Valuations
A value of an asset is equal to the present value of future cashflows
Valuation methods
1. Intrinsic method
2. Relative valuation
Intrinsic method
• Free Cash flows (to the firm and to equity)
• Dividend Discount Model
Relative Valuation
• Price multiples
The DCF (free cash flow) method has also become known as the Income Approach to valuations while the use
of price multiples is also called the Market Approach to valuations
Dividend discount model
The dividend discount model requires that we project the future dividends of the firm and discount the dividends
at a firms cost of equity. For equity the periodic cashflow is the dividend received and we can use the below
model to value:
Po = D1 /k - g
where:
Po = value of ordinary share
D1 = next period’s dividend [D1 = Do (1 + g)]
k = cost of equity
g = growth rate in future dividend
Nb the above formula assumes that there will be growth in dividends. If we assume that there will be no growth
in dividends , the present value of the dividends will be D1/k
Dividends are a function of policy as well as the prevailing economic environment. The growth rate in dividends
is often difficult to determine and the assumption of a constant growth rate may not be realistic. The dividend
discount model is more relevant when we are valuing a firm with steady earnings growth operating in a mature
industry sector. The assumption of a real growth rate which is similar to the expected real GDP growth rate plus
the expected inflation rate may be relevant for many companies operating in certain sectors. We can also make
further adjustments for productivity improvements
Limitations of the Dividend Growth model
The model is limited in the following respects:
• It assumes that growth is constant.
• It is applicable only where the required return is higher than the growth rate.
• As growth approaches the required rate of return, so the value of the shares approaches infinity.
• This is not likely to be a realistic valuation as it is highly improbable that a company would be able to
maintain this level of growth indefinitely. If growth exceeds the required rate of return, the model gives
a negative valuation to the shares, which is clearly absurd
A dividend growth that is greater than the earnings growth is not sustainable. This is intuitively obvious. It can
also be shown by the sustainable growth formula. An abbreviated version of the
SGR formula is: SGR = Return on equity X Retention ratio.
NB under this method we can use the two stage valuation
First estimate when growth fluctuates and when it goes into perpetuity
Price multiples
Price Earnings ratio
The P/E ratio ( Price per share/ EPS) measures the relationship between the company’s earnings per share and
the share price.
• When using the P/E ratio we need to find out about comparable companies of the companies acerage
sector
• Companies experiencing high growth rates in earnings will normally have high P/E ratios whilst
companies with a high level of financial leverage may have lower P/E ratios, to reflect the higher risk
profile of such companies.
Earnings yield equal to inverse of P/E ratio.
• We use the P/E ratio of a comparable listed company and make an adjustment for the lack of
marketability.
Disadvantages of PE ratio
• It is based on historical earnings figures, although companies may use the forward P/E ratio which
takes into account next year’s earnings. This may not be enough to reflect the future. Detailed models
require an analysis of the assumptions of future earnings, whilst the P/E ratio or EY approach do not
require any detailed analysis. Also, a high P/E ratio may simply reflect very low reported earnings in the
latest period, and which may be a temporary setback for that period only. A company incurring losses
will report a negative P/E ratio, which is meaningless P/E ratio
• The method is based on accounting earnings rather than cashflow
•
The use of forward P/E ratios
• A company may use expected earnings or forecast earnings to determine a valuation. It is
important to be consistent and apply a forward P/E of a comparable company and not the trailing
or historic P/E. Otherwise, we can make a significant error of principle in our valuation of a
company’s equity
• Value per share = forward P/E × forward EPS
Using EBITDA or EBIT multiples to determine enterprise value
• We use the P/E ratio to determine the value of ordinary equity but we use an EBITDA or EBIT multiple
to determine the enterprise value of the firm.
• The advantage of determining an enterprise value and using an EBITDA multiple is that we can ignore
differences in financial leverage. It also enables us to ignore differences in depreciation policies and the
situation where one firm has older assets and therefore a lower depreciation charge
Enterprise Value = EBITDA Multiple X Maintainable Earnings
Equity Value = Enterprise Value- Debt
Market to book ratio
Market to book ratios are often used to value banks
Book value per share = Shareholders equity/No. of ordinary share
Market to book = Share price/book value per share
Price to sales ratio
The price to sales ratio is calculated by dividing the sales per share into the share price. This ratio is often used
when companies are making losses and yet are growing sales
Free Cash Flow Model
Free Cash flow to the firm
• The free cash flow to the firm approach of valuing ordinary equity requires that we estimate the future
after-tax operating cash flows of the firm. We discount these cash flows at the company’s cost of
capital, and we deduct the value of debt to get to the value of ordinary equity. It is a direct valuation
which forces us to focus on the key drivers of value and the operations of the company.
