F3 – Financial Strategy CH12 – Business valuation

Chapter 12
Business valuation

Chapter learning objectives:

Lead Component Indicative syllabus content

D.2 Evaluate the (a) Evaluate different • Asset valuation

various valuation valuation methods
methods. • Valuation of intangibles
(b) Discuss the
strengths and • Different methods of equity valuation
weaknesses of each (share prices, earnings valuation,
valuation method dividend valuation, discounted cash flow
valuation)
• Capital Asset Pricing Model (CAPM)
• Efficient market hypothesis

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1. The efficient market hypothesis

The London Stock Exchange is semi-strong form efficient (you cannot beat the market in
the long-term unless you know something that the market doesn’t).
The share price of a company is the best basis for a takeover bid (to come up with a price).

2. Business valuation methods

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Valuation of quoted and unquoted companies

• Quoted (listed) company – will have stocks on the market. For selling a small number
of stocks, the value is the price a trader will use. But if a larger amount is going to be
sold (e.g. to acquire a majority of the shares), shareholders will need an extra incentive.
The market price will be the starting point for the calculation.
• Unquoted (unlisted) company – more difficult, as we do not have an obvious starting
point. We need to make estimates, most often based on a “proxy” company (similar
listed company). This is why we use betas, P/E ratios, etc.

3. Asset-based valuation
• In this method, the company is seen as being worth the sum of the value of its assets.
• Please remember to deduct borrowings when arriving at an asset value if just the equity
is being acquired.
• An asset-based valuation is most useful when a company is being broken up rather
than purchased as a going concern.
• This method gives a low valuation figure because it does not account for the value of
intangible assets.
• Useful for capital-intensive businesses rather than for service-sensitive businesses,
where many of the assets are intangible.

Alternative asset valuation bases

• Historic net book value
• Replacement value – calculates the cost of replacing the business assets. This may
be relevant if the assets are going to be used on an ongoing basis.
• Break-up value / net realisable value – this method can be used to set a minimum
selling price for the vendors, as they could liquidate the business as an alternative to
selling the shares.

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Strengths and weaknesses of asset-based valuations

Strengths Weaknesses

• The valuations are fairly readily • Future profitability expectations are

available. ignored.
• They provide a minimum value for the • Statement of financial position
entity. valuations depend on accounting
conventions, which may lead to
valuations that are different from
market valuations.
• It is difficult to allow for the value of
intangible assets such as intellectual
property rights.

Test Your Understanding 1 – Mark Company Ltd

The summarised balance sheet of Mark Company Ltd at 31st December 2016 is as follows:
$000
Assets
Non-current assets 25,000
Current assets 15,000
40,000
Equity and liabilities
Capital and reserves
$1 ordinary shares 5,000
Retained earnings 10,000
15,000
Non-current liabilities
5% unsecured bonds 20,000
Current liabilities 5,000
40,000

1) Calculate the value of one ordinary share of Mark Company Ltd, using an asset-based valuation
method.

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Mr A wants to make a bid for Mark Company Ltd.

He has estimated that the replacement cost of Mark Company Ltd’s non-current assets is $50
million.
2) Calculate the value of a share in Mark Company from Mr A’s perspective.

4. Valuation of intellectual capital/intangible assets

• It is recognised that goodwill, brands and other intellectual capital often have a
significant value.
• Intellectual capital (human resources, computer programs, patents and copyrights) is
the main contributor of value to an entity.
• However, the asset-based methods do not cover this value.

Two ways of valuing the intangible assets of an entity

1. Simple estimates
Value of intangibles = value of equity minus value of tangible assets

2. Calculated intangible value (CIV) method

Total value of entity = value of tangible assets + CIV
CIV is an adaption of the asset valuation method and suffers from the same
drawback as the basic valuation method, in that it is based on historical figures,
unlike DCF valuation, which looks forward into the future and is based on forecast
future outcomes when valuing a going concern.

Drawbacks of CIV
• CIV assumes future growth in the income from intangibles will be constant at the cost
of capital.
• CIV is based on profit rather than cash flow.
• CIV is based on industry average return, which might not be representative of the
company being valued.

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Test Your Understanding 2 – CIV

Company A is a financial services company. It reported a profit before tax in the most recent
financial year of USD 20,000,000, and the value of its tangible assets is $220 million.
The average return on tangible assets for firms in the financial industry is 9%, and the tax rate is
25%. Company A’s cost of capital is 14%.
What is the value of Company A using the CIV approach?

