DC Gardner Training TRAINERS IN FINANCE
Valuation of a Business
1. Cash Flow Based Valuation
2. The Cost of Capital
3. Asset Based Valuation
4. Valuation Based on Earnings Multiples
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 1 of 35
DC Gardner Training TRAINERS IN FINANCE
Cash Flow Based Valuation In this approach the value of a business is represented by the net present value of its future free cash flows. These are identified by preparing a forecast of the future free cash flows for an appropriate period, treating the final cash flow as a perpetuity with a given growth rate and discounting the resulting values back to the valuation date. This idea correlates better with reality than certain other ideas within corporate finance theory. A rational investor invests in order to secure a hopefully greater cash flow in the future. This analogy is exactly the same for a large corporate contemplating a major acquisition. This model has become the leading theoretically derived tool for the valuation of businesses and is used particularly for merger, acquisition and flotation situations. The power and the benefit of the model lies in the need to prepare reasonable forecasts of the likely future cash flow performance. This obliges the practitioner to properly understand the business and external and internal influences which are likely to have a significant impact on the future performance of the company.
The Approach When an investor acquires all the equity of a business which has no debt or cash, they are purchasing the benefit of all that business’s future free cash flows in perpetuity. Consequently they should be willing to pay the current Net Present Value of that business’s future free cash flows, adjusted for the value of any non–operating items. The process of preparing a free cash flow valuation is as follows: 1.
Prepare a forecast into the future of the business’s future free cash flows
2.
Identify an appropriate point in the future to treat as a terminal year (usually between 5 and 10 years into the future). Treat that year and all future cash flows after that point as a growing perpetuity
3.
Apply an appropriate discount rate to the resulting free cash flows
4.
Add up the discounted cash flows to identify the resulting value
5.
Add the value of any non operating assets or non operating cash flows
6.
Deduct the market value of the company's debt, net of cash, to get the equity value.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 2 of 35
DC Gardner Training TRAINERS IN FINANCE
Forecasting the Future It is sensible to start by extracting the historic free cash flows of the business we are attempting to value. This gives us an insight in to the actual pattern of cash flows we are likely to see into the future. This also forms a basis for our attempts to derive a reasonable forecast. An example of the elements of free cash flow are as follows: £'000 Earnings before Interest & Tax (EBIT)
85
+
Depreciation
10
–
Net Capital Expenditure
(15)
+/–
Increase/Decrease in Working Capital Investment
(10)
–
Notional taxes paid on an ungeared basis
(20)
FREE CASH FLOW
50
Traditionally the items above were derived from the profit & loss account and balance sheet of a company. To be absolutely correct they should be adjusted to a cash basis by adding back opening and closing accruals and prepayments. The purpose of adding back depreciation is to arrive at the cash generated by the operations of the company. There may be other items to adjust for such as profit/loss on disposal of fixed assets or changes in the level of provisions (all non-cash items). The net capital expenditure refers to the netting off of disposal proceeds against the capital expenditure for the year. The elements of the historic Free Cash Flow can be identified directly from Cash Flow Statements or Source and Application of Funds Statements in countries where companies are required to prepare these statements as follows;
– –/+ –
£'000 Cash flow from operating activities (before 95 movements in Working Investment) Net Capital Expenditure (15) Increase/Decrease in Working Capital Investment(10) Notional taxes paid on an ungeared basis (20) FREE CASH FLOW 50
The only value usually requiring adjustment is the taxation charge or tax paid in the period. Any tax shelter arising from the tax deductibility of debt should be added back to obtain an ungeared tax charge. This is usually achieved by identifying the amount of interest paid in the year and subtracting the tax value of this at the rate of corporate tax disclosed by the © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 3 of 35
DC Gardner Training TRAINERS IN FINANCE
company as being that applied to its taxable profits. Note, however, that if the company has interest income shown separately, the tax charge on this needs to be added back. Having identified the value of the historic cash flows we are now in a position to consider forecasting the elements of the free cash flow into the future.
Cash from operations Typically in a valuation exercise you would also have carried out extensive ratio analysis of the business concerned. This would have given you insights as to the historic rate of profit generation against sales and assets. You might also have measures of performance related to physical things such as retail outlets, units of output, employees, etc. The skill is to pick appropriate measures of future activity and then apply growth and returns multiples to them. Secondly, it is essential to assess and reflect in the forecast the extent to which the company is affected by economic cycles and other major economic factors such as commodity prices, exchange rates, population etc. Clearly this is a size issue. Is the company a local, regional, national, multinational or world scale business? The factors which are most likely to affect it can then be deduced. Margins for businesses whose performance varies with boom/bust cycles will vary substantially. Analysis of the historic trend should give insights as to a sensible range to ascribe to margin variation in the model. These are the major significant issues involved. Students should consult texts on business modelling if they wish to understand more.
Net capital expenditure The objective is to identify and incorporate in the forecast the value of non-discretionary capital expenditure likely each year into the future. If a business is likely to enter into a one off massive capital expenditure in the future this should be dealt with as a separate project. Unless the business has announced its intentions and investors believe the project will take place, such a project would be irrelevant to the valuation. Similarly, future business acquisitions are irrelevant as we are simply trying to value the existing business. Our historic ratio analysis should give us insights into the historic rate of capital expenditure. This can be adjusted for the likely future rate of development. Again this can be related to physical items such as store openings, factory investment, product development etc.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 4 of 35
DC Gardner Training TRAINERS IN FINANCE
Increase/decrease in working capital investment Our ratio analysis should have shown us the relationship between working capital investment and sales. Hence this is normally driven by the level of sales projected in order to arrive at the cash generated from operations.
Taxation paid on an ungeared basis Again this can be arrived at by reference to the historic actual tax rates, both in the profit and loss account and the cashflow tax rate. Timing differences can be substantial. In many countries, corporate tax is paid at the end of each quarter. Having prepared a forecast cash flow, it is important to test it for reasonableness, compare it with the historic trend of cash generation and consider the impact of economic cycles on future cash flows.
Identification of the terminal year The selection of the terminal year is an important issue. The discounted terminal value often represents over 50% of the overall valuation. Growth companies in particular have much of their value represented in the terminal value. There are a variety of approaches to this problem: 1.
