Spring 2022 End-of-year Exam on the Valuation of Companies- Finance, University of Missouri
What are some of the considerations when using earning multiple or price earning ratio as a measure of valuation of a company?
- How should ‘earnings' be defined?
- ‘Attributable’ earnings
- Recurrent earnings
- Forecast as historic earnings
Earnings for this purpose can most usefully be regarded as the profits of the company and its subsidiaries and associates after the deduction of the charges which rank ahead of the shareholders entitled to those earnings. Consequently, all interest charges owing to bankers or others should be deducted as these claims on the company's income and assets rank ahead of shareholders. Tax should also be deducted for this reason. If any proportion of income is attributable to outside shareholders of a subsidiary (for example if a subsidiary is not wholly owned by the company), this proportion, called 'minority interests' is also deducted. The above represents standard accounting treatment of 'earnings' as they would appear in an audited profit and loss statement in most countries, that is consolidated profit after interest, tax, and minority interests.
The principle is to match what is being valued with the earnings attributable to it or generated by it. If there are preference shares outstanding which are entitled to receive a certain dividend, this should be deducted from the earnings before the ordinary shares can be valued. If there are convertible securities outstanding which are likely to be converted, the interest should be added back to earnings (with appropriate adjustments for tax) and the earnings related to the enlarged number of shares in issue after conversion.
If a multiple is applied to a particular year's earnings to calculate a valuation, the implication is that the elements included in the earnings will be present in each year's earnings for the foreseeable future. Profits or losses which are made from activities which are not part of the company's regular business such as the sale of a fixed asset used in the business, are separately listed in account under the heading extraordinary items. Such items should not be included in earnings to which the multiple is applied for valuation purpose.
Recurrent earnings imply that the business is a going concern. For this purposes reason, depreciation should not be added back to earnings, as it is in a cash flow calculation. It is assumed that regular reinvestment at the level of the depreciation charge will be required to ensure that the earnings are indeed recurrent.
Earnings are expressed over a single financial period, often a calendar year Trading conditions may not fall conveniently into annual patterns. If a company has made a loss of 5 in the first half of the year and a profit of 10 in the second half the accounts will show earnings of 5 for the whole year (10 for the second half s 5 for the first) In this case, other things being equal, the year-end profitability is running at the annual rate of 20. To Using the published figure of 5 for the basis of valuation is likely to be misleading.
In assessing earnings, analysts will attempt to form as up-to-date a picture as possible. Past earnings are only of interest as a guide to the future. Reliable estimates and forecasts are much sought her. However, the degree of uncertainty in the estimates is likely to increase sharply beyond a few months in the future and the analysis will become more speculative.
In using a multiple of earnings to value a company, it is critical to ensure that all the elements included in the profits being multiplied are in fact appropriately treated in this fashion. What are the Items which are not best treated in this manner?
A company can be valued using its net assets. Using an example of a consolidated balance sheet, show how the valuation is achieved.
|Machinery and Equipment||15 = 50|
|Stocks and Work-in-Progress||28|
|Accounts Receivable and Pre-Payments||13|
|Bank Balance and Deposits||20 = 61|
|Accounts Payable and Accrued Charges||15|
|Bank Loans and Overdrafts||20|
|Proposed Dividend||5 = 45|
|Net Current Assets||16|
|Goodwill on Consolidation||5|
|Intangible Assets||5 = 26|
|Less: Deferred Liabilities|
|Deferred Taxation||5 = 30|
|Consolidated Net Assets||48|
|Consolidated Net Tangible Assets||38|
|Net Assets Per Share|
|(75 million shares in issue)||$0.64|
|Net Tangible Assets Per Share||$0.51|
Using an example, explain the composite approach to valuation of a company.
|Land and Buildings||50|
|Plant and Machinery||5|
|Current Assets: Stock||30|
|Cash||25 = 70|
|Current Liabilities: Creditors||15|
15 = 30
|Less; Long-Term Debt||10|
- Land and buildings are factories only half occupied by the company itself. The remainder are vacant or rented to third parties.
- Investment of $10 m consists half of an investment in a research and development company engaged in design work for the business and half of listed shares unrelated to the business.
- Cash balances of $25 m are not utilized in the business but are managed separately by an investment adviser. There is no foreseeable requirement for additional working capital in the business.
What are some of the methods that can be used for the valuation of a company?
- Cash flow
The dividend paid on an ordinary share divided by the share price and expressed as a percentage is called the 'dividend yield'. It is normally expressed gross, without taking any account of the recipient's tax position. Income-conscious investors may place a high weight on annual income received although they would acknowledge that capital gain is also part of the total return equation. Companies which pay out almost all earnings as dividend may be valued on this basis alone. Of course, as dividends and earnings are virtually identical in this case, valuation on the basis of dividends is also an earnings valuation.
In some markets, the stock exchange authorities will pay particular attention to the amount of dividend paid. They regard this as a more concrete return than the more speculative nature of capital gains. The fact that the company is able to pay out a substantial cash dividend is taken as a reliable test of strength.
Using cash flow as a basis for valuation is essentially similar to using earnings or dividends. However, as the format of analysis based on cash flows involves setting out figures for a significant number of years ahead, the analyst is forced to spell out assumptions on such matters as capital investment and working capital requirements, inflation and timing of tax payments. In addition, risk can be incorporated more systematically by using expected values for the various components of cash flow rather than single point estimates. A computer model can be constructed by assigning probability distributions to each variable. A large number of possible outcomes are then calculated to produce a probability distribution of valuation estimates.
The snag of carrying out such a valuation in the context of corporate finance transactions is that there is rarely sufficient reliable data about a company and its many variable features to make the numerous assumptions required for the analysis. If general assumptions are made concerning estimated flows, little is gained by using the cash flow method. The net cash flow for an average year begins to look like an adjusted figure for estimated earnings. If it is assumed that cash flows continue indefinitely, the discount rate begins to look like a reflection of the multiple.
Relatively simple businesses owning a single major capital asset such as a hotel. quarry or mine may be usefully assessed by the cash flow method. The nature of the investment in such a company is quite close to a capital investment in its major asset. The discounted cash flow method has for a considerable period of time been widely used in industry to make decisions about capital investments.
What are the factors influencing the pricing of a company?
- Rights issues
In flotation, pricing is chiefly based on comparison. An investor has a choice between buying a large number of existing shares or the new one which is being floated. Although novelty can have some appeal, investor inertia and a sentiment of "better the devil you know' may prevail unless there is a tangible incentive. The pricing of a flotation is therefore normally pitched at a discount to the ratings of the most comparable companies. The ratings of comparable companies themselves of course are influenced by fundamental factors such as price earnings ratio, net asset backing and dividend yield. However, setting the price is effectively at one stage removed from these fundamentals. It must also be remembered in a flotation or any other market exercise that the average investor is buying only a small number of shares and no premium for control or access to underlying assets is appropriate.
As rights issues are made by definition to a company's existing shareholders, the question of pricing is not so sensitive. Most markets will have a standard approach to pricing which again is based on the principle of a discount. In this case, the discount is not so much related to comparable companies as to the price of the company's own shares. Some incentive must be given to shareholders to take up the rights issue rather than simply buying more shares in the market which is a quicker and more convenient process. It is unlikely that fundamentals will be very relevant to the pricing discount itself, although of course they may have a significant bearing on whether to proceed with the rights issue in the first place.
As in the case of a rights issue, markets normally have their own standard discounts which apply to a placing of shares to investors other than existing shareholders. In this instance, the position of the existing shareholders is highly relevant. They will wish to see the shares placed as close to market price as possible so that share price does not come under pressure. They will also be concerned if their attributable earnings or assets per share are likely to be significantly diluted.
In launching a takeover particularly if it is contested, some premium over market price is required if the bid is not to fall flat on its face. It is also helpful if it can be demonstrated that shareholders of the target company will receive an increase in their income. If it is possible to offer them an increase in asset and earnings backing, this will also be of some effect particularly as it deprives the defense of a major argument.
At this stage, however, valuation becomes relevant. If the price for success is too high and exceeds the valuation on a theoretical basis, the board of the bidding company must consider whether they should withdraw from the fray. In this connection it is useful to set limits in advance, even if they are somewhat flexible. On the other side of the table, the board of the defending company must consider whether they should accept an offer at this level. Even if it could be successfully resisted, is it really in the shareholders' interests to continue the struggle?