Chapter 9: Business valuation Page 104

LO3: VALUATION OF EQUITY

3.1) Equity valuation models

▪ All equity valuation methods are based on rational estimates and assumptions.
▪ This means that there is logic to the valuation, and the valuation is obtained through
objective analysis and assessment.
▪ Each method produces a different valuation, but each valuation can provide useful
information and help with deciding what the offer price should be for mergers and
acquisition.
▪ The final price is often agreed through negotiation, and the management of the bidding
company must use judgement in deciding how high a price they might be willing to pay.
▪ The only ‘correct’ valuation is the price that the bidder makes and the shareholders in the
target company accept.
▪ We should be well prepared to:
- compute the value of business by using different valuation methods,
- discuss the assumptions on which the valuation is based; and
- Compare and then recommend (with reasons) a valuation that we consider
appropriate as a basis for making an offer to the target company shareholders.
▪ There are several approaches to making a valuation of the shares in a company:
1) Asset based valuation
(i) Net assets valuation by using replacement cost
(ii) Net assets valuation by using net realizable value
(iii) Net assets valuation by using book values
2) Income/market-based valuations
(i) P/E ratio multiple method
(ii) Earning yield method
(iii) Earning growth model
(iv) Dividend yield method
(v) Market to book ratio method
3) Dividend valuation models
(i) Dividend valuation model (without growth)
(ii) Dividend valuation model (with constant growth)
(iii) Dividend valuation model (with variable growth)
4) Cash flows based approaches
(iv) Free cash flows to equity method
(v) Free cash flows to firm method
Chapter 9: Business valuation Page 105

3.2) Assets based valuation methods

Introduction
▪ Assets based valuation methods focuses on the net assets of the company therefore it is
also known as ‘net asset valuation method’.
▪ Net assets of the company are determined after deducting liabilities from fair market
value of its total assets.
Value of equity = Value of net assets = All assets – All liabilities
Value per share = Value of net assets ÷ Number of outstanding shares
▪ This method is commonly used for liquidation scenario, goodwill calculation, and as a
secondary valuation method to DCF.
▪ It is highly favourable for core niches like the real estate sector.
▪ All asset-based valuation methods can be criticised, because unless there is an intention to
sell off all or some of a company’s assets, the value of a business comes from the expected
returns it will generate, not the reported value of its assets.
▪ Assets based valuation methods can be classified into following three categories:
- Net asset valuation by using book values from balance sheet
- Net asset valuation by using net realizable value
- Net assets valuation by using replacement cost
(I) Net asset valuation by using book values from balance sheet
▪ This approach uses the book values for assets and liabilities from balance sheet.
▪ Assets based valuation model generally uses the net tangible assets of a business and uses
intangible assets if it could be actively sold in market.
▪ Net assets valuation by using book value of net assets should be considered a minimum
valuation, and not one that the target company shareholders are likely to accept.
▪ An offer price would have to be in excess of book value (‘book value plus) for the bid to
have any chance of success.
Example 9.6 – ICAP Study Text
The following information is available about a private company, Company Z.
Rs.’000
Tangible non-current assets 250
Intangible non-current assets 75
Current assets 60
385
Ordinary shares of Rs. 1 each 50
Revaluation reserve 80
Retained profits 145
275
Bank loan 90
Current liabilities 20
385
Required: Compute value per share by using asset-based valuation of the shares of Company
Z assuming that intangible assets can be sold in market at a value equal to its book value.
Chapter 9: Business valuation Page 106

Solution
Assets based valuation by using balance sheet
Rs.’000
Assets
Tangible non-current assets 250
Add: Intangible non-current assets 75
Add: Current assets 60
385
Less: Liabilities
Bank loan (90)
Current liabilities (20)
= Value of net assets 275
Value per share = Rs. 275,000 ÷ 50,000 shares = Rs. 5.50 per share
Comments
▪ Under assets-based valuation, value per share is Rs. 5.50 but It is unlikely that the target
company shareholders will accept an offer below Rs. 5.50 per share, and the offer will
almost certainly need to be higher than Rs. 5.50 per share if the takeover is to succeed.
▪ Valuations based on other valuation methods should be compared with the asset-based
valuation. There should be some concern (for the bidding company) if a valuation based on
expected earnings, dividends or cash flows is lower than the asset-based valuation.
(II) Net assets valuation by using net realizable value
▪ Net assets of target company can be valued by using net disposal value or breakup value.
▪ If net assets are valued at net realizable value then it refers to the amount that shareholders
will receive when company is liquidated and its assets are sold off.
▪ Net realizable value of assets will only be relevant when it is higher than the value of
business as a going concern.
▪ A target company is normally acquired with the intention to continue its business so it’s
going concern value should be higher than its net realizable value of assets.
▪ A company can never be worth less than its break-up value.
Example 9.7 – ICAP Study Text
A company has assets that have been valued at Rs. 20 million. This valuation is based on the
current disposal value of the assets. The company has Rs.4 million of liabilities. It has share
capital of 200,000 shares of Rs. 0.25 each.
Required: Calculate value per share by using net asset valuation.
Solution
A valuation of the shares based on the net asset value of the company would be:
Value per share = Value of net assets ÷ Number of shares
Value per share = (Rs. 20 million – Rs. 4 million) ÷ 200,000 shares
Value per share = Rs. 80 per share
Chapter 9: Business valuation Page 107

(III) Net assets valuation by using replacement cost

▪ Replacement cost of asset is the cost of acquisition of net assets in open market.
▪ It is more accurate than book value of assets because replacement cost is likely be more
than book value of assets.
▪ Assets of the company will be undervalued if intangible assets are excluded.
▪ It is very difficult to value individual assets and liabilities.

3.3) Income based valuation methods

Introduction
▪ Income based valuation methods are also known as:
- Market based valuation methods; or
- Relative valuation methods; or
- Valuation using multiples.
▪ This is a type of secondary valuation technique which is applied to validate the primary
valuation techniques such as discounted cash flows model.
▪ This model determines the equity value by considering:
- earnings or dividend of a target company; with
- a multiple from similar listed company or industry average.
▪ Income based valuation methods can be classified into following four cateogries:
- P/E ratio method
- Earnings yield method
- Earning growth model
- Dividend yield method
(I) P/E ratio method
▪ P/E ratio stands for the price/earnings ratio which measures the ratio of market price per
share to annual earnings per share of the company.
P/E ratio = Market price per share ÷ Earnings per share
▪ It indicates that what market investors are willing to pay for a share based on its historical
or future earnings.
▪ Share prices reflect market expectations about earnings.
▪ Companies that the market investors believe will achieve higher earnings growth rates will
tend to be priced higher on a P/E ratio basis than companies that are expected to show low
earnings growth rates.
▪ For every company whose shares are traded on stock market, there is a P/E ratio.
▪ For private company whose shares are not traded on stock market, a suitable P/E ratio is
selected and used.
▪ We can rearrange P/E ratio for valuation of shares as follows:
Market price per share = Earnings per share x P/E ratio
(OR)
Market price per share = EPS of target company x suitable P/E ratio
(OR)
Total Market value = Profit after tax of target cosrt x suitable P/E ratio
Chapter 9: Business valuation Page 108