Predict when the company is likely to cease growing and become mature. This is represented by the point at which no further market share is likely to be gained. This might be caused by competitor reaction, saturation of the market or reaching other limitations represented by geography, population, relative wealth, etc. This method is best for new entrants in mature industries where market saturation is inevitable at some point, however innovative the management might be.
2.
For high growth companies it is much more difficult to predict saturation as the market itself has not reached a steady state condition. The forecast is therefore best constructed by assessing the likely rate of growth over the period it is felt such predictions can be made (which in the computer industry might be as little as three years) and then applying an estimate of the overall long term (or perpetual) growth rate that might reasonably be attained after that. This rate is the essence of the valuation. It is likely that the rate used would be lower than most commentators’ views, as it will be effectively discounted itself to reflect market uncertainties, quality of management issues, the effect of future unknown technological change, etc.
3.
The valuation process is particularly difficult in respect of industries vulnerable to high rates of technological change such as the computer industry. For a business growing so fast that there is no cash generation in the short or medium term (because of high rates of new investment), all the value is in the terminal value part
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 5 of 35
DC Gardner Training TRAINERS IN FINANCE
of the valuation. Indeed, the short term part of the valuation forecast might predict a negative free cash flow for some years. Clearly, then, acquisition and disposal values are driven more by the strategic implications of the firm’s activities to other competitors and the market need for the knowledge resident in such businesses rather than any one prediction of its future cash flow far into the future, as no one can predict with any certainty the eventual size of a company in such a sector 5 to 10 years from today. For companies whose performance is affected by the economic cycle it is important not to pick any one part of the cycle at which the long term growth rate is determined. Taking a point in the middle of an upswing and predicting an overall long term growth rate from there is likely to be the most realistic approach. Shown below is an illustration of the most appropriate forecast period to select to identify the terminal year and the long term growth rate to use. The grey curve represents the performance of the company over time. business illustrated is in a cyclical industry.
The
LONG TERM GROWTH RATE
0
1
2
3
4
5
6
7
8
9
YEARS
Thus, in the above illustration, if we project out earnings for the first seven years and then assume further earnings will follow the long term growth rate trend line, we are avoiding the mistake of taking the actual growth rate being experienced at year seven and assuming it will continue indefinitely.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 6 of 35
DC Gardner Training TRAINERS IN FINANCE
Calculation of the terminal value Having identified the year T that we are going to take as the terminal year (i.e. the last year of the forecast), we then treat the free cash flows projected from this point as a growing perpetuity, using the standard formula for a growing perpetuity, with the free cash flow in the first year of the perpetuity being CT(1+g). This gives:The value of the growing perpetuity =
CT (1 + g ) where: r−g
CT is the free cash flow in the terminal year r is the appropriate discount rate (This is dealt with in the next section) g is the long term growth rate from year T to infinity This gives us the value at the end of year T of all the future cash flows from year T+1 to infinity. The figure must then be discounted back from year T to the present (i.e. discounted for T years) to give us the Present Value of the cash flows after the terminal year to infinity. To be strictly correct, you need to choose year T such that the company has already achieved its long term growth rate in year T. This is to ensure that the capital expenditure and change in working investment in year T (and hence the free cash flow used to calculate the terminal value) are compatible with the long term growth rate.
Determination of an appropriate discount rate Having completed the construction of our free cash flow forecast and decided on a terminal year and a future indefinite growth rate, we are now in a position to discount the free cash flow forecast. In order to do this we need to identify the cost of capital for the business as this is the usual value taken as the discount rate. Let us look at the formula for the weighted average cost of capital. The formula is: D E + Ke V V Kd is the weighted average yield on the company’s debt Tc is the average rate of corporation tax in the company D is the market value of the company's debt Ke is the shareholders’ required equity return E is the market value of the company's equity V = D + E = The market value of the company.
WACC = Kd (1-Tc) Where:
And:
Ke= RF + (RM – RF) β
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 7 of 35
DC Gardner Training TRAINERS IN FINANCE
Where:
RF
RM β
is the return available from risk free investments of the same maturity as the investment (typically using government bond yields for the period of projections) is the average return from investment in the equity market. Typically, the difference between RM and RF (the equity risk premium) is about 5%. (beta) is a measure of the movement of the company’s share price relative to the market as a whole (if β is 1, the share price follows market movements)
Substitution into this formula gives us the cost of capital for the business. Because of its tax deductibility to a company, debt is cheaper in real terms than its market cost. Assuming Kd to be 8%, Tc to be 35%, the risk free rate to be 7%, the equity risk premium to be 5%, β of 1 (giving us Ke of 12%), and gearing of 50%, this would give us a WACC of 8.6%.
Adding the discounted cash flows to identify the resulting valuation Applying the discount rate to each year of the future free cash flows and the terminal value gives us the NPV of each year’s portion of the value. Finally we add these up and add the value of any non–operating assets or cash flows to give us the value of the business. The present market value of a company's debt (net of cash) should then be deducted to give the shareholder value.
Problems with the model and its assumptions 1.
The model is entirely driven by preparing a forecast of the likely future performance of the business concerned. As any accountant will tell you, it is extremely difficult to forecast forward even a few months with any degree of certainty, let alone several years into the future. The uncertainty inherent in the future is notorious for disrupting the best laid plans. Thus we can state as a corollary to this that the model is effective in inverse proportion to the degree of uncertainty faced by the company being valued. Thus if the company is engaged in the exploitation of a well understood mature market such as baking, the model is likely to yield fairly consistent results as different analysts’ estimates of the key variables in the forecast are likely to be similar. If the company is involved in fast moving markets subject to rapid technological change, then the model is more likely to show significant variations in value depending on the assumptions covering growth, period to market maturity and margins. Financial analysts are likely to express frustration at their inability to place significant reliance on their forecasting assumptions due to the general level of market uncertainty. Why then does this approach have any relevance to the process of business valuation?
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 8 of 35
DC Gardner Training TRAINERS IN FINANCE
A rational person invests in order to secure a risk adjusted return in the future. As this method of valuation is forward looking it obliges those responsible for the valuation process to properly assimilate the key competitive issues which allow the company to generate positive and hopefully growing returns in the future. The need to do this obliges the valuer to properly get to know the business so reducing the risk of error or misjudgement in the valuation process. 2.
Care needs to be taken about assuming that the key relationships present at the time of valuation will remain the same indefinitely. Thus margins, return on sales, expense levels and fixed and working capital investment may all change in the future as the business matures or faces an adverse more competitive environment. This should be reflected in the forecast. Historic analysis should also be performed to identify the historic performance through periods of intense adverse pressure.
