in
the business. Reinvested earnings should provide extra profits in the future, so that higher dividends
can be paid. When a company retains a proportion of its earnings each year, the expected annual
future growth rate in dividends can be estimated using the formula:

g = br

where:
g = annual growth rate in dividends in perpetuity
b = proportion of earnings retained (for reinvestment in the business)
r = the cost of equity capital, which is also assumed to be the rate of return that the company will
make on its investments of retained earnings.

The dividend growth model can therefore be restated as follows. (This is sometimes called the Gordon growth
model as well as the earnings retention valuation model.)

D0 (1+br)
P0 =
ke – br

4 Cash flow valuation method

a) Discounted cash flow basis

A discounted cash flow basis might be used when a takeover of a company is under consideration, to
value either

(1) the company in total (equity and debt capital) or

(2) the company’s equity shares only.

 The basic assumptions in a DCF-based valuation are as follows.

 The acquisition of the target company is a form of capital investment by the company making
the acquisition.
 Like any other capital investment, it can be evaluated by DCF, using the NPV method.
 After the target company is acquired, its cash flows will come under the control of the
company making the acquisition.
 A maximum valuation for the target company can therefore be obtained by estimating the
future cash flows from acquiring the company, and discounting these to a present value at a
suitable cost of capital (perhaps the acquiring company’s WACC).

b) Discounting estimated free cash flows and shareholder value analysis

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One way of estimating the cash profits or cash flows from a major acquisition is to estimate the free
cash flows of the target company and discount these to a present value. Free cash flow is the annual
cash flow after paying for all essential expenditures.

This method makes the following assumptions:

 Free cash flow can be defined in a variety of different, although similar ways. One definition
is that free cash flow in each year is the total earnings before interest, tax, depreciation and
amortisation, less essential payments of interest, tax and purchases of replacement capital
expenditure.
 The annual free cash flows that a company is expected to earn in perpetuity can be discounted
to a present value, using the company’s weighted average cost of capital (WACC) as the
discount rate.
 This discounted value of future free cash flows gives a total valuation for the company’s
equity capital (shares) plus its debt capital.
 The fair value of the company’s shares is therefore the present value of these free cash flows
minus the current market value of the company’s debt. This is known as shareholder value
and the approach is sometimes known as shareholder value analysis (SVA).

Shareholder value analysis

Shareholder value analysis estimates a value for the equity capital of a company by:
Calculating the present value of all future annual free cash flows to obtain a valuation for the entire
company, and then
Deducting the value of the company’s debt capital
Value of shares = PV of expected free cash flows (as defined) minus Market value of debt capital

B Asset-Based Valuation Method

Net Assets Value
Using an asset-based valuation, the value of a company is equal to the net assets attributable to the
equity shares. Intangible assets are only included if they have a realisable value.

Net assets attributable to equity = non-current assets

+ current assets
- current liabilities
- non-current liabilities
- preference shares

Choice of valuation base

The valuation can be used on various factors, for example:

Balance Sheet Value. This method suffers from being largely a function of depreciation policy, for
example, some assets may be written down prematurely and others carried at values well above their
real worth. Original costs may of little use if assets are very old.

Net realizable value. Individual assets are valued at the best price obtainable, which will depend
partly on the second-hand market and partly on the urgency of realising the asset.

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Replacement value. This method recognises the additional store of worth to be derived from the
future use of the asset.

Advantages and Disadvantages of Valuation Methods

Valuation Method Advantages Disadvantages

Earning based valuation
Dividend Valuation Model
Assets Based Valuation
It is simple in calculation
It uses total earning of company for
capitalization
It includes future growth
It uses present value technique
It is useful for setting floor value of
company
It is suitable for companies with high
tangible non current assets
Which P/E ratio is to use
Adjustment in P/E ratio is required if
valuing an unlisted company
Earnings may be affected by one-off
transaction.
It is difficult to measure future
dividend growth
It is inaccurate to assume that growth
will be constant
It creates zero value for zero
dividend companies
It creates negative value for high
growth companies, if g > ke
It ignores intangible assets and future
profits
It is less appropriate for service
oraganizations

Factors to consider in Mergers and Takeovers

Assets of shares:- most companies buy the victim company’s shares rather than transferring their assets.
Both are feasible.

