(LUẬN VĂN THẠC SĨ) The solutions for valuation in the equitization of state enterprises, the case of Vietinbank Insurance One Member limited Company

CHAPTER 3: THE COMBINATION OF THE VALUATION METHODS 71 3.1 The calculation of the weight rate 3.1.1 The calculation of the weight rate base on the view of author 3.1.2 The calculation o

VIETNAM NATIONAL UNIVERSITY, HA NOI

SCHOOL OF BUSINESS

PHAM TRUNG THANH

THE SOLUTIONS FOR VALUATION IN THE EQUITIZATION

OF STATE ENTERPRISES, THE CASE OF VIETINBANK INSURANCE ONE MEMBER LIMITED COMPANY

VIETNAM NATIONAL UNIVERSITY, HA NOI

SCHOOL OF BUSINESS

PHAM TRUNG THANH

THE SOLUTIONS FOR VALUATION IN THE EQUITIZATION

OF STATE ENTERPRISES, THE CASE OF VIETINBANK INSURANCE ONE NUMBER LIMITED COMPANY

TABLE OF CONTENTS

1 The necessity of the thesis 1

2 The purpose of the research 4

3 The objective and scope of research 4

1.2 The methods of the valuation of the firm 10 1.2.1 The free Cash Flow to The Firm 10 1.2.1.1 Theoretical Framework 10

1.2.1.3 The strengths and limitations of FCFF model 15

1.2.2.1 Theoretical Framework 16

1.2.2.3 The strengths and limitations of FCFE model 18 1.2.3 The dividend discount model 19 1.2.3.1 Theoretical Framework 19 1.2.3.2 The dividend discount model 19 1.2.3.3 The advantages and disadvantages 22 1.2.4 The price multiple valuation model 24 1.2.4.1 The price to earning method 24 1.2.4.1.1 The theoretical framework 24 1.2.4.1.2 The price to earning model 24 1.2.4.1.3 The advantages and disadvantages 25 1.2.4.2 The price to book value method 26 1.2.4.2.1 The theoretical framework 26 1.2.4.2.2 The price to book value method 27 1.2.4.2.3 The advantages and disadvantages 28 1.2.4.3 The economic value added method 29 1.2.4.3.1 The theoretical framework 29 1.2.4.3.2 The economic value added method 29 1.2.4.3.3 The advantages and disadvantages 31

CHAPTER 2: EMPIRICAL STUDY ON THE NON LIFE

INSURANCE INDUSTRY AND THE VALUATION OF VIETINSCO

2.2.3.1 The psychological factors 39 2.2.3.2 The economic factors 41

2.3 General view about Vietinsco 42

CHAPTER 3: THE COMBINATION OF THE VALUATION

METHODS

71

3.1 The calculation of the weight rate

3.1.1 The calculation of the weight rate base on the view of author

3.1.2 The calculation of the weight rate base on the interview experts

71

71

72 3.1.3 The calculation of the weight rate

3.2 The valuation matrix

Appendix 1 : Vietinsco historical Balance Sheet

Appendix 2: Vietinsco historical Income Statement

Appendix 3: Vietinsco Capital employed

Appendix 4: Vietinsco Ratio Forecast

Appendix 5:Vietinsco Working Capital Movement

Appendix 6: Financial Ratio

Appendix 7:Vietinsco Cash Flow Analysis

Appendix 8:Vietinsco sensitivity anaysis – Terminal Value approach –

Growth in perpetuity method of FCFF method Appendix 9: Vietinsco sensitivity anaysis – Terminal Value approach –

Growth in perpetuity method of FCFE method Appendix 10: Vietinsco sensitivity anaysis – Terminal Value approach –

Growth in perpetuity method of EVA method Appendix 11: The historical data on the return of rate the stock index,

treasury (a year), and Bonds (10 years) in US, 1928-2010 Appendix 12: Treasury Yield Curve Rates