3.
The discount rate needs to be selected with great care. If we are engaged in the sale of a business we would normally arrive at our view of value based on the cost of capital of the individual business or that of our group. Potential acquirers may enjoy a lower cost of capital because of aggressive treasury management or a favourable funding decision in the past. It is important therefore to examine what their perception of value is likely to be. Potential acquirers may also have a different perception of value depending on their own views of market growth and the financial benefit of any synergies they might achieve following the acquisition. Thus the valuation we arrive at from our own perception may be below the price achievable in the market. Other competitive issues may take the price much higher or lower.
4.
We are aware in the real world that gearing and dividend policies can affect the value of a business. Free cash flow forecasting ignores these issues. The calculation of the discount rate should take the gearing issue into account (In that the cost of debt will vary depending on the proportion invested; the cost of equity will also rise as it becomes a smaller and riskier proportion of the overall value invested.) The dividend issue is also ignored in the discount rate calculation. Finally the reinvested portion of cash generated is usually assumed to generate similar returns to the existing business. This may not necessarily be a sensible assumption.
5.
The model assumes an indefinite life for the business. Companies with a finite life expectancy such as mines, or companies whose income streams are related to fixed term leases such as the Channel Tunnel (which expires in June 2043) should forecast out to the likely end of the cash flow.
Conclusions Cash flow valuation models are used extensively in all types of valuation situations. They are most use in situations where there is a reasonable consensus as to the likely future conditions in the business’s markets and sector. © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 9 of 35
DC Gardner Training TRAINERS IN FINANCE
High growth businesses typically demonstrate little short term cash flow and thus most of the value lies in the terminal year's assumptions. Typically such businesses are in volatile markets often affected by rapid technological change. Here sensitivity analysis tends to demonstrate that the range of possible valuations is much larger than for the example in the previous case. The discount rate used should represent the long-term cost of capital and therefore may need adjusting for the impact of moving towards a long term ‘target’ capital structure and for interest rate considerations.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 10 of 35
DC Gardner Training TRAINERS IN FINANCE
Cost of Capital Introduction The cost of capital is one of the most important measures in finance. It is the yardstick for a range of analytical and decision-making activities undertaken by managers, shareholders, lenders and brokers in evaluating projects, businesses and companies. Using it, it is possible to do the following, among other things: 1. Evaluate capital spending plans 2. Rank different projects 3. Determine appropriate ratios of debt and equity in a company's capital structure 4. Compare prospective share purchases 5. Construct portfolios of projects, business, or companies and even 6. Compare the competitiveness of national economies. Perhaps because the cost of capital is such a fundamental tool for the financial industry, there has been great controversy about exactly how it should be determined. Most of the time, the discussion takes place in the context of corporate shares traded in the markets. A basic definition of the cost of equity capital comes from there: The cost of equity capital is the rate of return that must be given to an investor to prevent the price of the share from falling.
Capital Structure A company's cost of capital is made up of its cost of debt and its cost of equity. The mix of debt and equity is called its capital structure. The ratio of debt to equity measures the leverage of the company. Some components of the cost of capital can be measured readily, such as debt costs. The price of a company's borrowing using fixed, floating, long or short-term debt can be obtained easily from bankers and other market participants. Others, such as the cost of equity, can be calculated according to models which rely on expectations, (the Gordon Growth Model), or using models which measure earnings per share against the market price per share (The Earnings Yield Method) or on models which measure the volatility of a company's cash flows in relation to a diversified portfolio of other equity assets, placing the emphasis on relative risks (The Capital Asset Pricing Model). There are, in short, different ways to do it, depending on what the objectives are.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 11 of 35
DC Gardner Training TRAINERS IN FINANCE
Using Weighted Average Cost of Capital Consider that a firm's capital structure - its mix of debt and equity - can affect the size and riskiness of the firm's cash flows, and hence the value of the firm. Example ABC Corp pays 8% after tax for its bank debt. Its shareholders require a 12% rate of return. In evaluating capital spending plans for the coming year, the company's managers decide to finance the projects with debt. What is the cost of the projects? The intuitive answer is 8%, but this may create problems for the company: ■
In the coming year it finances with debt costing 8% projects which yield, say, 9%.
■
In year two, it could take up projects yielding 11%. The company has drawn down all its credit lines; the new projects would have to be financed with equity costing 12%.
To avoid this pitfall, a weighted average cost of capital is used instead. Calculating the weighted average cost of capital requires analysis of the components of capital and their individual costs. The main components are where K = Cost:– Kd Kd (1– t) Ke Po
= = = =
The interest rate on new debt The after tax debt cost, where t = the tax rate The equity return required by investors The share price
Note that the tax deductibility of interest costs lowers the effective cost of debt.The tax environment is important also in using the cost of capital to measure economic activities: for example, a project in a low-tax area could be evaluated against a lower required rate of return then a project in a high-tax area. For equity costs, the tax rates paid by equity investors will also be important - whether on capital gains or on dividend streams.
Leverage in Capital Structure Leverage is the ratio between debt and equity in a firm's capital structure. Assume for the purposes of this discussion that the firm we considered earlier maintains its 8% after tax debt cost, 12% equity cost, and that the cost of each component rises as the mix changes. We can illustrate the usefulness of measuring the weighted average cost of capital with different leverage ratios:
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 12 of 35
DC Gardner Training TRAINERS IN FINANCE
% Total (1)
Component Costs (2)
Weighted Average Cost Ka (1) x (2) ÷ 100 (3)
Debt Equity
0 100
8 12
0 12 12
Debt Equity
10 90
8 12
0.8 10.8 11.6
Debt Equity
20 80
8 12.2
1.6 9.76 11.36
Debt Equity
30 70
8.5 12.5
2.55 8.75 11.30
Debt Equity
40 60
9.5 13.0
3.8 7.8 11.6
Debt Equity
50 50
10.5 13.5
5.25 6.75 12.00
Debt Equity
60 40
11.5 15.0
6.9 6.0 12.9
In this table, the leverage ratio 30/70 gives the lowest weighted average cost of capital. Historically, companies kept to conservative debt levels for this reason. However a huge market - the LBO industry - was built in the late 80's by standing conventional attitudes to the debt/equity mix on their heads. The thinking behind this was the Modigliani-Miller proposition, first advanced in 1958. It argued that the cost of capital is unaffected by debt/equity ratios, that highly leveraged firms have a higher value because interest costs are tax deductible. The LBO market worked on arbitrage by investors into highly leveraged stocks, which were argued to be undervalued. Real-world effects - costs of failure, higher interest rates, poor management - did not exactly refute the MM proposition, but made the markets very wary of highly leveraged stocks. It became impossible for higher leveraged companies to increase either debt or equity levels.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 13 of 35
DC Gardner Training TRAINERS IN FINANCE
Cost of Equity – 3 Models As noted, there are three ways to think about measuring the cost of equity. We defined the cost of capital as the rate of return required by the investor to prevent the share price from falling. The Gordon Growth Model handles it this way: 1.