5. Earnings-based valuation
• We forecast the earnings and then apply a “multiple” to it.

P/E valuation method

• A very simple method
• Values the equity of a business by applying a suitable P/E ratio to business earnings,
i.e. profit after tax
Market value = Earnings × P/E ratio.
• Value per share = EPS × P/E Ratio
• For unlisted companies, use a proxy’s P/E ratio

Post-tax earnings:
The historic earnings figure should be adjusted for:
• One-off items that will not recur in the coming year
• Directors’ salaries, which might be adjusted after a takeover has been completed
• Any savings that might be made as a part of a takeover

Test Your Understanding 3 – Cup Company

Cup Company is an unquoted entity with recently reported after-tax earnings of $5,000,000. It has
issued 1 million ordinary shares with nominal value of $1 each. A similar listed entity has a P/E
ratio of 5.
What is the current value of one ordinary share in Cup Company using the P/E basis of valuation?

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The strengths and weaknesses of P/E method valuations

Strengths Weaknesses

They are commonly used and are well They are based on accounting profits
understood. rather than cash flows (one-off
transactions).

They are relevant for valuing a controlling It is difficult to identify a suitable P/E ratio.
interest in an entity.
It is difficult to establish the relevant level of
suitable earnings.

Earnings yield method

The earnings yield is the reciprocal of the P/E ratio, i.e. Earnings yield = 1 ÷ P/E Ratio
Value of company = Total Earnings ÷ Earnings Yield
Value per share = EPS ÷ Earnings Yield

6. Cash flow valuation

The dividend valuation model (DVM)

• The value of the company’s shares is the present value of the expected future
dividends discounted at the shareholders’ required rate of return
• If we assume that all cash flows to equity are paid out as dividends, the DVM would
give the same result as valuing the company by discounting cash flows to equity at the
cost of equity.
𝑫𝒐
DVM formula assuming a constant dividend = P0 = 𝑲𝒆
𝑫𝒐 (𝟏(𝒈)
DVM using constant growth = P0 =
𝑲𝒆+𝒈

g= forecast growth rate in dividends

P0 = value of company when d0 = total dividends
P0 = value of share when d0 = dividends per share

Dividend yield = (dividend/share price) × 100

Forecasting growth: Gordon’s Growth Model

g = r ×b
Where r = return on reinvested funds and
b = proportion of funds retained
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Example:
Company A generates an average return on its investments of 10% per year. In recent
years, the company has paid out 30% of its earnings as a dividend.
Using the Gordon Growth Model, the expected future growth rate is:
g=r×b
g = 0.10 × (1 – 0.30)
g = 0.07 = 7%

Strengths and weaknesses of dividend-based valuations

Strengths Weaknesses

Value is based on the present value of the It is very difficult to forecast dividends and
future dividend income stream. dividend growth.

They are useful for valuing minority For unlisted companies, it is difficult to
shareholdings where the shareholder only estimate the cost of equity.
receives dividends from the entity, over
which he has no control.

Uneven growth rates

• The dividend valuation 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 periods for which varying
growth rates apply and each should be valued separately.

Test Your Understanding 4 – Entity A

An entity, A, has just paid a dividend of $250,000. It has 2 million shares in issue. The current return
to shareholders in the same industry as entity A is 12%, although it is expected that an additional
risk premium of 2% will be applicable to entity A due to it being unquoted.
Calculate the expected valuation of entity A if the dividends are expected to stay constant for 3
years then grow at 4% per annum ever after.

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7. Cash flow valuation: Discounted Cash Flow method

• A value for the 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.
• It is theoretically the best way of valuing a business since the discounted value of
future cash flows represents the wealth of the shareholders.
• The cost of capital used to discount the cash flows should reflect the systematic risk of
the cash flows.

Cash flow to equity

• Cash flow to equity should be used in DCF valuations rather than post-tax post-
financing cash flows.
• Cash flow to equity is similar to post–tax post–financing cash flow, except that it
includes average sustainable levels of capital and working capital net cash flow
investment over the longer term rather than this year’s figure.
• Post-tax cash flows after financing charges are often used as an approximation for
cash flows to equity.
• However, where suitable information is provided in the question to enable cash flows
to equity to be calculated, cash flows to equity should be used in the DCF valuation
instead of post-tax financing cash flows.