• FCF = NOPAT (net operating profit after tax) + depreciation – net capital expenditure – net increase in
working capital WACC = weighted-average cost of capital (i.e. required return for the firm) Vn = terminal
value of the firm at the end of the explicit forecast period. This is often referred to as the enterprise
value. We then deduct the value of debt at the current date to obtain the value of ordinary equity.
Free Cash flow to equity
The free cash flow to equity is the amount of cash generated by the company which is available to be withdrawn
by the shareholders. It is operating after-tax cash flows less the net financing cash flows such as interest (after-
tax) and changes in debt levels
FCFE = Net profit after tax (and after financing costs) + depreciation – net capital expenditure – net increase in
working capital +/-change in debt financing
k = cost of equity
Vn = terminal value of the equity at the end of the explicit forecast period.
Terminal Value
The valuation of the firm is determined as the present value of the cash flows during the explicit period and the
present value of the terminal value (also known as the continuing value).
Value = PV of Cash flows during the Explicit Period + PV of the Terminal Value
Continuing Value= FCF (1+g)/(Wacc-g)
Maintainable Earnings Private company adjustments
•Transactions not at arms length
• No salary for owner
• Above market salary for family members
• Understated expenses for loss making business
• Private expenses on the company’s account
• Expenditure on private use assets
• Excess entertainment
• Related party adjustments
• Loans to owner, family members below market
Pitfalls
Confusing the valuation of the firm with the valuation of the equity. Valuation of equity requires bottom line
earnings/cash flows discounted at the cost of equity. Valuation of the firm requires operating profit/cash flows
discounted at the WACC.
Not adequately recognising a change in gearing during the valuation period and the effect this has on the cost
of capital.
Not recognising that earnings/cash flows emanating from new assets are riskier than those from replacement
assets, and that the discount rate should therefore increase.
Not being able to find comparable firms to use as benchmarks for relative valuations
Not recognising that control is worth something. Consider carefully what additional value is to be generated
through control.
Double counting risk by reducing expected returns and increasing the discount rate.
Double counting synergies by increasing expected returns and reducing the discount rate for the risk reduction.
Including a premium for control by up to three times, by increasing expected returns, reducing the discount rate
and adding a premium.
Increasing the discount rate to account for additional country risk. Most of the country (sovereign) risk is already
reflected in the risk-free rate.
Recognising the income from non-core assets and adding the value of these assets, as this constitutes double
counting
Comment [A9]: Trigger
-Acquisitions – Both Finance and Strategy
Companies may decide to increase the scale of their operations through a strategy of internal organic growth
by investing money to purchase or create assets and product lines internally. Alternatively, companies may
decide to grow by buying other companies in the market thus acquiring ready-made tangible and intangible
assets and product lines
Mergers and acquisitions can be integrated with Strategy, discussing whether the merger or acquisition
decision is in line with an entity’s strategic objective; Business Valuations to determine the price or value to be
paid for the target entity and Financial Statement Analysis to determine the exchange ratio using P/E ratios.
NB An acquisition decision should only be taken when it leads to increase in shareholders wealth. This
happens when the merger or acquisition creates synergies which increase revenue or reduce costs etc
Types of mergers
Horizontal- These result when two firms in the same industry merge ( In this Case HB )
Vertical -These occur where a firm either expands forward to the customer, or expands backwards to the raw
material supplier stage.
Conglomerate- These occur where firms in unrelated lines of business decide to merge.
Reasons for mergers
• Operating economies/ Market power
A merger may result in economies in production or distribution, such as lower unit costs
through higher production runs. This is often cited as a reason for a merger – particularly for
horizontal mergers
1. Operating economies may be effected by the following means:
• ■ Economies in purchasing;- Greater power over suppliers and achieve lower cost prices or extended
payment terms ( Horizontal merger- concern the competition industry might not allow this)
• ■ Standardisation and reduction in the number of products;- cost savings from producing similar or
complex products
• ■ Combination of production facilities and warehouses;- enable cost savings and effective utilisation
of space
• ■ Reduction in the number of retail outlets;- might reduce distribution costs
• ■ Combination of IT and administrative functions;- cost savings in
• respect of personnel and office rentals, and the integration of systems may result in benefits for
• the group
• ■ Consolidation of research and development programmes.
• A merger may result in a reduction in competitive pressures which may allow the combined company
to raise prices without losing market share.
• Mergers may be also be driven by strategic reasons such as ensuring the supply of key materials and
obtaining sales outlets for
the company’s products.
