b821 Block3unit6 Company Valuation

B821 Financial Strategy Block 3 Finance and Investment
Unit 6
Company Valuation
Prepared by the Course Team
Masters
This publication forms part of an Open University course B821, Financial Strategy. Details of this and other Open University courses can be obtained from the Student Registration and Enquiry Service, The Open University, PO Box 625, Milton Keynes, MK7 6YG, United Kingdom: tel. +44 (0)1908 653231, email general-enquiries@open.ac.uk Alternatively, you may visit the Open University website at http://www.open.ac.uk where you can learn more about the wide range of courses and packs offered at all levels by The Open University. To purchase a selection of Open University course materials visit http://www.ouw.co.uk, or contact Open University Worldwide, Michael Young Building, Walton Hall, Milton Keynes MK7 6AA, United Kingdom for a brochure. tel. +44 (0)1908 858785; fax +44 (0)1908 858787; email ouwenq@open.ac.uk
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CONTENTS
1 Introduction 2 Valuing the assets 2.1 Determining book value 2.2 Adjusting book value Summary 3 Market multiples 3.1 Market value 3.2 Dividend yield 3.3 Price-to-book ratio 3.4 Tobins q 3.5 PE multiple 3.6 Price to cash flow 3.7 Enterprise value to EBITDA 3.8 Specific valuation ratios 3.9 Comparison of market multiples Summary 4 Discounted cash flow 4.1 DCF valuation steps Summary 5 Valuation in context 5.1 Regulation 5.2 New issues 5.3. Privatisations 5.4. Mergers and acquisitions 5.5 Restructuring Summary Summary and conclusions Answers to exercises Appendix Brokers report on De La Rue References and suggested reading Acknowledgements 5
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1 INTRODUCTION
INTRODUCTION
This unit looks at company valuation in the context of investment. Both investors in shares and companies seeking to make acquisitions need to know how much a company is worth and how much to pay for their investment. This unit outlines a number of ways of valuing companies, using the techniques you have come across in earlier units, and will show how different valuation techniques can be used in different contexts. Company valuation is a fascinating topic since it requires an understanding of financial analysis techniques in order to estimate value; for acquisitions, it also requires the negotiating and tactical skills needed to fix the price to be paid. This unit should therefore strike a chord with you, whether you enjoy the number-crunching aspects of finance or whether you prefer a more intuitive, or even emotional, approach. In Unit 5, we considered investing in projects and how projectinvestment decisions should be taken. In Unit 6, we consider investing in whole companies rather than individual projects. Although the concept is much the same that is, you are investing in a stream of future cash flows the range of techniques applied is even more varied than for projects. This is because, for companies, there is often historical information in the form of accounting data available, whereas for projects there are often no existing assets or five-year histories to rely on. Also, even if a company is starting up, as was the case with Eurotunnel and Eurodisney, or with biotechnology companies such as British Biotech and Genentech, there are usually comparable companies which already have share prices and hence valuation multiples that can be used as a reference point. As the information available on companies is so much richer, so the techniques available for valuing companies are more varied. As we shall see, the techniques range from looking at the value of the balance sheet through to a fully fledged discounted cash-flow analysis, as well as the application of a simple profit or asset ratio. This unit also looks at the valuation decision inherent in any refinancing. Companies are now bought and sold, taken into private ownership and then made public again, with the financing structure a key element in their valuation.
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UNIT 6 COMPANY VALUATION
ACTIVITY 1.1
Try to think of companies that have been in the news recently where valuation has been a key issue. At the time of writing, in 2005, I can think of the following:
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The new issue of Google, the internet search-engine company. Shares were sold via an auction on the internet. The takeover of the Mersey Docks and Harbour Board based in Liverpool. This company was the subject of competing bids from private equity firms, seeking to benefit from buying the company and changing its financial structure.
A private equity firm is a fund that buys and sells companies for profit. It is usually financed by large investors.
Outline of Unit 6
The first part of this unit discusses the different valuation approaches that can be applied to estimate company value and the attractiveness of any company-investment decision. The valuation approaches we shall use can be split into three main types, depending on which type of data is used as the basis for valuation. 1 2 3 Asset values, which use balance-sheet data to estimate value (Section 2). Market multiples, which use share prices to establish comparative benchmarks for value (Section 3). Discounted cash-flow techniques, which use forecast data to estimate present value (Section 4).
We begin with the traditional cautious accounting approach of looking at the value of the assets to be acquired. We then consider the role of market multiples (for example, the commonly used PE ratio). Finally, we consider cash-flow based techniques of valuation, in particular operating free cash-flow models, which are closer to project-appraisal techniques. In order to do this, we use a discounted cash-flow Excel spreadsheet specifically designed for company valuation, called VAL. As in earlier units, we shall concentrate on Boots and De La Rue as our main corporate case studies, although we also consider the valuation of other companies, public-sector organisations (in the regulatory and privatisation contexts) and companies not listed on the major stock markets. We have already covered a number of the techniques outlined above in earlier units, so you should no longer find the mathematics or formulae you come across daunting. This unit concentrates on the differences in the techniques used for company valuation from those of financial analysis and of project appraisal. That is not to say that there are no overlaps. For example, lenders may be lending long term and hence concerned with the overall viability and value
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1 INTRODUCTION
of an organisation. Managers may be considering a make-or-buy decision in the sense that they are trying to choose between buying a company or making that companys products in-house. The second part of the unit (Section 5) looks at the four main situations in which company valuations are typically required regulation, privatisation and new issues, mergers and acquisitions and corporate restructurings, including venture capital and going private. As you will see, different methodologies are normally applied in different situations. Valuation is an important but not exclusive part of the investment-appraisal process. Strategic issues will need to be addressed, as well as considering whether the appropriate financing is available.
Aims of Unit 6
By the end of this unit you should be:
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familiar with the three main methods of company valuation book value, market multiples and discounted cash flow; able to appreciate the merits and disadvantages of each technique; able to decide on the most appropriate method or methods of valuation according to the circumstances regulation, new issue, privatisation, takeover or restructuring.
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2 VALUING THE ASSETS
VALUING THE ASSETS
Before we consider how to value companies, let us consider exactly what we mean by the term value. As Publilius Syrus pointed out, A thing is worth whatever the buyer will pay for it and what the buyer will pay will depend on a number of factors.
ACTIVITY 2.1
Suppose you are buying a second-hand teddy bear at auction. Why might you be prepared to pay more than you might have to pay for an equivalent new one? Suppose now you are considering buying a company which has just one machine. Why might you be prepared to pay more for the company than the cost of a machine of equivalent age and condition? In the first case, a number of factors come into play. The teddy bear might have rarity value it might have been Margaret Thatchers teddy bear and hence be collectable. It might have sentimental value to you it belonged to your mother but not have sentimental value for anyone else. It might be impossible to make teddy bears of this quality today for example, if it were made from some rare fur no longer available as hunting of the animal concerned is no longer allowed. For the company, sentiment is unlikely to play a role unless the acquirer is an individual unaccountable to stakeholders for whom financial motives predominate. On the other hand, the management of the machine company may be able to add value to the machines production in a way that your management cannot. Setting up a new machine from scratch may take time and the premium the company is likely to have to pay over equivalent asset value is perhaps more than offset by the immediate synergy benefits. Also, buying the company may give you access to the customer portfolio and to the associated cash flows. Such issues may be relevant to the valuation of a scruffy old teddy bear and to the valuation of a company. Never forget, even when you have determined the value to you, the difference between the value you have placed and what you actually end up paying makes valuation an art and not a science and makes negotiating skills paramount.
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Units 2 and 3 considered a number of stakeholders, including suppliers, lenders and equity investors. Suppliers and lenders have developed a number of techniques for assessing the credit-worthiness of enterprises, which may require a full cash-flow analysis, for example when the finance is specifically linked in with a project. In this unit, we consider the point of view of investors, primarily equity investors, although we do look at other stakeholders in the section on restructuring. As a result, we consider the value of the firm or organisation as a whole and deduct the value of any liabilities to lenders, minority interests, convertible debt holders and preference shareholders to obtain the value to existing ordinary shareholders.