Appendix 13: Estimate country Risk Premiums

Appendix 14: Interest rate per year

Appendix 15:The information market in the non life insurance field

LIST OF ABBREVIATIONS

CAPM Capital asset pricing model

CEO Chief executive officer

COGS Cost of gross sale

D Debt

DDM Dividend discount model

DIV Dividend value

DPS Dividend per share

E Earning

EBIT Earning before interest and taxes

EPS Earning per share

EVA Economic value added

FCF free cash flow

FCFE Free cash flow to equity

FCFF Free cash flow to firm

GDP Gross domestic product

NOPAT Net operating profit after taxes

OCF Operating cash flow/ cash flow from operating activities P/B Price to book

P/E Price to Earning

PV Present Value

ROA Rate of asset

ROE Rate of Earning

Vietinbank Viet Nam joint stock commercial Bank for industry and trade Vietinsco Vietinbank insurance one number limited company

WACC Weighted average cost of capital

WC Working capital

WTO World trade organization

LIST OF FIGURES:

Figure 1: Growth GDP (2002-2010)

Figure 2: Non cash charges

Figure 3: The structure of organization:

LIST OF TABLES

Table 2.1: FCFF for Vietinbank Insurance Company (2010-2015)

Table 2.2: The β information market in US

Table 2.3: The input information

Table 2.4: The Valuation using terminal value

Table 2.5: The valuation using FCFF method

Table 2.6: The FCFE for Vietinbank insurance Company 2010-2015

Table 2.7: The valuation using teminal value

Table 2.8: The Valuation using FCFE method

Table 2.9: The income statement

Table 2.10: The growth rate data

Table 2.11: The valuation using DDM

Table 2.12: The economic value added valuation

Table 2.13: The valuation using terminal value

Table 2.14: The valuation using EVA method

Table 3.1: The view of experts about the weight rate

Table 3.2: The weight rates

Table 3.3: The valuation matrix

FOREWORD

1 – THE NECESSITY OF THE THESIS

In the context of post-crisis global economy, Viet Nam’ economy has been growing continually to a high and stable speed Although the pace of global economic recovery is not all over the world, Asia has achieved quite well In Asia, Vietnam has continued to achieve the impressive growth After real GDP growth of 5.3% in 2009, Vietnam's economic growth forecasts to 6.78% in 2010 like China, Viet Nam is not only outstanding achievement by high growth but also a stable trend However, comparing with the growth of Thai Land (from -2.3 to 7.8%) and Malaysia (from -1.7% to 7.1%) , the growth of Viet Nam is the slower than the negative growth of countries in Asia in 2010

Figure 1: Growth GDP (2002-2010)

Resource: International Monetary Fund, World Economic Outlook Database, April 2011

However, the impressive growth performance is also accompanied with a number of macroeconomic issues

The first signs of risk appeared in 2007 when Viet Nam’ economy received a surge in foreign capital inflows that have not seen immediately after Vietnam joined the WTO It started to the credit boom and asset price bubbles Since then, the problem becomes more serious with a series of external shocks such as the world commodity price increases in 2008, the financial crisis and global economic crisis in 2009 and the national debt in

2010 in Europe Viet Nam now falls in unexpected high inflation rate in the entire East Asia and Pacific (6.5%) in 2009 and approximately 10% in 2010 (International Monetary Fund, World Economic Outlook Database, April 2011)

Secondly, Viet Nam’ economy also faces to pressure on currency, to decrease foreign exchange reserves, to be dismal stock market and balance

of high national interest rates compared to other fast growing economies in Asian Thus, although one of the most dynamic economies in the region, Vietnam’ economy is also an exception from the trend of emerging market such as more powerful currencies in general, strong capital inflows and increasing foreign exchange reserves

Besides, the competition between insurance companies and other financial services such as attracting savings deposits, securities, real estate business … is complex The requirement of customers in service of the insurance field is creasing, they are many the best choices and the best firm

for service them So, insurance companies want to attract the customers, they have to a detail strategy for making a strong brand name, to enhance a service quality by performing the commitment to the method, manner and compensation duration, to bring more value added service for customers instead of lowering premiums and promotion before More over, not only the number of foreign insurance companies licensed to operate in Viet Nam but also the number of domestic insurance companies are increasing, they have a strategy to dominate the market, increasing the market share in various forms including marketing and advertised techniques to accept losses for a long time ( even over 5 years ), the result of this strategy creates the unequal competition with other insurance companies but this operation

is suitable to the insurance business law The policy of insurance business management is more complete and more close to both promote self reliance

of insurance company and ensure the legitimate rights and interest of the clear and better insured