Gordon Growth Model:
A share price is reckoned to be equal to a cash flow of dividends over time, discounted by the cost return required by the investor. Po
= D1 (1 + Ke)
+
D2 (1 + Ke) 2
+ • • • •
Where Ke is the share price, D1, D2 the dividend stream and Ke the return required by investors in the share. If the investor expects dividends to grow at an constant rate, g, :Po
=
D1 Ke – g
=
D1
so Ke
+
Expected g Po
So the share price is based on expectations, that the value of the cash flows will not be reduced by increased risks and that growth will take place as anticipated. The weakness here is, of course, that expectations may not take enough account of the factors influencing the outcome. The next method makes no guesses about the future: 2.
Earnings Yield Method:
Earnings Yield
or
=
Earnings Per Share Market Price Per Share
Net Earnings Market Capitalisation
The return actually obtained can, of course, be higher or lower than expected: at a higher return, the stock will have been cheap: at a lower return, it will have been expensive.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 14 of 35
DC Gardner Training TRAINERS IN FINANCE
The most persuasive way to handle this mix of expectations, risks and valuations is through the Capital Asset Pricing Model, controversial at the time of its birth, but now established as a useful tool. 3.
Capital Asset Pricing Model:
Where
K1
=
Rf
+
B (Rm – Rf)
K1 Rf Rm B
= = = =
the required rate of return the risk-free rate the risk of the market the coefficient of risk of a particular stock
This approach draws its power from its separation of the elements which drive share prices. It looks at different kinds of risk to measure specific and generic risks and to diversify away from those which can be avoided. Its basis is in two things; a Portfolio Theory of risk management and a statistical measure of risk using standard deviation, known as "Beta". Thinking of risk, it is possible to identify a variety of different types. In the financial markets, they are ranked and priced with reference to a benchmark; almost always the 'risk free' rate of Government securities. From the investor's stand-point, the markets offer a range of credit qualities from risk free to high risk, at rates of return which should equate to the degree of risk involved.
Required Rate of Return (%) Kb
Capital Market Line
Ka
Rf Risk © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 15 of 35
DC Gardner Training TRAINERS IN FINANCE
Rf
= The risk-free rate of return:
Ka =The return required for capital asset A Kb =The return required for capital asset B
The required rate of return is the Risk-Free rate plus a premium for the risk of the particular stock.
Systematic and Unsystematic Risk In owning a portfolio there are risks you can avoid and risks you cannot avoid. Some risks are common to all shares - a change in the level of interest rates; for example. These are termed systematic risks. Others are particular to certain industries, or areas, or businesses, and may affect different shares in different ways. This is unsystematic risk.
Diversification Owning a portfolio of one stock means you are exposed to all the systematic risk and all the unsystematic risk peculiar to that stock. Diversifying the portfolio reduces exposure to unsystematic risk. An extensive study in the 1960's showed the following for high - quality stocks.
No of Securities in Portfolio
Standard Deviation of Portfolio Returns % per month
Correlation with Return on Market Index
1
7.0
. 54
2
5.0
. 63
3
4.8
.75
4
4.6
. 77
5
4.6
. 79
10
4.2
. 85
15
4.0
. 88
20
3.9
. 89
A well diversified portfolio leaves the investor with systematic risk only. Then measure the systematic risk of a stock: this is its volatility in relation to the market.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 16 of 35
DC Gardner Training TRAINERS IN FINANCE
Beta Coefficients The systematic risk of a stock is measured by how much its return moves against the return of the general market. The dots in the diagram are obtained by correlating the stock's rates of return to the market's rate of return, with each dot representing the correlation in one time period, for example a quarterly or annual period. The slope is drawn from the value of Beta representing the characteristic line of the stock being measured. This gives us a tool to assess the relative riskiness of a stock. The market's Beta is 1; a stock with a Beta less than 1 has systematic risk lower than the market; one with a Beta greater than 1 has systematic risk higher then the market. When the market moves, a lower beta share will move less than the market; a higher-beta share will move more, whether the market moves up or down. In essence, a higher-beta share is riskier than the market and a lower-beta share is less risky. In summary, under the Capital Asset Pricing Model the cost of equity equals the risk-free rate of return plus the Beta coefficient for the stock times premium for being in the market as opposed to being in risk-free capital assets. Applying this model to the stock market holders of assets can construct share portfolios with very precisely calculated volatilities. The model's usage has spawned the widespread use of index funds, to achieve the market rate of return: historic Beta values are calculated by brokerage houses and are readily available to professional investors. Companies use Beta values, not only that of their publicly traded stock, but also internallyestimated values, in capital spending decision-making. Certainly, to the extent that a company is being evaluated by the market using volatility coefficients, it makes sense to evaluate future projects in the same way.
Conclusion The cost of capital is the focal point of the financial analysis of economic activity. Different measures suit different purposes; risk adjusted measures on a portfolio basis offer a powerful way to evaluate stock markets. Corporate decision-making is keyed off the result of discounting future cash flows at required rates of return. Economic, monetary and fiscal policies create the environment in which capital costs are measured and are used to benefit regional or national wealth creation.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 17 of 35
DC Gardner Training TRAINERS IN FINANCE
Asset Based Valuation Introduction Asset based approaches to the valuation of a business are usually appropriate when the business is worth more in terms of its net asset value (the market value of the assets less liabilities) than as a profit or cash flow generating entity. This situation can occur in a variety of scenarios: ■
The business is in receivership or liquidation
■
The business is trading poorly or at a loss
■
The business enjoys the ownership of assets that are more valuable than the trade of the company itself.