Synergies:- concept of “2+2=5”.Many sources exist:

a) Economies of scale from horizontal combinations reduces costs and increase profits.
b) Buying suppliers can reduce profit charged on purchases i.e. cut out the middle man.
c) Improve badly managed /inefficient businesses.
d) Diversify to stabilise profits and cash flows.
e) Access companies that generate cash (Cash Cow)
f) Use the managerial talent of the victim in a more productive way.
g) Market power may allow consumer price increases and more profits.

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Valuation of other securities

The value of debt securities (bonds) is the present value of all future interest payments and the repayment of
the debt principal, discounted at the cost of the debt.

Valuation of irredeemable fixed rate debt

The value of irredeemable fixed rate debt is the present value of interest payments in perpetuity. The valuation
model for irredeemable debt is similar to the dividend valuation model with constant annual dividends.

Without Taxation

i
P0 =
rd

Where: i = amount of the regular fixed interest payment and rd is the interest yield (before tax)
required by the bond investor. By convention, bonds are usually valued at an amount per $100 or
€100 or £100 nominal value of the bonds.

With Taxation

i (1-T)
P0 =
rdt

Where T = Tax rate and rdt is interest yield after tax.

Valuation of redeemable fixed rate debt

The value of redeemable fixed rate debt is the present value of all future interest payments on the
bond to maturity, plus the present value of the principal repayment at maturity, discounted at the
interest yield on the bond.

Valuation of convertible bonds

The market value of a convertible bond is the higher of:
 the value of the bond as a straight bond that will be redeemed at maturity, and
 the present value of future interest payments up to the time that the bonds can be converted
into shares, plus the present value of the expected market value of the shares into which the
bonds can be converted.

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The efficient market hypothesis

The purpose of a stock market is to bring together those people who have funds to invest with those
who need funds to undertake investments. Companies seeking to raise equity are asking investors for
a permanent investment as equity shares have no redemption date. Investors may not be encouraged
to invest on these terms unless they can be convinced that they will be able to realise their investment
at a fair price at any time in the future.

For this to happen, stock markets must price shares efficiently. Efficient pricing means incorporating
into the share price all information that could possibly affect it. In an efficient market investors can
buy and sell shares at a fair price and companies can raise funds at a cost that reflects the risk of the
investments they are seeking to undertake.

A considerable body of finance theory has been built on the hypothesis that, in an efficient market,
prices fully and instantaneously reflect all available information. The efficient market hypothesis
(EMH) is therefore concerned with information and pricing efficiency.
Three levels or forms of efficiency have been defined: these are dependent on the amount of
information available to the participants in the market.

The nature of capital market efficiency

There are four types of capital market efficiency:

 Operational efficiency. A capital market is efficient operationally when transaction costs for
buying and selling shares are low, and do not discourage investors from taking decisions to
buy or sell.

 Informational efficiency. A capital market is efficient ‘informationally’ when available

information about companies is processed and made available to investors.

 Pricing efficiency. A market has pricing efficiency when investors react quickly to new
information that is made available in the market, so that current share prices are a fair
reflection of all this information. For pricing efficiency to exist, a capital market must also be
operationally and informationally efficient.

 Allocational efficiency. When there is allocational efficiency in a capital market, available

investment funds are allocated to their most productive use. Allocational efficiency arises
from pricing efficiency.

The purpose of the efficient market hypothesis (EMH)

The efficient market hypothesis (EMH) is a theory of market efficiency, based on research into share
price behaviour in stock markets. The purpose of this research is to establish the extent to which
capital markets show pricing efficiency.

According to this theory there are three possible levels or ‘forms’ of market efficiency:

Weak form
The EMH in its weak form says that the current share price reflects all the information that could be
gleaned from a study of past share prices. If this holds, then no investor can earn above-average
returns by developing trading rules based on historical price or return information. This form of the
hypothesis can be related to the activities of chartists using technical analysis. The EMH in its weak

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form questions the value of technical analysis, as share prices will move randomly if the market
shows weak form efficiency.

