M17EFA – Financial Statement

Analysis and Valuation

Company Valuation
 Learning objectives
By the end of this session students should be able to:
• Calculate the weighted average cost of capital (WACC)
and understand what it means
• Understand the term Free Cash Flows and use these to
help calculate the value of a business using discounted
cash flow (DCF) and net present value (NPV) techniques
• Understand the concepts of Residual Income (RI) and
Economic Value Added (EVA) and how these may be
used in company valuation
• Outline how ratios may be used to assist in company
valuation
 Company valuation
• We will consider company valuation based on:
– Asset values
– Discounted cash flows
– Residual income
– Economic Value Added
– Ratios
• There is no ideal measure of company valuation
• A company and it’s resources will be worth
different amounts to different individuals / groups
 The cost of equity
• Return expected by shareholders will comprise:
a) Risk free return
– Guaranteed returns (equivalent to return on
government securities)
b) Premium for business risk
– Reflects riskiness of nature of company’s business
activities
c) Financial risk
– Reflects individual circumstances of business (eg:
gearing)
 Capital Asset Pricing Model (CAPM)

Cost of equity = Rrf + B(Rm – Rrf)

Where:
Rrf = Return on risk free investment (eg: government
bonds)
Rm = Market return (ie: return achieved from investing
across whole of stock market)
B (Beta) = Measure of riskiness of investment being
appraised (Risk Free investment would have Beta of 0;
Investment in market as a whole would have a Beta
factor of 1)
 CAPM - Example
The current return on government securities is
8%, the average stock market rate of return is
12% and Jones plc has a beta value of 0.9.
Calculate the cost of equity for Jones plc
Cost of equity = Rrf + B(Rm – Rrf)
= 8% + 0.9(12% - 8%)
= 8% + 3.6
= 11.6%
 Cost of marketable debt

Cost of debt = Interest payable x (1 – tax rate)

Market Price of debt
Cost of marketable debt - Example
A company has 1m irredeemable 8% debentures each
with a nominal value of £1. The debentures are
currently valued at £1.2m. The company pays
corporation tax at 33%.
Cost of debt = (£1 million x 8%) x (1 – 0.33)
£1.2 million
= £80,000 x 0.67
£1.2 million
= 4.47%
 Cost of other fixed rate debt
Where debt is not marketable (ie: no market price):
Cost of debt = Interest rate x (1 – tax rate)
Example
A company has a 10 year loan with a fixed interest rate
of 12%. The company pays corporation tax at 33%.

Cost of debt = 12% x (1 – 0.33)

= 12% x 0.67
= 8.04%
 WACC
• Once we have calculated the cost of each
element of a company’s capital, we can calculate
the weighted average cost of capital as follows:

Example Cost of capital

Market Value (after tax)
£mil %
Ordinary shares 25 15
Debentures 15 9
Other debt 10 8
 WACC
• We can calculate the WACC as follows:
M.V. Cost Proportion Weighted
£mil % cost
Ordinary shares 25 15 50% 7.5%
Debentures 15 9 30% 2.7%
Other debt 10 8 20% 1.6%
Total 50 100% 11.8%
If an investment generates a return > 11.8%, it will
increase the wealth of the company.
 Net Present Value
• Value of shares in a business (and hence
the value of a business) is dependent on:
a) Expected future cash flows
b) Shareholders’ expected / required
rate of return
 NPV
• Can use NPV to calculate expected changes in
shareholder value:
a) Considers return from an investment over its whole
life
b) Uses cash flow and therefore not affected by
accounting policies and judgements used in arriving
at profit
c) Takes into account cost of capital and risk
(discounts forecast cash flows over life of
investment)
 Shareholder Value Analysis (SVA)
• In order to maximise shareholder wealth we
need to maximise the NPV of cash flows
generated by an investment
• Need to calculate free cash flows
– Cash flows generated by the business that are
available to equity shareholders and long term
lenders
 Free cash flows
• Determined by:
– Sales revenue
– Operating profit margin
– Tax rate
– Additional investment in working capital
– Additional investment in non current assets
• These value drivers will generate free cash flows
and impact on shareholder wealth
• Anything that changes these drivers will impact on
shareholder wealth
 Free cash flows - Example
During the year ending 31 October 20X9,
Duckworth plc has sales of £100 million and an
operating profit margin of 15%. Depreciation
charged during the year amounted to £1 million
The rate of tax is 30% of operating profit. During
the year £1.5 million was invested in additional
working capital and £2.5 million in new non current
assets. Calculate the free cash flows generated
during the year ending 31 October 20X9.
 Free cash flows – Duckworth plc
We can calculate free cash flows as follows:
£m
Sales revenue 100.0
Operating profit (£100m x 15%) 15.0
Add: Depreciation (non cash item) 1.0
Tax (£15m x 30%) (4.5)
11.5
Replacement of existing non current assets (1.0)
Additional working capital (1.5)
Additional non current assets (2.5)
Free cash flows 6.5
 Improving shareholder wealth
• Can improve shareholder wealth through a
combination of:
– Increase in sales revenue
– Improve operating profit margin (eg: reduce
operating expenses)
– Reduction in tax rate
– Reduce investment in working capital (eg: reduce
inventory or receivables)
– Reduce investment in non current assets (eg:
improve asset turnover)
 Shareholder Value
• Business gets its long term funds from:
a) Debt
b) Equity (ordinary shareholders)
• Therefore lenders and ordinary shareholders
both have a claim on the total value of a business
• Shareholders’ value
= Total business value – MV of outstanding debt
 NPV and company valuation
McDonald plc is an oil company with oil reserves
forecast to last for 15 years. It has 10 million shares
currently trading on the stock market at a price of
£3.25 each. It also has debt of £7 million. Free cash
flows for its next accounting period are forecast to
be £8 million. This figure is expected to decline by
£800k pa for each of the next four years, after
which it will stagnate at £3 million until oil reserves
are fully depleted. Given that you seek a return of
8%, would you invest in McDonald plc at the
current share price?
 Solution
Year Cash flow Discount Discounted
£’000 factor@ 8% Cash Flows
£’000
1 8,000 0.9259 7,407.2
2 7,200 0.8573 6,172.6
3 6,400 0.7938 5,080.3
4 5,600 0.7350 4,116.0
5 4,800 0.6806 3,266.9
6-15 3,000 4.566 13,698
Total business value 39,741
 Solution
Total business value = £39,741,000
Shareholder value = £39,741,000 - £7,000,000
= £32,741,000
Market value of share capital = 10 million x £3.25
= £32,500,000