■
The business trades in highly marketable assets such as property or quoted securities.
■
The business owns or controls intangible assets such as brands, patents or intellectual property.
This method of valuation is probably used more often in the real world that any other. Asset based valuation represents the worst case scenario in all valuation situations. If things should go wrong, the only recoverable value from the situation may be the underlying net asset value.
Source of Information The purchaser usually has access to historic financial and management accounting information together with additional information usually provided by specialist valuers of the assets concerned.
Valuation Method There are four approaches to the valuation of assets ■
fair market value
■
liquidation value
■
adjusted book value
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 18 of 35
DC Gardner Training TRAINERS IN FINANCE
■
replacement cost
Professional valuers use a number of different approaches to applying these values to assets. Essentially these are as follows: ■
looking at the second hand market for such assets - fair market value (optimistic) or liquidation value (pessimistic)
■
looking at the replacement cost for such assets - depreciated replacement cost
■
looking at what the asset could earn - adjusted book value
Liabilities When a manager purchases a group of assets, usually from a receiver or liquidation, it is because those assets are collected together in one location and usually in a condition such that they can be quickly made to be productive. Contrast this with the problem of acquiring such assets piecemeal, where many additional costs would be incurred in creating some entity and making it quickly productive. Thus the buyer has some incentive to also assume existing liabilities which will crystallise in the future if necessary, providing they are offset directly against the asset value. The assumption of liabilities may also reduce the amount of cash required to acquire control of the assets. The most common liability to acquire is the contingent liability to employees relating to their redundancy entitlement in the event of their being made redundant in the future, this being based on their length of service prior to the receivership. Receivers will often indicate to bidders that bids assuming this liability are likely to be preferred. (Legislation in the UK makes it impossible to avoid such liabilities). A buyer may also choose to assume all trade liabilities (on a direct offset basis) in order to protect and preserve the ongoing nature of the business, rather than allowing the receiver to damage the company's existing market position by crystallising them into bad debts. Purchased liabilities have a nasty habit of increasing in value! Look for ways to cap disclosed liabilities and retain an element of the price for 12 months to settle any undisclosed liabilities, Have the seller indemnify the purchaser for any undisclosed liabilities. Ensure the books and records are complete and fully up to date. Confirm and agree the extent of liabilities by direct contact with creditors.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 19 of 35
DC Gardner Training TRAINERS IN FINANCE
Practical Pitfalls to watch for 1.
Let us start with two truisms ■ Assets always turn out to be worth less than you pay for them whereas liabilities always increase in value over time. ■ It is not what you know when you acquire such a business that matters, it’s what you don't know that subsequently causes grief!
Buying unproductive businesses from receivers is not an activity for those who have no experience of the process. Experienced advisers and managers are essential. There is usually considerable time pressure involved in such situations. Assets markets can disappear overnight if economic conditions worsen. Do not assume market conditions will remain constant. Plan on the assumption of increases in financing costs and depressed sales and margins. 2. The safest thing to do is simply to purchase assets alone without taking on any responsibility for any existing liabilities. The usual method of doing this is to purchase a new company and have this entity acquire the relevant assets. Things to avoid are taking over existing leases (There may be onerous obligations to maintain assets in the state they were at the beginning of the lease ) and contingent liabilities attached to assets. The objective should be to obtain clean unencumbered title to the asset concerned. If you acquire shares in an existing company you are automatically exposed to all liabilities that company may have contracted in its history from its original incorporation. Clearly it is usually impossible to completely satisfy a potential purchaser that the company’s past liabilities are all disclosed. If there are good reasons for acquiring liabilities together with a bundle of assets, then attempt to minimise any possible future liabilities by obtaining indemnities and warranties. Attempt to determine any uncrystalised liabilities by contact with the party concerned. Confirm the precise value of all liabilities. Work to make all liabilities certain and free of additional cost in the future. 3. Retain your own valuer, ensure any valuations are up to date and consider the extent to which they are conditional or qualified. 4. Examine all assets personally and verify their existence. If it is a machine see it working. Assess the condition and quality of all assets. Have tests performed where appropriate. Use trusted specialists where available. 5. Consider how the asset fits into the business plan and the expenditure that will be required to make it productive.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 20 of 35
DC Gardner Training TRAINERS IN FINANCE
6. Consider the effects of taxation: ■ How it affects the acquisition of the asset ■ The tax impact on any subsequent disposal or write off the asset ■
The value of any intrinsic existing unrealised tax liability such as roll over relief or reversing capital allowances
7. Finally, pay only what the assets are worth to you. Discount the market value for all additional costs you would incur to get the asset productive or realise them at a later date. Use a solicitor to ensure that you obtain complete and unencumbered title to all assets.
Conclusion Asset based valuations are often a feature of purchases of assets/businesses from distressed or disadvantaged sellers, sometimes under the shadow of imminent insolvency made under considerable time pressure. Whilst the assets/business concerned can often be a acquired at a substantial discount to comparable market values, there is always a reason for such forced disposals. It is absolutely essential that the intending purchaser fully understands and verifies the reasons for sale as it is often the information which is not disclosed by the seller which subsequently causes the purchaser to regret his purchase and sustain unforeseen losses.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 21 of 35
DC Gardner Training TRAINERS IN FINANCE
Dividend Valuation Gordon's Dividend Discount Model For an investor with an infinite horizon or, for practical purposes, anyone with a reasonably long term perspective, the FUNDAMENTAL DETERMINANT OF STOCK VALUE IS THE DIVIDEND FLOW. Since ownership of an equity bestows nothing but the right to a future stream of dividends, it is theoretically correct to calculate the value of the equity as the present value of that stream of dividends. The concept that a common stock is worth the present value of future dividends is captured in the following equation:
P0 =
d d2 d1 n + +........ + (1 + k ) (1 + k )2 (1+ k)n
∞ dt = ∑ t t=1 (1 + k )
Dividend Streams and Discount Rates Three types of dividend streams can be considered: 1.
Dividends are expected to remain unchanged – ZERO GROWTH MODEL.
2.
Dividends are expected to grow at a constant rate g – CONSTANT GROWTH MODEL
3.
Dividends are expected to grow at a variable rate – VARIABLE GROWTH MODELS.