2.1
DETERMINING BOOK VALUE
Determining book value is centred around the balance-sheet value of a company as presented in the latest Annual Report. We look first at the book value given in the balance sheet and then look at how we can adjust book value in a number of ways in order to get a closer approximation of how much we might be prepared to pay. Table 2.1 Consolidated balance sheet of Boots as at 31 March 2004
Notes Group 2004 m
281.5 1,499.4 74.7 1,855.6 Current assets Stocks Debtors falling due within one year Debtors falling due after more than one year Investments and deposits Cash at bank and in hand 13 14 14 15 690.8 516.0 165.9 239.1 110.5 1,722.3 Creditors: Amounts falling due within one year Net current assets 16 (1,135.3) 587.0
Group 2003 m
301.3 1,516.5 84.7 1,902.5 638.6 536.6 114.0 293.1 203.4 1,785.7 (1,155.6) 630.1
Parent 2004 m
1,106.7 1,106.7 1,205.3 502.6 223.0 1,930.9 (455.2) 1,475.7
Parent 2003 m
1,387.4 1,387.4 4.6 275.0 24.5 304.1 (175.1) 129.0
Fixed assets Intangible assets Tangible assets Investments
10 11 12
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Total assets less current liabilities Creditors: Amounts falling due after more than one year Provisions for liabilities and charges Net assets Capital and reserves Called up share capital Share premium account Revaluation reserve Capital redemption reserve Merger reserve Profit and loss account Equity shareholders funds Equity minority interests 21, 22 21 21 21 21 21 17 20
2,442.6 (382.9) (177.2) 1,882.5 193.9 0.3 244.2 15.2 310.8 1,116.9 1,881.3 1.2 1,882.5
2,532.6 (401.8) (160.9) 1,969.9 203.5 260.3 5.6 310.8 1,189.2 1,969.4 0.5 1,969.9
2,582.4 (869.6) 1,712.8 193.9 0.3 15.2 1,503.4 1,712.8 1,712.8
1,516.4 (315.0) 1,201.4 203.5 5.6 992.3 1,201.4 1,201.4
You can access the 2004 Table 2.1 shows the consolidated balance sheet for Boots as at and later Boots annual 31 March 2004. In terms of valuation based on book value, the reports, which will have principle here is that a company is worth to its ordinary the notes to the accounts, on their investor website, shareholders the value of its assets less the value of any liabilities www.boots-ir.com to third parties. This is sometimes referred to as net asset value, shareholders funds or the book value of the equity. From Equity shareholders are Table 2.1, we can see that shareholders funds available for Boots known as common stockholders in the USA. equity shareholders were 1,881.3m at 31 March 2004. In a note Fully diluted means that to the accounts, we are told that at the year end there were we have assumed all possible shares are issued. 775.5 million allotted, called up and fully paid shares in issue, giving a book value per share of 1,881.3m/775.5m =2.426 per share. In the same note, readers are told that there are executive share-option schemes outstanding which, if all exercised, would involve the issue of a further 0.1 million shares. If we assume that these are all exercised, this would increase the number of shares to 775.6 million giving what is known as a fully diluted book value per share of 2.425. This compares with, at 31 March 2004, a Boots share price Part of Boots current assets of 6.20.
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ACTIVITY 2.2
What does the book value of a company represent? Does it represent:
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the liquidation value of the assets less the liabilities; the replacement cost of the assets less the liabilities; the market value of the assets less the liabilities; the value of the business as a going concern: that is, the economic value of the assets less the liabilities; the value of the business to a potential purchaser: that is, including synergy benefits; the sunk cost: that is, how much has already been invested in the company?
Book value represents a mixture of these, rather than a single one of them. It includes some assets at historic cost, some written down to liquidation value, some written up to current value (for example, property) and some written down over their estimated useful lives using some arbitrary depreciation method. Depending on the accounting jurisdiction and on the type and age of assets held by each company, the book value will be somewhere along the spectrum between historic cost and current market value. However, the book value will not be an estimate of economic value since, in the main, assets are not valued using the present value of forecast future cash flows. For example, in the case of Boots, the fixed assets owned by Boots are small in relation to revenues and, as we have seen, Boots market value is much higher than the book value of the assets it manages.
A sunk cost?
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2.2
ADJUSTING BOOK VALUE
In this section we look at how asset values in the accounts can be adjusted to offer a closer estimate of economic value than does the conventional book value or net asset value of the company.
Tangible assets
Tangible fixed assets are typically depreciated according to accounting estimates of their expected useful lives. Land and buildings may be depreciated over a period of, say, forty years whereas plant and equipment may be written off over five or ten years. However, if the market value or realisable value of the assets is lower than the depreciated book value, tangible assets are typically included in the balance sheet at this lower market value. Book values of assets therefore give some clue to current values, but not an accurate one as they do not, for example, fully take account of inflation or obsolescence. If, however, the analyst has more detailed information on the type and age of assets than is available from the accounts, it is possible to adjust book values of fixed and, indeed, current assets to a closer estimate of current value. It is easier to do this for a small company actively seeking a purchaser than for a large quoted company fending off a hostile takeover bid where you will not be allowed access to the company before you buy it.
It is rumoured that when Ford acquired Jaguar in 1989 after a hostile takeover battle, Ford management had a shock when entering the Jaguar car factory. We thought we were back in Victorian times, they are reputed to have said!
Depending on the accounting jurisdiction, property assets (that is, land and buildings) may be carried on the balance sheet either at historic cost or at recent market valuation and this choice can radically affect book value. For example, in the United Kingdom, property owned by companies is often revalued on a regular basis and included in the accounts at close to current values. Boots does this, as you can see from the extract overleaf. Where properties are What value obsolete computers? valued by surveyors using estimates of rental income, they can be considered to be included at economic value (the present value of future income generated) rather than historic cost.
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Investment properties were valued on the basis of existing use value at 31 March 2004 by the groups own professionally qualified staff.
Extract from Boots Annual Report for the year ended 31 March 2004
International Financial Reporting Standards (IFRS), applicable to EU listed companies for finance years starting after 1 Jan 2005, allow fair value for property as well as historic cost. This will mean a major change for the asset values and return on capital ratios for French and German companies, for example. In addition, IFRS requirements on accounting for leases will have the effect of placing some leased property on the balance sheet which was previously off balance sheet, as at present for companies such as Boots.
In some countries, such as the USA, France and Germany, property is always included at historic cost and this can lead to the book value being much lower than the current value. Interestingly, the impetus in the United Kingdom for the inclusion of property at current value was market driven. Many acquisitions in the United Kingdoms takeover boom of the early 1970s were made by would-be asset strippers who felt that company share prices and balance sheets did not fully reflect the value of the underlying assets. They made hostile bids for the companies and then stripped out and sold the assets whose value had been hidden from view. To protect their company from such asset strippers, managers sought to spell out to the market the true value of their property assets by including them not at historic cost, but at recent market value. Revaluation also meant that companies could appear to offer more security to their bankers for loans, although this proved not to be the case when property prices crashed in the late 1980s in the United Kingdom and in the late 1990s in the Far East. Revaluation of assets also has the effect of reducing one of the performance measures applied to companies, return on assets (or return on capital employed). As a result, some companies choose to lease rather than own the properties they needed. Boots, for example, held land and buildings valued at 700.2m at 31 March 2004, but during that financial year also paid 182.2m to lease property. If they had owned the properties and had put them on the balance sheet, the value of land and buildings would have increased by, say, 2,089.8m and this would have substantially reduced the ratios for the return on equity and the return on capital employed. Another fixed asset which may be included at other than historic cost is property under construction. Some countries allow companies to capitalise the interest they pay on debt related to the construction, rather than write it off as an expense.