▪ The earnings per share (EPS) or profit after tax (PAT) of target company might be:
- an EPS of recent year end, or
- an average EPS for a number of recent years or
- a forecast of EPS in a future year.
▪ The suitable P/E ratio is selected as follows:
- For listed company, the average P/E ratio of similar listed companies in stock market;
(or)
- For unquoted company, P/E ratio of a similar public company is scaled down by a
specific percentage (say 10%) due to:
➢ Weak liquidity of shares
➢ Risk level
➢ Level of managerial skills
▪ The P/E ratio valuation method is commonly used as one approach to valuation for:
- The valuation of a private company seeking a stock market listing for the first time
- The valuation of a company for the purpose of making a takeover bid.
Example 9.7 – ICAP Study Text
The EPS of a private company, ABC Company, was Rs. 15 last year and is expected to rise to Rs.
18 next year. Similar companies whose shares are quoted on the stock market have P/E ratios
ranging from 10.0 to 15.6. The average P/E ratio of these companies is 12.5.
Required: Compute market value per share for ABC Company by using different versions of
P/E ratio model.
Solution
Valuation of ABC Company’s share can be determined by using any of the following versions of
P/E ratio model:
By using expected EPS and average P/E ratio
Market value per share = Expected EPS x Average P/E ratio
Market value per share = Rs. 18 x 12.5 = Rs. 225 per share
By using expected EPS and P/E ratio of similar company
ABC Company is a private company so we may use lower level of P/E ratio (i.e., 10 times) for
similar quoted company to match level of private company.
Market value per share = Expected EPS x P/E ratio of similar quoted companies
Market value per share = Rs. 18 x 10 = Rs. 180 per share
By using expected EPS and adjusted P/E ratio
Adjusted P/E ratio of similar quoted company can be used for private company.
Market value per share = Expected EPS x Adjusted P/E ratio of similar quoted companies
Market value per share = Rs. 18 x (10 x 90%) = Rs. 162 per share
By using EPS of last year and adjusted P/E ratio
Market value per share = Recent EPS x Adjusted P/E ratio of similar quoted companies
Market value per share = Rs. 15 x (10 x 90%) = Rs. 135 per share
Chapter 9: Business valuation Page 109

Example 9.8
X Ltd. has the following financial information available:
- Share capital in issue: 2 million ordinary shares at a par value of Rs. 50 per share
- Current EPS of X Ltd. = Rs. 80 per share
- Current market price per share of X Ltd. = Rs. 320 per share
X Ltd. wants to purchase 1 million shares of Y Ltd., and 500,000 shares in Z Ltd. Y Ltd. is
quoted company but Z Ltd is an unquoted company.
- Current EPS of Y Ltd = Rs. 65 per share
- Current Market price of Y Ltd. = Rs. 162.50 per share
- Current EPS of Z Ltd. = Rs. 45 per share
Required: By using P/E ratio model, find out the market value per share of
(i) Y Limited and
(ii) Z Limited
Solution
(i) Market value per share of Y Limited by using P/E ratio model
Market value per share = EPS of Y Limited x Suitable P/E ratio of X Limited
Market value per share = Rs. 65 per share x (Rs. 320/Rs. 80)
Market value per share = Rs. 65 per share x 4 times = Rs. 260 per share
(ii) Market value per share of Z Limited by using P/E ratio model
Z Limited is an unquoted company so its market value per share can be determined by using:
- P/E ratio of X Limited
- P/E ratio of Y Limited
- Adjusted P/E ratio of X Limited
Market value per share = EPS of Z Limited x Suitable P/E ratio
Market value per share = Rs. 45 per share x 4 times = Rs. 180 per share (or)
Market value per share = Rs. 45 per share x (Rs. 162.5/Rs. 65) = Rs. 112.5 per share (or)
Market value per share = Rs. 45 per share x (4 times x 90%) = Rs. 162 per share
Strengths and weaknesses of P/E ratio model
▪ The main advantage of a P/E ratio valuation is its simplicity.
▪ By taking the annual earnings of the company (profits after tax) and multiplying this by a
P/E ratio that seems ‘appropriate’, an estimated valuation for the company’s shares is
obtained.
▪ 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.
It might be apparent that the P/E ratio valuation method has a number of weaknesses:
▪ It is based on subjective opinions about what EPS figure and what P/E ratio figure to use.
▪ It is not an objective or scientific valuation method.
▪ It is based on accounting measures (EPS) and not cash flows. However, the value of an
investment such as an investment in shares ought to be derived from the cash that the
investment is expected to provide to the investor (shareholder).
Chapter 9: Business valuation Page 110