Similarly, the discount rate (k) can be assumed to remain constant or to change over time. Within the framework of the CAPITAL ASSET PRICING MODEL (CAPM), the discount rate or REQUIRED RETURN ON A STOCK can be calculated as follows:
Rs = R f + Bs (Rm − R f )
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 22 of 35
DC Gardner Training TRAINERS IN FINANCE
This required return can then be used as the IMPLIED DISCOUNT RATE in the Dividend Discount model to determine the proper value for the stock. If the IMPLIED return is greater than the REQUIRED return, the stock is UNDERVALUED and vice versa.
1.
Zero Growth Model
Here, both dividends and the discount rate are expected to remain constant, in which case:
P=
d k
This formula is applicable only to the valuation of preferred stocks or to the common stocks of very mature companies like electric utilities whose dividends are likely to show little, if any, secular growth. In the following example (mature US electric utility company), the appropriate discount rate is derived from the recent relationship between the yield on the particular stock and the yield on the high-grade bonds.
2.
Constant Growth Model
The assumptions underpinning this model are that:(a)
Dividends grow at a constant rate g over an infinite time horizon
(b)
The discount rate k is greater than the growth rate g.
p=
d k−g
This form of the dividend discount model is applied to the problem of valuing companies that are growing at normal or average rates. It can be used to value the overall market and very large mature companies. The model is not suited to the valuation of high growth and cyclical companies; this is the major drawback of this version of the model. The constant growth model says that the value of a stock is equal to its year ahead forecasted dividend per share d capitalised by the difference between the company's discount rate k and its growth rate g.
p=
3.
$2 = $50 (.09−.05)
Variable Growth Model
While "continuous growth" in excess of the discount rate (g>k) is an unreasonable assumption because it produces infinite present values, many companies do exhibit very © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 23 of 35
DC Gardner Training TRAINERS IN FINANCE
rapid growth for 5, 10 or more years. Ultimately, usually as a result of product obsolescence or competition, the growth slows. Analysts deal with such cases by assuming that growth will pass through one or more stages of deceleration until finally settling down at a constant growth rate equal to that of the average company. The constant growth formula is applied to determine the value of the stock at that point, and that assumed TERMINAL PRICE is discounted to the present and added to the present value of the dividends paid during the rapid growth period.
n do(1 + g )t 1 P0 = ∑ t t=1 (1+ k1 ) =
+
dn + 1 1 × k − g2 ) (1 + k )n ( 2 1
Present value of dividends assumed during rapid growth period
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
+
Present value terminal price
of
Page 24 of 35
DC Gardner Training TRAINERS IN FINANCE
Difference Between Two and Three Stage Dividend Discount Models The two stage and three stage dividend discount models differ essentially in the way that they allow for a shift in above normal growth to growth in line with the corporate average. The two stage model assumes an abrupt one step down in the growth rate, while the three stage model, because of the provision of a middle stage, allows for a gradual tapering in the growth rate. This middle stage offers a generally more realistic way of portraying the real world pattern of growth and decline than the two stage model. Fortunately, there are computer programs that calculate the discount rate for the three stage model
Two Stage
g = 20%
g = 20%
g = 10%
E.P.S. Growth
Three Stage
g = 10%
2nd Stage
Stage 1 Stage 2
Stage 3
Time
USEFUL REFOMULATIONS OF :
Since p =
d =P k−g
d d , then (k − g ) = k−g p
That is, given assumptions about k and g, a constant growth stock would be considered fairly valued at a price that produces a dividend yield equal to k-g.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 25 of 35
DC Gardner Training TRAINERS IN FINANCE
Thus, k =
d + g . That is, the required total return on a stock is obtained by adding the p
estimated dividend growth rate to the first year's dividend yield. Since d = (1-b)E where (1-b)
= Payout rate
E
= Earnings
b
= Retention rate
and, g = br, where r = rate of return on retained earnings Thus, p =
d (1 − b)E = k−g k − br
or
p/ e=
(1− b) k − br
Price Earnings Ratio and the Discount Rate There are two instances where the p/e ratio would be an appropriate indicator of the discount rate for a stock. One obvious case is where the company pays out all of its earnings as dividends, so that the earnings variable becomes identical to a dividend variable and the p/e ratio is the same as a price dividend ratio. Therefore, the retention rate b becomes zero and the P/E ratio is then equal to the reciprocal of the discount rate.
P/E =
(1− b) k − br
=
(1− 0) 1 = k − (o )r k
The second instance is where the company has opportunity only to reinvest earnings at the discount rate. This is indicative of the absence of growth opportunities and is the classic finance case known as EXPANSION, where the growth rate is expected to be only average. Here, where the return on reinvested earnings is equal to the discount rate (r = k), the P/E ratio is then equal to the reciprocal of the discount rate. That is,
P/E =
(1− b) k − br
=
(1− b) 1 = k (1 − b) k
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 26 of 35
DC Gardner Training TRAINERS IN FINANCE
Applying Dividend Discount Models There are both advantages and disadvantages in the use of dividend discount models for stock valuation purposes. The following summarises the pros and cons of this model in the real world.
Advantages 1.
The DDM's implicit and underlying assumption that ownership of an equity bestows nothing to the holder other than the right to a future stream of dividends is theoretically correct and appealing .
2.
The model's focus on long term valuation appeals to long term investors like pension funds that shun high portfolio trading turnover.
3.
The DDM approach to valuation facilitates the comparison of different securities of a single issuer.
4.
DDM valuation models lend themselves to sensitivity analysis simply by adjusting the underlying assumptions.
5.
Because dividends are the most comparable item of the income statement when looking across borders, a DDM can be used in valuing companies across different countries
6.
The DDM approach to valuation can also be applied to markets. Thus, it can be used as a tool for ASSET ALLOCATION.
Disadvantages 1.
Small changes in both the assumed discount rate (k) and growth rate (g) produce large differences in Valuation. For example, assume a stock with a dividend of $2 per share. Interest rates are 9% on bonds and the risk premium is 3-5%. The growth rate could be 6-10%. What is the range of value for the stock?
P low =
$2 = $25 .14−.06
Phigh =
$2 = $100 .12–.10
The stock price can be justified if it is anywhere between $25 and $100! Realistically, there is no single discount rate (k) or growth rate (g) that can be applied to a stock. Instead, reasonable ranges of these values should be estimated. But when k and g are ranges, all that can be computed is a value range for the stock. © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 27 of 35
DC Gardner Training TRAINERS IN FINANCE
2.