The equalization of state enterprises is considered an effective tool to enhance competitiveness, to improve the management capacity and management administration, to improve the efficiency of property management and the development of various kinds of products and services, what supply the needs of increasingly complex and diverse customers

The equalization of state owned enterprises is also committed to participate in Viet Nam's integration into the international economy However, the equalization of state enterprises should comply with the requirements strategy, coordinating between the State's policy with

Vietnam's commitments and the basic characteristics of the economy of Vietnam Therefore, the equalization of state owned enterprises such as Vietinsco if to be done right, Vietinsco will enhance completely in domestic and foreign markets as well as to meet the management requirements of the particular business, to contribute to raise the efficiency of Vietinsco in particular and to promote growth and economic development in general Moreover, Vietinsco is a component of the Vietinbank, the equitization of state owned enterprises is part of a roadmap for equitization

of Vietinbank

2- THE PURPOSE OF THE RESEARCH

Theoretical methods of valuation of enterprises in the equitization of state enterprises resolve the need of business valuation

The purpose of the research is to analyze and to evaluate the business activities of Vietinsco

On the basis of theoretical research on business valuation in the equitization of state enterprises and Vietinsco of valuation process, the thesis proposes the value of Vietinsco what it is suitable with price market and the provision of law

3- THE OBJECTIVE AND SCOPE OF RESEARCH

The objective of research is Vietinsco and the business of Vietinsco

The scope of research is comprehensive Vietinsco, regardless of

branch’ Vietinsco Therefore, the financial statements of Vietinsco will be

the range of focused research topics

4- THE METHOD OF RESEARCH:

To achieve the research objectives, author mainly use to the methods

in the thesis such as analysis, synthesis, comparison, qualitative method, quantitative method, and technical method in related research topics of the

thesis

5- OUTLINE OF THE THESIS:

In order to provide an overview of the structure of the thesis, author briefly introduces each chapter as following

Preface:

It provides the background that familiarizes the reader to the subject The thesis’ research problem is formulated and defined, and followed by purpose Author introduced general information about the economy, the industry and market of insurance

Chapter 1: Framework:

This chapter will present a theoretical review on the fundamental firm valuation models as well as frameworks that has been chosen as a base for the empirical study

Chapter 2: Empirical study on non life insurance industry and the valuation of Vietinbank insurance company

Author presented the non life insurance market in this chapter The second part of this chapter is to analyze and calculate the value of the vietinbank insurance company base on the theoretical framework of chapter

1

Chapter 3: The combination of valuation methods

Using the view of author and experts, we know about the weight rate

to determinate the value of the Vietinbank insurance company

Chapter 4: Conclusion and recommendation

CHAPTER 1: FRAMEWORK

1.1 OVERVIEW

The determined valuation of the firm is a process of determined monetary value for the firm that this value can be accepted by buyers or investors The firm is determined the valuation when the firm is operating and to be interested by investors

The determined valuation of the firm is an important stage in the process of the innovation firm, restructuring the economy, and also often using by the restructured organization, the restructured line production or a part of business of the firm

Some issues to be pay attention in the determined valuation of the firm

- The price of the firm is determined at a specific time: with the firm, its value is only determined when there is a need for certain transaction such as trade, separation, merger, joint venture … In other word, the value

of the firm is determined to supply the specified purposes Because the character of the firm is a operating organism, its material is always incessantly active Thus, the value of the firm is determined by the certain methods, it bases on the information, data, documents at a specific time, specially it must be considered analysis in the context of the market at this time When the conditions of data, of market change, the value of the firm

is also change So the determined valuation of the firm is always linked to

a specific time, if a certain conditions of market change, the value of the firm will not be used amid it must be redetermined

- The value of the firm depends on the future results of this estimated firm:

As the mention above, the buyers pays the sellers the price of the firm, the purpose of the buyers is earn money from the future operation of the firm The valuation of the firm depends on two factors: future expected earn and expected rate of the capital of investors