(II) Earning yield method

▪ Earning yield is the reciprocal of P/E ratio and it reflects the percentage return on
investment of market investors.
▪ With the earnings yield method of valuation, a company’s shares are valued using its annual
earnings and a suitable earnings yield.
Earning yield ratio = Earnings per share ÷ Market price per share
(OR)
Market price per share = EPS of target company ÷ Suitable Earning Yield ratio
(OR)
Total Market value = Profit after tax of target Co. ÷ Suitable Earning yield ratio
▪ A suitable earnings yield for a private company might be similar to the earnings yield on
shares in similar quoted companies.
▪ It might be more appropriate to select an earnings yield that is higher than the earnings
yield for similar quoted companies, to allow for the higher risk of investing in private
companies.
Example 9.9 – ICAP Study Text
The earnings of Kickstart, a private company, were Rs. 450,000 last year. Stock market
companies in the same industry provide an earnings yield of about 9% to their shareholders.
Required: Using the earnings yield method of valuation, suggest a suitable valuation for the
equity shares in Kickstart.
Solution
Market value of shares = Profit after tax of Kickstart Co ÷ Suitable Earnings Yield ratio
Market value of shares = Rs. 450,000 ÷ 0.09 = Rs. 5,000,000
However, since Kickstart is a private company, a higher earnings yield should possibly be used
for the valuation. If an appropriate earnings yield for Kickstart is 10%, say, the valuation of its
equity would be:
Market value of shares = Profit after tax of Kickstart Co. ÷ Adjusted Earning Yield ratio
Market value of shares = Rs. 450,000/10% = Rs. 4,500,000.
(III) Earnings growth model
▪ According to earnings growth model, market value of target company’s share can be
estimated by discounting forecast earnings by the cost of capital.
▪ Earnings growth model assumes that growth rate will remain constant and market value
can be estimated by using following formula:
Market value of company = E1 ÷ (WACC – g)
Where
g = growth rate of profit after tax
E1 = Profit after tax of next year = E0 x (1 + growth rate)
E0 = Profit after tax of recent year
WACC = Weighted average cost of capital
Chapter 9: Business valuation Page 111

Example 9.10 – ICAP Study Text

A company has just announced earnings of Rs. 50 million. Earnings are expected to grow at
5%per annum into the foreseeable future. The risk adjusted cost of capital appropriate to this
industry is 15%.
Required: Compute the value of company by using earnings growth model.
Solution
E1 = Rs. 50 million x (1+0.05) = Rs. 52.5 million
WACC = 0.15
g = 5% = 0.05
Market value of company = E1 ÷ (WACC – g)
Market value of company = Rs. 52.5 m ÷ (0.15 – 0.05) = Rs. 525 million
(IV) Dividend yield method
▪ Dividend yield shows the amount of dividend received in cash by investors against market
price of share.
▪ With the dividend yield method of valuation, a company’s shares are valued using its annual
dividends and a suitable dividend yield ratio.
Dividend yield ratio = Dividend per share ÷ Market price per share
(OR)
Market price per share = Dividend of target company ÷ Suitable Dividend Yield ratio
(OR)
Total Market value = Dividend of target Co. ÷ Suitable Dividend Yield ratio
▪ A suitable dividend yield for a private company might be similar to the dividend yield on
shares in similar quoted companies.
▪ It might be more appropriate to select a dividend yield that is higher than the dividend yield
for similar quoted companies, to allow for the higher risk of investing in private companies.

3.4) Dividend valuation models

Introduction
▪ Dividend valuation is a quantitative method of valuing the price of a company’s share.
▪ Market price per share is equal to present value of all future expected dividends in
perpetuity are discounted at shareholder’s required rate of return.
▪ Shareholders required rate of return, also known as cost of equity, is determined by using:
- capital asset pricing model (CAPM) or
- Arbitrage pricing theory model (APT).
▪ The dividend valuation model is a more objective because it uses cash-based approach to
the valuation of shares.
▪ The dividend valuation model is sub-divided into three categories:
- Dividend valuation model (without growth)
- Dividend valuation model (with constant growth)
- Dividend valuation model (with variable growth)