Fin management materials / 5 P4AFM-Session07_j08
.pdf
SESSION 07 – BUSINESS VALUATION
6.3Forecasting growth rates
¾Gordon’s growth approximation states that growth is achieved by retention and reinvestment of funds.
g = bre
b |
= |
proportion of profits retained |
re |
= |
return on equity |
¾Take an average of r and b over the preceding years to estimate future growth.
re |
= |
Profit after tax |
= |
Profit after tax |
||
Shareholders'funds |
Net assets |
|||||
|
|
|
||||
b |
= |
Retained profit |
|
|
||
|
|
|
|
|||
Profit after tax |
|
|
||||
|
|
|
|
|||
¾However the use of the accounting ratio for return on equity can be challenged as:
It often overstates the return on new investments. This is because the book value of equity does not include many of the true reserves of companies e.g. the value of human capital. This will be particularly true in the service sector.
Even in the industrial sector the ratio is distorted by accounting policy e.g. whether property is revalued to market value (as in IFRS) or left at historic cost (as in US GAAP)
¾In the long-run the return on new investment should fall until it equals the firm’s cost of equity. As the Free Cash Flow model needs to forecast a sustainable growth rate to infinity this would appear a reasonable assumption.
¾Furthermore it is more relevant to analyse the proportion of cash generated by the firm that is reinvested, rather than the proportion of accounting profits. This is found by comparing:
−net reinvestment = capital expenditure – new finance raised
−FCFE (pre-reinvestment) = operating cash flow – interest – tax
¾An improved model is therefore:
b |
= |
Net reinvestment |
|
FCFE(pre - reinvestment) |
|
||
re |
= cost of equity geared e.g. from CAPM |
||
0711
SESSION 07 – BUSINESS VALUATION
Example 4
Free Cash Flow to Equity (before reinvestment) = $123.29m
Net reinvestment = $95.25m
Cost of equity 7.2%
Required:
Value the company’s equity.
Solution
6.4 |
Free Cash Flow to the Firm (FCFF) |
|
Earnings before interest and tax (EBIT) |
x |
|
Tax on EBIT |
(x) |
|
|
|
___ |
Net operating profit |
x |
|
Add: depreciation, amortisation and other non-cash charges |
x |
|
Deduct: capital expenditure |
(x) |
|
Increase/decrease in working capital |
(x)/x |
|
|
|
___ |
FCFF |
|
x |
|
|
___ |
¾It is important to note that FCFF represents the cash flows available to all of the company’s investors, both equity investors and debt investors. Therefore FCFF is pre interest.
¾Theoretically FCFF should be forecast from year one to year infinity. In practice a detailed forecast may be performed for several years and then an assumption made about a sustainable growth rate to perpetuity
¾As FCFF represents the cash flow available for distribution to all providers of finance (as interest or dividend) it should be discounted at the average return required by all providers of finance i.e. WACC
¾The result gives the total theoretical value of the firm
¾Value of the firm = value of equity + value of debt
¾In most situations we are only interested in the value of the equity. For example in an acquisition the predator company buys the shares of the target company, not its debts – it does however take over responsibility for the debts, reducing the equity value.
0712
|
SESSION 07 – BUSINESS VALUATION |
|
|
Value of the firm |
x |
Market value of debt |
(x) |
|
___ |
Value of equity |
x |
|
___ |
The equity valuation should reconcile to that from the FCFE model.
Example 5
Arrow plc is considering purchasing the entire share capital of Target plc.
Arrow operates on a five year planning horizon and believes that Target will be able to generate operating cash flows (after deducting funds for necessary reinvestment) of $1 million per annum before interest payments.
The following information is also relevant but has not been included in the above estimates.
(1)Target’s head office premises can be disposed of, and its staff can be relocated in Arrow’s head office. This will have no effect on the operating cash flows of either business but will generate an immediate net revenue of $2m.
(2)Synergistic benefits of $200,000 per annum should be generated by the acquisition.
(3)Target has loan stock with a current market value of $1.5m in issue. It has no other debt.
(4)Arrow estimates that in five years’ time it could, if necessary, dispose of Target for an amount equal to five times its annual cash flow.
Arrow believes that a WACC of 20% per annum reflects the risk of the cash flows associated with the acquisition.
Calculate the maximum price to be paid for Target plc. Ignore taxation.
Solution
0713
SESSION 07 – BUSINESS VALUATION
7VALUE ADDED METHODS
7.1Economic Value Added (EVA)™
EVA is simply a new name for the concept of residual income which was introduced in previous papers. However exam questions at this level are likely to be more challenging and therefore a more technical definition is required:
Adjusted earnings before interest and tax (see note) Tax on EBIT
Net operating profit
Less: capital invested × WACC
EVA
x
(x)
___
x
(x)
___
x
___
¾Note – EVA is actually a registered trademark of the US consultants Stern Stewart and Co. who suggest a large number of possible adjustments to EBIT. The main adjustments include:
Capitalisation and amortisation of all research and development expenditure;
Capitalisation but no amortisation of goodwill;
Capitalisation of assets under operating leases;
Use of economic depreciation which tries to measure the amount of cash that must be set aside for the replacement of non current assets.
¾Capital invested means the book value of equity + debt i.e. capital employed
¾Capital employed × WACC = minimum return required by investors = “normal” profit
¾EVA tries to measure “economic” profit as opposed to the financial accounting profit shown in the accounts. Economic profit represents the surplus profit being generated above the minimum level required by the company’s investors.
7.2Market Value Added (MVA)
¾EVA should be forecast from year one to year infinity. In practice a detailed forecast may be performed for several years and then an assumption made about a sustainable growth rate to perpetuity.
