Business valuation is ‘an art not a science’.

These are the words used by many ACCA

financial management tutors (including myself) when introducing this topic to students
preparing for Advanced Financial Management. The words imply that when trying to
value the equity capital of a business, there is range of possible correct answers, all of
which can be justified as being the most appropriate. To a certain extent this is true but,
as I like to put it, ‘there are different degrees of correctness’.

Questions on Business Valuations are included in every Financial Management exam.

The questions have typically tested the ‘basic’ equity valuation methods of:

 net assets
 dividend valuation model (or dividend growth model)
 earnings model using P/E ratio or earnings yield

The Advanced Financial Management syllabus builds on those methods tested at the
lower level paper. The concept is the same – to find the value of equity. However, the
techniques and methods are more sophisticated. As I stated above, ‘there are different
degrees of correctness’.

The primary purpose of this article is to demonstrate how to tackle an Advanced

Financial Management business valuation question. The detailed understanding of this
topic will be gained from your studies, whichever mode you choose to use. My aim is to
show you how to successfully apply this knowledge under exam conditions.

Equity valuation – categorising the methods

As stated above, there are more methods and models that can be used to find an equity
share price in Advanced Financial Management. The official textbooks explain these in
detail and choose different ways of categorising them within their material. I prefer to
take a simple view of equity valuation by allocating the methods into two main
categories:

 Pre-acquisition
 Post-acquisition

Under the first category, the question will be asking the students to ascertain an equity
value for a company. The entity may be a private company and, hence, no stock market
price exists or that even if the company is listed, the market price may not be
appropriate for the relevant situation. The valuation methods appropriate here are:

 net assets
 dividend valuation model (or dividend growth model)
 earnings model using P/E ratio or earnings yield
 net assets + calculated intangible value (CIV)
 free cash flows (FCF)

Past questions have, in my view, clearly indicated which method should be used to
arrive at the share price. However, it is fair to say that the free cash flow model has
been tested more than any other method.

Post-acquisition valuation requires a different mindset and series of methods. Here,

students will need to ascertain the value of the combined companies after acquisition.
More importantly, past exam requirements have requested students to ascertain the
percentage gain or loss to both groups of shareholders – those of both the buying and
selling companies.

The post-acquisition valuation methods are:

 bootstrapping – applying the price earnings ratio of the buyer to the combined expected
earnings of the two entities
 combining the pre-acquisition values of the two companies and appending these with
the fair value of the synergies
 free cash flows (FCF) – present value of the combined companies FCF using the
relevant discount rate.

As I have stated above, your preparation should include ample time to study and
understand the equity valuation methods above, allowing you to apply your knowledge
successfully in the exam room.

Below is a worked sample question illustrating how I would tackle a 25-mark exam style
question, based broadly on previous exam content.

Borgonni and Venitra

Borgonni Co is a very successful entity. The company has consistently followed a
business strategy of aggressive acquisitions, looking to buy companies that it believes
were poorly managed and hence undervalued. Borgonni can be described as a modern
day conglomerate and its business interests stretch far and wide.

Its board of directors has chosen the takeover targets with care. Always looking for
companies with potential, but which were poorly managed and having a below par
market value, Borgonni has maintained its price earnings (P/E) ratio on the stock market
at 12.2.

Borgonni’s 20X3 figures show a profit after tax of $886m and it has 375m shares in
issue.

Venitra Pvt is a well-established owner-managed business. In financial terms it has a

rather chequered history with its up and downs corresponding directly with the state of
the global economy. Over the past five years, its profits have fallen each year with the
20X3 values standing at:

$m

Revenue 1,500

Operating profit 480

Interest (137)

Profit before tax 343

Taxation @ 25% (86)

Profit after tax 257

Number of shares in issue 150m

 $m

EPS $1.72

However, with economists predicting an upturn in the Western economies, Venitra’s

management team feel that revenue will increase by 6% per annum up to and including
20X7. The company’s operating profit margin is not expected to change for the
foreseeable future.

Operating profits are shown after deducting non-cash expenses (including tax allowable
depreciation) of $125m. This is expected to increase in line with sales. However, the
company has recently spent $210m on purchase of non-current assets. Venitra’s
management believes this value will have to increase by 10% per annum until 20X7 to
enable the company to remain competitive. Venitra has estimated its overall cost of
capital to be approximately 12%, but this assumes it will maintain its debt to equity ratio
at 40:60.

Some of Venitra’s major shareholders are not so confident about the future and would
like to sell the business as a going concern. The minimum price they would consider
would be the fair value of the shares, plus a 10% premium. Venitra’s CFO believes the
best way to find the fair value of the shares is to discount the forecasted free cash flows
of the firm, assuming that beyond 20X7 these will grow at a rate of 3% per annum
indefinitely.

Requirement
(a) As at 1 January 20X4, prepare a schedule of Venitra’s forecast free cash flows for
the firm. Ascertain the fair value of the Venitra’s equity on a per share basis.
(10 marks)

(b) Borgonni intends to make an offer to Venitra based upon a share for share swap.
Borgonni will exchange one of its shares for every two Venitra shares. Assuming that
Borgonni can maintain its earnings rating at 12.2, calculate the percentage gain in
equity value that will earned by both groups of shareholders?
(8 marks)

(c) What factors should the Venitra shareholders consider before deciding whether to
accept or reject the offer made by Borgonni?
(7 marks)
(25 marks)
 Solution


At this stage, you can choose one of two ways to follow my approach to answering
this question. My solution to each part along with the relevant explanation is shown
below.

