ACCA paper f9 financial management study materials F9FM session18 d08

1 REASONS FOR BUSINESS VALUATION Ü To determine the value of a private company e.g.. in a merger or takeover - note that the quoted share price is only relevant for taking a minority sh

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OVERVIEW

Objective

Ü To estimate the value of one share or of a company’s equity in total

Ü To be familiar with all ratios commonly used in business analysis

BUSINESS

VALUATION

BUSINESS VALUATIONAND RATIO ANALYSIS

RATIO ANALYSIS

Ü Reasons for business valuation

Ü Nature of valuation

Ü Asset based valuations

Ü Earnings based valuations

Ü Dividend based valuation

Ü Profitability

Ü Liquidity

Ü Efficiency

Ü Gearing

Ü Investor ratios

1 REASONS FOR BUSINESS VALUATION

Ü To determine the value of a private company e.g for a Management Buy Out (MBO) team;

Ü 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;

Ü To aid in decisions on buying/selling shares in private companies;

Ü To place a value on companies entering the stock market i.e Initial Public Offerings – IPO’s;

Ü To value shares in a private company for tax/legal purposes;

Ü To value subsidiaries/divisions for possible disposal

Ü 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

Ü 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

Ü 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

Ü The final price will result from negotiations between the parties

Ü In the following sections the following methods of valuation will be considered:

̌ asset based valuations

̌ earnings based valuations

̌ dividend based valuations

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3.1 Net Book Value (NBV)

Ü Simply uses the balance sheet equation i.e

Equity = assets - liabilities

Ü 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

Ü For the above reasons a valuation based upon balance sheet net assets is not likely to be reliable

3.2 Net Realisable Value (NRV)

Ü This estimates the liquidation value of the business

Equity = estimated net realisable value of assets - liabilities

Ü This may represent the minimum price that might be acceptable to the present owner of

the business

Ü 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

Ü This can be viewed as the cost of setting up an identical business from nothing

Equity = estimated depreciated replacement cost of net assets

Ü This may represent the maximum price a buyer might be prepared to pay

Ü Problems:

̌ technological change means it is often difficult to find comparable assets for the purposes of valuation ;

̌ ignores unrecorded assets;

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 Per Earnings

share ordinary per

price Market

Earnings per Share (EPS) =

shares ordinary issued

of Number

dividends preference

and tax after Profit

Therefore:

Ordinary share price = P/E ratio × EPS

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

Ü Earnings yield is simply the reciprocal of the P/E ratio

Earnings Yield =

share per price Market

Therefore:

Ordinary share price =

Yield Earnings EPS

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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

$ $

(56,000)

(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

Solution

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

Ü This method fails to take growth in to account and therefore can lead to an under-valuation

Ü 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

Solution

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5.2 Dividend Valuation Model

Ü If dividends are expected to remain constant e.g on preference shares:

re

D Where P0 = today’s share price

D = dividend per share

re = required return of equity investors

Ü If dividends are forecast to grow at a constant rate in perpetuity

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

Ü Problems:

̌ determining growth rate of dividends;

̌ determining appropriate required return for unquoted company;

̌ little relevance for valuing a majority shareholding as such an investor has the

ability to change the dividend policy

Example 3

Claygrow Ltd is a company which manufactures flower pots The following

data are available

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

Solution

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6.1 Profitability ratios

Sales

profit

Sales

tax and interest before

s liabilitie current

-non + funds rs' Shareholde

tax and interest before

funds rs' shareholde Ordinary

dividends preference

- tax after

6.2 Liquidity ratios

Current ratio =

s liabilitie Current

assets Current

Quick or acid test ratio =

s liabilitie Current

inventory assets

6.3 Efficiency/activity ratios

sales credit Annual

receivable accounts

purchases credit

Annual

payable accounts

sales of cost Annual

inventory

Cash conversion cycle = inventory days + receivables days – payables days

Total asset turnover =

assets Total Sales

Fixed asset turnover =

assets Fixed Sales

6.4 Gearing/Risk ratios

Financial gearing:

reserves Capital

s liabilitie current

+

employed Capital

s liabilitie current

Ü gearing can also be referred to as leverage

Operational gearing:

100 costs operating Variable

costs operating Fixed

costs operating Total

costs operating

Interest cover =

expense Interest

tax and interest before

Profit

Cash flow coverage =

expense Interest

operations from

generated Cash

6.5 Investor ratios

Earnings per ordinary share (EPS)

issue

in shares ordinary of

number average

Weighted

dividends preference

- tax after Profit

=

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

Diluted EPS =

g outstandin s

PDS' shares

ordinary average

Weighted

s adjustment PDS

dividends preference

- tax after Profit

+ +

Dividend cover =

dividend Ordinary

dividend preference

-tax ater Profit

dividend Ordinary

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Earnings yield =

price share Ordinary

Total Shareholder Return (TSR) =

year of start at price Share

dividends price

share end

× 100

Example 4

Cathcart Inc

Statement of financial position at 31 December 200X

Non - current assets

Current assets

_ _ 1,000

3,200 _

Equity

Non-current liabilities

Current liabilities

_

3,200 _

Cathcart Inc

Income statement for the year ended 31 December 200X

_

_

_

_

_ Dividends

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

(b) Operating profit margin

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(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

(l) Earnings per ordinary share

(m) Dividend cover

(n) Dividend yield

(o) Price earnings ratio

Key points

ÐBusiness valuation is not a science – different analysts use different

techniques

ÐYou 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

ÐRatio 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

You should now be able to:

Ü prepare and justify a range of prices for valuing a business in a variety of

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EXAMPLE SOLUTIONS

Solution 1

Valuation of 200,000 shares = 200,000 × P/E ratio × EPS

= 200,000 × 12.5 ×

400,000

20,000) (140,000−

= $750,000

Solution 2

yield Dividend Dividend

Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of unquoted company - say 13% (subjective)

13

012

= 92 cents per share

Estimated value of 2,000 shares = $1840

Solution 3

(i) Constant dividend Po =

0.2

(ii) Constant growth in dividend Po =

0.05) (0.2

(1.05) 0.25

(iii) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 =

$0.748 plus

Present value of growing dividend from year 6 onwards

0.05) (0.20

(1.05) 0.25

1.2

1

_

$1.451 _

(iv) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 $0.748

Present value of $2.00 in five years’ time = $2.00 ×

1.2

1

_

$1.552 _

Solution 4

(a) Gross profit margin

000 ,

(b) Operating profit margin

000 ,

(c) Return on capital employed

600 800 200 000 , 1

+ +

(d) Return on equity

1800

20

-160 × = 7.8%

(e) Current ratio

=

600 1,000 = 1.67: 1 (f) Acid test ratio

=

600

600 = 1: 1 (g) Receivables days

3,000500 × = 61 days (h) Total asset turnover

=

3,200 3,000 = 0.94

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(j) Proportion of debt finance

OR

1800 800

charge Interest

tax and interest before

Profit

=

60

400 = 6.67 (l) Earnings per ordinary share

=

1,000

20

(m) Dividend cover

=

125

20

price share Ordinary

share ordinary per

=

$1.40

cents

(o) Price earnings ratio =

EPS

price Share

=

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