Business Valuation Methods

• Business valuation is a process to estimate the economic value of an owner's interest in a business.
• Financial market participants use valuation to determine the price to pay or receive in a business sale.
• Common valuation methods include market capitalization, earnings multipliers, and book value.
• A valuation assignment must specify the reason and circumstances, which is formally known as the business value standard and premise of value, before measuring value.

Learning Objectives

• Outline concepts applied in asset valuation.
• Understand the effects of risk and return on valuations.
• Apply the constant dividend growth model to value ordinary shares.
• Utilize a two-stage valuation dividend model for ordinary shares.
• Apply the Free Cash flow model to value a company’s equity.
• Use relative valuation methods like the price-earnings (P/E) ratio for ordinary shares.

Competence Framework Expectation

• Using various methods, analyses, calculate, estimate, and forecast a range of values for a business for review/input.
• Methods include: asset-based, transaction-based (e.g., discounted cash flow, EVA, MVA), and market-based approaches.
• Explain the shortcomings of valuation methodologies.
• Identify critical assumptions and facts in a valuation estimate: ownership structure, legal risk, accuracy factors, sustainability risks, and growth strategies.

Valuations

• Equity shares, preference shares, debentures and bonds, and convertible securities can be valued.
• Options can be valued using the Black-Scholes model, understanding how changes in the key drivers impact option value.
• You can select valuation’s appropriate basis, including earnings, dividend growth model, and net assets. Free cash flow, and market-based approaches can be part of the appropriate basis too
• Valuations are necessary for mergers, considering qualitative factors.

Assumed Knowledge

• Relevant costing principles
• Discounted cash flow principles
• Cost of capital principles

Integration

• Topic integrates with Mergers and Acquisitions to ascertain the values of equity in transactions.
• Relevant costing principles are used to identify future cash flows for inclusion in a cash flow projection.
• Cost of capital is used for identification of the appropriate discount rate.
• Taxation principles are also a key factor to consider when determining the tax implications of cash flows.

Course Notes

• Key issues: meaning of valuations, valuation myths, risk/return effect on value, and ordinary share valuation (Dividend Growth Model, Free Cash Flow model, relative valuations, Economic Value Added).

Valuation Myths

• Quantitative models are always accurate, valuations are objective, valuations are precise, valuations are valid over long periods, and the valuation number is paramount, are all incorrect.

Building Blocks of Valuation

• Considers the amount of each future cash flow, the timing of these cash flows, the riskiness of future cash flows, and the required rate of return.

Risk and Return Effect on Value

• Higher return on an asset means a higher value if both assets have similar risk.
• Higher risk asset has a lower value if both assets offer the same return.

Required Return

• To determine the present value of future cash flows, a need for a discount rate arises
• Required return on ordinary shares is called the cost of equity.
• Methods include: net assets value, market capitalization, dividend discount model, free cash flow model, price multiples, economic value added, and adjusted present value.

Market Capitalization

• Market capitalization refers to the market value of a company's shares multiplied by the number of shares issued.

Net Assets Method

• The value of a share in a particular class is equal to the net tangible assets divided by the number of shares.
• Intangible assets (including goodwill) are excluded unless they have market value.
• If goodwill is shown in the accounts, it should be reflected in another valuation method.
• Development expenditure shown in accounts relates to future profits, not physical assets.

Advantages and Disadvantages of Asset-Based Valuations

• Advantages: simplicity and provision of base value.
• Disadvantages: exclusion of future earnings potential, dependency on accounting conventions, and exclusion of intangible assets.

Price-Earnings (P/E) Ratio Method

• P/E ratio relates earnings per share to a share's value.
• The formulas are P/E ratio = Market value/EPS and market value per share = EPS × P/E ratio.
• Market valuation or capitalization = P/E ratio x Earnings per share or P/E ratio x Total earnings.
• Higher P/E ratio means a higher price for a given EPS figure.

Earnings Yield Valuation Method

• Earnings yield method is another income-based valuation model. The formula is: Earnings yield (EY) = (EPS/Market price per share) × 100
• Market value =Earnings/EY

Advantages and Disadvantages of Earnings-Based Valuations

• Advantages: can value a controlling stake and is easily understood.
• Disadvantages: difficulty in identifying suitable P/E ratio for unlisted entities, reliance on accounting profits, and difficulty in establishing sustainable earnings.

Dividend Growth Model

• The formula is: P0 = D0(1+g) / (ke-g)
• D0 = Current year's dividend, g = Growth rate, ke = Shareholders' required rate of return, P0 = Market value.