(a) Venitra – Forecast Free Cash Flows and Value of Equity

Notes and explanations:

1. As we are preparing a valuation as at 1 January 20X4, I have set up columns for each
future period. I need to prepare a detailed forecast for the first four years only. After
20X7, the FCF of the firm will increase at the rate of 3% per annum. I have started with
a 20X3 column just as a reference point.
2. Revenue has been increased by 6% per annum using the 20X3 sales as a base point.
3. The operating margin in 20X3 was 32% (480/1,500). This will be maintained for the
foreseeable future.
4. One key factor is to ignore the interest payment. FCF for the firm must EXCLUDE
interest. This is because the cost of capital used to discount these flows is the company
WACC. The WACC takes into account the interest element and its tax benefit.
5. Income tax on company profits is charged at 25%. In this case, it is to be paid in the
same year as the profits are earned.
6. The operating profit is after deducting non-cash expenses, which are allowable for
taxation. These include tax allowable depreciation. In this question, these expenses will
increase in line with sales and they have to be added back after the tax charge has
been computed.
7. Venitra needs to set aside cash each year to maintain its non-current asset (NCA) base.
The amount of capital expenditure will increase by 10% per annum for the next four
 years.
Please note that in some past questions, it has been assumed that the non-cash
expenses equal the required investment in NCAs. Hence, the add back and deduction
will cancel out.
8. The forecast FCF for the firm is a simple totalling up process for the first four years.
After 20X7, the FCF are expected to grow at a rate of 3% per annum indefinitely.
Therefore, the 20X8 value is calculated as $305m x 1.03.
9. As stated in point 4, the relevant discount rate to apply to the FCF of the firm is Venitra’s
WACC. This has been estimated as 12%. The first four discount factors have been
copied from the discount tables provided at the end of the exam paper. The discount
factor for 20X8 and beyond must take into account both a 3% per annum growth rate as
well as a cost of capital of 12%. The financial mathematics for a delayed perpetuity with
an annual growth rate is (1/(0.12 – 0.03) x 0.636).
10. The value of the entity is the total of the present value of the forecast FCF. However,
this amount represents a combination of the debt and equity together. Venitra’s equity is
equal to 60% of the value of the firm.
11. The question requirement is to ascertain the equity value per share. Therefore, $1,866m
/150m = $12.44. This is the fair value of one share of Venitra.
12. Finally, I have computed the P/E ratio for Venitra. Although this was not specifically
asked for, this value will be needed for part (b).

(b) Percentage gain in equity value – both groups of shareholders

The first stage is to compute the current market price per share for Borgonni:

$m

20X3 – Earnings 886

x
 $m

P/E ratio 12.2

Value of equity $10,809m

No of issued shares 375m

Value per share (Po) $28.82

Borgonni expects to maintain its P/E ratio after acquiring Venitra. Therefore, the post-
acquisition value of the two entities combined together can be ascertained by applying
Borgonni’s P/E ratio to the sum of the latest earnings of each company. As the P/E ratio
of Borgonni (12.2) exceeds that of Venitra (7.23) this is known as ‘bootstrapping’.

$m

Borgonni – 20X3 PAT 886

Venitra – 20X3 PAT 257

1,143

P/E ratio – Borgonni 12.2

 $m

Post-acquisition value $13,945m

The purchase is to be funded via a share for share exchange. Borgonni will issue one
new share in its company in return for every two shares in Venitra.

Borgonni issued share capital 375m

Additional shares issued (150m/2) 75m

New total issued share capital 450m

The new equity value for a Borgonni share is now $13,945m/450m = $30.99.

However, although many candidates may stop at this point (believing they have reached
Utopia!) the requirement has not been addressed. The question asks candidates to
ascertain the gain that will be made on the equity value to each group of shareholders.
Looking at each in turn:

Borgonni shareholders’ gain (($30.99 – $28.82)/$28.82) x 100 = 7.53%

To compute the gain for the Venitra shareholders, the candidate must first compute the
post-acquisition value of a Venitra share. Venitra shareholders gave up two shares in
their company to receive one new Borgonni share. Therefore, the equivalent post-
acquisition value of a Venitra share will be $30.99/2 = $15.50.

The fair value of a Venitra share, per part (a), was $12.44. Therefore, the Venitra
shareholders gain 24.60%.

(c) Factors to consider – for the Venitra shareholders

There is no one correct answer to this part. As long as the candidate produces a
reasonable number of valid points, they will earn decent marks.
 My answer would read as follows:

 Venitra shareholders wanted a gain of at least 10% on the fair value of the shares.
Based upon the figures, they are gaining nearly 25%, which is likely to encourage them
to accept the offer.
 The share for share exchange may be beneficial for tax planning. Any capital gain
earned on the sale of the shares will be rolled over until the gain is realised in cash.
 Venitra may decide to reject this bid believing that Borgonni will make a more lucrative
offer in the future.
 The fair value of the Venitra shares has been based upon forecasts and estimates.
Some sensitivity analysis needs to be carried out to ensure the value is robust.
 There is no guarantee that Borgonni can maintain its P/E ratio at 12.2. There may well
be an element of dilution given the much lower P/E of Venitra. Hence, the post-
acquisition value is then uncertain.
 Not all Venitra shareholders want to sell the company. The constitution of the company
may allow the takeover to be blocked unless a certain percentage majority of the
shareholders agree.
 Venitra shareholders may also feel that as the economic conditions are improving, their
business prospects and value will get better. They may reject Borgonni’s approach and
stay as an independent company.

As you can see, business valuation questions require you to have a disciplined
approach and to demonstrate that you have studied and understand this key area of the
syllabus. Although equity valuations are an ‘art not a science’, you have to produce an
answer that is pleasing to the eyes of the examining and marking team.

Sunil Bhandari, freelance tutor

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