I. INTRODUCCIÓN
1.2 Trabajos previos
1.2.2 Nacional
In this section we will look at company valuation in addition to share valuation. You will see that a number of different methods can be used to value a company. Valuations using these methods can often differ significantly from the total of shareholders’ funds on a company balance sheet.
The main methods that are required to be understood more comprehensively for this study module (and the ones that will be concentrated on) are as follows:
Price Earnings Ratio (P/E Ratio)
Net Asset Value (NAV)
Free Cash Flow and
Dividend Valuation Model (DVM) P/E Method
This is probably the most common and popular method to adopt when trying to value a company share, as the historic price earnings ratio compares a businesses share price with its latest profit figures and that is what is most likely to attract, or otherwise, new
shareholders and hence new capital investment.
This method calculates the value of a company’s shares by using the following formula:
Market value per share EPS P/E ratio
This method makes use of a company’s level of earnings to calculate its value; the EPS used can either be an historical one, an average of past figures, or a prediction of a future figure.
The latter is the best but care must be taken when using forecasts, especially with the figures used for growth in earnings. Similarly an appropriate P/E ratio should be used. The P/E figure used depends upon:
(a) How secure the earnings of the company are – the more secure the earnings, the higher the P/E ratio. Companies with high gearing levels tend to have lower P/E ratios reflecting greater financial risk.
(b) Expectations of future profits – the higher the expected earnings, the higher the P/E ratio. Adjustments may be made for past profit trends and the reliability of the
estimates. (Expectations of future profits can be calculated using the discounted cash flow techniques which we shall discuss later in the course.)
(c) Companies which are unquoted generally have a P/E of between 50% and 60% of a company which is quoted on the Stock Exchange and around approximately 70% of shares quoted on the AIM, reflecting their reduced marketability and smaller size.
However, an unquoted company with earnings of £300,000 or more and growing at a regular rate may have a higher P/E ratio because it may be able to be quoted on the AIM.
(d) General financial and economic conditions.
(e) The industry or industries which the firm is in and the prospects of those sectors.
(f) Liquidity and asset backing, including the nature of assets – specialised assets with a restricted resale market may reduce the P/E ratio.
(g) The make-up of the shareholders and the financial status of any major shareholders.
(h) Companies dependent on one or two key individuals and their skills may have their P/E ratio lowered.
Sometimes the P/E ratio of a company being acquired may be increased to reflect the improvements the predator thinks they can introduce into the “victim” company, although often such improvements are not realised.
Example
Sinbad plc is considering acquiring Flower Ltd. Sinbad plc’s shares have been quoted recently at an average of £6.40 and the recently published EPS of the company is 40p.
Flower Ltd has 100,000 shares and a current EPS of 50p. Suggest an offer price for Flower Ltd.
Answer
First we have to decide a reasonable P/E ratio. The P/E ratio for Sinbad plc is 640/40 16.
Assuming Flower Ltd is in the same industry its P/E ratio can be based on Sinbad plc’s P/E ratio, adjusted for the fact that it is not quoted, its growth prospects, and riskiness of its earnings. (If Flower Ltd is in a different industry then a typical P/E ratio for that industry could be used as a basis for the calculations.)
Using Sinbad plc a P/E ratio for Flower Ltd can be estimated as, for example, 16 50% 8.
A value for the shares can then be calculated as 8 50p £4. This price would be the basis for negotiations on the value of the company.
Net Asset Method
With this method the company is viewed as being worth the total of its net assets and this makes the balance sheet the critical part of the business that is needed for share valuation purposes. If the share value is undertaken using this method, it is often necessary to update the balance sheet values, to ensure that the basis on which the valuation is done is as accurate as possible.
The premise that the value of a class of a company’s shares is equal to the net tangible assets of the company attributable to those shares is the basis of this method of calculating share values. Intangible assets are only included in the calculation if they have a
recognisable market value, e.g. a copyright. To calculate the value of a share we simply divide the value of the assets attributable to a class of shares by the number of shares in the class.
Whilst this may seem to be an easy method in principle, in practice it can be quite difficult, the problems arising from arriving at a value for net assets. The problems include the following:
Are the assets to be valued on a going concern or break-up basis?
Are any assets covered by prior charges?
How can the assets be valued – is a professional valuation required?
What are the costs of sale – redundancy, taxation charges on disposal?
Have all the liabilities been identified and correctly valued, including contingent liabilities?
If you are given the information to do so in an exam question on valuation, always calculate the net assets per share. There are two reasons for this:
(a) The value shows the amount a shareholder could expect to receive if the company went into liquidation. A potential shareholder could compare the asking price for the shares with the net assets per share value to calculate the maximum possible loss if the company fails to provide the promised dividends and earnings figures.
(b) An adjustment may be required in a scheme of merger to the value of the companies’
shares to reflect differences in asset-backing – shares with higher net assets per share figures could be expected to gain a higher price.