¾EVA can then be discounted to present value using the WACC.
¾Discounted EVA is known as Market Value Added (MVA).
¾MVA represents the theoretical excess value of the firm above book value.
0714
|
SESSION 07 – BUSINESS VALUATION |
|
|
Capital invested |
x |
MVA |
x |
|
___ |
Market value of equity + debt |
x |
|
___ |
7.3Shareholder Value Added (SVA)
SVA simply represents the change in shareholders’ wealth during a period. It measures the change in equity valuation per a free cash flow model and deducts any additional share capital injected during the period:
Theoretical equity valuation at end of year |
x |
Theoretical equity valuation at start of year |
(x) |
|
___ |
Increase in equity value |
x |
Additional equity finance introduced |
(x) |
|
___ |
SVA during the year |
x |
8PRACTICAL POINTS
¾When valuing any business it is important not only to provide a range of theoretical values using any of the methods discussed above but also to take into account any other practical information in the question.
¾Points worth considering:
are all of the assets of the business recorded? Particularly in the service sector there are likely to be many human resource assets.
will key employees leave after the acquisition and what effect would this have on the value?
do key staff have long service contracts?
do surplus staff have long service contracts with early termination penalties?
when forecasting future figures can these be based upon past figures or does the acquirer plan to make significant changes to the business?
who is the value being estimated for, the buyer or the seller?
are there any restrictive covenants in the target company’s debt agreements regarding takeovers?
are there other bidders who are likely to push up the price?
0715
SESSION 07 – BUSINESS VALUATION
Key points
Business valuation is not a science – different analysts use different techniques.
You need to enter the exam with a range of methods at your disposal and choose the most relevant depending what data is available and whether you are required to value a minority stake or the equity in total.
Cash flow-based methods are considered to be the superior approach for valuing the firm’s equity in total.
FOCUS
You should now be able to:
¾prepare and justify a range of values for a share or the entire equity of a business.
0716
SESSION 07 – BUSINESS VALUATION
EXAMPLE SOLUTIONS
Solution 1
Valuation of 200,000 shares |
= |
200,000 × P/E ratio × EPS |
|
|
= |
200,000 × 12.5 × |
(140,000 −20,000) |
|
400,000 |
||
|
|
|
|
|
= |
$750,000 |
|
Solution 2
Share price |
= |
Dividend |
|
Dividend yield |
|||
|
|
Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of unquoted company - say 13% (subjective)
Share value |
= |
|
12 |
|
0.13 |
|
|||
|
|
|
||
|
= |
92 cents per share. |
||
Estimated value of 2,000 shares = $1840
Solution 3
(i) |
Constant dividend Po = |
0.25 |
|
|
|
|
= |
$1.25 |
|||||
0.2 |
|
0.25(1.05) |
|
|
|||||||||
|
|
|
|
|
|
|
|
|
|
|
|
||
(ii) |
Constant growth in dividend Po = |
|
|
= |
$1.75 |
||||||||
(0.2 −0.05) |
|
||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
||
(iii) |
Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 |
= |
|||||||||||
|
|
|
|
|
|
|
|
|
|
|
$0.748 |
||
|
plus |
|
|
|
|
|
|
|
|
|
|
|
|
|
Present value of growing dividend from year 6 onwards |
|
|||||||||||
|
0.25(1.05) |
× |
1 |
|
|
|
|
|
|
= |
$0.703 |
||
|
|
(0.20 −0.05) |
1.25 |
|
|
|
|
|
|
||||
|
|
|
|
|
|
|
|
|
_______ |
||||
|
|
|
|
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|
|
|
|
|
$1.451 |
|
|
|
|
|
|
|
|
|
|
|
_______ |
||
(iv) |
Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 |
$0.748 |
|||||||||||
|
Present value of $2.00 in five years’ time = $2.00 × |
1 |
|
|
$0.804 |
||||||||
|
1.2 |
5 |
|
||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
||
|
|
|
|
|
|
|
|
|
|
|
_______ |
||
$1.552
_______
0717
SESSION 07 – BUSINESS VALUATION
Solution 4
Retention rate = 95.25/123.29 = 0.7726
g = 0.7726 ×0.072 = 5.56% |
|
||
Value = |
123.29 - 95.25(1.0556) |
= $1805m |
|
(0.072 −0.0556) |
|||
|
|
||
Solution 5
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
$m |
$m |
$m |
$m |
$m |
$m |
Operating cash flow |
|
1.000 |
1.000 |
1.000 |
1.000 |
1.000 |
Sale of head office |
2.000 |
|
|
|
|
|
Synergistic benefits |
|
0.200 |
0.200 |
0.200 |
0.200 |
0.200 |
Disposal |
______ |
|
|
|
|
5.000 |
|
______ ______ ______ ______ ______ |
|||||
Net cash flow |
2.000 |
1.200 |
1.200 |
1.200 |
1.200 |
6.200 |
PVF @ 20% |
1.000 |
0.833 |
0.694 |
0.579 |
0.482 |
0.402 |
Present value |
2.000 |
1.000 |
0.833 |
0.695 |
0.578 |
2.492 |
Present value |
$7.598m |
Less Value of loan stock |
($1.500m) |
|
_________ |
Maximum value of Target |
$6.098m |
Commentary
(1)The estimated disposal value of Target is included to compensate for Arrow’s short planning horizon. It is assumed that the estimated disposal value is an approximation of the present value of cash flows from year 6 onward.
(2)The market value of loan stock has to be deducted from the total value of the business to arrive at an equity value.
0718