The first factor is future income to be determined from future estimated results of the operating business The higher results of operating business in the future is estimated by the investors , the valuation of the firm

is higher, and on the contrary, the valuation of firm is lower

The second factor is the ratio of the capital of expected investors This is the opportunity cost of capital that the investors estimate to base on the ratio of the capital achieved to the minimum capital with the level of risk

- The value of assets is determined on the basis of its future profits:

According to principle account, book value is historical cost, any goods and assets of firm are accounted on the books that it reflects the purchased price The market prices exclude the inflation Therefore, in the case of inflation, the book value will not reflect the intrinsic value of assets, goods what the firm is using and managing them

Unlike the principle account, the valuation of the firm is the process

of determined value of the firm The firm is an operating organism, all assets of the firm are used to do the business and to joint the process of making profit of the firm Therefore the value of an asset is determined on basis of its future profits The asset will be higher value when it can create

to more profits in the future and vice verse

- The net asset value affects the value of the firm;

In the firm, all assets are managed and used to aim the highest economic efficiency of the firm However, it is not all assets of the firm that the firm manages, are owned by the firm The asset of the firm (the net asset value of the firm) is the value of the assets of the firm except debt payable Thus, when the value of the firm is determined, we not only consider the managed assets of the firm, but also look the resource of capital assets The value of the firm is only suitable when the assets of the firm are eliminated debts

- The relationship of supply and demand affect the market value of the firm:

The market value of an asset is a sale price of this asset This price is

a common price in the determined market condition In fact, the information about the asset and the price of this asset is often not available, so the value

of an asset is the price of this asset that almost buyers will pay

But in fact, investors often use the various methods to make the value

of the firm Specially, each investor has research, valuation, market analysis

of his individual, so many investors also use the same method of valuation

of the firm but the result of valuation is different The difference of the result has the reason of investors’ different information input and risk perception

For the firm, the last value of this firm depends on the market demand, so the firm has many interested buyers in the market, the value of this firm will much higher than the real value of it

1.2 THE METHODS OF THE VALUATION OF THE FIRM:

At the moment, there are many methods to evaluate the value of the firm in the world However, in the scope of this thesis, the author will focus the main methods such as the free cash flow to firm, the free cash flow to equity, the Dividend discount model, the price to earning, the price to book value, the economic value added

1.2.1 THE FREE CASH FLOW TO FIRM:

1.2.1.1 THEORETICAL FRAMEWORK:

Based on the principle, the value of the asset must be equal to what it will receive from this asset in the future That mean we must estimate how much the cash flow to generate from this asset in the future Because the

firm is always expected to operate forever, or at least it is not easy for us to estimate the time of the close firm, this cash flow is estimated forever

This method of valuation of the firm, including debt and equity, is used to estimate the cash flow after eliminated the operating cost and taxes but excluding loan In order to determine the price of capital share, the value of the firm is continuously eliminated debt value This is the general, highly scientific method

1.2.1.2 THE FCFF MODEL:

Present value of FCFF of the general model:

Firm value = FCFF discounted at the WACC

Firm value = Σ [FCFFt / (1 + WACC)t)] Σ: t = 1 to infinite

Equity value = firm value - debt value

Equity value = Firm value - MVd MVd: the market value of debt

Dividing the total value of equity by the number of outstanding shares gives the value per share

WACC can be either based on the current market weights of equity and debt or target weights In case of market weights-based WACC, the formula is

WACC = MVd / [MVd + MVe] x rd (1 - T) + MVe / [MVd + MVe] x re Where

 MVd is the market value of debt

 MVe is the market value of equity

 rd is the pre-tax cost of debt

 re is the cost of equity

 T is the tax rate

The cost of debt can be obtained directly from the market as the yield

to maturity on the company's debt or comparable companies' debt To calculate the cost of equity we can use methods such as CAPM, Arbitrage pricing theory or cost of debt plus risk premium

If FCFF is growing at a constant rate g, the value of the firm is:

Firm value = FCFF1/(WACC - g) = FCFF0(1 + g) / (WACC - g)

Computing FCFF from net income:

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv – WCInv

Where:

 NI: Net income available to common shareholders It is the company's earnings after interest, taxes and preferred dividends

