STRATEGIC LEVEL

Subject Financial Strategy (F3)

Salman Faiz
Lecturer MBA(Distinction), BBA(First Class)Hons, ACCA Affiliate (Multi-subject prize winner), ACMA, CGMA

Module Study Session 4-03 - Valuation

Code F3/SF/21
 FS with Salman
Study Session 04-03 – Content

In study session 4-01 & 4-02 we have explored three main growth strategies (namely – acquisition,
merger, and divestment), but the execution of any of those strategies firstly require the valuation of the
target business.

Business/Company valuation is normally done using the below methods:

1. Asset based valuation

2. Earnings based valuation (P/E Method)
3. Dividend based valuation
4. Discounted cash flow based valuation

Note – Valuation amount also depends on whether the entity value (equity + debt) or equity value is
being considered.

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1. Asset Based Valuation

This method involves valuing a business by considering its individual asset values, where three types of
values can be derived based on the requirement:

i. Entity value = Fixed assets + Current assets – Current liability

ii. Equity value = Fixed assets + Current assets – Current liability – Long term liabilities

iii. Ordinary equity value = Fixed assets + Current assets – Current liabilities – Long term liabilities –
Preference shares

Note – Fixed asset value can be derived via; Book value or Net replacement value/Continuation value or
Net realizable value/ Breakup value or PV of future cash flows.

Advantages Disadvantages
• Provides minimum value of the company • True value of a business comes from assets
for negotiations (floor value) working together, so assets taken
• Good valuation method if the motive is separately might not represent the real
asset striping value of the business
• Are available/taken asset values accurate
• Future earnings capacity not considered
• Only tangible assets are considered
(Intangibles assets not considered)

The problem of intangible assets not being incorporated under asset base valuation can be rectified
by undertaking an intangible asset valuation technique, and adding that to tangible asset value
available or calculated.

Intangible Asset Valuation

Intangible assets are generally defined as knowledge base value creation, and can be theoretically
segregated to:

• Intangible Assets (intellectual capital) – Goodwill / Brands / Human resources

• Intellectual assets - Knowledge which is defined and codified such as drawing, computer
program or collection of data
• Intellectual property – Intellectual assets which can be legally protected such as patents,
trademarks and copyrights.

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There are two main methods available in valuing intangible assets:

a. Simple estimate
Value of Intangible Assets = Value of Equity* – Value of Tangible Assets

*Should be calculated using;

• Market capitalization (MPS * No. of shares)
• Earnings based
• Dividends based
• Cash flow based
b. Calculated Intangible Value (CIV) method

This method involves comparing the earning from tangible assets of the company with that of
industry, and if the company’s earnings are superior that additional amount is recognized as value of
intangible assets. CIV calculation depends on how information is given:

Option 01 Option 02

Step 1 - Calculate the ratio of average profit Step 1 – Apply industry ratio (average profit
before tax to average tangible assets of the before tax to average tangible assets) to
company and the overall industry separately company’s tangible assets

Step 02 – If the company’s ratio is superior to Step 02 – Compare the above value with the
industry, the excess percentage is multiplied to company profit before tax
the company tangible asset value to get the
value of intangibles Step 03 – Convert the above excess value to post
tax
Step 03 – The above value is converted to post
tax Step 04 – Assume the above value is perpetual,
and calculate PV using company WACC or
Step 04 – Assume the above value is perpetual, Industry COC.
and calculate PV using company WACC or
Industry COC.

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2. Earnings Based Valuation (P/E Method)

If the company is already quoted we will have a readily available share price (and we can assume share
price represents future earnings capacity of the business), and we can use this to derive the equity value
of the business.

But if a company is unquoted, then a readily available share price will be unavailable (unless there was a
recent private share transaction), then we can use what is known as proxy (similar quoted) company PE
method. Once the value is derived from this method we normally discount it by 25% - 35% due to lack of
marketability and higher risk of an unquoted business vis-à-vis to a quoted business.

Note – in doing the proxy PE method we use proxy company PE ratio, and the target company current
earning (PAIT), however current earnings is actually a historic figure and should be adjusted for future
considerations (as shown below) to make it more representative.

- Non-recurring one off items should be removed (Ex:- Disposal profit or loss on NCA)
- New salaries after takeover should be included
- Savings due to synergistic effect after takeover should be included
- Preference dividend should be removed to get the true (ordinary) equity value

Advantages Disadvantages
• Commonly used • Difficult to identify a suitable P/E ratio for
• Easily understood an unlisted entity
• Difficult to establish earnings
• Based on accounting profits rather than
cash flows

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3. Dividend Based Valuation (DVM or DGM)

As identified under study session 13, we can also use the DVM and DGM methods to get the present
value of equity, but this time around we will assume dividend, cost of equity, and growth rate (as
appropriate) are known and then business valuation is done.

