1 Share Valuation A short story

2 Sheer Fiction PLC – a brief history in time Sheer Fiction Ltd. is a specialist internet company which deals in novels, dramas and other ‘invented’ works. It was created in December 1995 by a two entrepreneurs with initial capital of £200,000. This capital was made up of 200,000 shares of £1 each. Each entrepreneur contributed equally to the project – capital £100,000. In the original plan, one of the entrepreneurs would run the company, and take a salary; the other would simply be a ‘sleeping partner’ investing for the dividend and possible share growth.

3 First Year of operation The following information is taken from the Profit and Loss statement for 1996: Total income:£250,000 Total expenditure:£210,000 Net Profit: £40,000 The final figure is the net profit, after all taxes and expenses have been paid.

4 Analysis of the first year (1996) The net profit made by the company was £40,000, As a percentage of the original investment this is 20%. Compared to the bank rate, and the rate of inflation (which were then running at just under 5%), then this represented an excellent return. The company declared a dividend of 10p per share, and each of the original entrepreneurs got £10,000 as a result. The other £20,000 was retained by the company for investment in equipment.

5 Dividend 1996 At the end of 1996, the company declared a dividend of 10%, giving a total of £20,000 to its shareholders, and retaining £20,000 for further investment. At the beginning of 1998, the company’s balance sheet had: Share Capital £200,000 Retained Profit £20,000 Total£220,000

6 Second Year of operation (1997) The following information is taken from the Profit and Loss statement for 2001: Total income:£420,000 Total expenditure:£370,000 Net Profit: £50,000 The final figure is the net profit, after all taxes and expenses have been paid.

7 Analysis of the second year (1997) The net profit made by the company was £50,000, As a percentage of the original investment this is 25%. Compared to the bank rate, and the rate of inflation (which were still then running at just under 5%), then this is represents an amazing return. At the end of this year, there was disagreement between the shareholders. The entrepreneur who was managing the company, wished to declare a small dividend of 5%, and retain the other profits to invest in new equipment and building work. The other wished to declare a large dividend of 20% as the return on his original investment.

8 Dividend 1997 At the end of 1997, the company declared a dividend of 10% or 10p per share, giving a total of £20,000 to its shareholders, and retaining £30,000 for further investment. At the beginning of 1998, the company’s balance sheet had: Share Capital £200,000 Retained Profit £50,000 Total£250,000

9 Floating the company 1998 The disagreement between the two entrepreneurs proved irresolvable, and they decided at the beginning of 1998 to sell the company, and to recover their original investment. The manager would continue in that capacity, drawing a salary. The company would be ‘floated’ on the Stock Exchange. The question is: how much is the company now worth? That is, how much could they expect to get for their original £1.00 shares?

10 Valuing the Shares – discussion At the beginning of 1998, the balance sheet showed: Share Capital £200,000 Retained Profit £50,000 Total£250,000 There were 200,000 shares: What was their face value? What was their actual value? What do you think their market value would be?

11 The worth of the company Consider the following 4 factors: The bank rate was currently less than 5% The company was a going concern and had been turning in profits of 20% and 25% during the past two years They declared dividends of 10% in each of the previous two years. The company had grown 25% in the last 2 years: the original capital was £200,000; by the time of the sale it had grown to £250,000.

12 The worth of the company Given the bank rate of 5%, An investor would think that 10p per share was an excellent return, and would certainly have been willing to pay at least £1.00 per share to get that return. They might also, in the circumstances, have been prepared to pay up to £2.00 per share, simply because that gave a rate of return equal to the bank rate. In this case, the company’s growth record (25% in two years) meant that potential investors they would be likely to sell their shares in two year’s time for a healthy profit. This means that the shares might have an even higher market value – say around £2.50

13 Summer 1998, and beyond The shares were floated on the Stock Exchange, in June 1998 with a guide price of £2.25. There was a lot of interest and at the end of the first day, shares were changing hands for £2.85 each. That was the high point; shares settled down to a value of around the £2.40 mark for the rest of the year. From the share price rose steadily. By summer of 2001 it stood at £3.42 By mid 2002 the share price was £1.79, and one year later was £2.33

14 Balance Sheet: 2003 Sheer Fiction PLC Fixed Assets£800,000 Current Assets Stock£500,000 Debtors £50,000 Creditors: Amounts falling due within 1 yr. Trade Creditors-£100,000 Tax -£50,000 Creditors: Amounts falling due after 1 yr. Long Term Loan-£200,000 £1,000,000 Capital & Reserves Share Capital( 500,000 shares, £1 each)£500,000 Capital Reserves£250,000 Retained Profits£200,000 Profit for the Year £50,000 £1,000,000 How did the company get to this position? – That’s another story

15 Activity 1 1. Examine the Balance Sheet in the previous slide. What indicators are there of the current performance of the company? 2. The current market value of Sheer Fiction shares is £2.43 per share. Do you think this currently represents a good investment? Why?

16 Activity 2 1. Examine the Spreadsheet SheerFiction.xls This gives the Balance Sheet and the Profit & Loss account. There are also some other indicators calculated, which may help make a decision. 2. Do these indicators confirm or contradict your previous conclusions? In order to answer this question, you will need to examine the presentation ‘Financial Ratios’. This explains the meaning of some of the ratios used.