 NCC: Net non cash charges They represent depreciation and other non-cash charges minus non-cash gains The add-back of net non-cash expenses is usually positive, because depreciation is a major part

of total expenses for most companies

 Int (1 - Tax rate): After-tax interest expense

We add this back to net income because

o FCFF is the cash flow available for distribution among all suppliers of capital, including the debt-holders, and

o Interest expense net of the related tax savings was deducted in arriving at net income

The add-back is after-tax, because the discount rate in FCFF model (WACC) is also calculated on the after-tax basis

 FCInv: Investment in fixed capital It equals to capital expenditures for Property, Plant & Equipment minus sales of fixed assets

 WCInv: Investment in working capital It equals to the increase in short-term operating assets net of operating liabilities

Note that working capital for cash flow and valuation purposes is defined to exclude cash and short-term debt (which includes notes payable and the current portion of long-term debt)

o Cash and cash equivalents are not taken into consideration, because it is the change in this account that is explained by FCFF

o Notes payable and the current portion of long-term debt are also ignored, because these accounts pertain to financing decisions, and FCFF describes operating and investing activities only

Note: Non cash charges

If an analyst wants to use an add-back method, the analyst must be careful to add back only non-cash component of such charges As one example, restructuring charges can involve cash expenditures and non cash charges For example, severance expense, which is incurred in the same year, should not be added back to net income, because it is a cash charge

On the other hand, a write-down in the value of assets as part of a restructuring charge is a non cash item

Sometimes non-cash items should be subtracted from, instead of being added back to, net income Examples are non-cash gains on sale of assets, or reversal of previous restructuring charges

Particular diligence should be exercised in determining effect of deferred taxes and tax benefits of employee stock plans on FCFF Deferred taxes generate cash flows only if they are expected to reverse in the future, otherwise they should be added back to net income in calculation of FCFF

Conversely, employee stock ownership plans generate cash flows only if they are not reversed in the future Consequently, benefits associated with employee options should be subtracted from net income for the purpose of FCFF forecasting, if their reversal is expected in the near future

We summarize the common non cash charges that impact net income and indicate for each item whether to add it or subtract it from net income in arriving at FCFF:

Figure 2: Non cash charges

1.2.1.3 THE STRENGTHS AND LIMITATIONS OF FCFF MODEL:

The advantages:

 Wide applicability for different dividend and financing policies

 In contrast to dividends, a record of free cash flows is observable for any company

 Since FCF model is based on the capital exceeding operational needs,

it is useful for valuation of control ownership that allows investors to redeploy this capital

The disadvantages:

 If FCF < 0 due to capital demands

Many companies have negative free cash flow for years due to large capital demands Since prediction of free cash flow far in the future would be imprecise, FCF model cannot be used for growth companies

 The new firm or the shortly operational firm: it is not enough historical data to estimate the future data

 The firm is operated by the cycle of business: it is easy to estimate wrongly the data that it is calculated in the peak position or the bottom of recession

 The firm, which has useless assets or invented assets, has the incorrect estimation by forgetting the profitability of these assets

 The restructured firm or the firm relating the merge and acquisition: the measured influence of the restructure, the synergy is very difficult but they are main influences to relate the most value of the firm

 Besides, this method is required the level of finance The calculation

of the cash flow in the future is still asked the information of the firm, the industry, the macro economy Thus, it is more suitable to the firm than to the private

1.2.2 THE FREE CASH FLOW TO EQUITY MODEL:

1.2.2.1 THE THEORETICAL FRAMEWORK:

In the economic market, investors are always interested in the solvent, the ability of received the initial investments of capital This is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment

1.2.2.2 THE FCFE MODEL:

Present value of FCFE

Equity value = FCFE discounted at the required return on equity (r)

These cash flows belong to the stockholders only Therefore, the present value of FCFE stream gives us the intrinsic value of a company:

Equity value = Σ[FCFEt / (1 + re)t]

Σ: t = 1 to infinite

Similarly, if FCFE is growing at a constant rate g, the value of the equity is: Equity value = FCFE1/(r - g) = FCFE0(1 + g) / (r - g)

Computing FCFE from FCFF

FCFE is the cash flow available to common stockholders

FCFE = FCFF + Net borrowing - Int (1- Tax rate)