In this example, we have capitalised the leases by assuming they are to be paid over twenty years. The present value of 182.2m paid each year for twenty years and discounted at an assumed cost of debt of 6% gives 2,089.8m. If you need to revise this formula, see Vital Statistics, Section 4.2.2.
Interest is capitalised on tangible fixed assets in course of construction or development. The capitalisation rate applied depends on whether the construction is financed by specific borrowings (based on actual interest rate) or whether it is financed by general borrowings (based on the weighted average rate of non-specific borrowings).
Extract from Boots Annual Report for the year ended 31 March 2004
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Indeed, in the USA and some other countries the capitalisation of interest is a requirement.
Intangible assets
In the 1980s, another balance-sheet item came under scrutiny by the asset strippers, in this case intangible assets. Examples of intangible assets include expenditure on research and development, brand values, intellectual capital and goodwill. Research and development (R&D) expenditure does not buy a tangible asset, such as a ship or factory, but represents cash spent on a knowledge base which may generate future revenues. It can be argued, however, that R&D does create an intangible asset whose life is more than one year and, as a result, should be capitalised on the balance sheet and depreciated over its expected life of, say, five years. Most countries do not allow or encourage the capitalisation of R&D although, under IFRS for example, development activities (rather than pure R&D) can be capitalised if future economic benefits can be linked to them. These development activities will then be amortised (depreciated) in the income statement over their expected economic life. There is also some argument for capitalising spending on other forms of knowledge, as in database systems within consultancy firms or expertise provided by professional employees in investment banks. This is known as intellectual capital and firms such as Scandia, a Swedish insurance company, have pioneered approaches to the valuation of intellectual capital for inclusion in the balance sheet. There is, however, always the possibility that these types of asset can choose to walk away, in contrast to ships or factories! Another type of intangible asset over which there has been controversy is brand names for example, whether or not to capitalise the value of the Coca Cola brand or the Amazon.com brand on their respective balance sheets. Some United Kingdom companies did do this in the 1980s, with firms such as Rank Hovis McDougall, a food manufacturer, putting brand values of 0.5bn on the balance sheet. Again, the methods used for valuing brands are linked to forecast cash flows related to the brands and hence to economic value. So capitalisation of brands will give a closer approximation to market value than would the exclusion of the brands. Current accounting policy in this area is somewhat confused: for example, under IFRS, brands can currently be capitalised if they have been acquired through the purchase of a company, but not if they have been built up from scratch. This points up the major difficulty in using book values to compare companies across countries and sectors the role of goodwill. The intangible asset goodwill arises as a result of the fact that book values of companies typically do not reflect their economic values. Hence the prices paid for companies, especially high value-added firms such as advertising agencies and consulting firms, typically far exceed their book values. The difference
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between the price paid for a company and its book value is known as goodwill and may appear on the acquiring companys balance sheet. In some cases, the value or realisable goodwill may even exceed the value of the acquiring companys shareholders funds, if acquisitions have featured large in a companys strategy. Under IFRS, goodwill is capitalised in the balance sheet as an intangible asset. If, as is likely in the case of a brand name, its expected economic life is more than twenty years, it will not be amortised in the same way as, for example, development activities. Instead, the company concerned is required to conduct an annual impairment test: if the estimated value in use or sale value is below the carrying value in the balance sheet, the balance-sheet value must be written down and the difference put through the income statement.
This is a simple explanation of a complex area. For further information see the IASB website, www.iasb.org.
The main point to note here is that companies which make substantial acquisitions, particularly in growth businesses, will acquire goodwill which, if capitalised, will increase book value substantially relative to a company, in the same sector, that has grown organically. In the case of Boots, goodwill acquired had been written off against reserves to the value of 394.3m by 31 March 2004. If this had been capitalised, equity shareholders funds at that date would have been 2,275.6m instead of 1,881.3m.
Off-balance sheet items

We have seen how fixed assets and intangible assets can be understated or overstated in the balance sheet. Another possible area where the value of shareholders funds can mislead is its exclusion, by definition, of what are known as off-balance sheet items. These can be leases, pension assets or liabilities, employee-related liabilities and other contingent liabilities which may be mentioned in the notes to the accounts (or not, depending on whether managers view them as material at the date of the accounts). Leasing represents a form of secured lending for asset investment and can be viewed as an alternative to conventional debt. One of the early advantages of leases was that assets acquired under lease and the associated leases themselves (since the assets were technically owned by the lessor rather than the lessee or user) did not need to be included in the balance sheet. Companies seeking to reduce disclosed levels of debt often chose leasing as a means of doing this. In the early 2000s, companies such as France Telecom did this via sale and leaseback of some of their properties. Although finance leases where essentially all of the risks and the rewards incident to ownership remain with the lessee are now required under IFRS to be on balance sheet, there is still scope for some leases to be off balance sheet. Pension fund surpluses or deficits, the difference between the present value of the pension funds assets and the present value of the pension funds liabilities, can be substantial relative to corporate
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Sale and leaseback involves selling a property and leasing it as a tenant. The company still occupies the property.
profits. For example, as at 31 December 2003, it was estimated that the aggregate deficit of Europes top fifty companies alone was E4,287 million. Under IAS 19, companies are required to disclose pension fund actuarial gains and losses. They can do this immediately and avoid having to put them through the income statement, instead disclosing them in the Statement of Recognised Income and Expense (SORIE). This is to allow the companies to continue accounting for pensions in the same way as they are required to do under FRS 17. Alternatively, they can defer some of the gains or losses, but must do so via the income statement. Given the size and volatility of actuarial gains and losses relative to income, net pension fund assets or liabilities have to be taken into account in any estimate of adjusted book value. Box 2.1 gives the example of how ICIs pension fund deficit has affected the value that potential bidders for the company place on the company. Other assets or liabilities which may be off balance sheet can include liabilities that must be paid to employees, such as health-care benefits in the USA, the granting of shares to directors or staff below cost and redundancy payments to directors and employees, which may need to be made in the event of a restructuring or takeover. Contingent (possible) liabilities which are off balance sheet can also include pollution costs or likely law-suit costs, such as those currently in progress against the tobacco industry, or the costs of rectifying the mistakes made when selling personal pensions in the United Kingdom during the early 1990s.
BOX 2.1 UNITED KINGDOM PENSION DEFICITS

When is a United Kingdom pension deficit a poison pill? For most private equity groups, scouring all sectors for somewhere to house their cash, a deficit can be an unfortunate deal-breaker. The first reason is that size matters. Some oft-mooted targets sport deficits that would put off even the bravest private equity house. ICIs 1bn FRS 17 deficit, for example, is a third of its market capitalisation. A second problem is the difficulty of quantifying the liability. In ICIs case, analysts routinely use only a proportion of the deficit in their valuation models. Private equity houses, like the life assurers which could potentially take the liability off the companys books altogether, would be more likely to apply a premium to the deficit. Another challenge is that small changes to the discount rate or assumed longevity make huge differences to deficits, particularly when they are as large and as mature as ICIs. Finally, in a hostile approach, trustees are not required to open the books, which can make the risks impossible to value. Nor is valuation the only issue. Private equity firms like to show their investments a clean pair of heels after a few years. But
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new legislation means that, even once the business has been sold, if the purchaser is unable to honour the pension promises, the former owner may be held responsible. Moreover, in most cases pension fund trustees or the actuaries to the trustees control the level of contributions into the fund. If they believe the companys covenants would worsen in the event of a buyout, they can demand increased or one-off payments from the company, as well as requiring the deficit to be moved up the creditor queue. Such problems scuppered Permiras approach to WH Smith last year, as well as Philip Greens putative move on Marks and Spencer. While it is not impossible to imagine a trade buyer being interested in ICI, the characteristics of its pension fund make a private equity bid seem out of the question.
(Financial Times, 6 June 2005)
Tables 2.2 and 2.3 give an example of how an adjusted book value might be determined.
