1. F9 Financial Management

2. 2 Section G: Business Valuations Designed to give you the knowledge and application of: G2. Models for the valuation of shares G3. The valuation of debt and other financial assets

3. 3  Asset-based valuation models, including: [2] i.net book value (SOFP basis) ii.net realisable value basis iii.net replacement cost basis  Income-based valuation models, including: [2] i.price / earnings ratio method ii.earnings yield method  Cash flow-based valuation models, including: [2] i.dividend valuation model and the dividend growth model ii.discounted cash flow basis Learning Outcomes G2: Models for the valuation of shares

4. 4 Why do we need to value shares? create a valid tax basis conversion from private to public company proposal for merger / takeover justify the realisation on disposal of shares Need to value shares ?

5. 5 Assets based valuation models Income-based valuation models Cash flow-based valuation models Business valuation models  Net book value basis  Net realisable value basis  Net replacement cost basis  Price / earnings ratio method  Earnings yield method  Dividend valuation model & dividend growth model  Discounted cash flow basis Business Models

6. 6 Asset-based valuation models Net book value (SOFP basis) Net book value (NBV) business valuation based on the accounting books of the business Example A company’s share capital is $100m (10m shares of $10 each) and its reserves and surplus is another $100m. The net worth of the company would be $200m (equity and reserves) and net book value would be $20 per share ($200m divided by 10m outstanding shares). Assets Liabilities - = Book value Owner’s equity Net book value per share Net book value Number of outstanding shares

7. 7  accounting records may not accurately reflect the true value of the assets  book value is based on historical cost which is not the same as market value Limitations of net book value method NRV = Selling price of the asset Liquidation cost Payment of other liabilities -- Net realisable value basis Net realisable value (NRV) the residual value after selling assets, deducting liquidation cost and paying off liabilities NRV of assets will be only an estimate When arriving at NRV should be adjusted for:  estimated value of non-current assets – their NBV  estimated value of other assets – their NBV  eliminate book values of goodwill & other intangible assets  estimated liquidation costs

8. 8 Net replacement cost basis Replacement cost the amount required to replace an asset at current prices different from fair market value or net realisable value Example Book ValueEstimated Replacement Value $%$ Cash at bank5,0001005,000 Debtors70,00010070,000 Stock200,000115230,000 Fixed assets15,00012018,000 Total outside liability(90,000)100(90,000) 200,000233,000 Valuation – Net replacement value233,000

9. 9 Income-based valuation models Price / earnings ratio method Price / earnings (P/E) ratio  assumes that the corporation will be worth some multiples of its future earnings  used to measure how cheap or expensive the stock’s share price is Value of company = Total earnings x P/E ratio Example A company earned $15m last year, with one million shares outstanding, and had earnings per share of $15($15m/1m). The current market price is quoted at $100. Therefore, the company’s P/E multiple will be 6.67 times ($100/$15). If the company's earnings rises to $18m and, accordingly, EPS rose to $18. Assuming the same P/E multiple, i.e. investors are willing to pay $6.67 for every $1 of last year's earnings, the company’s valuation using the P/E ratio method will be $120m ($18 x 6.67).

10. 10 Limitations of P/E ratio method based on earnings & actual profits, which are not good indicators of actual value creation for shareholders selection of multiplier is not consistent Benefit of P/E ratio method one can analyse the market valuation of a company’s shares relative to the wealth, the company is actually creating Earnings yield method Earnings yield  earnings per share for the most recent 12 months divided by market price per share  inverse of P/E ratio  quoted as a percentage  useful in comparing a share valuation or the market’s valuation relative to bonds Earning Yield Method Continued …

11. 11 Example A company earned $10m last year, with one million shares outstanding, had earnings per share of $10($10m /1m). The current market price is quoted at $100. The P/E ratio would therefore be 10 ($100/$10). Therefore, required earnings yield = EPS/Share price x 100 = 10/100 x 100 = 10% If we assume the company will maintain the same level of earnings, annual maintainable expected earnings are $10m Capitalised value = $10m/10% = $100m Advantages of earning yield method forward-looking measure as it uses expected earnings encourages forecasting of future performance Limitation of earning yield method uses the earnings from the financial statements, which is largely subjective Continued …

12. 12 Cash flow-based valuation models Dividend valuation model & dividend growth model Dividend discount model Dividend growth model Example A company pays a $1 annual dividend. If we assume that the company will pay that dividend indefinitely, then how much is an investor willing to pay for this company? Assume that the expected return or, more appropriately, the 'required rate of return' is 5%. Then, according to the dividend discount model, the company should be worth $20.00 ($1.00/0.05).  worthwhile tool for equity valuation  assumes that any share is ultimately worth no more than what it will provide investors in current and future dividends Dividend discount model

13. 13 Dividend growth model  considers 2 basic factors: expected: expected dividends & expected return  assumes a constant dividend  created by Myron Gordon  variant of discounted dividend model Alternatively Po =Po = Example A company pays a $1 annual dividend. If we assume that the company's dividend will grow by 3% annually, then how much is an investor willing to pay for a share in this company? Assume that the 'required rate of return' is 5%. Then, according to the Gordon Growth Model, the company will be worth $50.00 ($1.00/ (0.05 - 0.03)).

14. 14 Discounted cash flow method Discounted cash flow approach  calculates value of a business by discounting its future cash flows at a rate which reflects the risk inherent in the business  recognises the time value of money by discounting future cash inflows & outflows to the present Discounted cash flow technique requires the valuer to forecast the future cash flows of the company for at least 4 to 5 years & to assess the likely cash benefits and costs arising from business transactions assess an appropriate discount rate, which is usually the subject company’s weighted average cost of capital (WACC) Weighted average cost of capital (WACC) calculates the expected cost of new capital for a firm taking into consideration the relative weights of equity and debt V e V d WACC = ------------ K e + ------------ K d (1 – T) V e + V d V e + V d Where, K e = Cost of equity K d = Cost of debt V e = Market value of equity V d = Market value of debt T = Corporate taxation

15. 15 Recap  Asset-based valuation models, including: [2] i.net book value (SOFP basis) ii.net realisable value basis iii.net replacement cost basis  Income-based valuation models, including: [2] i.price / earnings ratio method ii.earnings yield method  Cash flow-based valuation models, including: [2] i.dividend valuation model and the dividend growth model ii.discounted cash flow basis

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