The estimates of g and k may be incorrect. Consequently, DDM rankings of stocks may tend to rank as BUYS those stocks where the estimates are too optimistic and rank as SELLS those stocks whose estimates are too pessimistic. Thus, the execution of any dividend discount model rests heavily on the assumptions underlying the company's projected financial statements.
3.
It is recognised that assumptions about corporate development in STAGE 3 (15 years or more in the future) are extremely tenuous. Furthermore, even small differences in key assumptions regarding stages 1 and 2 produce large differences in calculated intrinsic values.
4.
Investors have shorter time horizons than those required to solve the dividend discount model.
5.
Many rapidly growing companies pay little or no dividend, and speculation on when such payments will begin is felt to be futile. That is, the model cannot cope when
k=g d , when k = g k −g p = 0 (Incorrect) d k= +g p =) k = g p=
6.
The dividend discount model does not take quality of reported earnings into consideration. Furthermore, reported earnings are subject to considerable manipulation, a fear that helped to popularise the use of cash flow analysis. On this basis, many analysts argue that CASH FLOW, rather than earnings, is the true determinant of dividend paying capability and therefore should - more than EPS forecasts – be the focus of equity analysis.
7.
Intuitively appealing though it may be, the relating of share price to future dividends via projected earnings growth does not jibe perfectly with reality. In particular, highly cyclical companies do not produce steady earnings increases year-in and year-out, yet the formula
p=
d k−g
assumes a constant rate of growth. In analysing deep cyclical stocks, an attempt needs to be made to normalise the inputs. 8.
Trying to anticipate/forecast when dividend payments will change dramatically is impossible.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 28 of 35
DC Gardner Training TRAINERS IN FINANCE
9.
DDMs are biased in leading to the conclusion that "low P/E" or "high yield" stocks are undervalued. Thus, the DDM is really a more sophisticated elaboration of the "low P/E - high yield" anomaly in the efficient market.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 29 of 35
DC Gardner Training TRAINERS IN FINANCE
Earnings Based Valuation Introduction Earnings based approaches to the valuation of a business are usually appropriate when the business is regarded as enjoying a reliable and sustainable earnings stream, and has a professional management team. Owner managed businesses usually fail this test. Owner managers tend to run their businesses autocratically and rely on personal supervision and involvement to maintain control and provide management direction. In the event they leave or lose interest, the underlying business tends to have little resilience and often goes into immediate decline. Finally, owner managers are often the principal salesman for their businesses; consequently there is no independent business as such without the owner manager. Assuming, then, that we have a business which is generally considered to be resilient, and enjoying a sustainable and hopefully increasing earnings stream, how do we use this data to arrive at a valuation?
Identification of Sustainable/Maintainable Earnings The first problem with any earnings valuation is identifying which earnings should be valued. Accountants and company valuers usually take the earnings from last year’s audited accounts (unless they were untypical, in which case the earnings in the last four quarters or a weighted average of recent years might be used) – and then make adjustments to them to arrive at what they call “sustainable” or “maintainable” earnings. Such adjustments generally fall under two headings: (i) accounting adjustments and (ii) strategic adjustments. (i)
Accounting Adjustments
The subject company may have “unusual” or “creative” accounting policies, requiring adjustments to income or (more usually) expenses and hence earnings. The more usual adjustments are for: ■
Depreciation policy
■
Stock valuation
■
Goodwill amortisation
■
Research and development amortisation
■
Capitalised interest and other expenses such as start–up costs
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 30 of 35
DC Gardner Training TRAINERS IN FINANCE
■ (ii)
Exceptional and extraordinary items
Strategic Adjustments
The valuer will also want to adjust for any imminent changes in earnings (this could alternatively be dealt with by adjusting the P/E ratio – although that is more difficult). He or she will need to consider the “quality” (stability) of earnings, whether they are cyclical, whether any major products are in decline, how the company will be affected by future competition and the power of buyers and suppliers, and how the company will be affected by technology changes or other environmental factors.
Determining an appropriate p/e ratio Prior to the development of cash flow valuation methods this was the principal method of pricing new issues and arriving at an estimate of value in acquisition and disposal situations. Whilst remaining extremely valuable, particularly for assessing reasonableness of pricing by comparison with other similar quoted business, this method suffers from being based on profits rather than cash flow, is vulnerable to variations in accounting practice between companies and lacks the formal rigour of a cash flow valuation. An examination of the financial pages of any business newspaper will reveal extensive tables of share prices with various other ratios offered. Key amongst them is the price/earnings ratio or P/E ratio. This is the relationship between the current share price and the most recently published value for earnings per share or EPS. The annual accounts of all companies normally show the value of the earnings per share generated each year and usually also disclose the trend of EPS change over the previous few years. In the UK, the accounting standard FRS 3 defines Earnings Per Share as follows:“The profit in pence attributable to each equity share, based on the profit (or in the case of a group the consolidated profit) of the period after tax, minority interests and extraordinary items and after deducting preference dividends and other appropriations in respect of preference shares, divided by the number of equity shares in issue and ranking for dividend in respect of the period”. The key task is to determine a reasonable P/E ratio to apply to a company's earnings to arrive at a market value for the company. This is normally achieved by identifying 4 to 6 comparable companies. It is rarely straightforward as no one company is ever directly comparable to another. Usually it is necessary to start with a sample of at least 12 companies in the same industry sector, eliminating those of least relevance as the exercise progresses. Size, profitability, geographical spread, product offer, growth rate and capital structure will all affect the extent to which the companies are comparable.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 31 of 35
DC Gardner Training TRAINERS IN FINANCE
Ideally using a spreadsheet or financial analysis package to assemble the data, extract the relevant financial data from each of the companies’ published accounts. Adjust this data to eliminate any discrepancies due to different accounting policies. Use this data to calculate the key accounting ratios to assist us in arriving at a league table of the performance and value of each of the peer group companies. Having completed this task, apply current market prices to the data to arrive at the current valuation of each company on the basis of the data available. Market value = Sustainable earnings x P/E multiple It is wise to ensure that there are no special factors affecting any of the share prices in the sample by reviewing the share price trend over the last three years. Comparison with the relevant sector and market indices is also sensible. Out of this exercise should appear a consensus estimate of a fair P/E to apply to the company being valued. Any companies in the sample which are materially at variance with the rest should be carefully reviewed to identify the reasons for the anomaly.