However, under another accounting procedure ...
Table 2.2
Salt and Pepper plc balance sheet

m
Year-end 31 December
Long-term assets Property, plant and equipment Intangibles Other assets Total long-term assets Current assets Cash and marketable securities Accounts receivable
135.3 63.1 24.8 223.2
17.4 70.4
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Inventory Other current assets Total current assets Total assets Current liabilities Accounts payable Other current liabilities Total current liabilities Long-term liabilities and equity Long-term debt Long-term creditors Equity (23.5 million shares of 1 nominal value) and reserves Total long-term liabilities and equity Total liabilities and equity
38.1 16.1 142.0 365.2
48.3 32.3 80.6
115.2 13.4 156.0 284.6 365.2
Book value =
Net assets (equity) 156.0 m = = 6.64 m Number of shares 23.5m
Table 2.3
Salt and Pepper plc adjusted book value

m
365.2 50.0 4.8 50.0 470.0 (80.6) (128.6) (24.0) 236.8
Adjusted book value

Book value of assets + Adjustment for replacement cost on inventory, plant and equipment + Overfunding of pension fund + Undervaluation of intangibles = Adjusted book value of assets Current liabilities Long-term liabilities Contingent legal liabilities = Adjusted book value of equity
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Adjusted book value per share =
Adjusted book value of equity Number of shares 236.8 m = 23.5m = 10.08
Up to now, we have been unclear on exactly which value we are seeking to determine. We have noted that book value needs to be adjusted to obtain a closer estimate of economic value. In certain circumstances, however, economic value can be less than book value or net realisable value. Figure 2.1 helps to put the alternative definitions of value in context: when buying a business, we are seeking what economists such as Coase (1937) termed opportunity value.
Opportunity value
lower of
Replacement cost
higher of
Economic value
Net realisable value
Figure 2.1
Definitions of value (Gregory, 1992)
EXERCISE 2.1
Look at the consolidated balance sheet in the De La Rue 2004 Annual Report. Suggest ways in which you think the book value could be adjusted to reflect opportunity value better.
SUMMARY
In this section, we have looked at the book value of a company from the perspective of the value of the balance sheet to equity shareholders and have considered how this book value might be adjusted to take into account:
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more recent valuations for current and fixed assets; intangible assets, including R&D, intellectual capital, brand names and goodwill; off-balance-sheet items, such as leases, pension funds and contingent liabilities.
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3 MARKET MULTIPLES
MARKET MULTIPLES
In Section 3, we shall consider the main ratios that are applied to a companys book value, profits or cash flows in order to estimate its value. The ratios we shall consider are price to book, Tobins q, price to earnings (or PE), price to cash flow and enterprise value to EBITDA. The attraction of using simple multiples to value a company is clear the mathematics is easy and multiples can be compared across companies, sectors and countries. It is reassuring to know that you have paid ten times profit when your competitor paid eleven times, or that you have sold a company for twice its book value when the going rate is 1.8 times. If a company is unlisted and has no share price, the market multiple for a similar quoted company can be used, but if the company is already quoted, there may be no need to apply a multiple from another company. The market value of the companys shares gives a clear statement of value.
For a revision of enterprise value and EBITDA, see the Glossary, Block 2 and OUFS.
3.1
MARKET VALUE
The starting point for determining market multiples is the market values of companies whose shares are listed and hence quoted on a stock market. A publicly listed company, one with shares listed on a stock exchange, has its share price quoted by market makers whose job it is to provide a market in shares. This gives an instant picture of a companys value. As you know, the market value of a company may be derived by multiplying the share price by the number of shares in issue. In the case of Boots, at 31 March 2004, this gave a market capitalisation or market value of 6.20 6 775.5 million = 4,808m or 4.808bn. For large companies traded on the major exchanges the share price will represent a price at which the shares were very recently traded and will therefore give an up-to-date valuation. For less frequently traded shares, in closely held companies or traded on emerging stock markets, the price may be somewhat out of date or may not be realistic for a larger than average trade. Less liquid stocks will have wider spreads between the bid and offer prices to reflect their lack of liquidity making it more difficult for traders or market makers to sell on or buy back the shares. It is important to note the warning of stock exchange authorities about their role in reporting market prices. The following is the London Stock Exchanges version:
We desire to state authoritatively that Stock Exchange quotations are not related directly to the value of a companys assets, or to the amount of its profits, and consequently these quotations, no matter
Bid and offer prices are the prices at which you can sell (bid) and buy (offer) shares on the stock market. The offer price is higher than the bid price to allow the trader a profit margin. Market makers earn a living by buying and selling shares, making their profit from the bid/offer spread.
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what date may be chosen for references, cannot form a fair and equitable basis for compensation. The Stock Exchange may be likened to a scientific recording instrument which registers, not its own actions and opinions, but the actions and opinions of private and institutional investors all over the country and, indeed, the world. These actions and opinions are the result of hope, fear, guesswork, intelligence or otherwise, good or bad investment policy, and many other considerations. The quotations that result definitely do not represent a valuation of a company by reference to its asset and earning potential.
(London Stock Exchange)
With this caution in mind, we should make additional comments about the term price, since it is important to understand which price is relevant in the context of share value. First, the Stock Exchanges caution is essentially warning us that the share price given may not be a fair market price. A fair market price implies at least a semi-strong form of efficient market (as described in more detail in Unit 1), where prices reflect all publicly available information about a company and where the price quickly adjusts to any new relevant information. Possible sources of inefficiency are manifold. One example that we have already mentioned in Section 2 of this unit is that balance sheets may hide undervalued or overvalued assets or liabilities, not all of which will necessarily be clear to equity analysts. Enron, when it filed for bankruptcy in 2001, was seen after the event to have a low book value due to the existence of substantial off-balance sheet liabilities. Although some of these liabilities could have been deduced from a close study of the accounts, this was apparently not done before the company failed. Another example of
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inefficiency is where someone has prior information, say, on a takeover bid for a company, which is not publicly available. One of the risks of investing in emerging markets is that the quality of publicly available information may be poor and there may well be relevant inside information not available to, say, overseas investors. Second, the term market price refers to the publicly quoted price of a share. This implies that the share is marketable and that an investor can always be found who is willing to buy the share at the quoted asking or offer price, or sell it at the quoted bid price. It also refers to the price for a relatively small number of shares. Anyone wishing to acquire a large or controlling stake might well have to pay a premium over the quoted share price. Similarly, anyone wishing to sell a large stake might have to sell at a discount. Third, there is a time element affecting share prices. The share price is quoted at a single point in time, for a specific transaction with a specific market maker. The next minute, when faced with a different trade, this market maker or another may quote a different price. The essentially temporary nature of quoted market prices makes market valuation rather volatile. For example, the price of a large firm such as Boots can vary by 5% in a day and, indeed, shares do so quite regularly. Prices of shares of small companies or companies in a volatile sector, such as that of the internet shares, can easily move by 20% or 30% in a single day. This may be to do with new information, which is fundamental to the company, or simply to do with supply and demand considerations for this particular share or company. Finally, there may be factors other than the future prospects of a company that affect the relationship between price and economic value. Specific examples include:
l
While such shares can easily be moved by 30% in a day if the new information is important enough, this does not mean such large movements are commonplace!
Shareholder loyalty for example, ownership of shares in a football club, such as Manchester United. Shareholders physically demonstrated their unwillingness to sell to US financier, Malcolm Glazer, in 2005. Additional benefits to shareholders for example, the Isle of Wight Ferry Company fought off a hostile takeover bid because of the threat to shareholders concessionary pricing on fares. Also, preference shareholders of P&O, also the subject of takeover bids, get discounts on ferry crossings. Employee loyalty an example is the community and trade protest that supported Pilkington when facing a hostile bid from BTR. In this case, the share price was raised sufficiently to deter the predator. A premium for control for example, Forte (now swallowed up by Granada) paid a premium for the small number of voting shares in the Savoy Hotel Group (compared with the price paid for the non-voting shares) in order to acquire control. Fashion for example, the late 1990s preference for new economy internet and technology shares instead of old economy companies such as Boots or De La Rue.
