BUSINESS AND SECURITIES VALUATION

Shareholder Value
 Value Based Management – value is created when companies invest capital at returns that
exceed the cost of that capital.
 Value drivers – key drivers that affects the value of the company. They should be ranked in terms
of their impact on value and responsibility assigned to individuals who can help the organisation
meet its target
 Shareholder Value Analysis (SVA) – Framework for evaluating options for improving shareholder
value by determining the trade-offs between reinvesting cash in the company, distributing cash to
shareholders and investing in new business. SVA is an approach to financial management which
focuses on total return to shareholders in terms of both dividends and price growth, calculated as
the present value of future free cash flows of the business discounted at the weighted average
cost of capital of the business less the market value of its debt. SVA can aid managers in
focusing on activities which create value instead of short term profitability. A difficulty with this
method is the clarifying of a terminal value at the end of the planning horizon, which could be as
much as five to ten years.
 Economic Value Added (EVA) – Excess of Net operating profit after tax over capital charge
(WACC x Capital Employed). EVA adds to shareholders value
 Cash Flow Return on Investment (CFROI) – It represents the discount rate at which the
discounted future annual cash flows expected to be generated over the useful life of a firm’s
assets are equal to the current cash value of the firm’s net operating assets.
 Market Value Added – Market value of debt + Market value of equity - Book value of debt – Book
value of equity; MVA is related to EVA because MVA is simply the present value of the future
EVAs of the Company. Also measured as MVA / Book value; high MVA indicates that the
company has created wealth for its shareholders.
 Total shareholder return = (Share price at end – Share price at beginning) + Cash paid to
shareholders / Share price at beginning. Can be used for listed companies only.
Valuation Techniques

 Asset Based Model

 Market Relative Model
 Dividend Valuation Model
 Dividend Yield Model
 Discounted free cash flow model
 Economic Value Added
 Adjusted Present Value Approach
Asset Based Model (Cost Approach)

 Work out NAV by using fair values. Exclude intangible assets unless they have
market value such as patents and copyrights.

 Problems exist in selection of valuation bases – replacement or realisable, going

concern or break up value.

 Asset Basis of valuation normally provides the lower value for share valuation for
profitable companies. This may be relevant for loss making companies but this also
carries complications
 It is also used as a measure of comparison in a business combination – two
companies may have different asset base that may warrant a premium.
Asset Based Valuation – Impact of IFRS 13

 Under the fair value approach asset and liabilities are revalued periodically to reflect
changes in their value
 Financial instruments have to be “marked to market” under IAS 39 or IFRS 9
 Fair value is defined “as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date”
 The standard requires that the following are considered in measuring fair value:
 The asset or liability being measured
 For a non financial asset, the highest and best best use of the asset
 The principal market of the asset (where the most activity takes place) or where there is no
principal market, the most advantageous market (in which the best price could be obtained)
in an orderly transaction
 Valuation techniques (fair value hierarchy)
 Three level hierarchy for the inputs used in valuation”
 Identical assets
 Inputs other than quoted prices that are observable for the assets or liability eg any quoted
price for similar assets in active markets or for identical or similar assets in non quoted
markets. E.g. interest rates, yield curves, interest rate swaps or forward foreign currency
contracts
 Unobservable inputs: ie. Using the best available information, including entity own data and
assumptions about market exit value e.g..private equity or venture capital
Asset based valuation in M&A

 Under IFRS 3, subsidiary assets and liabilities must be measured in fair value except
in limited cases
 Non current assets – the highest and best use of the asset
 Restructuring and future losses cannot be considered
 Contingent liability must be provided
 Intangible assets must be identifiable:
 Separable and can be transferred or exchanged either individually or together with a related
contract asset or liability
 Arises from contractual or legal rights
 Some of intellectual capital includes –patents, trade marks and copyrights, franchises and
licensing agreements, R&D, Brands, Technology, management and consulting process,
know how, education, vocational qualification, customer loyalty, distribution channels and
unique methods of distribution, management philosophy, quality and skill of employees
 Exceptions to the IFRS 13 principle:
 Deferred tax – IAS 12 values
 Employee benefits – IAS 19 values
 Indemnification assets – employee benefit or a contingent liability
 Reacquired rights – value on the basis of the remaining contractual term of the related
contract regardless of whether market participants would consider potential contractual
renewals in determining its fair value
 Shares held for use – IFRS 5 values
Market Relative Model (Market Approach)

 Price / Sales
 Price / EBITDA
 Price / EBIT
 Price / Book Value
 Price / Earnings
 Price / Cash Flow
Either Price or EV can be used

 Steps:
 Identify comparable firms that have similar operations to the firm whose value is in
question.
 Identify measures for the comparable firms in their financial statements – earnings, book
value, sales, cash flow – and calculate multiples of those measures at which the firms
trade.
 Apply these multiples to the corresponding measures for the target to get that firm’s
value.
 Determine average value

 Pitfalls
 Not very reliable but gives an indication of value
 Normalized PE has to be worked out
PE Ratio

 A high PE ratio may indicate:

 Optimistic expectations especially for small start up companies on a fast growth curve i.e.
internet companies
 Security of earnings
 Status – PE ratio of quoted companies would be higher than PE of unquoted companies
 The following table (on page 2) gives accounting data from 1994 annual reports of six
biotechnology firms. The market value of equity of five of the firms is also given. All
numbers are in million.
 Genentech had a book value of $1,349 million in 1994.
 From these numbers estimate a value for Genentech, Inc.
 Based on the valuation from a. what would analyst’s recommendation be buy, sell or hold,
knowing that Genentech’s actual traded value (of equity) at the time was $5,637.6 million?

Market value
of equity P/B Sales Earnings

Amgen 8,096.7 5.6 1,571.0 406.0

Biogen 1,379.0 3.6 152.0 15.0
Chiron 2,233.6 4.6 413.0 28.0
Genetics Institute 925.0 2.5 138.0 -7.0
Immunex 588.5 4.5 151.0 -34.0
Genentech ? ? 795.4 124.4
Dividend valuation model (Income Approach)
Gordon’s growth model : P0 = D1 / ke - g
In general, the value is given by discounting the future stream of dividends and the
terminal value at the shareholders required rate of return.
Example
We have: 1. the dividend forecast for 5 years
2. required rate of return 10% ( = 1.10)
We assume: 1. dividend will stay the same after year 5
We can calculate the value of perpetuity using the
assumed dividend in year 6 (T+1)
1 2 3 4 5 6
Dividends 2.00 2.10 2.60 2.50 2.50 2.50
t
(1+r) 1.10 1.21 1.33 1.46 1.61
PV of dividends 1.80 1.70 2.00 1.70 1.60
Total PV of
dividends 8.80

Value of Perpetuity 25.00

PV of Perpetuity 16.11

Value of equity 24.90

2.00 2.10 2.60 2.50 2.50 2.50
V0E      
2 3 4
(1.10) (1.10) (1.10) (1.10) (1.10) 0.10 5
(1.10) 5
V0E 1.80  1.70  2.00  1.70  1.60  16.11 24.90
 Example
We have: 1. the dividend forecast for 5 years
2. required rate of return 10% (r = 1.10)
We assume: 1. dividend will grow at 3% after year 5
We can calculate the value dividend in year 6 (= dividend in year 5 x
1.03)
We can calculate the value of perpetuity using the dividend in year 6
1 2 3 4 5 6
Dividends 2.00 2.10 2.60 2.50 2.50 2.58
t
(1+r) 1.10 1.21 1.33 1.46 1.61
PV of dividends 1.80 1.70 2.00 1.70 1.60
Total PV of
dividends 8.80

Value of Perpetuity 36.79

PV of Perpetuity 23.70

Value of equity 32.50

E 2.00 2.10 2.60 2.50 2.50 2.50 1.03

V      
0 2 3 4 5
(1.10) (1.10) (1.10) (1.10) (1.10) 1.10  1.03 (1.10)5
V0E 1.80  1.70  2.00  1.70  1.60  23.70 32.50
The disadvantages of DDM

 A firm may be profitable and worth a lot and have a zero dividend payout (e.g.
Microsoft)
 How do we value that firm?

 A firm can borrow to pay dividends, which has nothing to do with investing and
operating activities that create value

 Dividends are distribution of value not the creation of value

Discounted Free Cash Flow Valuation (Income Approach)

• Rationale:
• The firm is a combination of a number of projects; the value of the firm is the
NPV of the net expected future cash flows from all the projects
• The DCF valuation model identifies the operating and investment activities that use
cash accounting
• It forecasts and discounts future investment and operating cash flows into net
present values

• Free cash flow is cash flow from operations that results from investments minus cash
used to make investments.

 Discounted (Free) Cash Flow Valuation

 First: forecast free cash flows over future finite horizon (usually 5 to 10 years)
 Second: forecast cash flows beyond the finite horizon year (making some
assumptions – we’ll see that later)
 Third: discount by appropriate cost of capital for operations
 Fourth: calculate the present value of expected future cash flows; this value represent
the value of the firm
 Fifth: subtract the value of debt from the value of the firm to get the value of equity
 What happens if financial assets are more than financial obligations?
Free cash flow

 EBIT
 Less Tax on EBIT
 Add non cash charges
 Less capital expenditure
 Plus / Minus WC movement
 Plus salvage value received
 A Simple illustration of FCF valuation
Forecast Year
2000 2001 2002 2003 2004 2005
Earnings 12.00 12.36 12.73 13.11 13.51 13.91
Free cash
flow 9.36 9.64 9.93 10.23 10.53
Equity 100 103 106.09 109.27 112.55 115.93

Let’s value the equity at the end of 2000 using the pro forma
free CF forecast, assuming:
a. there is no debt → so VF=VE and (C-I) = d (since F=0),
and
b. cost of capital of 10% (f = 1.10)
We see that free CF is forecasted to grow at 3% per year
• If this rate is forecasted to continue, the value of the firm
(and the value of the equity with no debt) is:

10.53 1.03
9.36 9.64 9.93 10.23 10.53 1.10  1.03
V0E       133.71
1.10 1.21 1.331 1.4641 1.6105 1 . 6105

continuing value in 2005 = free cash

flow for 2006 capitalized at cost of
capital adjusted for growth

• As free cash flow is forecasted to grow at 3% per year

from 2002 onwards, the valuation can be made using a
shorter forecast horizon:

E 9.36
V 
0 133.71
1.10  1.03
 DCF Analysis: Practical Problems
- Difficult to Apply: Requires long forecast periods to
recognize value-added from free cash flows because
value gained is not matched against value given to
generate value; the more the company reinvests, the
longer the forecast period must be
- Suspect concept: fails to recognize value generated that
does not involve cash flows; investment is treated as a
loss of value
- Professionals forecast earnings: Analysts don’t
forecast free cash flows; they prefer earnings as they
represent a measure of success in operations
Economic Value Added (EVA) (Value Based Model)

PV = C + EVA1 + EVA2 + ….
1+WACC (1+ WACC)2

Where C is the invested capital

EVA = (ROIC – WACC) x Previous years’ invested capital

Where ROIC = Current year NOPAT / Previous years’ invested capital

Invested capital is capital employed using Net Operating Assets and Liabilities

Adjustments in NOPAT:

 Spending on intangibles is added back as they create long term value e.g. training, advertisement.
Also capital employed is adjusted
 Provisions are added back since these are not real costs
 Finance leases should not be capitalized
 Depreciation is economic cost rather than accounting cost
Adjusted Present Value Approach

 Determine ungeared cost of capital by using the geared cost of capital

 Determine present value of cash flows by discounting at ungeared cost of capital
 Determine present value of tax shield by discounting at gross interest rate
 Determine total value of cash flows including terminal value
 Deduct debt value to determine equity value
Synergy

Existence of synergy increase shareholders value in acquisition

Revenue synergy arises from

 Increased market power
 Marketing synergy
 Strategic synergy
 These are difficult to quantify

Cost synergy results primarily from the existence of economies of scale

Financial synergy:
 Diversification : Acquiring another firm as a way of reducing risk cannot create wealth
for two publicly traded firms with diversified stockholders, but it could create wealth
for private firms or closely held publicly traded firms where the owners may not be
diversified personally
 Cash slack: When a firm with significant excess cash acquires a firm with great
project but insufficient capital, the combination can create value
High growth start up

Projecting economic performance

 Identifying drivers with reasonable financial projections

 Period of projection should be large enough for stabilised operations

 Forecasting growth
 G = b x r where b = % of retention and r = ROIC
 Two key drivers of ROIC are Profit Margin and Asset Turnover Ratio (or revenue
growth ratio)

Valuation models:
 Asset based methods: Not appropriate since tangible assets may be low
 Market based methods: Difficult to find comparator companies
 Discounted cash flows: if expected to generate positive cash flows in the near future

 V = R – C/ r – g or R(r-gR) – C/ (r – gC)