Chapter 10 Business valuation By the end of this session you should be able to: calculate the value of a whole entity (quoted or unquoted), a subsidiary entity or division using a range of methods including taxation evaluate the validity of the valuation methods used and the results obtained in the context of a given scenario and answer questions relating to these areas.

Chapter 10

Chapter 10 1 Introduction to business valuation 1.1 Factors affecting the value of a business Business valuation is not a precise, scientific process. The value of a business is affected by:  reported sales, profits and asset values  forecast sales, profits and asset values  type of industry  level of competition  range of products sold  breadth of customer base  perspective – the buyer and the seller will often have different expectations and hence may value the business differently. The valuation methods covered below give suggested values of a business. The final value is then agreed between buyer and seller after a process of negotiation

Chapter 10 1.2 Quoted and unquoted companies When valuing a quoted company, the current stock market share price should be used as a starting point for the calculations – but not necessarily a definitive final figure – consider that a buyer will often have to pay a premium. When valuing an unquoted company, estimates often have to be made, based on available information taken from similar quoted companies (‘proxy’ companies). In practice, it can be difficult to find a similar quoted company.

Chapter 10 1.3 Overview of basic valuation methods

Chapter 10 2 Asset based valuation 2.1 Introduction to asset based valuation In this method the company is viewed as being worth the sum of the value of its assets. Remember to deduct borrowings when arriving at an asset value if just the equity is being acquired, but not if only the physical assets and related liabilities are being purchased without acquiring any liability for the borrowings.

Chapter 10 2.2 Alternative asset valuation bases Book value Value is suffered by largely a function of depreciation policy. For example, some assets may be written down prematurely and others carried at values well above their real worth. Thus, this method is of little use in practice.  Replacement value Useful for the buyer. if the buyer wants to estimate the minimum price that would have to be paid to buy the assets and set up a similar business from scratch (especially if an estimate of intangible value can be added on).  Breakup value / Net realisable value Useful for the seller. Considers the amount they would receive if they were to liquidate the business as an alternative to selling the shares.

Chapter 10 2.3 Strengths and weaknesses of asset based valuation

Chapter 10 2.4 CIV (Calculated Intangible Value) Goodwill, brands and other intellectual capital (intangible assets) often have a significant value. Indeed often intellectual capital is the main contributor of value to an entity. However, the asset based methods covered above do not incorporate this value

Chapter 10 The CIV method The CIV method compares the total return that the company is generating against the return that would be expected based on industry average returns on tangible assets. Any additional return is assumed to be the return on intangible assets. This additional return is assumed to continue in perpetuity and can be Converted into a present day value for intangibles (the Calculated Intangible Value, or CIV) by discounting at the company’s cost of capital. Then: Total value of the entity = Value of tangible assets + CIV

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 10 Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Asset based valuation: Now try TYU questions 1 and 2 from Chapter 10. CIV: Now try TYU question 3 from Chapter 10.

Chapter 10 3 Earnings based valuation 3.1 The P/E valuation method Value per share = EPS × P/E ratio Total value of equity = Total post-tax earnings × P/E ratio Which earnings figure? Starting point: The current post-tax earnings, or EPS BUT this is historic, not expected, future earnings. Adjust for factors such as:  one-off items which will not recur in the coming year (e.g. debt write offs in the previous year)  directors' salaries which might be adjusted after a takeover has been completed  synergies.

Chapter 10 Which P/E ratio? An unquoted company will not have a market-driven P/E ratio, so an industry average P/E, or one for a similar company, will be used as a proxy. However, proxy P/E ratios are also sometimes used when valuing a quoted company too – if a quoted entity's own P/E ratio is applied to its own earnings figure, the calculation will just give the existing share price.

Chapter 10 3.2 Strengths and weaknesses of the P/E valuation method

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 10 Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Now try TYU questions 4 and 5 from Chapter 11

Chapter 10 Cash flow based valuation – the dividend valuation model (DVM) 4 4.1 The DVM theory and formula The value of a share is the present value of the expected future dividends, discounted at the shareholders’ required rate of return.

Chapter 10 4.2 Strengths and weaknesses of the DVM

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 10 4.3 Note on growth rates The dividend valuation model formula cannot be used directly when the annual growth rate is expected to change. In such cases, the entity’s lifespan should be segmented into the periods for which the varying growth rates apply, and value each separately Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Now try TYU questions 6 and 7 and Illustration 1 from Chapter 11.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 10 Cash flow based valuation – using discounted cash flows 5 5.1 Overview of method The value of equity is derived by estimating the future annual after tax cash flows of the entity, and discounting these cash flows at an appropriate cost of capital. This is theoretically the best way of valuing a business, since the discounted value of future cash flows represents the wealth of the shareholders. Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Now try TYU questions 8 from Chapter 10.