Since shareholder value slightly exceeds the stock market

value of shares, the company is worth investing in.
 NPV - Assumptions
• NPV makes several simplifying assumptions:
– Forecast cash flows are accurate
– Cost of capital remains the same throughout the
period
– Level of risk is the same as that of other investments
and remains the same throughout the period
– Cash flows take place at the end of the year
– Inflation is 0% throughout the period (can
incorporate inflation into our calculations)
– Rate of taxation remains the same throughout the
period
 Residual Income
£

Operating profit X
Less:
Notional cost of capital (X)
(cost of capital % x investment)
Residual Income X
 Residual Income
• Sometimes called economic profit
• Takes into account return on investment
required by shareholders
• Positive RI will increase shareholder wealth
• Based on figures easily available from financial
statements
• However – based on profit which is subjective
(and affected by accounting policies)
 Residual Income - Example
Whitehaven plc provides you with the following
information for the year ending 31 0ctober 20X0:
£m
Operating profit before tax 6.0
Capital employed 38.0

Shareholders require a return of 13%. Calculate

residual income for the year ending 31 0ctober 20X0.
 Whitehaven - Solution
£m
Operating profit before tax 6.00
Less: Notional cost of capital (4.94)
(13% x 38.0m)
Residual income 1.06

A positive RI indicates that shareholder wealth has

increased during the year.
 Residual value and DCF
• Morse plc has capital employed of £10 million
(taken from SFP). Its WACC is 8%. Residual
income for the next 5 years is forecast as:
2011 £700,000
2012 £750,000
2013 £800,000
2014 £750,000
2015 £700,000

• Calculate the value of Morse plc

 Solution
Year Cash flow Discount Discounted
£’000 factor@ 8% Cash Flows
£’000
1 700 0.9259 648.1
2 750 0.8573 643.0
3 800 0.7938 635.0
4 750 0.7350 551.3
5 700 0.6806 476.4
Total DCF 2,953.8
Capital employed 10,000.0
Value of company 12,953.8
 Economic Value Added
• Version of Residual income devised by
management consultants Stern Stewart
• Uses more precise definitions:
a) Profit after tax (more relevant to shareholders)
b) Required return is after tax WACC
c) Capital employed is total assets – current
liabilities
 EVA - Example
Whitehaven plc provides you with the following
information for the year ending 31 0ctober 20X0:
£m
Operating profit before tax 6.0
Tax on operating profit 1.8
Total assets less current liabilities 38.0

The company has a WACC of 8%. Calculate EVA for the

year ending 31 0ctober 20X0.
 Whitehaven - Solution
£m
Operating profit before tax 6.00
Less: Tax (1.8)
Operating profit after tax 4.2
Less: Notional cost of capital (3.04)
(8% x 38.0m)
EVA 1.16