• If constant dividend paid

𝑑𝑜
𝑃𝑜 =
𝐾𝑒

• If dividend paid with constant growth rate

𝑑𝑜 (1 + 𝑔)
𝑃𝑜 =
𝐾𝑒 − 𝑔

Note 1 – if the dividend used is ‘just paid’ then the value derived is known as ex-dividend value.

Note 2 – If the dividend is ‘just about to be paid’ the value derived does not represent the true value
because with the dividend payment expectation the value is likely to be higher with the payoff
expectation, thus we can add the dividend to the derived value to get the cum-dividend value.

Note 3 – if dividends are not available we can use the earning as a substitution and undertake the
valuation.

Advantages Disadvantages
• Value is based on the PV of the future cash • Forecast may be inaccurate
income (dividend) • It can be difficult to identify the Ke
• Appropriate for valuing the shares for IPO • Consistent dividend policy and consistent
and of minority shareholders growth rate is unlikely for a real world
company

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4. Discounted Cash Flow Based Method

This method involves forecasting future net cash flows (NCF) of the business and then discount from an
appropriate rate to get the present value of the business. We can use this method to derive the entity
and equity value separately.

Entity Value (equity + debt) Equity Value

Profit after interest and tax + After tax

Profit after interest and tax
interest
WACC Ke

*information relevant to both equity and debt *information relevant to only equity holders
taken for valuation taken for valuation

*although profit values are taken as NCF, we know profit is on accruals accounting and that even non-
cash items are involved, thus we can get a better NCF by undertaking the below free cash flow
calculation.

Free Cash Flow

FCF to Firm = PAIT + After tax interest + FCF to Equity = PAIT + Depreciation - Increase in
Depreciation - Increase in WC - Increase in CAPEX WC - Increase in CAPEX - Debt repayment

Entity Value = FCF to Firm / WACC Equity Value = FCF to Equity / Ke

Advantages Disadvantages
• Considered as best method of valuation • Forecast may be inaccurate
with future prospects considered • Discount rate may be inaccurate
• Time value of money considered • Difficult to determine planning horizon and
• True value of the entity can be identified value beyond planning horizon
• Basic NPV method does not evaluate
further options available on the investment
• Risk factors may not be considered
• It assumes tax rate and discount rates are
constant through the period

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Study Session 04-03– Practice Questions

Asset Base Valuation

Q1. Sari is a family owned company that manufactures parts to the motor industry. The entity has been
struggling in recent years and the owners are now considering their options.

Extracts from the latest accounts show the book value of their assets to be worth:

The company has trade payables standing at $0.66m and the bank overdraft is now at

$2.15m. The non-current assets would only be worth 42% of the book values if sold immediately.
Similarly, the inventory would realise $0.32m if disposed of today. A factoring company has valued the
trade receivables at 72% of the book value.

The net cash available to distribute to the shareholders if the business did NOT continue as a going
concern is $____________________ (INSERT CORRECT FIGURE IN THE BOX)

Q2.

What is the value of Asad Co's intangible assets?

A $1.672m
B $1.314m
C $1.210m
D $0.951m

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Q3. UUU Co is a financial services company based in the USA.

It reported a profit before tax in the most recent financial year of USD 28.5Mn, and the value of its
tangible assets is USD 210Mn.

The average return on tangible assets for firms in the financial services industry is 9%. The tax rate is
25% and UUU Co’s cost of capital is 14%.

What is the value of UUU Co using the CIV approach?

A USD 51.4Mn

B USD 217.2Mn

C USD 238.5Mn

D USD 261.4 Mn

Q4

Company XX is using the Calculated Intangible Value {CIV} company valuation method to value its
intangible assets.

Key data:

• XX has a WACC of 12%, cost of debt of 7% and cost of equity of 14%

• Net profit before tax for XX is $50 million
• XX’s tangible assets are $67 million
• Average industry return on tangible assets is 16%
• Corporate income tax is 20%

Complete the following CIV calculation:

CIV = [$50 million – ([UNKNOWN FIGURE 1] X $67 million)] X [UNKNOWN FIGURE 2]/ 0.12

[UNKNOWN FIGURE 1] is

A 0.16
B 0.12
C 0.07
D 0.14

[UNKNOWN FIGURE 2] is

E 0.80
F 0.20
G 1.20
H 1.80

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Q5

You are a management accountant working for Mega Co.

The directors of Mega Co have asked you to prepare some business valuation calculations for a potential
target company, Mini Co.

They are particularly keen for you to use an asset based valuation method.

Which THREE of the following are potential problems with valuing Mini Co using an asset based
method?