Unless otherwise told in an exam situation you should use the balance sheet figures
provided, adjusted for intangible assets, to calculate the share values. However, you should list any concerns that you have along the above lines regarding the figures given.
Dividend (Valuation) Models
These models are based on the assumption that the market value of ordinary shares represents “the sum of the expected future dividend flows, to infinity, discounted to present values”.
The model used under this method varies with the assumptions used. The simplest model assumes that dividends will remain at a constant level in the future. The value of a
company’s shares can be calculated using the formula:
Market value
Tinkeywinkey Ltd’s shareholders expect a dividend yield of 12% and have been told that dividends per share for the foreseeable future will be 20p. Calculate the value of
Tinkeywinkey’s shares if they have 100,000 in circulation.
Answer
Using the above formula to calculate the value of one share:
Value 166.67p.
The value of all 100,000 shares value of one share number of shares in issue so the value of the company 166.67p 100,000 £166,670.
In other words, a shareholder in Tinkeywinkey who accepted a yield of 12% on an investment of £1.67, would be prepared to pay £1.67 for a share which paid him a dividend of 20p, or 12% on a nominal value of £1.
However, as we will see in a later study unit, shareholders prefer a constant growth in their dividends. In order to reflect this in valuing the company using a dividend method we have to predict future growth in dividends – which generally reflects predicted changes in a
company’s earnings. When the expected growth figure has been determined we can
calculate the value of the company’s shares using the Dividend Growth Model or Gordon’s Model of Dividend Growth.
where: Po the current ex dividend market price do the current dividend
g the expected annual growth in dividends
r the shareholder’s expected return on the shares
The expression do(1 g) represents the expected dividend in the next year.
Example
Poh Ltd is expecting to pay a dividend of 20p this year, increasing at a rate of 5% per annum.
If its shareholders have a required return of 15%, calculate the current market price.
Answer
The dividend yield method is often used when valuing small shareholdings in unquoted companies. The reasoning behind the model is that such shareholders, being unable to influence a company’s earnings to any extent, will only be really interested in the dividends they receive from holding their shares. This method assumes that a share price is equal to the value of all the dividends it will attract during the time it is held, plus the amount received when it is sold (the sale price will reflect future dividends expected at the point of sale).
Amounts of cash received in the future are worth less than cash received today, so we must discount the future values to compensate and express them in terms of their equivalent value today. The discount rate used is the cost of the capital provided (which is the yield the
investor expects to receive from his investment in the company). (We will cover this topic in much greater detail later in the course.)
This discounting can be expressed as:
Po 1 2 2 3 3 3 3
where D dividend (i.e. D1is dividend in next year) To calculate D1, D2, D3, etc.:
D1 do(1 g)2
D2 do(1 g)3 D3 do(1 g)4
This model can be expanded to allow for potential growth in the dividend rate, and can be simplified to the dividend growth model shown above:
Po
Dipsey Ltd, whose shareholders require a return of 20%, expects to pay no dividends for the following three years, but then expects to be able to pay a dividend of 10p per share for the foreseeable future. What is the value of its shares?
Answer
There is no return in the first three years so the price is:
0 0 0 4 (1.20)
10p 5
(1.20)
10p ...
Because the cash flows continue into the foreseeable future this will be the same as:
0.20 p
10 at time t3
The present value of £1 a year forever at r% growth is r 1.
Therefore the price today
(0.20) p
10 3
(1.20)
1
(1.20) 50p
3 28.94p (say 29p) Note that growth will usually be expressed as a percentage.
Discounted Future Profits
This method is sometimes used when a company intends to purchase another’s assets and invest in improvements in order to increase future profits. It is best illustrated using an example.
Example
Bear plc is proposing to acquire Lion plc who is currently just breaking even. Bear feels that the investments it plans to make should lead to the following after-tax figures (ignoring any price paid) for Lion:
Year Earnings
£000
1 85
2 88
3 92
4 96
5 96
Bear wishes to recover its investment within five years. If the after-tax cost of capital is 12.5%, what is the maximum price Bear should be prepared to pay?
Answer
The maximum price is the one where the discounted future earnings exactly equal the purchase price paid.
Year Earnings Discount Factor Present Value (Earnings × Discount
Factor)
£000 £
1 85 0.893 75,905
2 88 0.797 70,136
3 92 0.712 65,504
4 96 0.636 61,056
5 96 0.567 54,432
Present Value 327,033
Therefore the maximum purchase price would be £327,033. (Don’t worry if you do not understand the discount factors at this stage; they will be fully explained later in the course.) The Berliner Method or Free Cash Flow Method
This method is calculated by using the average of share prices obtained using the net assets method and the earnings methods (see above).
This method is also known as the free cash flow approach. The method may be difficult to adopt in practice as it needs forecasts of working capital (see later in the course) and taxation to ensure that estimates of future cash flows and their timings are accurate.