2. Barriers to entry ( can be done through vertical acquisitions where a firm controls the pdn inputs)
3. Supply chain security – no disruption in supply of inputs
4. Economies of scale -The larger scale of operations may give rise to what is called economies of scale
from a reduction in the cost per unit resulting from increased production, realized through
operational efficiencies. Economies of scale can be accomplished because as production increases,
the cost of producing each additional unit falls.
5. Economies of scope - Scope economies or changes in product mix are another potential way in which
mergers might help improve the performance of the acquiring company. Economies of scope occur
when it is more economical to produce two or more products jointly in a single production unit than
to produce the products in separate specializing firms. Scope economies can arise from two sources:
(a) The spreading of fixed costs over an expanded product mix
(b) Cost complementarities in producing the different products- Use example of bank services i.e
deposits , loans, insurance services
6. Managerial skills – proper management may result in an improvement in the FP of the entity
7. Tax considerations and assessed losses-
An expansion strategy through acquisition is associated with exposure to a higher level of business and
financial risk.
The risks associated with expansion through acquisitions are:
• Exposure to business risk - Acquisitions normally represent large investments by the bidding
company and account for a large proportion of their financial resources. If the acquired company
• does not perform as well as it was envisaged, then the effect on the acquiring firm may be
catastrophic.
• Exposure to financial risk - During the acquisition process, the acquiring firm may have less than
complete information on the target company, and there may exist aspects that have been kept
hidden from outsiders.
• Acquisition premium - When a company acquires another company, it normally pays a premium over
its present market value. This premium is normally justified by the management of the bidding
company as necessary for the benefits that will accrue from the acquisition. However, too large a
premium may render the acquisition unprofitable.
• Managerial competence - When a firm is acquired, which is large relative to the acquiring firm, the
management of the acquiring firm may not have the experience or ability to deal with operations on
the new larger scale, even if the acquired company retains its own management.
• Integration problems - Most acquisitions are beset with problems of integration as each company has
its own culture, history and ways of operation.
A coherent acquisition strategy should be based on of the three strategies:
1. Acquire undervalued firms
2. Find firms that are undervalued
3. Access to necessary funds
4. Skills in executing the strategy
5. Diversify to reduce risk-
Comment [A10]: Trigger -Strategy and synergy
The criteria that should be used to assess whether a target is appropriate will depend on the motive for the
acquisition. The main criteria that are consistent with the underlying motive are:
1. Benefit for acquiring undervalued company - The target firm should trade at a price below the estimated
value of the company when acquired. This is true of companies which have assets that are not exploited.
2. Diversification - The target firm should be in a business which is different from the acquiring firm's business
and the correlation in earnings should be low.
3. Operating synergy- The target firm should have the characteristics that create the operating synergy. Thus,
the target firm should be in the same business in order to create cost savings through economies of scale. Or it
should be able to create a higher growth rate through increased monopoly power.
4. Tax savings - The target company should have large claims to be set off against taxes and not sufficient profits.
The acquisition of the target firm should provide a tax benefit to acquirer.
5. Increase the debt capacity - This happens when the target firm is unable to borrow money or is forced to pay
high rates. The target firm should have capital structure such that its acquisition will reduce bankruptcy risk and
will result in increasing its debt capacity.
6. Disposal of cash slack - This is where a cash rich company seeks a development target. The target company
should have great projects but no funds. This happens when for example the target company has some exclusive
right to product or use of asset but no funds to start activities.
7. Access to cash resources - A company with a number of cash intensive projects or products in their pipeline,
or heavy investment in R&D might seek a company that has significant cash resources or highly cash generative
product lines to support their own needs.
8. Control of the company - In this case the objective is to find a target firm which badly - managed and whose
stock has underperformed the market. The management of an existing company is not able to fully utilize the
potential of the assets of the company and the bidding company feels that it has greater expertise or better
management methods. The bidding company therefore believes that the assets of the target company will
generate for them a greater return than for their current owners. The criterion in this case is a market valuation
of the company that is lower than for example the value of its assets.
9. Access to key technology - Some companies do not invest significantly in R&D but acquire their enabling
technologies by acquisition. Pharmaceutical companies who take over smaller biotechs in order to get hold of
the technology are a good example of this type of strategy.
There are three types of synergies which are
1. Revenue – arises through increased market power, marketing and strategic synergies
2. Cost -arises through economies of scale and scope
3. Financial
I. Diversification ( two independent companies)
II. Cash slack
III. Tax savings (
IV. Debt capacity
Acquisition can be financed through
• Sale of shares or assets
• Cash or share swap . For cash the risk is borne by acquirer and share swap both.
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