Significant formulae Relevant earnings
1.
EPS =
2.
The price earnings ratio is
P/E ratio =
AV. no of ordinary shares in issue
Current share price EPS
or
Value of the business Relevant earnings
Thus this becomes: Value of the business = Relevant earnings x P/E ratio
Problems with the model and its assumptions 1.
The Black Box Test. The model assumes an indefinite life for the business. Thus it is only really suitable for businesses of reasonable size and critical mass. We are assuming that the business is a black box which will continue to produce a hopefully increasing flow of earnings into the future. If the business is vulnerable in any way to any specific risk other than the general risks faced by all similar companies in the sector, care should be taken before assuming similar P/E's can be applied. If the company is not a black box, perhaps because it depends on an individual or specific individuals this method of valuation may not be appropriate.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 32 of 35
DC Gardner Training TRAINERS IN FINANCE
Earnings will often provide the starting point for valuation in smaller businesses. However, their relative vulnerability and less certain profit flows will reflect in the selection of a lower P/E multiple. 2.
No two businesses are the same. The multiples used are usually derived from observing the market price and P/E multiples achieved by other similar businesses who are listed on a recognised stock exchange. Care must be taken to weight each one appropriately for the actual differences in size, profitability, geographical spread, product offering, growth rate and capital structure. They are not directly comparable. Secondly you would normally use data from a market being in the same domicile as the target company.
3.
Differences in accounting policies. EPS and total earnings figures need to be adjusted for differences in accounting policies amongst different companies in the same sector. Usually accounting policies in particular industries tend to be similar, so any anomalies this exercise reveals should be carefully considered. Secondly, in the 1980's it was usual to take a profit figure for the calculation of EPS based on profits before extraordinary items, the argument being that these were exceptional and should therefore be ignored. Increasingly however companies attempted to have any unusual costs allocated so that extraordinary items started to appear every year. This is why the definition of earnings for disclosure is now based on a much more restrictive definition of extraordinary items. Financial standards setters have come to realise that reporting cash flows is a more honest disclosure of the results of a business. The identification of Profits is much more subjective and judgmental involving areas such as depreciation and stock valuation.
4.
P/E's can be high for two reasons. Firstly, because the company and the sector it is in are highly rated and the company is perceived to have exceptional growth prospects. Secondly, the company might have achieved unusually low profits in the previous year so that the P/E ratio looks flattering. Care should be taken to examine the published accounts of the other companies chosen to ensure that there are no special or unusual circumstances which might warrant adjustment of their results.
5.
The effects of taxation may need to be considered depending on the use of the model, particularly in asset rich companies with large potential capital gains liabilities. The tax charge in all companies consists of two elements. Firstly, the amount of corporation tax payable on the profits for the current year. Secondly, the amount transferred to or from the deferred tax reserve. Where full provision is not being made for potential liabilities it may be necessary to adjust the figures.
Conclusions 1.
The model is the best quick and dirty way of arriving at a tentative valuation for a company. A first stab at the value of a business can be arrived at in minutes using this methodology.
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 33 of 35
DC Gardner Training TRAINERS IN FINANCE
2.
Before the arrival of cash flow methodologies, earnings based valuations were the prime method of valuation. In essence it is a commonsense approach. What do similar businesses change hands for in the market place? Adjust our view of value for any different features of our product and that's the price.
3.
The model is a little over simplistic. Paragraph 52 of FRS 3 - Reporting Financial Performance states:
"It is not possible to distil the performance of a complex organisation into a single measure. Undue significance, therefore, should not be placed on any such measure which may purport to achieve this aim. To assess the performance of a reporting entity during a period all components of its activities must be considered." The comments above are directed mainly towards performance assessment. However they are equally applicable to valuation. Here then is the prime weakness of this valuation approach. Reported earnings are only one facet of value. In a sense they are a lagging indicator of value. A company could have been investing for many years in people and training, investments which would depress reported profits. This may, however, pay off in enhanced results in the future. This model does not allow for such issues. Because of the shortcomings of earnings, valuation, analysts have turned to using other multiples. The methodology is essentially the same: (a)
Identify the “accounting number” to be valued in the subject company, based on (usually) last year’s audited accounts or a weighted average of recent years’ results
(b)
Analyse comparable companies to determine their valuation as a multiple of the same “accounting number”
(c)
Use the average multiple from the comparable companies (often ignoring extreme value) to value the subject company
The multiples most commonly used are: (i)
Enterprise value (“EV”) of company (i.e. MV of equity plus MV of debt) as a multiple of Earnings before Interest and Tax (“EBIT”)
(ii)
EV of company as a multiple of Earnings before Interest, Tax, Depreciation and Amortisation (“EBITDA”)
(iii)
EV of company as a multiple of Turnover (MV of equity is also used as a multiple of turnover)
(iv)
EV of company as a multiple of Free Cash Flow
(v)
EV of company as a multiple of Book Value of company
(vi)
MV of equity as a multiple of Book Value of equity
The main advantages of methods (i) to (iii) are that these methods increasingly remove the scope for “creative accounting”. © 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 34 of 35
DC Gardner Training TRAINERS IN FINANCE
Method (iv) recognises the link between value and Free Cash Flow, although it bases the valuation on historic rather than forecast cash flows. This drawback can be partially overcome by the use of a prospective multiple based on an estimate of current year earnings. Clearly the reliance placed on the resulting multiple will depend on the confidence placed in the earnings forecasts. You can get some feel for this by looking at how the forecast used compares to the consensus forecast, and how wide a range there is in the forecasts made by different analysts. For high-growth companies prospective multiples may be calculated for up to five years ahead. Methods (v) and (vi), which are particularly popular in the US, appeal because they recognise the concept of “adding value” to the original capital, but they suffer from the serious drawbacks that the “book value” of equity is dependent not only on the level of retained earnings, but also on the many different accounting policies used by the individual company. It is not much of an exaggeration to say that the book value can be what the directors want it to be! Undoubtedly, the use of such multiples is an improvement on the traditional P/E ratio. But, at the end of the day, to quote Jon Peacock, Head of Corporate Finance at Price Waterhouse, UK, “Multiples are a way of expressing the answer, not of getting to it.”
© 2006 DC Gardner Training C:\Ian\Powerpoint files\Euromoney\HSBC\valuation_of_a_business.doc
Page 35 of 35