Note re CAPM
The Capital Asset Pricing Model is a further method of valuing shares. It is used especially to determine the required yield on equity when the shares are being priced before a Stock Market listing. We shall cover this topic in a later study unit, but we mention it here to remind you to include it in your revision of this stage.
Worked Example
The following question is taken from the June 2006 examination paper.
The directors of Steel Ltd are considering putting in a bid to purchase a rival company Bronze Ltd.
The most recent accounts of Bronze Ltd shows the following:
Profit and Loss Account for the year ended 31-12-05
£’000 £’000
Sales 3,064,100
less: Cost of sales (924,100)
Gross Profit 2,140,000
less: Distribution expenses 225,000 Advertising expenses 308,000
Marketing expenses 568,000 (1,101,000)
Net Profit before tax 1,039,000
Corporation tax (311,700)
Net profit after tax 727,300
Dividend (127,300)
Retained profit 600,000
Balance Sheet as at 31-12-05
£’000 £’000 £’000
Fixed Assets Cost Depreciation NBV
Land 500,000 500,000
Buildings 1,200,000 (300,000) 900,000
Fixtures 280,000 (40,000) 240,000
Motor vehicles 370,000 (50,000) 320,000
2,350,000 (390,000) 1,960,000 Current Assets
Stock 640,000
Debtors (trade) 110,000
Prepayments 40,000 790,000
Current liabilities
Creditors (trade) (346,800)
Taxation (311,700)
Dividends (127,300)
Bank overdraft (38,500) (34,300)
Long term liabilities
8% Debentures (secured) (114,000)
Net Assets 1,811,700
Financed by Capital
Ordinary shares (£1par) 1,500,000
Reserves
Profit and loss 285,000
Revaluation 26,700
1,811,700
Additional Information
1. A professional surveyor has recently established the following current realisable values of the assets of Bronze Ltd
£
Land 650,000
Buildings 780,000
Fixtures 80,000
Motor Vehicles 260,000
Stocks 610,000
Trade debtors 100,000
2. The estimated cash flows of Bronze Ltd (ie after tax, interest and replacement investment) over the next ten years are estimated as follows:
£
2006 225,000
2007 275,000
2008 290,000
2009 360,000
2010 – 2015 380,000 p.a.
3. The directors would be seeking a return of 14% if they went ahead with the purchase.
4. A similar business to Bronze Ltd listed on the stock exchange has a Price Earnings (P:E) ratio of 8:1
5. No strategic investment is envisaged over this period.
Required:
(a) Calculate the value of a share in Bronze Ltd using the following valuation methods:
(i) Net asset ratio (ii) P:E ratio
(iii) Discounted (free) cash flow
(b) What are the main disadvantages of each method?
Answer
(a) (i) Net asset ratio:
£ Net asset value – per accounts 1,811,700 Adjustments:
Land 150,000
Buildings (120,000)
Fixtures (160,000)
Motor vehicles (60,000)
Stocks (30,000)
Trade debtors (10,000)
Adjusted net asset value £1,581,700
Valuation per share is
1,500,000
£1,581,700
= £1.05 per share (ii) P:E ratio:
Profit after tax = £727,300
P:E ratio = £727,300 x 8 = £5,818,400 Valuation per share is
1,500,000
£5,818,400
= £3.88 per share
(iii) Free cash flow:
Cash flow Present value
Year £ £
2006 225,000 197,325
2007 275,000 211,475
2008 290,000 195,750
2009 360,000 213,120
2010 – 2015 380,000 ^ 874,760
1,692,430 Assume Current assets = Current liabilities
Long term loan (debentures) (114,000) 1,578,430
^ combined aggregate annuity value, based on annuity table Valuation per share is
1,500,000
£1,578,430
= £1.05 per share (b) Main Problems
(i) Net asset ratio
Fixed asset values are usually based on current historic cost less depreciation.
Different depreciation methods result in different values of fixed assets and, whatever method of depreciation is used, the book values are unlikely to correspond to market values. Although companies do revalue their assets periodically, this is a subjective exercise, often undertaken by the directors themselves.
Values of stock may not be reliable, especially if the accounts were prepared some time ago. Companies often “window dress” their accounts at year- end and stock values in some industries are often outdated.
Some accounts may be uncollectable. Provision should have been made for bad and doubtful debts, but the bidder should be wary of the extent of this allowance.
(ii) Price Earnings
The earnings figure can be distorted by accounting policies.
The current earnings may be untypically high or low and it may be more appropriate to take the average earnings over the last few years.
It is difficult in reality to find close substitutes – i.e. companies which produce the same product lines, serve the same markets and have similar management capabilities.
Companies have different potential for growth.
(ii) DCF
Can the future investment be accurately predicted?
How can we measure the discount rate?
Over what time period should we assess value?