Free cash flow

This is the cash generated by the business that is freely available for distribution to
investors after having met all the immediate obligations of the business and the investment
in the working capital and in non-current assets that is necessary to sustain the business
on an ongoing basis.

How to calculate cash flow data from profit data

Free cash flow to all investors (FCF) Free cash flow to equity (FCFE)

1. Start with PBIT 1. Start with PBIT

2. Deduct tax for the year excluding tax 2. Deduct tax for the year and
relief on the interest interest to give profit for the year
3. Adjust for non-cash items, e.g. add 3. Adjust for non-cash items, e.g.
back depreciation depreciation
4. Adjust for cash items such as Capex/ 4. Adjust for cash items such as
disposal of non-current assets/ Capex/disposal of non-current
changes in working capital assets/changes in working capital,
new debt raised/debt repaid
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Note: Tax can be calculated as (PBIT – Note: Tax can be calculated as (PBIT –
Interest) × tax rate, or if tax depreciation Interest) × tax rate, or if tax depreciation
allowances differ from depreciation, tax is allowances differ from depreciation, tax is
(PBIT + depreciation – tax depreciation (PBIT + depreciation – tax depreciation
allowances) × tax rate allowances – interest) × tax rate

Approach 1 Approach 2

1. Identify the FCF of the target 1. Identify the FCFE of the target
company (before interest) company (after interest)
2. Discount at WACC 2. Discount at Ke (cost of equity)
3. NPV of the cash flows before 3. NPV of equity
allowing for interest payments
4. Subtract the value of debt from step 3
to obtain the value of the equity

Test Your Understanding 5 – Free cash flow to investors (Katty)

The recently published accounts of Katty plc show the following figures:

$ million
Profit before interest and tax 240
Interest 30
Profit after interest but before tax 210
Tax expense (tax rate 30%) 63
Depreciation 5
Capital expenditure 50
Increase in working capital 10
Debt repayment 15

Calculate the free cash flow to all investors.

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Strengths and weaknesses of cash-based valuations

Strengths Weaknesses

• Theoretically the best method for • It is difficult to forecast cash flows

valuation accurately
• It can be used to place a maximum • It is difficult to determine an
value on the entity appropriate discount rate
• It considers the time value of money • The basic NPV method does not
evaluate further options that may exist

8. Deriving a suitable cost of capital for discounting

Modigliani and Miller’s (M&M’s) equations

Cost of equity = keg = keu + (keu – kd)Vd(1-t)/Ve
WACC = kadj = keu[1 – (VDt/(VE + VD)]
Ve = value of equity
Vd = value of debt
Ke = cost of equity
Keg = cost of equity in geared company
Keu = cost of equity in an ungeared company
Kd = cost of debt must be gross of tax
Kadj = the weighted average cost of capital in a geared company
t = corporation tax rate
WACC = weighted average cost of capital

The capital asset pricing model (CAPM)

Enables us to calculate the required return on investment given the level of risk associated
with the investment as measured by its beta factor.

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Systematic and unsystematic risks

These two elements make up the risk associated with the company.

Systematic risk:
The risk of the company’s cash flow being affected to some extent by general
macroeconomic factors such as tax rates, unemployment or interest rates.

Unsystematic risk:
Risk of the company’s cash flows being affected by some specific factors such as strikes,
R&D success, system failures, etc.

Beta factor (ß)

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole. Beta is used in the capital asset pricing
model (CAPM), which calculates the expected return of an asset based on its beta and
expected market returns. Beta is also known as the beta coefficient.
The beta factor of the whole market is 1. Market risk makes market returns volatile, and
the beta factor is simply a yardstick against which the risk of other investments can be
measured.
Beta values fall into four categories:
ß>1 = the shares have more systematic risk than the stock market average
ß<1 = the shares have less systematic risk than the stock market average
ß = 1 the shares have the same market risk as the stock market average
ß = 0 the shares have no risk at all

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if
ß = 1.25, the shares have 25% more systematic risk than the stock market average
ß = 0.80, the shares have 20% less systematic risk than the stock market average

The security market line (SML)

The security market line gives the relationship between the systematic risk and return.
• Risk-free security:
This carries no risk and therefore no systematic risk and therefore has a beta of zero.
• The market portfolio:
This represents the ultimate in diversification and therefore contains only systematic
risk; it has a beta ß of 1.