A positive EVA indicates that shareholder wealth has

increased during the year.
Return on capital employed (ROCE)
• Organisations will usually only invest in
something if it will improve its ROCE
• ROCE represents return that an organisation
makes on it’s resources (capital employed)
• Problems involve:
– Several different definitions of ROCE and capital
employed
– Uses profit, which is itself based on judgements
(eg: bad debts) and the accruals concept
 ROCE
Company Company Company
A B C
£ million £ million £ million
Current Profit for the 6.0 7.0 9.0
year after tax
Expected future Profit for 7.5 7.8 11.5
the year after tax
Target Return (%) 12% 12% 12%
Using ROCE calculate the lowest and highest
valuation for each of the above companies.
 ROCE
Value of company based on current profits:
• Company A (= £6m / 0.12) = £50 million
• Company B (= £7m / 0.12) = £58.3 million
• Company C (= £9m / 0.12) = 1=£75 million
Value of company based on expected profits:
• Company A (= £7.5m / 0.12) = £62.5 million
• Company B (= £7.8m / 0.12) = £65 million
• Company C (= £11.5m / 0.12) = £95.8 million
 Return on capital valuation
• Indicates range of prices company would pay
to acquire Co A, B or C
• However:
– Profit subjective
– Required return is subjective and depends
on a number of factors including:
• Attitude to risk
• Cost of capital
• Sector in which you are operating
 PE Ratio
Company Company Company
A B C
Profit for the year after
tax £6.0 £7.0 mil £9.0 mil
PE Ratio 9 7 7
Valuation (£6.0 x 9) £54 mil £49 mil £63 mil

Indicates value of company based on market

expectations
 PEG Ratio
PEG = P/E Ratio
Projected annual growth rate in earnings

PEG = 1 Market is pricing share to fully reflect earnings

per share growth potential
PEG > 1 Share currently overvalued or market expects
EPS growth to be higher than forecast
PEG < 1 Share currently undervalued or market does
not expect company to achieve forecast EPS
growth
 PEG Ratio
Company Company Company
A B C
PE Ratio 9 7 7
Forecast growth in
annual earnings 5% 3% 6.5%
PEG Ratio (9 / 5) 1.8 2.3 1.1

Indicates value of company based on market

expectations and projected growth rates.
 Enterprise value to EBITDA
= Enterprise value (EV)
EBITDA

EBITDA = Earnings before interest, tax, depreciation

and amortisation
EV = Value of entire business
= Market value of equity + Market value of
debt + Minority interest + pension
provisions + other claims
 Enterprise value to EBITDA
• Commonly used valuation multiple
• Allows comparison with other companies
• Based on current EBITDA, ratio indicates how many
years it would take to pay back your investment, if
company was purchased at its current market value
• EBITDA used as it:
a) Is easily obtained from financial statements
b) Gives an approximation to cash flow
c) Not distorted by interest (way company is funded), tax,
or depreciation policy
Enterprise value to EBITDA - Example
A company has 100,000 shares in issue each with a market
value of £5. It also has 100,000 debentures each with a
market value of £1.10. From its most recent financial
statements EBITDA is £71,350. Calculate the EV/EBITDA
multiple.
EV = (100,000 X £5) + (100,000 X £1.10)
= £500,000 + £110,000
= £610,000
EBITDA = £71,350

EV / EBITDA = £610,000 / £71,350

= 8.5
Using ratios to forecast future revenues
• We can use ratios to assist in forecast future
performance
• For example:
Lewis plc currently has capital employed of £1
million. Investors in Lewis plc require a pre-tax
return of 8%. During the past 4 years Lewis plc has
generated a profit from operations of 5%. Forecast
the level of sales revenue that the company will
require in order to attain the target rate of return
for investors.
 Solution
Required profit from operations = £1 million x 8%
= £80,000
Profit from operations = 5%
Sales Revenue ? 100%
Expenses ? 95%
Profit from operations £80,000 5%

Required Sales Revenue = £80,000 / 5%

£80,000 / 0.05
£1,600,000
 Solution
Required profit from operations £1 million x 8%
=
= £80,000
Profit from operations = 5%

Sales Revenue £1,600,000 100%

Expenses £1,520,000 95%
Profit from operations £80,000 5%
 Solution
• Based on a profit from operations of 5%, in
order to achieve the required rate of return of
8%, Lewis plc must achieve revenues of at
least £1,600,000
 Summary
• Number of factors affect valuation of a
company
• Several different ways to arrive at a valuation
• If forecasts are incorrect, valuation will also be
incorrect
• No ideal method
• Necessary to use a number of methods (DCF, RI,
Ratios) and make comparisons with other
companies operating in same sector
 Reading
• Atrill and McLaney ‘Management Accounting for
decision makers’ (FT Prentice Hall 6th Edition 2011)
– Chapters 8-9
• Frykman and Tolleryd ‘Corporate Valuation’ (FT
Prentice Hall, 2nd edition, 2010)
– Chapters 3-7
• McKenzie (4th edition 2010)
– Chapters 12, 18
• Penman ‘Financial statement analysis and security
valuation’ (McGraw Hill 4th edition 2010)
– Chapters 3-6, 13, 15