1801
OVERVIEW
Objective
¾
To estimate the value of one share or of a company’s equity in total.¾
To be familiar with all ratios commonly used in business analysis.BUSINESS VALUATION
BUSINESS VALUATIONAND RATIO ANALYSIS
RATIO ANALYSIS ¾ Reasons for business valuation
¾ Nature of valuation ¾ Asset based valuations ¾ Earnings based valuations ¾ Dividend based valuation
1
REASONS FOR BUSINESS VALUATION
¾
To determine the value of a private company e.g. for a Management Buy Out (MBO) team;¾
To determine the maximum price to pay when acquiring a listed company e.g. in a merger or takeover - note that the quoted share price is only relevant for taking a minority shareholding;¾
To aid in decisions on buying/selling shares in private companies;¾
To place a value on companies entering the stock market i.e. Initial Public Offerings – IPO’s;¾
To value shares in a private company for tax/legal purposes;¾
To value subsidiaries/divisions for possible disposal.2
NATURE OF BUSINESS VALUATION
¾
When a business is valued it is not a precise exercise and there is often no unique answer to the question of what it is worth e.g. the value to the existing owner may be significantly different to the value to a potential buyer.¾
There are a variety of different methods of valuing businesses which may produce different overall values. These can be used to determine a range of prices.¾
The relevant range of values is: the minimum price the current owner is likely to accept; the maximum price the bidder is likely to pay.
¾
The final price will result from negotiations between the parties.¾
In the following sections the following methods of valuation will be considered: asset based valuations1803
3
ASSET BASED VALUATION METHODS
3.1
Net Book Value (NBV)
¾
Simply uses the balance sheet equation i.e. Equity = assets - liabilities¾
Problems: balance sheet values are often based upon historical cost rather than market values; net book value of assets depends on depreciation policy;
many key assets are not recorded on the statement of financial position e.g. internally generated goodwill.
¾
For the above reasons a valuation based upon balance sheet net assets is not likely to be reliable.3.2
Net Realisable Value (NRV)
¾
This estimates the liquidation value of the businessEquity = estimated net realisable value of assets - liabilities
¾
This may represent the minimum price that might be acceptable to the present owner of the business.¾
Problems: estimating the NRV of assets for which there is no active market e.g. a specialist item of equipment ;
ignores unrecorded assets such as internally generated goodwill;
3.3
Replacement cost
¾
This can be viewed as the cost of setting up an identical business from nothing Equity = estimated depreciated replacement cost of net assets¾
This may represent the maximum price a buyer might be prepared to pay.¾
Problems: technological change means it is often difficult to find comparable assets for the purposes of valuation ;
4
EARNINGS BASED VALUATION METHODS
4.1
Price/Earnings Ratios
The published P/E ratio of a quoted company takes into account the expected growth rate of that company i.e. it reflects the market’s expectations for the business.
Using published P/E ratios as a basis for valuing unquoted companies may indicate an acceptable price to the seller of the shares.
Price/Earnings (P/E) ratio =
Share
This can be used for valuing the shares in an unquoted company. Step 1 Select the P/E ratio of a similar quoted company.
Step 2 Adjust downwards to reflect the additional risk of an unquoted company and the non-marketability of unquoted shares.
Step 3 Determine the maintainable earnings to use for EPS.
4.2
Earnings Yield
¾
Earnings yield is simply the reciprocal of the P/E ratio. Earnings Yield =Ordinary share price =
Yield Earnings
1805
Example 1
You are given the following information regarding Accrington Ltd, an unquoted company.
(a) Issued ordinary share capital is 400,000 25c shares.
(b) Extract from income statement for the year ended 31 July 19X4.
$ $
Profit before taxation 260,000
Less Corporation tax ________ (120,000)
Profit after taxation 140,000
Less Preference dividend 20,000
Ordinary dividend 36,000
______ (56,000) ________
Retained profit for year 84,000
________ (c) The P/E ratio applicable to a similar type of business (suitable for an
unquoted company) is 12.5.
Required:
Value 200,000 ordinary shares in Accrington Ltd on an earnings basis.
5
DIVIDEND BASED METHODS OF VALUATION
5.1
Dividend yield
Dividend yield =
share pre price Market
share per Dividend
× 100
Therefore share price =
yield Dividend
share per Dividend
Step 1 Determine the dividend for the unquoted company
Step 2 Choose a published dividend yield for a similar quoted company
Step 3 Adjust this dividend yield upwards to reflect the greater risk of an unquoted company and the non-marketability of unquoted company shares.
¾
This method fails to take growth in to account and therefore can lead to an under-valuation¾
It also has little relevance for valuing a majority shareholding as such an investor has the ability to change the dividend policy.Example 2
An individual is considering the purchase of 2,000 shares in G Ltd.