The weak form of the efficient market hypothesis has been tested by subjecting series of share prices
or indices to statistical tests to determine whether there is any correlation between past and present
prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past
prices. Another series of tests has been to establish whether trading rules enable above-average
returns to be earned. These tests attempt to determine if it is possible to earn above-average returns
by following standardised trading rules.

Semi-strong form
The semi-strong form of the EMH says that the current share price will not only reflect all historical
information, but will also reflect all other published information. If this holds, then no investor can
be expected to earn above-average returns from trading rules based on any publicly available
information. This form of the hypothesis can be related to fundamental analysis. Fundamental
analysis attempts to identify over- or undervalued companies through studying publicly available
information. The EMH in the semi-strong form suggests that any publicly available information will
already be captured in the current share price.
Studies have shown that it is not possible to benefit from always buying shares when good news is
published. This is explained by the fact that the speed at which the market reacts to public
information is so rapid that individual investors cannot adopt a policy that will consistently result in
exceptional profits from a quick reaction to good news.

Strong form
The strong form of the EMH says that the current share price incorporates all information, including
non-published information. This would include insider information and views held by the directors
of the company. If this holds, then no investor can earn above average returns using any information
whether publicly available or not.
It is difficult to test this proposition as with ‘insider information’ it should be possible to gain some
advantage. A member of staff involved in a takeover bid could predict the likely movement in the
share price of the companies concerned. It would then be possible to buy or sell shares in the
companies before the details of the takeover bid were published. As ‘insider trading’ is illegal, it is
difficult to test this form of the EMH.

Implications of EMH for financial managers

If capital markets are efficient, the main implications for financial managers are:
 the timing of issues of debt or equity is not critical, as the prices quoted in the market are
‘fair’;
 a company cannot mislead the markets by adopting ‘creative accounting’ techniques;
 the company’s share price will reflect the net present value of the company’s future cash
flows, so managers must only ensure that all investments are expected to exceed the
company’s cost of capital.

A summary of the hypothesis is as follows:

 the weak form of efficiency is where share prices reflect all historical information;
 the semi-strong form of efficiency is where share prices reflect all publicly available
information;
 the strong form of efficiency is where share prices reflect all information (public and
internal) and is the perfect information environment.

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Practice Questions
1. Being a financial director you are asked to calculate the range of bid price to be offered to
Alpha plc. Financial information relating to Alpha plc

Number of shares outstanding 1 million

Earning per share 85.0c
Payout ratio 40%
Dividend growth 4%
Industry average price earning ratio 10 times
Cost of equity 12%

Required:
Calculate the value of Alpha plc using the following methods
i) Price/earning ratio
ii) Dividend growth model

2. It is now 2010, and Y plc has paid out the following dividend out of income earned in past
five years
Annual
Year Dividend
Earnings
2005 56,000 28,000
2006 58,000 29,000
2007 64,000 32,000
2008 62,000 31,000
2009 66,000 33,000
Y plc can earn 20% on re-investment.

Required:
Estimate the average rate of growth of dividend p.a. using
i) The rate of growth in past
ii) The ‘rb’ model

3. Strong plc is considering to take-over weak plc which operates in same industry but not
listed, following information is related to financial position of both companies:

Weak Strong
Number of shares outstanding 1 million 2 million
Annual Earnings 350,000 840,000
Payout ratio 40% 60%
Dividend growth 4% 7%
Market price of the share N/A $4.2
Cost of equity 12% 10%

Required:
Calculate the value of Weak plc using the following methods
i) Price/earning ratio
ii) Dividend growth model

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4. Following information is related to annual cash flow of RBT plc which is under consideration
of take-over by HRD plc
Year Free
Cash Flow
1-5 250,000
6-15 300,000
Afterwards 450,000

Weighted average cost of capital is 10% and 14% of RBT and HRD respectively.

Required
You are required to calculate the value of company using free cash flow’s present value
technique.

5. A company has assets that have been valued at $20 million. This valuation is based on the
current disposal value of the assets. The company has $4 million of liabilities. It has share
capital of 200,000 shares of $0.25 each.

A valuation of the shares based on the net asset value of the company would be:

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