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Despite these caveats, it would be foolish to look a gift horse in the mouth and ignore the share price as an estimate of value. Given the number of analysts studying publicly quoted shares as a full-time occupation, surely their combined expertise must enable them to get close to the economic value of a particular firm? As we shall see later, complexities arise, as they did during the lifetime of Eastern Electricity, when there are differences of opinion on the appropriate valuation method and when there is a takeover in the offing, implying a possible premium for control. This explains why Eastern Electricitys value varied so much over its relatively short life as a company in the private sector. We now consider a number of ratios which can be applied to a company to obtain an estimate of its value. One reason for so doing might be that the company is not publicly quoted and so has no share price to provide an indicator of value.
Note that we can apply ratios or multiples to individual shares or to the company as a whole.
Instead, a ratio based on a similar listed company or on a sector average can be used to value the private company. Alternatively, ratios can be used to compare companies in the same sector or to compare stock markets in different countries. This is called relative valuation. Company A may be seen to be cheap relative to Company B or Market C expensive to Market D.
3.2
DIVIDEND YIELD
The first market multiple, dividend yield, is a measure of the income yield from a share. It is the dividend per share divided by the share price. Traditionally, investors were interested in the dividend yield for tax and income purposes high-rate taxpayers preferred low dividend-paying shares and income seekers preferred high dividend-paying shares. Investors now prefer to concentrate on total return, rather than just the dividend. Total return can be thought of as the dividend received plus any capital gain or loss on disposal. Another way of looking at total return is to consider dividend yield and dividend growth. We saw in Unit 4 that one way of estimating the expected equity rate of return, via the dividend-valuation model, was to estimate next years dividend yield and the forecast dividend growth rate. This was expressed as
E( R i ) =
D1 +g Pi
We can rearrange this equation to give
D g = E( R i )
i Pi
In this way, we can see what level of dividend growth, g, the share will have to offer to achieve a particular expected return. For example, if an investor wants 12% return on a share with a dividend yield next year of 3%, future dividends will have to grow
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an average of 9% a year to achieve this. If inflation is expected to be an average of 4% a year, this implies about 5% real growth. It is up to the investor to decide if this is possible for this particular company.
EXERCISE 3.1
Calculate the dividend yield of De La Rue given a share price of 3.19 and assuming that the expected dividend per share next year, D1, will be 16p. Given a cost of equity capital of 11.5% (from Unit 4), what would be the implied expected dividend growth rate?
3.3
PRICE-TO-BOOK RATIO
The price-to-book ratio is simply the ratio of the share price to the book value per share or, at the company level, the ratio of the market value of the equity to the book value of shareholders funds. For example, in the case of Boots, using the 31 March 2004 share price of 6.20 per share and given a book value of 2.425 per share:
Price-to-book =
6.20 = 2.56 2.425
This implies that investors were at that time willing to pay 2.56 times the book value for Boots shares because of the growth potential which went with them. What does 2.56 times the book value actually mean? Well it is meaningless on its own. What it can be used for is to compare Boots with appropriate United Kingdom companies, with the sector in which Boots operates and with comparable companies from other countries with many caveats relating to the difficulties of comparing book values of companies operating under different accounting regimes (or even choosing different methods of accounting within the same accounting regime). It can also be compared with Boots price-to-book ratio over time. A year earlier, for example, the price-to-book ratio was 2.2 compared with 2.6. This implies what is known as a re-rating of Boots. Was this a general phenomenon across all shares? For example, did the price-to-book ratio for the FTSE-All Share Index or FTSE 100 Share Index (of which Boots is a constituent) increase as much, or was this a re-rating of Boots relative to the market? Further investigation is needed. So although the price-to-book ratio is difficult to interpret just saying that investors are prepared to pay over 21=2 times book value is insufficient making a comparison with history, with other companies, with the sector and with the market provides a framework for discussing Boots value. The price-to-book ratio can also be applied to chemists retailing companies that do not have a market price. For example, suppose a company in the same sector as Boots had shareholders funds
(book value) of 100m. Applying the Boots price-to-book ratio would give it a valuation of 256m. This may not be the best estimate of opportunity value, but it is at least a starting point. Remember that adjustments could be made to book values to make the two companies book values comparable by, say, dealing in a consistent way with properties and goodwill. For example, if we capitalised the operating leases for Boots as we did in Section 2, the adjusted book value would be 3971.1m or 3971.1m/775.5m = 5.12 per share. The price-to-book ratio would then fall to 6.20/5.12 = 1.21.
3.4
TOBINS Q
The price-to-book ratio is also discussed in the context of stock market levels when it is referred to as Tobins q. The precise definition of Tobins q is
Tobins q = =
Market capitalisation Replacement cost of assets net of liabilities Number of shares in issue Market price of the share Replacement cost of assets net of liabilities s
Notice that the denominator has been adjusted to reflect replacement cost of fixed and current assets rather than historic cost. This is because Tobins q is based on the idea that stock markets, if the takeover market for companies were efficient, would operate at a Tobins q of 1. If Tobins q were greater than 1, managers seeking to set up a project from scratch and considering the alternative of buying a company already running the equivalent assets, would choose to set up from scratch as the cheaper option. If, however, Tobins q were less than 1, it would be cheaper to acquire a company rather than start from scratch. This would happen until prices went up to make Tobins q equal to 1 again.
2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 1900 1920 1940 1960 Year 1980 2000
Figure 3.1
Tobins q for the US market from 1900 to 2003
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If we consider Tobins q, which is shown in Figure 3.1 for the US market from 1900 to 2003, we can see that it was unusually high in the 1990s. Even if markets are not efficient in the sense that Tobins q is always exactly 1, we should have expected that prices would fall when Tobins q reached the heady levels it did in the late 1990s. Bears of the market at that time used Tobins q as a reason to predict an imminent crash. Bulls of the market argued that Tobins q would have been expected to rise over time as, compared with the 1950s and 1960s, the index reflected companies with fewer tangible assets and more intangible assets, such as intellectual capital, than in the past (for example, Microsoft as opposed to US Steel) and these intangible assets were not included in balance sheets and hence in determining Tobins q.
ACTIVITY 3.1
Looking at Figure 3.1, what has happened to the US stock market since the time of writing? Were the bulls or the bears right in their understanding of the relevance of Tobins q? From Figure 3.1, we can see that Tobins q did indeed fall back to more usual levels after the market declines of 2000 to 2002. Currently, the market does not look particularly cheap or dear according to Tobins q.
3.5
PE MULTIPLE
The most popular multiple for valuing companies whether at the share, company or market level is the price-to-earnings ratio or PE ratio. This is simply
PE ratio =
o Share price Market capitalisation = Earnings per share Earning for shareholders
In this way, any company can be valued by multiplying its earnings by the appropriate PE multiple. As for the price-to-book ratio, but more so, PE ratios are calculated for companies, sectors, markets, and over time, often with little attention paid to the accounting differences which distort earnings and hence PE ratios. The attraction of the PE ratio is that it uses historical and current data to say something about the future. The higher the PE ratio, the more the investor is prepared to pay and hence the more bullish he or she must be about the companys future. For example, the higher the expected growth rate in earnings, the higher the PE ratio. However, the PE ratio is also affected by what is known rather poetically as the quality of earnings. The riskier or more volatile the expected future earnings stream, the less the investor will be prepared to pay and hence the lower the PE ratio. A classic example of this is the banking sector in the United Kingdom and in other countries. In the United Kingdom, in 1990, the FTSE Actuaries
Earnings per share is earnings for equity shareholders divided by the number of shares in issue.