G Ltd has 50,000 shares in issue and the latest dividend payment was 12 cents per share.
G Ltd is similar in type of business, size and gearing to H plc. H plc has a published dividend yield of 10%.
Required”
Suggest a price that the individual might pay for the 2,000 shares in G Ltd.
1807
5.2
Dividend Valuation Model
¾
If dividends are expected to remain constant e.g. on preference shares:Po =
re D
Where P0 = today’s share price
D = dividend per share
re = required return of equity investors
¾
If dividends are forecast to grow at a constant rate in perpetuityPo =
g re
g) (1 D0
− +
=
g re
D1
−
where Do = most recent dividend D1 = dividend in one year
g = growth rate
Step 1 Determine current dividend and estimated growth rate
Step 2 Determine the required return − for example by using the Capital Asset Pricing Model (CAPM) on a similar quoted company and then adjusting upwards to reflect greater risk/lack of marketability of unquoted shares
¾
Problems: determining growth rate of dividends;
determining appropriate required return for unquoted company;
Example 3
Claygrow Ltd is a company which manufactures flower pots. The following data are available.
Current dividend 25c per share
Required return on equities in this risk class 20%
Required:
Value one share in Claygrow Ltd under the following circumstances. (i) No growth in dividends
(ii) Constant dividend growth of 5% per annum
(iii) Constant dividends for five years and then growth of 5% per annum to perpetuity
(iv) Constant dividends for five years and then sale of the share for $2.00.
1809
6
RATIO ANALYSIS
6.1
Profitability ratios
Gross profit margin = 100
Sales profit
Gross ×
Operating profit margin = 100
Sales
Return on Capital Employed (ROCE) = 100
s
6.2
Liquidity ratios
Current ratio =
6.3
Efficiency/activity ratios
Accounts receivable days = 365
Inventory days = 365
sales
Cash conversion cycle = inventory days + receivables days – payables days
Total asset turnover =
assets Total
Sales
Fixed asset turnover =
assets Fixed
6.4
Gearing/Risk ratios
Financial gearing:
Debt to equity = 100
¾
gearing can also be referred to as leverage Operational gearing:100
6.5
Investor ratios
Earnings per ordinary share (EPS)
Diluted EPS should also be calculated where a company has a complex capital structure that includes Potentially Dilutive Securities (PDS’s). These are securities in issue which involve an obligation to issue shares in the future e.g. convertible debt, warrants.
1811
Total Shareholder Return (TSR) =
year
Cathcart Inc
Statement of financial position at 31 December 200X
$000 $000
Non - current assets
Cost less depreciation 2,200
Current assets
Inventory 400
Receivables 500
Cash 100
Retained earnings 800
Non-current liabilities
10% bond 600
Preferred shares (10%) ($1 par) 200
Current liabilities
Cathcart Inc
Income statement for the year ended 31 December 200X
$000 $000
Turnover 3,000
Cost of sales (2,400)
_____
Gross profit 600
Operating expenses (200)
_____
Profit before interest and tax 400
Interest (60)
_____
Profit before tax 340
Income tax (180)
_____
Profit after tax 160
_____ Dividends
Ordinary 125
Preference 20
Current quoted price of $1 ordinary shares in Cathcart Inc $1.40 _____
Required:
Calculate each of the following ratios for Cathcart Inc: (a) Gross profit margin
1813 (d) Return on equity
(e) Current ratio
(f) Acid test ratio
(g) Receivables days
(h) Total asset turnover
(i) Fixed asset turnover
(j) Proportion of debt finance
(k) Interest cover
(m) Dividend cover
(n) Dividend yield
(o) Price earnings ratio
Key points
³
Business valuation is not a science – different analysts use different techniques.³
You need to enter the exam with a range of methods at your disposal and choose the most relevant depending what data is available and whether you are required to value a minority stake or a business in total.³
Ratio analysis is also a subjective area – different analysts calculate ratios in slightly different ways. If the exam question does not define exactly how a certain ratio should be calculated then state your definition, show your workings and be consistent between companies/years. Often it is the change in ratios which is more relevant than their absolute level.FOCUS
1815
EXAMPLE SOLUTIONS
Solution 1
Valuation of 200,000 shares = 200,000 × P/E ratio × EPS
Solution 2
Share price =
yield Dividend
Dividend
Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of unquoted company - say 13% (subjective)
Share value =
Solution 3
(i) Constant dividend Po =
Solution 4
(a) Gross profit margin
= 100
(c) Return on capital employed
= 100
(h) Total asset turnover
1817 (j) Proportion of debt finance
= 100
(l) Earnings per ordinary share