Where:

 Net borrowing: Borrowing of new debt minus repayment of old debt

 Int (1- Tax rate): Net distributions to debt-holders need to be

subtracted from FCFF to calculate FCFE

FCFE can be calculated from net income Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv Then:

FCFE = NI + NCC + Net borrowing - FCInv – WCInv

of total expenses for most companies

 FCInv: Investment in fixed capital It equals to capital expenditures for PP&E minus sales of fixed assets

 WCInv: Investment in working capital It equals to the increase in short-term operating assets net of operating liabilities

1.2.2.3 THE STRENGTHS AND LIMITATIONS OF FCFE MODEL:

The advantages and the disadvantages of the FCFE model are the same as the advantages and disadvantages of the FCFF model But there are other disadvantages; the FCFE model required the information of debt of the firm in the future, including the amount and the interest rate However,

if the structure of capital of the firm is estimated too much change or the credit market is unstable, the amount of debt of the firm that must paid, is not estimated, so the valuation of the firm based on the FCFE is not accurate

1.2.3 THE DIVIDEND DISCOUNT MODEL:

1.2.3.1 THE THEORETICAL FRAMEWORK:

As you know, the only cash flow you receive from a firm when you buy publicly traded stock is the dividend The simplest model for valuing equity is the dividend discount model, the value of a stock is the present value of expected dividends on it In fact, there are specific companies where the dividend discount model remains a useful took for estimating value

1.2.3.2 THE DIVIDEND DISCOUNT MODEL:

The general Model:

When an investor buys stock, she generally expects to get two types

of cash flows – dividends during the period the stock and an expected price

at the end of the holding period Since this expected price is itself determined by future dividend, the value of a stock is the present value of dividends through infinity

Value per share of stock = t

c t t

DPS E

) 1 (

) (

Where: DPSt = expected dividends per share

Kc= Cost of equity

The rationale for the model lies in the present value rule, the value of any asset is the present value of expected future cash flows discounted at a rate appropriate to the riskiness of the cash flows

There are two basis inputs to the model – expected dividends and the cost on equity To obtain the expected dividends, we make assumption about expected future growth rates in earnings and payout ratios, the required rate of return on a stock is determined by its riskiness, measured differently in the different models – the market beta in the CAPM, and the factor betas in the arbitrage and multi factor models The model is flexible enough to allow for time varying discount rate, where the time variation is caused by expected changes in interest rates or risk across time

In this thesis, the author use to the two stage dividend discount model for valuation of Vietinsco This two stage growth model allows for two stages of growth an initial phase where the growth rate is not a stable growth rate and a subsequent steady state where the growth rate stable and

is expected to remain so for a long term While, in most cases, the growth rate during the initial phase is higher than the stable growth rate, the model can be adapted to value companies that are expected to post low or even negative growth rate for a few years and the revert back to stable growth

The model is based upon two stages of growth, an extraordinary growth phase that last n years and a stable growth phase that lasts forever afterwards

Extraordinary growth rate: g% each year for n years, stable growth:

( ) 1

n t

chg t t

P k

1

n st c

n n

g k

DPS P



Where: DPSt= Expected dividends per share in year t

Kc = cost of equity (hg: high growth period; st: stable growth period)

Pn= price (terminal value) at the end of year n

G- extra ordinary growth rate for the first n years

Gn = steady state growth rate forever after year n

Calculating the terminal price:

The same constraint that applies to the growth rate for the Gordon Growth rate model, i.e that the growth rate in the firm is comparable to the nominal growth rate in the economy, applies for the terminal growth rate gn

in this model as well

In addition, the payout ratio has to be consistent with the estimated growth rate If the growth rate is expected to drop significantly after the initial growth phase, the payout ratio should be higher in the stable phase than in the growth phase A stable firm can pay out more of its earnings in dividends than a growing firm

One way of estimating this new payout ratio is to use the fundamental growth model