A The asset based method might under-value Mini Co if it has significant intangible assets

B The asset based method might over-value Mini Co if it has recently revalued its non-current assets

C The asset based method will not be useful if Mini Co has been making losses in recent years

D The asset based method ignores the future prospects and earnings potential of Mini Co

E Mega Co, as the acquiring company, will be interested in the replacement cost valuation of Mini Co's
assets, but replacement costs might not be readily available.

PE Based Valuation
Q6. Alpha Co has a P/E ratio of 16 and post-tax earnings of $200,000. Beta Co has a P/E ratio of 21and
post-tax earnings of $800,000. Gamma Co has a P/E ratio of 20 and post-tax earnings of $600,000.

What is the rank order of the size of these companies, ranked by value? (largest first)

A Alpha, Beta, Gamma

B Alpha, Gamma, Beta
C Gamma, Alpha, Beta
D Gamma, Beta, Alpha
E Beta, Gamma, Alpha
F Beta, Alpha, Gamma

Q7. GGG Co is intending to take over FFF Co.

GGG Co has a P/E ratio of 10 and post-tax earnings of $5m, and FFF Co has a P/E ratio of 8 and post-tax
earnings of $3m.

GGG’s directors estimate that if they were to acquire FFF there would be annual synergies of $0.5m for
the new combined company. Additionally they estimate that the P/E ratio of the new company would be
9.5.

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On the basis of these estimates, what is the maximum that GGG should pay for the entire share capital
of FFF?

A $24.00 million
B $30.75 million
C $33.25 million
D $80.75 million

Q8. Company A and Company B operate in the same industry, but have different price earnings (P/E)
ratios as follows:

P/E ratio

Company A 8

Company B 15

Which of the following is the most probable explanation of the difference in the P/E ratios between the
two companies?

A Company B has a greater profit this year than Company A

B Company B is higher risk than Company A
C Company B has higher expected growth than Company A
D Company B has higher gearing than Company A

Q9. A company has 70,000 issued shares at 50c per share which are currently trading for 204c.

The company paid $6,000 in dividends to ordinary shareholders and $2,000 to preference shareholders.
Profit after taxation was $17,000 and $10,000 was paid in taxation.

What is the Price Earnings (P/E) ratio of the company?

A 5.3
B 8.4
C 9.5
D 15.8

Q10. A high P/E ratio is usually seen as an indication that:

A The company's earnings are poor

B The company is likely to grow
C The share is over priced
D The dividend is excessive

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Q11. The following data is available for Pop Inc:

P/E ratio : 10

Dividend cover : 4 times

Share capital : $2 million in 25c shares

The dividend is 2c per share

What is the total market price of Pop Inc?

A $1.6 million
B $6.4 million
C $8 million
D $64 million

Q12. Clare Co is looking to value 100% of its equity.

It currently has a profit after tax of $1.5 million, but this includes an element of profit from the sale of
land of $0,325 million. A suitable P/E ratio is 8.

What is the value of Clare Co using a P/E ratio method?

A $9.4 million
B $12 million
C $15.3 million
D $18.7 million

Q13. The directors of Veena Co, an unlisted entity, want to value the entity's shares using the

P/E method.

The entity recently reported a profit after tax of $800,000 - which the directors think is sustainable for
the future.

They have found a similar company that is listed that has a P/E ratio of 10. From a full review it is
thought that Veena Co is worth about 25% less than the listed company.

What is the value of Veena Co, using the P/E method?

A $4.3 million
B $6 million
C $8 million
D $10.4 million

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Q14. Company A is owned by its three directors and they want to sell the business.

The current profit after tax is $500,000. At the moment the directors are only paid small salaries as they
take most of their returns in the form of dividends.

Once the company is sold, the cost of directors' salaries in Company A will need to be increased by
$40,000 in total to attract sufficiently high quality new directors.

A suitable P/E ratio is 5 and the tax rate is 30%.

What is the value of Company A, using a P/E valuation?

Dividend Based Valuation

Q15. An all equity company is just about to pay a dividend of $0.60 per share. The company confidently
expects the dividend to grow at 10% a year. The company has estimated its cost of capital to be 13%.

What would you expect the current quoted share price to be?

A $22.00
B $22.60
C $20.00
D $20.60

Q16. Jenduri is a private company that is considering listing its shares for the first time on a local stock
exchange via an initial public offering (IPO). They intend to list 30% of their 4 million shares on to the
market.

The company advisors have prepared the following schedule of equity valuations per share:

What is the most appropriate valuation for the IPO?

A $0.50
B $1.72
C $2.34
D $3.35

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Q17. Zudun Co's is a quoted company with an equity market value of $598m. Their last reported profit
after tax was $52m. ETA Co is a family owned business that operates in the same industry as Zudun Co.
ETA's board of directors is considering either a trade sale or a listing via an IPO.