Rf = is the point on the graph where the line cuts the y-axis, beyond which the higher the
systematic risk, the higher the required rate of return.
The SML and the relationship between the required return and risk can be shown using
the following formula:

Ke = Rf + (Rm – Rf) * ß
Ke = required return from individual security
ß = beta factor of individual security
Rf = risk-free rate of return
Rm = return on market portfolio

The alpha value of a share:

• The alpha value of a share is simply its average abnormal return (meaning actual return
minus expected return).

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• Alpha values can either be positive or negative, and in a perfect world, they should be
zero. In other words, the average return that the shares actually do produce should be
the same as the return indicated by the CAPM.

Criticism of CAPM
• CAPM is a single-period model.
• CAPM assumes no transaction costs associated with trading securities.
• Any beta value calculated will be based on historic data, which may not be appropriate.
• The risk-free rate may change considerably over short periods of time.
• CAPM assumes an efficient investment market where it is possible to diversify away
risk.
• The idea that all unsystematic risk is diversified away will not hold true if stock changes
in terms of volatility.
• CAPM assumes all stocks relate to going concerns, and this may not be the case.

Asset betas, equity betas and debt betas

• The beta factor is the measure of the systematic risk of an entity relative to the market.
• This risk will be dependent upon the level of business risk and the level of financial risk
(gearing) associated with the entity.
• The beta factor of the geared entity will be greater than the beta factor for an equivalent
ungeared company.
The relationship between the beta factors for ungeared and geared companies is given as
follows:
𝑽𝒆 𝑽𝒅(𝟏+𝒕)
ßu =ßg + ßd
𝑽𝒆(𝑽𝒅(𝟏+𝒕) 𝑽𝒆(𝑽𝒅(𝟏+𝒕)
ßg = the equity geared beta measures the systematic business risk and the
systematic financial risk of a company’s shares
ßu = the ungeared/asset beta measures the systematic business risk only
ßd = the debt beta measures the risk associated with the debt finance
Note: we usually assume that debt is risk-free and hence that the debt beta is zero
If this is the case, the second term in the formula disappears, and the formula
becomes:

𝑽𝒆
ßu =ßg
𝑽𝒆(𝑽𝒅(𝟏+𝒕)
Note:

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• The entity’s systematic risk is important in the CAPM formula.

• Shareholders are only interested in systematic risk because they hold well-diversified
portfolios.
• The systematic risk of an entity is measured by its beta.
• Shareholders in a geared company suffer two types of systematic risk, i.e. business
and financial risk.
• The business risk of a company refers to the risk associated with operating cash flows.
• Financial risk is the increased volatility of dividend payments to shareholders as
gearing increases.
• The systematic risk of a company arises out of the risky nature of the company’s
business caused by:
- Revenue sensitivity
- Proportion of fixed to variable production costs
Systematic financial risk arises out of how the company has financed itself:
• Gearing
• Capital structure

Use of the formula: degearing and regearing the beta factors

Please note:
1) A company’s equity beta will always be greater than its asset beta, except
2) If it is all-equity financed and so has no financial risk, when its equity beta and asset
beta will become the same.
3) Companies in the same area of business will have the same asset beta, but
4) Companies in the same area of business will not have the same equity beta unless
they also happen to have the same capital structure.

Application to business valuation:

Both of the methods start from the assumption that you have been given an equity beta for
a proxy company.
Method 1:
I. Use the formula to derive the proxy entity’s unguarded beta factor.
II. Assume that this beta factor also reflects the business risk of the entity being valued.
III. Regear this ungeared beta to reflect the capital structure of the entity being valued.
IV. Use CAPM to derive a cost of equity for the entity being valued and if necessary
use this ke in the standard WACC formula to find the entity’s WACC.

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Method 2:
I. Use the formula to derive the proxy entity’s ungeared beta factor.
II. Use CAPM to find an ungeared cost of equity Keu for the proxy entity.
III. The assumption is that this keu is also a measure of the ungeared cost of equity
being valued (same business risk).
IV. Use M&M’s WACC formula to calculate the WACC of the entity being valued.

NOTE: Method 2 can only be used to calculate WACC, whereas Method 1 derives both
cost of equity and WACC. Both of the methods will give the same answer.