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industry sector PE for banking was 6.24, compared with an average PE ratio for the non-financial shares of 10.77. By June 2005, banks were doing relatively better, trading on a PE ratio of 12.34 compared with a non-financial PE ratio of 15.73 (see Table 3.1).
PE ratios are not calculated for companies with negative earnings. You will therefore never see a negative PE ratio!
Another problem with the PE ratio is the definition of earnings per share that is used in its calculation. For example, in the US, the PE ratio on the top 500 shares, measured by the S&P 500 index, was 30 in June 2003. After adjusting for pension costs and the cost of executive stock options, the adjusted PE ratio was over 50, making the US market look much more expensive.
Table 3.1
United Kingdom Sector PE Ratios as at 24 June 2005
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ACTIVITY 3.2
Look at Table 3.1 which shows sector PE ratios and find the industrial or commercial sectors with the three highest and three lowest PE ratios. Try to explain the differences in terms of quality of earnings and earnings growth potential. The sectors with the three highest PE ratios are Information Technology Hardware, Electronic and Electrical Equipment and Investment Companies. For the first two of these, high PE ratios are probably due to low earnings and high growth prospects. Investment companies are valued on their asset value (investments) rather than their earnings. The sectors with the three lowest PE ratios are Steel and Other Metals, Construction and Building Materials and Forestry and Paper. All three of these sectors are basic or commodity industries with relatively low growth prospects.
PE ratios enable relative comparisons across time, across companies, across sectors and across countries. A company can be considered cheap or dear according to its relative PE ratio. How are PE ratios used in valuation? The calculation technique is simple. For example, when Rolls Royce was privatised, the closest comparable company, British Aerospace, was trading on a PE multiple of 11. Rolls Royces share price was based on a multiple of 10 times its earnings to make it relatively cheap compared with British Aerospace. Another example could be the pricing of an unquoted company in a takeover where the sector PE is 15 on average. The exit PE the PE ratio implied in the sale price might be 13, perhaps to reflect lower growth prospects than the sector average. A number of factors should be taken into account to ensure that the comparisons among between companies are valid. For example:
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Glamour stocks typically have high PE ratios. Louis Vuitton Moet Hennessy (LVMH) is one such share, on a PE ratio of over 30 in 2005.
the accounting methods used by each company to calculate earnings might be different for instance, one company might record R&D as an expense, the other capitalise it; the financial year-ends might be different (although in some countries this is not allowed) so that the earnings of each company relate to different parts of the seasonal cycle; one company may have experienced an atypical drop in earnings, which would have the effect of artificially boosting the PE ratio;
If we consider Boots, Table 3.2 gives the companys income statement for the year ended 31 March 2004. Taking the earnings per share figure of 52.9p and a share price of 6.20, we obtain a PE of 6.20/0.529 = 11.72.
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Table 3.2
Boots income statement year-end 31 March 2004

Notes 2004 m
5,326.4 5,326.4 (1.4) 1 5,325.0 551.2 551.2 (1.1) 2 3 3 3 1 5 550.1 32.5 3.9 586.5 (5.5) 581.0 6 (167.7) 413.3 (0.7) 412.6 8 21 9 (226.3) 186.3 52.9p
2003 m
5,087.5 234.9 5,322.4 (2.2) 5,320.3 532.3 22.5 554.8 (1304) 441.6 5.1 (34.5) (123.2) 389.0 103.2 492.4 (191.9) 300.5 (0.5) 300.0 (230.7) 69.3 35.8p
Turnover Continuing operations excluding acquisitions Turnover from continuing operations Discontinued operation Total turnover Operating profit Continuing operations excluding acquisitions Operating profit from continuing operations Discontinued operation Total operating profit /(loss) on disposal of Profit/ fixed assets Provision on loss on closure of operations Loss on disposal of business Profit on ordinary activities before interest Net interest Profit on ordinary activities before taxation Tax on profit on ordinary activities Profit on ordinary activities after taxation Equity minority interests Profit for the financial year attributable to shareholders Dividends /profit retained (Loss)/ Earnings per share
EXERCISE 3.2
Using a De La Rue share price of 3.19 and the annual report for 2004 or OUFS to determine 2004 earnings, calculate the PE ratio for De La Rue. If the Support Services sector PE ratio was then 21.61, comment on De La Rues PE ratio relative to that of its sector at that time.
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3.6
PRICE TO CASH FLOW

There is a problem with the choice of earnings figures similar to that for the PE ratio.
The third ratio that can be used to determine value is the ratio of price to cash flow. This ratio is problematic in that there are, as you saw in Unit 3, many definitions of cash flow. If, however, you are using the ratio in the context of the share price (which is the numerator in this ratio), the cash flow figure in the denominator should be the cash flow available to shareholders. Thus, we can define the ratio of price to cash flow to be
Price to cash flow =

where
Share price Market capitalisation = Cash flow per share Cash flow
Cash flow = Operating cash flow + Other income + Interest received Interest payable Taxation Cash flow = Operating profit + Depreciation Capital expenditure + Other Income Net interest payable Changes in working capital Taxation In Table 3.3, which gives an analysis of Boots cash flow for the five years 20002004, we can observe the annual cash flows plus estimates of what the money was used for. The table has been drawn up using the definition of cash flow from the equation above that available to shareholders. Table 3.3 Boots cash-flow analysis
This definition of cash flow does not tie in with any of the definitions in Unit 2: it is yet another variation on a theme, but is important as we shall use it to value companies.
Comparative analysis of cash flow and change in debt Mar-04

Operating profit before exceptional items Depreciation Capital expenditure Other income Net interest received/ (paid) Change in working capital Taxation 551.2 136.7 (42.3) 32.5 (22.6) 134.1 (167.7)
Mar-03
590.4 162.8 (24.1) 5.1 103.4 (136.0) (192.7)
Mar-02
625.5 163.4 (102.2) (6.0) 13.2 (207.7) (191.2)
Mar-01
603.1 159.9 (405.0) 3.2 1.1 156.5 (158.8)
Mar-00
573.3 154.4 (221.0) 12.9 5.9 (295.8) (154.4)
Net cash flow available to shareholders* Exceptional gain/loss
621.9 (32.4)
508.9 (157.7)
295.0 (22.4)
360.0 0.0
75.3 0.0
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Disposals & acquisitions Dividends paid Shares repurchased Shares issued Funds available/ (needed) for debt Net actual change in debt
(2.2) (229.1) (264.6) 0.3 93.9 (91.6)
386.8 (238.3) (455.2) 0.1 44.6 (45.0)
(21.1) (234.5) (45.9) 0.7 (28.2) 36.1
(42.7) (224.0) 0.0 8.8 102.1 (102.4)
6.7 (216.3) (95.4) 0.5 (229.2) 223.0
*Using the definition of cash flow given in Section 3.6
As at 31 March 2004, Boots has a share price of 6.195 and 775.5 million issued shares, but Boots had a share repurchase programme, which meant that 38.3 million shares had been bought back (and cancelled) during the period. Using the derived cashflow figure for year 2004 of 621.9m, equivalent to 621.9m/775.5m = 80.19p per share, we obtain a price-to-cash-flow ratio of Boots price-to-cash-flow ratio = Share price/Cash flow per share = 619.5/80.19 = 7.72 On the other hand, if we decide that the cash flow should be attributed to the shares outstanding at the beginning of the year, since the repurchase scheme is a use of the cash flow attributable to shareholders, then we get a derived cash flow per share of 621.9m/813.9m = 76.42p per share and a price-to-cash-flow ratio of Boots price-to-cash-flow ratio = 619.5/76.42
= 8.11
Note that a fair case can be made for either method, since the cash-flow figure is based on what went on throughout the year, but the share price is appropriate for the number of shares outstanding at the time (31 March 2004). It is, though, important to be consistent with the method chosen through the years of analysis.
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Similar calculations for the years 2000-2003 give price-to-cash-flow ratios of 2003 2002 2001 2000 9.38 20.50 15.66 65.25
This example demonstrates the difficulties of using a price-to-cash flow multiple as a valuation measure. Cash flow after taxes, interest and capital expenditure in particular may vary widely from year to year and hence give misleading valuations for companies. In contrast, earnings are smoother than cash flows, because accounting rules require standard depreciation policies and the matching of revenues and costs as far as possible. This makes the PE multiple more stable over time than the price-to-cash-flow multiple. A second disadvantage of the ratio of price to cash flow is that different analysts use different definitions of cash flow in the ratio. You have seen in Section 2 of Unit 3 a number of different definitions for example, free cash flow and operating free cash flow and these are only some of a wide number of possible definitions. In practice, the Unit 3 definition of free cash flow, which uses depreciation as a surrogate for capital expenditure and deducts changes in net operating assets or working capital, is often used as a measure of cash flow for shareholders. Currently, many analysts define cash flow for this ratio to be simply earnings plus depreciation (that is, before capital expenditure and increases in net operating assets). The reason for this is that it is easy to calculate and the numbers are usually available for comparison, whatever the accounting regulatory framework. It is clearly, however, nothing like operating free cash flow. From Table 3.3, the earnings-plus-depreciation definition would give a cash flow for the year 2004 of 687.9m and a price-to-cash-flow ratio of 6.97 (using year-end number of shares) or 7.31 (using year-start number of shares). Cash-flow valuation can be important, however, in the context of takeovers, especially leveraged buyouts. In such situations, though, it is likely to be operating cash flow that is important, because the gearing (and thus interest payable and taxable profits) will be significantly different after a buyout than before. The main conclusion on price-to-cash-flow ratios seems to be beware! Check your definitions. In this course, we have stuck to the definitions recommended in the Financial Times and outlined in Box 3.1 overleaf. The hope is that, over time, analysts, managers, accountants and investors will come to agree a standard set of definitions making everyones life much easier. (The term amortisation, as used here, relates to the depreciation of intangibles.)
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BOX 3.1 CASH FLOW

Cash is King. Though the phrase is a clich, the notion that investors ought to be looking at a companys cash flow rather than merely its accounting profits is valid. The only snag is that defining cash flow is slippery. Different companies stockbrokers and consultants calculate it in different ways. Some semantic tidying-up is needed. The starting point should be recognition that there is no correct definition of cash flow, just as there is no single measure of profit. But just as investors distinguish between operating profit, pre-tax profit and earnings, it is important to be precise about which sort of cash flow one is talking about. Below are the definitions Lex proposes to use. EBITDA: earnings before interest, tax, depreciation and amortisation has caught on as a valuation tool, especially for judging the relative attractiveness of companies in the same industries across borders for example, European telephone companies. Typically, ratios of sales or enterprise value (market capitalisation plus debt) to EBITDA are calculated. The appeal is that these measures strip out the different depreciation, capital structures and tax regimes in different countries. Closely allied to EBITDA is operating cash flow. The only difference is that adjustments are made for changes in working capital. Operating cash flow is the top line of United Kingdom cash-flow statements, where it is described as cash flow from operations. While working capital changes can be important in any single year, they tend to even out over time. So for trend analysis, EBITDA is normally a better measure. But, EBITDA is not a Holy Grail, precisely because it is calculated before many of the costs business has to bear. Most important is capital expenditure. Without investment, companies would wither on the vine. The snag is that for most companies, only a portion of the CAPEX is required to maintain the business while the rest is used for expansion. Ideally, companies would give a breakdown; but, in practice, they do not. That means that estimates of maintenance CAPEX the investment needed to maintain the value of the companys assets is subjective though not worthless. Of course tax is also a cost to business and certainly if one wants to discount cash flows to calculate net present value, one needs to take it into account. For this purpose the best measure is operating free cash flow: operating cash flow minus CAPEX and tax (but before interest). Discounting such cash flows by a companys cost of capital will give its enterprise value from which net debt needs to be deducted to calculate the value of the equity. Sometimes, though, one is interested simply in how much cash is left over for shareholders in which case interest should also be subtracted. This free cash flow is the amount available for paying dividends, cutting debt, and making acquisitions.
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At other times it is useful to think of dividends as given and subtract them to give residual cash flow. This number, which is often negative, is the cash available for repaying debt and acquisitions. It is not very useful for valuation purposes, but in judging how much debt and dividends a company can support, it is invaluable.
(Financial Times, 27 December 1997)
3.7
E N T E R P R I S E V A L U E T O E B I T DA
As mentioned in Box 3.1, a ratio that has become popular relatively recently as a valuation tool for companies is enterprise value (EV) to EBITDA. This ratio is different in several respects from PE or price-to-cash flow ratios. First, it considers the value of the enterprise as a whole, not merely the equity element. The profits it measures are the profits before interest and tax and hence are independent of financing choice. Interest payments are clearly affected by the amount of debt finance and corporate tax payments are also affected since debt interest typically attracts corporate tax relief. Profits before both taxes and interest are not affected by the financing choice. The second characteristic of the ratio is that the profits considered are also before depreciation and amortisation. This means that EBITDA is not equivalent to cash flow, since it is before capital expenditure or its accounting surrogate, depreciation. Thus, companies with very different capital expenditure programmes will not be seen to be different using this ratio. The main advantage of this ratio, however, is its stability we saw how volatile the cash-flow ratio could be. Enterprise value is typically defined to be the market value of the equity plus the market value of net debt plus the market value of any preference shares or convertibles plus minority interests. The idea is to include any long-term capital provided by all types of investors. The equity element is easy to calculate and preference shares may also have a market price. However, when prices are not available, analysts often proxy the market value with the book value. They certainly do this for the net debt element of enterprise value. You may be wondering what we mean by net debt. The idea here is to include only debt that represents long-term capital to the business. Determining the debt element of the enterprise value will involve a decision as to whether any short-term debt should be included and whether cash should be netted off. In the case of De La Rue, in 2004, with a long-term cash mountain, such cash should not be netted off it was an asset, because it was expected that it would be invested in the business, and not negative capital. Turning to Boots and using the figures from
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Table 2.1, as well as the notes to the accounts, we have the following calculation for enterprise value at 31 March 2004 EV = Market value of equity + Book value net debt = 775.5m 6 6.20 + 331.6m long-term borrowings + 156.5m short-term borrowings 110.5m cash = 5,195.7m Note that, in this example, we have excluded trade creditors and netted-off cash (deeming these to be part of short-term financing). Thus, the enterprise value of Boots at 31 March 2004 was 5195.7m. If we now turn to Table 3.2, we find that the EBITDA for Boots for the year ended 31 March 2004 was 586.5m of total operating profit before tax, interest and exceptional items, plus 128.8m of depreciation to give an EBITDA of 715.3m. Thus for Boots at 31 March 2004 EV/EBITDA = 5,195.7m/715.3m = 7.26 The equivalent figures at 31 March 2003 would have been EV = 4,313.14m + 361.1m + 186.9m 203.4m = 4,657.74m EBITDA = 534.2m EV/EBITDA = 8.7 As you can see the EV/EBITDA tends to be more stable than the price-to-cash-flow ratio. In the bull market of the late 1990s, some analysts looked not at profits or cash flow or even EBITDA, but at revenues and calculated the EV/sales ratio. This ratio was particularly useful during the internet bubble for valuing companies such as Amazon. com, since such companies often had negative cash flows and negative earnings. The higher the EV/sales ratio, the higher the expected operating margin or the greater the growth expectations for a particular company. In summary, the main attractions of the EV/EBITDA ratio are its stability and its independence from capital structure, as well as its freedom from any distortions due to differences in depreciation policies between companies. This independence of tax and accounting differences enables comparison of companies across national boundaries and has been of particular use in the valuation of privatised utilities worldwide. These utilities have had very different capital and asset structures, according to their level of modernity and which government was responsible for privatisation. EV/EBITDA helped, for example, in the valuation of TELCO in 2002 (see Box 3.2), since comparison could be made with quoted
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companies such as British Telecom, even though it had a different gearing ratio and a different asset base.
