Managerial Accounting and Finance 3B

Valuations
Chapter 6
 Learning Objectives
• Describe the basic concepts to be applied in the
valuation of assets
• Value debentures, bonds and preference shares
• Value ordinary equity using:
– The dividend discount model
– The free cash flow model
– Various price multiples
– The Economic Value Added approach
• Adjust valuations for issues such as marketability,
share options and non-controlling interests
 Valuations: An overview
Key idea:
 Valuations: An overview
Keeping valuations in perspective:
 The risk and return relationship
Mean-variance rule
Investment A Investment B
Return R1 000 000 R1 200 000
Risk 9% 9%

Investment A Investment B
Return R1 000 000 R1 000 000
Risk 9% 12%
 The risk and return relationship
Comparing rates of return

Investment A Investment B
Return R1 000 000 R900 000
Cost R10 000 000 R8 000 000
 Required rate of return
The required rate of return is:
 What are we valuing?
A company (A)

Debt[l) Equity (o)

 What can be valued?

Debentures and bonds

Preference shares

Equity
 Valuing equity shares
Methods:
1. Dividend discount models

2. Price multiples

3. Free cash flow models

4. EVA discount model

5. Net asset value model

 Dividend Discount Model
Key idea:

When appropriate
-Valuing the equity of the firm
-Minority stake (no control over dividend policy)
 Dividend Discount Model
The basic idea:

When we have constant growth

 Dividend Discount Model
The growth rate
Growth rates are difficult to estimate. Potential
methods of estimating the growth rate include:
1. Implicit growth rate from dividend discount
model.
2. Arithmetic mean
3. Geometric mean
4. Sustainable growth rate
 Dividend Discount Model
Self study sections
1. How do we value shares if investors are selling in
a few years time? (p. 6-12)
2. What is the role of future earnings? (p. 6-13)
3. Is it possible to increase the value of a
company’s shares by increasing dividends? (p. 6-
13)
4. Limitations of dividend discount model (p. 6-14)
5. Zero growth in dividends (p. 6-14)
 Price multiples
Key idea:
 Price multiples
Remember from Financial Statement Analysis:
 Price multiples
Common adjustments for PE ratio
 Price multiples
Example of adjustments
PE Ratio Earnings Yield
Listed comparative
Poor marketability
Limited transferability
Smaller firm size
Loss of key management
Control premium
Private rate
 Price multiples
Earnings
We should always use the latest maintainable
earnings.
Common adjustments include:
1. Adjustment for non-recurring items
2. Adjustments for non-arms length transactions
3. Adjustments for accounting policies
 Price multiples
Earnings
Enterprise value vs equity value
 Price multiples
Advantages
- Quick, easy and understandable
Disadvantages
- Based on historic earnings
- Past is not reflective of the future
- Earning manipulation
- Temporary drop in earnings for a period
- Incurrence of losses
- Using accounting profit and not cash flows
- Considerable subjectivity
 Price multiples
Self study sections

1. The use of forward P/E ratios (p. 6-21)

2. Market to book ratio (p. 6-22)
3. Price to sales ratio (p. 6-23)
 Free cash flows
Again, we can value the equity directly or
indirectly:
Enterprise approach – indirect
Equity approach – direct

The enterprise approach is the most commonly

used approach.
 Free cash flows
Enterprise approach – Calculating cash flows
 Free cash flows
Enterprise approach – terminal values
It is not possible to predict cash flows indefinitely.
Thus, we predict a terminal value when the
company reaches a steady state.
 Free cash flows
Enterprise approach
 Free cash flows
Equity approach – Calculating cash flows
 Free cash flows
Equity approach – terminal values
It is not possible to predict cash flows indefinitely.
Thus, we predict a terminal value when the
company reaches a steady state.
 Free cash flows
Something to watch out for…TAX!

Net operating profit after tax

Net profit after tax
Net operating profit before tax
Net profit before tax
 Common pitfalls to watch out for
1. Confusing the value of the firm with the value of equity.
2. Not recognising a change of gearing during the period.
3. Cash flows from new assets are riskier than replacement
assets.
4. Not being able to find a comparable benchmark.
5. Not recognising that control is valuable.
6. Double counting risk.
7. Double counting synergies.
8. Triple counting the control premium.
9. Adjusting the discount rate for country specific risk.
10. Double counting income from non-core assets.
 Self-Study Sections
• The Economic Value Added approach (p. 6-26)
• The valuation of rights (p. 6-28)
• The impact of share options on equity
valuations (p. 6-28)
• Leases and valuations (p. 6-29)
• Valuations and the financial manager (p. 6-30)