Corporate Reporting, ICAG Exams

BUSINESS VALUATION

2.1 Introduction

Price represents the consideration at which assets are exchanged. How is this price
determined?

The interaction of demand and supply helps to establish fair amounts at which prices of
goods and services are established. On the capital markets, trading of stocks establishes
prices of existing stocks because of interaction of demand and supply.

Companies listed on the stock exchange have shares listed on the exchange which have
market price.

Price is value and hence the market price of shares listed on the stock exchange
communicates the value of those companies.

A listed/quoted company therefore has a readily available market value through its
market capitalization.

The value of the total shares listed by a company on the stock exchange is known as market
capitalization (Market price x no. of shares issued).

Unquoted companies however do not have readily available price and hence value.
Valuation techniques are employed in order to place value on the existing shares of
unquoted companies. This value is usually known as the economic value.

Valuation is about determining (economic) value of a company or its equity shares.

Economic value is the value placed on a company or an instrument based on the expected
benefits from the company or the instrument.

Economic value is hence subjective since it depends on the expected benefits from the
instrument/company being valued to the valuer.

2.2 Why do we value a business?

For a quoted company, as hinted earlier, there is available market value. However, where
an acquisition or a merger is to take place, the target company is valued despite its existing
market value.

An unquoted company is valued also for the following reasons:

➢ At the instance of acquisition, there is the need to establish the fair value of the target
company so as to determine fair purchase consideration.
➢ At the instance of mergers or amalgamation, there is a need to find the fair values of the
businesses involved.
➢ To place value on the shares of a company that are to be listed on the stock exchange.
➢ To determine the value of shares of bank’s customer in an unquoted company which are
intended to serve as collateral.

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➢ When shares in an unquoted company are sold privately, the buyer and seller have to
agree on the price and the fair price is estimated through valuation (i.e the minimum price
the seller is willing to accept and the maximum price the buyer is willing to pay).

2.3 Valuation models

In placing value on a business, we require a basis or unit to measure it. The bases include assets,
income, cash flows or dividend. The following models can therefore be used:

➢ Asset-based valuation models which focus on the value of the company’s assets;

➢ Income-based valuation models which focus on the future earnings of the company.
Income-based valuation methods include the following: P/E ratio method and Earnings
yield method.

➢ Dividend valuation models: These methods are based on dividend payable to

shareholders;

➢ Cash flow-based valuation model: This uses the expected or forecasted cash flows of
the target company over a defined time.

2.3.1 Asset-based valuation model (Net assets method)

This method calculates the value of a company based on the net assets. Net assets can be
calculated at their liquidation values or going concern values. Market value could therefore be
net realizable value or replacement cost value.

Preferably, the market value basis is used so that assets are put at their replacement values and
liabilities are also put at their discounted amounts where necessary. So, assets and liabilities
are valued, being guided by fair value measurement as given in IFRS 13, Fair value
measurement.

Net assets is the difference between total assets and total liabilities. Where preference share
capital exists, this has to be deducted to arrive at net assets attributable to only ordinary
shareholders (Note: valuation is done from the view point of ordinary shareholders).

Value of a Business=𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠−𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠−𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Estimating fair value under IFRS 13, fair value measurement

Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.

Fair value is a market-based measurement, not one that is entity specific. As such, when
determining the price at which an asset would be sold (or the price paid to transfer a liability),
observable data from active markets should be used where possible.

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An active market is a market where transactions for the asset or liability occur frequently.
Active market could be principal market or most advantageous market.

IFRS 13 says that fair value should be measured by reference to the principal market. The
principal market is the market with the greatest activity for the asset or liability being measured.
The entity must be able to access the principal market at the measurement date. This means
that the principal market for the same asset can differ between entities.

If there is no principal market, then fair value is measured by reference to prices in the most
advantageous market. The most advantageous market is the one that maximises the net
amount received from selling an asset (or minimises the amount paid to transfer a liability).
Transaction costs (such as legal and broker fees) will play a role in deciding which market is
most advantageous. However, fair value is not adjusted for transaction costs because they are
a characteristic of the market, rather than the asset

Therefore, in determining fair value of assets and liabilities we use the following data (inputs).

Level 1 inputs are quoted prices for identical assets in active markets (principal markets or
most advantageous market, if principal market is not available).

Level 2 inputs are observable prices that are not level 1 inputs. This may include:
– Quoted prices for similar assets in active markets
– Quoted prices for identical assets in less active markets
– Observable inputs that are not prices (such as interest rates).

Level 3 inputs are unobservable. This could include cash or profit forecasts using an entity’s
own data. A significant adjustment to a level 2 input would lead to it being
categorized as a level 3 input.

Priority is given to level 1 inputs. The lowest priority is given to level 3 inputs.

All assets and liabilities can be categorised into financial and non-financial assets/liabilities.

Financial assets are measured at usually level one input since there are identical assets in a
principal market available or most advantageous market which we can observe their prices.
However, where such assets are not there, we move to level 2 inputs, and in a rare case, no
level 2 data is also available, we move to level 3 inputs.

Unlike financial assets, finding identical assets for non-financial assets is usually difficult, and
hence non-financial assets are usually measured at level 2 inputs such as observable prices of
similar assets. If this is also not available, then we move to the entity’s own internal model
(level 3 input).

In finding the fair value of non-financial assets, we are guided by the principle of highest and
best use. That is given the various uses market participants can put the non-financial asset to,
estimating the fair value of each of the uses, which one has the highest fair value. The highest
figure becomes the fair value. In applying the highest best use, we are also guided by these
expectations of the market:
• The use should be legally permissible;
• The use should be financially feasible;

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• The asset is physically possible.