Advantages and Disadvantages of Dividend-Based Valuations

• Advantages: based on expected future income and useful for valuing a minority stake.
• Disadvantages: growth rate estimation difficulty, cost of equity estimation difficulty for unlisted companies, and difficult to value companies not paying dividends.

Valuing an Organization Using Free Cash Flow

• The free cash flow can be calculated directly or by adding the cash flows to debt holders.
• Value of the firm = PV of future operating cash flows discounted at the firm's cost of capital (WACC).
• The formula for firm value is: PV of cash flows during explicit period + PV of Terminal Value.

Definitions

• Free Cash flow (FCF) = Net operating profit after tax (NOPAT) + depreciation – capital expenditure - increase in net working capital.
• Value of ordinary equity = Value of firm less value of debt.
• FCFE = NOPAT + depreciation - capital expenditure - increase in net working capital - financing costs +/ (-) increase/(decrease) in debt financing.
• Discount rate = cost of equity (NOT WACC).

Free Cash Flow Method for Firm Valuation

• It is very similar to carrying out a net present value calculation
• Value of the organization = sum of discounted free cash flows over the appropriate horizon.

Valuation if free cash flows remain constant

• The value of the organization is the free cash flow divided by the cost of capital.
• PVO = FCF0(1 + g) / K-g
• g is the growth rate and K is the cost of capital.

Terminal Values

• The terminal value of a project or a stream of cash flows is the value of all the cash flows occurring from period (n + 1) onwards.
• Terminal value is equivalent to the salvage value remaining at the end of the expected project horizon.
• Organization value = sum of discounted free cash flows plus the discounted terminal value.
• Terminal value is determined by dividing the free cash flow at time (n + 1) by the cost of capital.

• FCFn+1 = FCFn(1 + g)
• TVn = FCFn(1+g) / 0.10-0.05.

Organization Valuation Using FCFE

• The value of equity is the present value of the free cash flow to equity, discounted at the cost of equity (Ke), plus the terminal value discounted at the cost of equity.
• The value of the organization is the value of equity plus the value of debt.
• Vn(equity) = FCFEn+1/ K-g, with g as the expected growth rate.

Valuation Indicators: Price Multiples

• Price Multiples, Enterprise Value Multiples, and Momentum Indicators

Price Multiples

• Earnings Per Share (EPS) is a driver of value while related to stock returns.
• Drawbacks: Zero, negative, or small earnings might not give a true business value.
• This is because management has discretion for earnings and you need to consider Permanent vs Transitory earnings.

Trailing P/E

• It uses last year's or past earnings and is preferred when forecasted earnings are unavailable.

Forward P/E

• It uses future earnings and is preferred when past earnings are not representative of the future.

Issues in Calculating EPS

• EPS dilution
• Underlying earnings
• Normalized earnings
• Differences in accounting methods

Method of Comparable

• Benchmark the value of the multiple choices on: Industry peers, industry/sector indexes, broad market index, and firm’s historical values

Using Peer Company Multiples- The Law of One Price

• Advantage: firms are typically similar to the subject firm, consistent with the idea of identical assets selling for the same price.

Risk and Earnings Growth Adjustments

• Analyze whether differences in P/Es can be explained by differences in fundamentals, ex. risk and earnings growth.

Price-to-Book Multiple Rationale and Drawbacks

• Rationales: book value is usually positive, more stable, and is appropriate for financial firms.
• Drawbacks: Does not recognize non-physical assets and can be misleading when asset levels vary, may be misleading due to accounting practices, less helpful when assets are old..

Adjustments to Book Value

• Address intangible assets, inventory accounting, and fair value.
• Adjust for Off-balance sheet items
• The formulas are Book value per share = Equity / Number of ordinary shares, Market to book ratio (MBR) = Share price / Book value per share (BVPS), Share price = MBR × BVPS.

Price-to-Sales (P/S) Ratio

• Formula: Share price / Sales per share.
• Drawbacks: Sales can be easily manipulated

Rationales for P/S Ratio

• Sales less easily manipulated
• Sales are always positive
• It is more appropriate for mature, cyclical, and distressed firms
• P/S is more stable than P/E and can explain stock returns.

Dividend Yield (DY)

• Only one component of return
• Dividends are less risky than future than capital gains.
• Drawback: the market may not favor dividends

Inverse Price ratios inverse

• Price-to-earnings → Earnings yield
• Price-to-book → Book-to-market
• Price-to-sales → Sales-to-price
• Price-to-dividends → Dividend yield

Enterprise value

• Useful for comparing firms of different leverage and capital utilization, and it is usually positive.
• Exaggerates cash flow
• Free Cash Flow to the Firm (FCFF) is more strongly grounded.
• Enterprise Value (EV) = Market value of shares + Debt – Cash – Investments