Test Your Understanding 6 – Harvey Company

Harvey Co is an unlisted company with an estimated debt:equity ratio of 1:2. Post-tax cash flows
before financing charges have been forecasted, so a suitable WACC is needed for discounting.
Since Harvey Co is an unlisted company, it has been difficult to derive a WACC for Harvey directly,
and the managers of the entity have decided to use proxy information as a starting point.
Information for Pocket Company, a listed company in the same business sector as Harvey Co is as
follows:

Pocket
Company
Current geared equity beta 1.86
Current capital structure ratio by market value 1:1

Tax rate = 30%

Return on stock market in recent years 12% per annum
Debt is assumed to be risk-free and has a pre-tax cost of 5% per annum
Calculate a suitable WACC for Harvey Co.

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9. Solutions to Test Your Understanding questions

Test Your Understanding 1 – Mark Company Ltd

Assuming that the figures in the financial statement are realistic:
The valuation is:
$000
Assets
Non-current assets 25,000
Current assets 15,000

40,000

Less: Unsecured bonds (20,000)

Less: Current liabilities (5,000)
15,000
Value per share = $15,000,000/5,000,000
Value per share = $3 per share

Mr A’s perspective
Value per share = ($15,000,000 + $50,000,000 - $25,000,000)/$5,000,000
Value per share = $40,000,000/$5,000,000 = $8 per share

Test Your Understanding 2 – CIV

Current pre-tax profit = $20 million (A)
Less: Industry ROA × Tangible assets = $220×9% = $19.8 m (B)
Excess annual return (pre-tax) (A-B) $0.2 m (C)

Post-tax excess annual return $0.2m (1-0.25) =$0.15 m

CIV assuming constant perpetuity = $0.15 m/0.14 = $1.07 m
The total value of Company A = $220 m + $1.07 m = $221.07 m

Test Your Understanding 3 – Cup Company

EPS = $5,000,000 ÷ $1000,000 = $5 per share
Value per share = P/E × EPS
Value per share = 5 × $5 per share
Value per share = $25

Test Your Understanding 4 – Entity A

Separate the future dividend stream into two parts:
First, split the constant dividend into three years:
Present value of expected dividends: 250,000×AF1-3 (14%) = $0.580m
Perpetuity from year 4:
Use the formula for DVM, then adjust for the fact that the dividend stream starts in year 4, not
year 1 as normal:
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[250,000 × 1.04]/0.14 – 0.04] ×DF3(14%) = $1.755m

Total value = $0.580m + $1.755m
Total value = $2.335
Value per share = 2.335/2 = $1.17 per share.

Test Your Understanding 5 – Free cash flow to investors (Katty)

The recently published accounts of Katty plc show the following figures:

$ million
Profit before interest and tax 240
Less: Tax expense based on PBIT (240*30%) (72)
Add: Depreciation 5
Less: Capital expenditure (50)
Less: Increase in working capital (10)
Free cash flow to all investors 113

Test Your Understanding 6 – Harvey Company

Method 1:
Step 1:
Pocket Company’s ungeared/asset beta is calculated and then used as an estimate of
Harvey Co’s asset beta.
Since debt is risk-free, use
/0
ßu = ßg /0(/1(2+3)

2
ßu = 1.86 × 2(2(2+4.64)

ßu = 1.09

Step 2:
A geared/equity beta of Harvey Co is calculated next. Harvey Co’s equity beta will reflect
the business risk of Harvey Co and Pocket Co and the capital structure of Harvey Co (1:2)
D:E
/1(2+3)
ßg = ßu[1+ /0
]
2(2+4.64)
ßg = 1.09[1 + 7

ßg = 1.47

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Step 3:
Equity beta will now be input into the CAPM to give a cost of equity capital for Harvey Co:
ke = Rf + [Rm – Rf]ßg
ke = 5% + [12% - 5%]×1.47
ke = 15.3%

Step 4:
Calculation of WACC:
/0 /1
ko = keg[/0(/1] + kd(1-t)[ /0(/1]

ko = 15.3%×(2/3) + 5%×(1-0.30)×(1/3)
ko = 11.4%

Method 2:
Step 1:
As above, the existing geared/equity beta of Pocket Co is degeared, to give an
ungeared/asset beta of 1.09
Step 2:
Input this ungeared beta into the CAPM formula to give an ungeared cost of equity keu.
Keu = 5% + [12% - 5%] × 1.09
Keu = 12.6%
Step 3:
Use the M&M WACC formula:
Kadj = keu (1 –tL)
Kadj = 12.6%(1 – 0.30* 1/3) = 11.4%
This is the same as above.

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11. Chapter Summary

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