The current use of a non-financial asset can be assumed to be the highest and best use, unless
evidence exists to the contrary.

Note that in estimating fair value all transactions cannot be deducted. Transaction cost be legal,
broker fees, etc. However, transportation cost is not regarded as transaction cost, and is
therefore deducted as it is seen as a characteristic of the asset and not the market.

2.3.2 Price-Earnings ratio (P/E) method

This valuation technique employs a very important market-based ratio that compares the
market value of a company to its book, P/E ratio.

P/E signifies the confidence the market has in confidence. A higher value shows that the market
has more confidence in a company. In the context of valuation, an unquoted company does not
have P/E ratio since this ratio is based on market price which is even the essence of valuation
exercise.
A P/E ratio of a similar listed company or a weighted one (where more than one similar listed
company is used). The market value of the unquoted company is calculated as:

Value per share=𝑃/𝐸 𝑥 𝐸𝑃𝑆

Earnings = Profit after tax - preference share dividend

There are differences in risk (idiosyncratic/unsystematic risk) of a company listed on the stock
exchange and a company that is not listed. Unlisted companies are deemed to be riskier, hence,
taking a P/E ratio of a listed company and giving an unlisted company the same P/E is not
realistic since the market does not have the same confidence in the unlisted company.

Hence this value has to be reduced using a discounting factor. The discounting factor
commonly used ranges from 20% to 50%.

2.3.3 Earnings yield method

This is an earnings-based valuation technique and it computes the value of a company based
on the future earnings and the earnings yield picked from that of a similar listed company.

𝐸𝑃𝑆
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑

Once again, because of differences in risk between a listed company and an unquoted company,
there is the need to discount the value to account for the differential risk.

This is achieved by ‘grossing up the earnings-yield’ of the proxy company by the risk-
differential perceived or estimated, to arrive at a risk-adjusted earnings yield for the target
company (i.e company being valued).

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2.3.4 Dividend yield method

This method computes value by using dividend payable in the future of a target company and
dividend yield of a similar listed company.

It is computed as follows:
𝐷𝑃𝑆
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑

The denominator, ‘dividend yield’ is computed by grossing-up the dividend yield of the proxy-
company by the perceived or estimated differential risk.

Valuation based on dividend such as dividend yield method is used when valuing smaller
shareholdings.

2.3.5 Dividend valuation model

This model estimates the value of a business as the discounted value/ present value of future
dividend payable to equity shareholders.

Since dividend payment unlike interest payments is not certain, assumptions are made on the
certainty/timing of dividend payments and the quantum.

The model assumes three (3) possible scenarios on the timing and quantum of dividend
payments:
➢ Annual dividend payment is constant;
➢ Annual dividend payment is not constant, but changes at a constant growth rate;
➢ Annual dividend payment is not constant, but changes at a variable growth rate.

Where annual dividend is constant

Value of a target company is estimated as present value of the constant dividend payments.
Note that the equity shares which we are valuing are ‘perpetual’ investments, hence, if their
cash flows are assumed to be constant, we have a clear case of a ‘perpetuity’.

The PV of constant perpetuity is used in valuing such company.

𝐷𝑃𝑆
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

Where annual dividend changes at constant growth rate

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The cash flows of the target company will be in the form of ‘growing or increasing perpetuity’.
The value of such a company using the dividend valuation model is the present value of the
future dividend payments.

Having identified that we have a case of growing perpetuity, we shall use the present value of
growing perpetuity formula to discount the future annual dividends changing at a constant
growth rate.

𝐷0 (1 + 𝑔)
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 − 𝑔

The ‘g’ is the constant growth rate. Where, cost of equity is not given, it is computed using
the Capital Asset Pricing Model (CAPM) as follows:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑓 + 𝛽𝑒 (𝑟𝑚 − 𝑟𝑓 )

Where,

𝑟𝑓 = 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒

𝛽𝑒 = 𝑒𝑞𝑢𝑖𝑡𝑦 𝑏𝑒𝑡𝑎

𝑟𝑚 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛

The difference between market return and the risk-free rate is known as market or equity
risk premium.

Calculating the growth rate, ‘g’

The growth rate, where it is not given, can be calculated using:

➢The future value formula

➢Gordon’s growth rate
Calculating the growth rate, ‘g’, using future value formula

𝐹𝑉 1/𝑛
=( )
𝑃𝑉

Where:

𝐹𝑉=𝑡ℎ𝑒 𝑙𝑎𝑡𝑒𝑠𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)

𝑃𝑉=𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 (𝑒𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒)

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𝑛=𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑜𝑣𝑒𝑟 𝑤ℎ𝑖𝑐ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 ℎ𝑎𝑠 𝑐ℎ𝑎𝑛𝑔𝑒𝑑

𝑟=𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

Calculating growth rate, g, using the Gordon’s growth rate

The growth rate in dividend paid to shareholders can be taken as equivalent to the sustainable
growth rate. Sustainable growth rate is calculated as:

Sustainable growth rate= Return on equity (ROE) x retention ratio

Retention ratio is the proportion of earnings ploughed back in the company, or not paid to
shareholders as dividend in a particular year.

2.3.6 Discounted cash flow method

Using discounted cash flow method, we estimate the expected cash flows from the company’s
operations for a defined number of years, say 5 years. These future cash flows are then
discounted at the company’s weighted average cost of capital (WACC).
The discounted value of each year’s cash flows when added together is the total value of the
company.
The discounting factors are computed using the formula:
1
=
(1 + 𝑟)𝑛

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