Expected Growth = Retention ratio * Return on equity

1.2.3.3 THE ADVANTAGES AND DISADVANTAGES:

The advantages

 Since the two-stage dividend discount model is based upon two clearly delineated growth stages, high growth and stable growth, it is best suited for firms which are in high growth and expect to maintain that growth rate for a specific time period, after which the sources of the high growth are expected to disappear One scenario, for instance, where this may apply is when a company has patent rights to a very profitable product for the next few years and is expected to enjoy super-normal growth during this period Once the patent expires, it is expected to settle back into stable growth Another scenario where it may be reasonable to make this assumption about growth is when a firm is in an industry which is enjoying super-normal growth because there are significant barriers to entry (either legal or as a consequence of infra-structure requirements), which can be

expected to keep new entrants out for several years The assumption that the growth rate drops precipitously from its level in the initial phase to a stable rate also implies that this model is more appropriate for firms with modest growth rates in the initial phase

 The model work best for firms that maintain policy of paying out most of residual cash flows – i.e, cash flows left over after debt payments and reinvestment needs have been met – as dividends

 The second problem with this model lies in the assumption that the growth rate is high during the initial period and is transformed overnight to

a lower stable rate at the end of the period While these sudden transformations in growth can happen, it is much more realistic to assume that the shift from high growth to stable growth happens gradually over time

 The focus on dividends in this model can lead to skewed estimates of value for firms that are not paying out what they can afford in dividends In particular, we will under estimate the value of firms that accumulate cash and pay out too little in dividends

1.2.4 THE PRICE MULTIPLE VALUATION METHOD:

1.2.4.1 THE PRICE TO EARNING METHOD:

1.2.4.1.1 THE THEORETICAL FRAMEWORK:

This method is based on the ideal, if two stocks is similar, including the same risk, the same profit margin, the same prospect growth…), the stock, that has lower price multiple, is consider valued lower than other stock

This approach of discount cash flow model is suitable both in theory and in practice For the relative valuation techniques, there are two main issues following:

- Do the reason or the any inference to choice multiple price appropriate? Is the shortcoming of each price multiple?

- How is the price multiple defined?

Many investors want to estimate the value of share thought income multiple price model As we know, income what shareholders have a right

to receive is net income of the firm So, it is one of the methods that investors estimate the value of stock is used to decision, they are ready to pay how money for a dollar of expected benefit

1.2.4.1.2 THE PRICE TO EARNING MODEL:

The formula:

P/E = the current market price/ earning per share

As we know, the price of stock may be used to the infinite period dividend discount model by this following formula:

Pi = D1/(k-g)

Where:

Pi: value of stock

D1: dividend per share

K: discount rate

G: dividend growth

If divided two sides of this formula for E1 (expected income in the next

12 months) The result would be followed:

Pi/E1 = (D1/E1)/ (k-g)

This model shows that the P/E ratio is determined by:

- The rate of proposed dividend

- The expected rate of return of stock

- The expected rate of dividend growth

1.2.4.1.3 THE ADVANTAGES AND DISADVANTAGES

The advantages:

 According to security analysts, earnings continue to be the primary driver of investment value

 P/E is widely recognized and used by investors

 Differences in price/earnings ratios may be related to differences in long-run average returns, according to empirical research

The disadvantages:

 P/E does not make economic sense with a negative EPS As a result, only companies with positive earnings can be ranked according to their P/E ratios and a number of companies with negative earnings have to be excluded from this analysis

 Volatile, transitory portion of earnings makes it difficult to calculate P/E, because only permanent or recurring income can be a determinant of the company's value Splitting a company's earnings into recurring and period-specific elements is difficult

 Management discretion in choice of accounting methods reduces comparability For example, management may pursue income-smoothing policy which can significantly distort a company's net income and lead to inaccurate valuation of the company's stock if P/E is used

1.2.4.2 THE PRICE TO BOOK VALUE METHOD:

1.2.4.2.1 THE THEORETICAL FRAMEWORK:

Book value per share attempts to represent the investment that common shareholders have made in the company, on a per-share basis It can be calculated by subtracting all liabilities and preferred stock from the total assets Since the P/B ratio contains price per share in the numerator,

we restate the book value on a per share basis by dividing it by the number

of fully diluted shares outstanding

1.2.4.2.2 THE PRICE TO BOOK VALUE MODEL:

A price to book ratio is a price multiple comparing a company's current market share price to its book value per share

P/B ratio = market price per share / book value per share

Computation of Book Value:

The computation of book value is as follows:

(Shareholders' equity) minus (the total value of equity claims that are senior

to common stock) = Common shareholders' equity (Common shareholders' equity)/(number of common stock shares outstanding) = book value per share

Possible senior claims to common stock include the value of preferred stock and dividends in arrears on preferred stock

Some adjustments are needed to make the multiple to be more accurate to reflect the shareholders' investment, and more comparable

among companies The adjustments include excluding certain intangibles, restating inventory values using a different inventory method, adding back certain off-balance sheet liabilities, etc

1.2.4.2.3: THE ADVANTAGES AND THE DISADVANTAGES OF THE P/E MODEL

 The P/B multiple compares market value of residual assets with their book value, consequently it is most relevant when applied to companies with liquid assets (e.g financial companies) and in case of significant doubt about the entity's ability to continue as a going concern

 Some empirical research suggests that the P/B multiple may be a determinant of long- run returns on equity

Disadvantages:

 The book value recognizes accounting assets only It does not include any other valuables such as human capital and good reputation of a company

 The book value may be distorted by certain accounting practices, such as expensing of Research & Development, which depress the residual asset value

 Historical cost-based approach of generally accepted accounting principles leads to outdated and less relevant book values, significantly departing from the true value of shareholders investment

 Using the P/B ratio is inappropriate when comparing companies with distinctly different business models, especially in part of the fixed asset requirements A service company is expected to have a higher P/B multiple than a manufacturer of automotive parts when both companies are fairly valued

 Share repurchases or issuances may distort historical comparisons

1.2.4.3 THE ECONOMIC VALUE ADDED METHOD:

1.2.4.3.1 THE THEORETICAL FRAMEWORK:

Economic Value Added (EVA) is a measurement tool that provides a clear picture of whether a business is creating or destroying shareholder wealth EVA measures the firm’s ability to earn more than the true cost of capital EVA combines the concept of residual income with the idea that all capital has a cost, which means that it is a measure of the profit that remains after earning a required rate of return on capital If a firm’s earnings exceed the true cost of capital it is creating wealth for its shareholders

1.2.4.3.2 THE ECONOMIC VALUE ADDED MODEL:

A discussion on Economic Value Added has to begin with the origin

of the concept EVA is based on the work of Professors Franco Modigliani and Merton H Miller In October, 1961, these two finance professors published “Dividend Policy, Growth and the Valuation of Shares”, in the Journal of Business The ideas of free cash flow and the evaluation of business on a cash basis were developed in this article These ideas were extended into the concept of EVA by Bennett Stewart and Joel Stern of Stern, Stewart & Company

Economic Value Added is defined as net operating profit after taxes and after the cost of capital (Tully, 1993) Capital includes cash, inventory, and receivables (working capital), plus equipment, computers and real estate The cost of capital is the rate of return required by the shareholders and lenders to finance the operations of the business When revenue exceeds the cost of doing business and the cost of capital, the firm creates wealth for the shareholders

Formula:

EVA = NOPAT – (WACC x invested capital)

= [EBIT x (1-t)]-WACC

where: Dollar Cost of Capital = (Cost of capital % ) x (Total Capital)

NOPAT = Net Operating Profit after Taxes

WACC = after-tax weighted average cost of capital in decimal terms

T= marginal tax rate

WACC = Dollar Cost of Capital

Invested capital = net working capital + net fixed assets

= book value of long term debt + book value of equity

In practice, both accounting NOPAT and Total Capital are adjusted to correctly estimate EVA:

1 Research &Development expenses are capitalized and amortized This increases NOPAT accordingly

2 Charges for capital for strategic investments are suspended if they are not expected to generate a return immediately

3 Goodwill is capitalized Total Capital is adjusted for accumulated amortization and amortization expense is added back to NOPAT

4 Non-cash tax expense is removed

5 Last in, first out reserve is added back to the Total Capital and NOPAT is adjusted for the change in last in, first reserve

6 Operating leases are treated as capital leases

7 Nonrecurring items are eliminated from the income statement

1.2.4.3.3: THE ADVANTAGES AND THE DISADVANTAGES OF THE ECONOMIC ADDED MODEL:

The advantages: