Lecture 4

Company Valuation

www.bradford.ac.uk/management

Learning Objectives
Value a company and its shares using: Net Assets Value method Price:Earnings Ratio method Discounted Cash Flow method Discuss the limitations of these three methods
Reading: Pike and Neale: Ch 12

Company Valuation
WHY do we want to value companies?
Armed with knowledge of valuation principles:
we can value acquisition candidates (and also assess own firms value when defending!) valuation for privatisation valuation for flotation (IPO - Initial Public Offerings)

How Do We Value Companies?

Quoted Companies
do we trust the market value? is the stock market efficient?

Unquoted Companies
use various techniques of valuation

The Three Basic Valuation Methods

Net asset value (from the Balance Sheet) Price-earning multiples (focus on the P&L) Discounted cash flow /Shareholder value analysis

Remember Your Accounting!

What did the accounting equation say? Assets dont grow on trees! i.e. every asset has to be financed somehow Total Assets = Total Financing = [Equity + Debt] Valuation methods tend to focus on equity value i.e. value of net assets:

Net Asset Value / Equity Value = [Total assets - total debts]

Total Company Value vs.Equity Value

Total Company Value is also called Enterprise Value (= equity + debts)

How to acquire a firm:

a) to buy a whole company, ie, buy equity and pay off the debt. It is usually more expensive.
b) to buy out the owners equity stake and to take responsibility for the debt. usually, carry the debt on (assume it)

Net Asset Value (NAV)

Remember, NAV = Net Assets = Value of Shareholders Stake
From the accounts:
NAV NAV

Total Assets

Total Liabilities Current Liabilities

Fixed Assets = + Current Assets

+ Long-term Debt

Illustrative Example
Shark vs. Minnow Shark proposes to take over Minnow
Assume:
Minnows depreciation charge = 0.3m p.a.

Shark vs. Minnow extracts from accounts

Shark m 12.2 7.3 (2.2) (3.5) 13.8 10.0 3.8 13.8 2.4 2.40 24p 10:1 Minnow m 3.5 3.7 (1.1) (0.5) 5.6 5.00 0.2 0.4 5.6 1.5 n/a 30p n/a

Fixed assets (net) Current assets Current liabilities 10% long-term loan stock(bonds) Net assets Ordinary share capital (par value 1) Share premium Profit and Loss Account Shareholders funds Profit after tax attributable to ordinary shareholders Current market price/share EPS P:E ratio

NAV of Minnow
What is NAV of Minnow? NAV = [FA + CA - CL - LTD] = [3.5m + 3.7m - 1.1m - 0.5m] = 5.6m
Or, in terms of value per share NAV = 5.6m/5m = 1.12 per share But what is the value of the whole company? Total assets: 3.5 + 3.7 = 7.2m

Problems with the NAV

Fixed Assets usually valued at Historic Cost Some debtors may not be collected Are there any off-balance sheet liabilities? Are the accounts reliable? Window dressing/creative accounting Fundamental Problem: Ignores Earning Power of the Assets

Price:Earnings Multiples
Remember, P:E ratio = Price per share Earnings per Share EPS (Earnings per Share)= Profit after Tax / No of (ord.) Shares For example, Suppose EPS = 20p and a share price = 2 P:E ratio = 2 / 0.2 = 10:1

Price:Earnings Multiples
Indicates how the market values each 1 of firms profits Suggests how quickly firm will recover its current share price via earnings High PER indicates good growth potential

Price:Earnings Multiples
Alternatively, P:E ratio = Value of equity Profit after tax ( value of equity = share price x no of shares) Value of equity = [Profit after tax] x [P:E ratio]

P:E Valuation of an Unquoted Company

Take the P:E Ratio for a comparable quoted company - Shark? ie, P : E = 10 Apply to maintainable profits of target firm Minnow: Value of equity = [Profit after tax] x P:E ratio = 1.5m x 10 = 15m Value per share = 15m / 5m = 3 Lower the P:E ratio, lower the valuation -- e.g. if P:E = 6, value of equity = 1.5 * 6 = 9m

Problems with the P:E Approach

Uses accounting profits as a basis, with all its distortions e.g. inter-company comparisons suspect How close a fit is the surrogate? different mgt. ability, markets, products, etc i.e. different growth capacities

Comparability of quoted and unquoted companies stock market awards a premium for size, stability and marketability

EBITDA
Earnings (profit) Before Interest, Tax Depreciation and Amortisation

A more cash-oriented yardstick

Rough guide to operational cash flow

Often combined with capital employed to yield Cash Flow Return on Investment CFROI = EBITDA/Capital Employed Used on a comparative basis i.e as a cross- check on value

Discounted Cash Flow (DCF)

The DCF model states that the value of the owners stake in a company is the sum of future discounted free cash flows:

FCFn FCF1 FCF2 V0 ... 2 (1 r ) (1 r ) (1 r ) n

Where FCF = Free Cash Flow r = the rate of return required by shareholders.

What is Free Cash Flow?

Free cash flow cash left in the company after meeting all operating expenditures, all mandatory expenditures such as tax payments and investment expenditure.

Free cash flow (FCF) = Operating profit + Depreciation Interests Taxes Investment expenditure

Discounted Cash Flow (DCF)

Predict future cash flows from operations Roughly, profit after tax, plus depreciation Adjust for known investment needs e.g. to replace worn-out equipment, expansion Result is FREE CASH FLOW Discount at shareholders required return Value of equity = Sum of discounted FCFs

Minnows Cash Flows

How much is the cash flow? CF = Profit after tax + Depreciation (roughly) = [1.5m + 0.3m] = 1.8m How much investment is required to replace worn-out assets (replacement expenditure)? assume this expenditure = depreciation charge FCF = [1.8m - 0.3m] = 1.5m

Minnows Value
Lifetime of company? -- Assume perpetuity Recall the formula for calculating PV of a perpetuity
PV perpetuity C r

Value = Free Cash Flow / Discount rate

-- Assume investors require 15% return

Value of equity = 1.5m / 15% = 10m

Value per share = 10m / 5m = 2

Problems with the DCF Approach

Still based on accounting figures i.e. PAT Can the future investment be accurately predicted? Assessing the required return Assessing the relevant time horizon if less than perpetual, what to assume for later years? No further cash flows??

So what have we learned??

How to value a company by applying
- NAV

- P:E ratio and

- DCF

The limitation of each method.

Thank you !