Chapter 10 5.2 More details on cash flows and cost of capital Free cash flows Ideally, free cash flows should be used in DCF valuations rather than post-tax, post-financing cash flows. Free cash flows are similar to post-tax, post-financing cash flows, except that they include average sustainable levels of capital and working capital net cash flow investments over the longer term rather than this year's figures. Post-tax cash flows (after financing charges) are often used as an approximation for free cash flows. An appropriate cost of capital In some exam questions, you will be told directly which cost of capital to use. However, in other cases you will be expected to either calculate or select an appropriate cost of capital. It is then important to understand the following relationships:

Chapter 10

Chapter 10 5.3 Overview of methods

Chapter 10 5.4 Cost of capital – note on proxy information The cost of capital used must reflect the risk of the entity's cash flows.  Quoted company – easy to identify cost of capital, using the huge amount of information which is publicly known.  Unquoted company (or a division of a company) – much more difficult (due to lack of available information) to identify an appropriate cost of capital. If a cost of capital is not given, or if is difficult to derive one, a proxy cost of capital from a similar quoted company could be used instead. Much more detail on deriving a suitable cost of capital is presented in the next section below.

Chapter 10 5.5 Strengths and weaknesses of the discounted cash flow method

Chapter 10 6 Deriving a suitable cost of capital for discounting 6.1 Risk adjusted cost of capital When using a proxy cost of capital, care must be taken to ensure that it reflects the business risk and the capital structure of the entity being valued. If necessary, a risk adjusted cost of capital could be used. 6.2 Modigliani and Miller's (M & M's) equations Modigliani and Miller's (M & M's) equations can be used to adjust an entity's cost of equity or WACC to reflect a different capital structure.

Chapter 10 6.3 The Capital Asset Pricing Model (CAPM) The CAPM enables us to calculate the required return from an investment given the level of risk associated with the investment (measured by its beta factor). Before showing how the CAPM formula can be used to derive a suitable risk adjusted cost of capital for discounting, we first need to introduce the model and explain the terminology surrounding it. In order to explain how the CAPM works, it is first necessary to introduce the concepts of systematic and unsystematic risk.

Chapter 10 Diversification of unsystematic risk If the investor has approximately 25 well-chosen shares in his portfolio, the unsystematic risk will be eliminated. Systematic risk cannot be eliminated by diversification.

Chapter 10 The CAPM formula and the beta factor

Chapter 10 Criticisms of the CAPM  Single period model – so values calculated are only valid for a short period  Beta values are calculated based on historic data – problem if the company has changed capital structure or business risk  Risk free rate may change over time  CAPM assumes an efficient market where it is possible to diversify away unsystematic risk, and no transaction costs

Chapter 10 6.4 Asset betas, equity betas and debt betas In order to calculate cost of equity and / or WACC for use in business valuation, we first need to expand our understanding of beta factors. The beta factor is a measure of the systematic risk of an entity relative to the market. This risk will be dependent on the level of business risk and the level of financial risk (gearing) associated with an entity. Hence, the beta factor for a geared company will be greater than the beta factor for an equivalent ungeared company

Chapter 10

Chapter 10 Use of the formula – degearing and regearing beta factors Suppose a question tells you that the ABC company has a gearing ratio (D : E) of 1 : 2, the shares have a beta value of 1.45 (the equity beta), and the corporate income tax rate is 30%. Then: Assume debt is risk free and debt beta is zero unless told otherwise. ßeu = 1.45 × [2 / 2+1(1–0.30)] = 1.074 Four very important implications: A company's equity beta will always be greater than its asset beta, except if it is all equity financed (and so has no financial risk), when its equity beta and asset beta will be the same. Companies in the same 'area of business' (i.e. same business risk) will have the same asset beta, but companies in the same area of business will not have the same equity beta unless they also happen to have the same capital structure.

Chapter 10 6.5 Application to business valuation There are two ways in which the gearing/degearing formulae above can be used to derive a cost of equity and/or a WACC that can be used in business valuation Both methods start from the assumption that you have been given an equity beta for a proxy company.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Chapter 10 Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Now try Illustration 3 and TYU question 10 from Chapter 10

Chapter 10 7 Summary of valuation methods – when should each be used? 7.1 Circumstances when each valuation method is useful

Chapter 10 OT Questions You should now be able to answer all the TYU questions from Chapter 10 in the Study Text and questions 141 to 180 inclusive from the Exam Practice Kit. For further reading, visit Chapter 10 from the Study Text.