Financial data relating to ETA Co:

Issued ordinary share capital ($1shares) 3m

Profit after tax $11.12m
Recently paid dividends $3.34m
Estimated cost of equity 10%

Assume that retained profit is fully invested in new projects at least generating an equivalent to Ke
rate.

Complete the following schedule relating to ETA Co to 2 decimal places:

EPS $
Value per share using dividend valuation $
modelper share using the P/E model
Value $

Cash Flow Based Valuation

Q18. Win Co wishes to ascertain the value of its equity. It has prepared the following schedule of
forecast post-tax cash flows before financing charges:

Year 1 Year 2 Year 3 Year 4

Sm 283 291 298 305

The forecast year 4 cash flows are expected to grow at rate of 3% per annum after year 4 into
perpetuity. Win Co has a cost of equity of 15% and a WACC of 12%. The entity's debt is believed to be
worth 30% of the total value of the entity.

What is the value of Win Co's equity?

A $891m
B $2,178m
C $2,536m
D $3,111m

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Q19. The expected after-tax cash flows of Thomas, an all equity financed company with 2Mn shares in
issues, will be as follows:

Year GBP

1 120,000

2 100,000

3 140,000

4 50,000

5 onwards 130,000

A suitable cost of capital for evaluating Thomas is 12%.

What is the valie of Thomas’s equity (in total) using the DCF basis of valuation?

A GBP 392,050

B GBP 1,006,300

C GBP 1,007,340

D GBP 1,475,383

Q20. Eden Inc has recently published its latest accounts showing profit after tax of $23.12m, after
deducting interest of $4.89m. Tax allowable depreciation was $4.55m and the company expects profits
to grow at 5% per annum indefinitely.

The company policy is to maintain its asset base by reinvesting cash to a value equal to the tax allowable
depreciation. Eden has estimated its cost of equity at 12%, which is included in the company WACC of
10%

Assuming that profit after tax is the equivalent to cash flows, what is the value of the equity capital?

A $346.80m
B $485.52m
C $588.21m
D $683.76m

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Q21. The most recent financial statements for Nye Co show the following:

$000
Interest 210
Investment in Non-Current Assets 378
Dividends 134
Operating Profit 879
Investment in Working Capital 143
Depreciation 167
The company pays tax on company profits at the rate of 22%.

What is Nye Co's free cash flow (to the nearest $000)?

A $68,000
B $168,000
C $332,000
D $335,000

Q22. Which of the following correctly describes the discounted free cash flow method that can be used
to value an entity's equity?

A Deduct interest and dividends in arriving at the forecast free cash flows and then discount the
latter at the cost of equity
B Discount the forecast free cash flows at the entity's WACC and then deduct the market value of
the entity's debt
C Forecast the free cash flows, without deducting taxation, and discount these at the entity's
WACC
D Deduct interest but not dividends in arriving at the forecast free cash flows and then discount
the latter at the cost of equity

Q23. Tanu Inc has 1 million $0.50 par value shares in issue. It generated free cash flow of $1.5 million
last year and expects this figure to grow by 4% per annum in the future.

Tanu Inc has a cost of equity of 14% and a WACC of 10%. It has $500,000 of bonds in issue, trading at
$80 per $100.

What is the estimated value of a Tanu Inc share?

A $7.80
B $12.80
C $15.60
D $25.60

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Q24. After months of planning, Thierry Co released news to the market of its expansion strategy.

Prior to the release, Thierry had a market capitalisation of $42.6 million, an authorised share capital of
$1 million and an issued share capital of $500,000 (made up of 50 cent shares).

The expansion strategy is expected to generate an NPV of $5 million.

Assuming strong form market efficiency, what will be the effect on Thierry's share price?

A Increase by $10
B Increase by $5
C No change
D Increase by $20

Q25. A company is planning to sell a wholly owned subsidiary (B) on 1 January 20X1 and is preparing a
valuation for B as at that date using a discounted cash flow approach.

Additional information:

• The net operating cash flows of B are forecast to be $250 million in the year to 31 December
20X1 and are expected to remain at this level every year thereafter.
• New equipment at a cost of $200 million will need to be paid for on 1 January 20X1. Tax
depreciation allowances can be claimed over 4 years on a straight line basis on this equipment.
• The corporate income tax rate is 30%. Tax is paid a year in arrears.
• Assume all cash flows arise at the end of the year unless stated otherwise.
• B has a financial year ending 31 December each year.

The trainee accountant has begun to produce an analysis of net cash flow for the valuation which is
shown below. All figures are in $ million.

Select the TWO grid points that contain an error.

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Additional OTQs

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