3.8
SPECIFIC VALUATION RATIOS

Value drivers are key factors that affect value: for example, the number of bank branches of a retail bank or the amount of funds both in terms of value and the actual number under management for a fund management company.
Finally, there are a number of specific value drivers that are used in certain sectors as valuation tools and for comparisons. They are based on the idea that profit and cash flow depend on a key driver which can form part of a valuation ratio. For example, supermarkets may be valued on a per square metre basis, mobile phone companies on a multiple of the number of subscribers (see Box 3.2), and fund-management companies on a percentage of the value of the funds under management.
EXERCISE 3.3
Think of possible value drivers and hence valuation multiples for: (a) fashion boutiques (b) advertising agencies (c) airlines.
3.9
COMPARISON OF MARKET MULTIPLES
So far we have described each of the key market ratios which are used in valuation. These were dividend yield, price to book, Tobins q, PE ratio, price to cash flow, EV/EBITDA, EV/sales, and sector-specific ratios. Table 3.4 summarises the pros and cons of each valuation multiple. Table 3.4 Pros and cons of valuation multiples
Pros
Net asset value Easy to calculate. It comes straight from the accounts. Useful for special situations such as companies that deal predominantly in easily valued fixed assets.
Cons
Relies on accounting value and not economic value. Accounting standards in different countries can vary. Accounts are often out of date and subjective as to valuation. How much value in a fire-sale? What about possible tax payments in a fire-sale?
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Tobins q
Has economic rationale. Useful for valuation of markets. Tries to adjust historic values.
Still dependent on accounting values, albeit adjusted. Comparisons over time may be biased by changes in types of company included in stock market indices. If earnings erratic, PE ratio should be normalised. Doesnt fully take account of the time value of money. Sensitive to accounting standards. Investment requirements are overlooked. Confusion over definition of cash flow. Ignores time value of money. Can be variable over time. Ignores capital expenditure requirements. Ignores differences in tax rates between companies. In calculating EV, the book value is often used as a proxy for the market value of debt which may distort comparisons. Ignores time value of money. Ignores value to shareholders, taxes, capital structure. Doesnt fully take account of time value of money.
PE ratio
Commonly used ratio. Easy to calculate.
Price to cash flow
Takes investment into account. Represents real cash belonging to shareholders. Commonly used ratio. More stable than cash flow. Allows companies with different financial structures to be compared. Allows international comparisons.
EV/ /EBITDA
EV/ /sales
Commonly used ratio especially in countries where earnings are not meaningful numbers. Enables accounting distortions to be minimised. Commonly used for valuation purposes, especially in acquisitions. Allow companies whose earnings may be meaningless to be compared. Gives reference points within a sector. Allows feed-in to concept of value drivers.
Sectorspecific ratios
May mask important differences between companies. Doesnt fully take account of the time value of money. Considers only one value driver.
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Each analyst, manager, investor and accountant will use different ratios in different contexts and we shall discuss this in greater depth in Section 5. As examples, we show you a case study using EV/EBITDA and specific valuation ratios (see Box 3.2) and an extract from a brokers report on De La Rue reproduced as the Appendix in this unit, but which you have already seen in the Appendix of Unit 3. These examples will give you a feel for how analysts use ratios to decide whether a particular share is a good buy or not.
BOX 3.2 WHEN TO USE EV/EBITDA AND SPECIFIC VALUATION RATIOS: COMPANY AND TRANSACTION MULTIPLES VALUATIONS
An investment banker would always use multiple methods to value a company to get a range of estimates, which may differ from the price the company will be sold at because of the likely competition during the bidding process, financial constraints of potential acquirers and different companies valuation for each acquirer each potential acquirer has its own expected synergies with the company, as well as different estimates of the country risk, whether they are familiar or not with the market context. The example of TELCO, a true fixed and cellular telecom company that operates in Africa and was valued, when it was privatised, in 2002, was chosen to illustrate the use of specific valuation ratios e.g. comparable company and transaction multiple valuations. For confidentiality reasons the name has been changed.
Methodology
Comparable company multiples:
l
The comparable company valuation is based on comparable company multiples. TELCO is a fixed-line and mobile player; pure cellular, pure fixed and both fixed/mobile listed telecom companies as close as possible to TELCO in terms of business, size, geographic presence, profitability and financial structure were sampled. The following industry standard financial benchmarks were retained: Enterprise value (EV)/sales EV/EBITDA, EV/subscribers.
The above data multiples were then calculated from brokers business forecasts and applied to TELCOs forecasts in order to estimate the enterprise and equity values, as though TELCO was a listed company. (TELCOs forecasts were those provided in the DCF valuation see Box 4.1.) Pure fixed and pure cellular companies were used to perform a sum-of-the-parts valuation. The sum-of-the-parts method is
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based on the addition of TELCOs fixed-line and mobile businesses separate valuations obtained with, respectively, pure fixed company multiples and pure mobile company multiples.
l
Both fixed and mobile players constituted the sample called fixed/mobile comparables.
Comparable multiples valuation
Comparable transaction valuation Only two transactions Multiples used: EV/Population EV/Fixed lines
Comparable company valuation
Sum-of-the-parts*
Fixed/Mobile
Pure fixed + pure mobile companies Multiples used: EV/EBITD EV/Sales EV/Cellular subscribers
Both fixed/mobile companies Multiples used: EV/EBITD EV/Sales
Multiples applied to TELCOs forecasts from 2002 to 2006 *Sum-of-the-parts valuation values each part of the company separately and adds up the results to get a value for the whole
Comparable transaction multiples:

l
Comparable transactions of both fixed and mobile operators during the 2000/2001 period were examined and a comparable transaction valuation was determined from them. Only two transactions were directly comparable to the TELCOs transaction: Privatisation of the Tanzanian incumbent telecoms operator (TTCL) in March 2001. Privatisation of the Ugandan incumbent telecoms operator (Utel) in May 2000.
Valuation synthesis
Following the above mentioned methodology, TELCOs enterprise value was estimated at between $611 million and $908 million, with an average of $750 million. Therefore, considering a net financial
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debt of $444 million, TELCOs equity value was estimated to be close to $315 million. Enterprise value Equity value
Sum-of-the-parts 732 Fixed/mobile comparable 611 Fixed/mobile transactions 819 Retained range 611 0 908 1500 1250 908 1009
Sum-of-the-parts 288 565
Fixed/mobile comparable 167 464
Fixed/mobile transactions 375 Retained range 167 0 200 400 464 600 800 1000 806
500 1000 In USD million
In USD million
Table 3.5 lists the key ratios generated by the broker for De La Rue in their investment report. Note how brokers calculate past years multiples and forecast future years multiplies.
Table 3.5
Key data for De La Rue

2004a 2005e
658.1 55.9 22.3 15.05 4.4 15.8 7 3.1
2006e
674.4 62.9 26.93 15.8 4.6 6.4
2007e
701.6 68 30.4 16.59 4.8 5.9
Turnover (m) Pre-tax profit (m) EPS (p) DPS (p) Dividend yield (%) PE EV/EBITDA ROE (%)
682.5 58.7 24.2 14.2 4.1 16.1 5.4
Source: Merrill Lynch a = actual, e = estimate EPS earnings per share DPS dividend per share PE PE ratio EV/EBITDA enterprise value to earnings before interest, tax, depreciation and amortisation ROE return on equity
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EXERCISE 3.4
Use 2004 accounting data and a share price, as before, of 3.19, to calculate the following valuation multiples for De La Rue. (a) Dividend yield. (b) Price to book. (c) PE ratio. (d) Price to free cash flow. (e) EV/EBITDA. (f) EV/Sales. (g) EV/Total assets. Compare your answers for dividend yield, PE ratio, EV/EBITDA and ROE with the brokers estimates for 2004 in Table 3.5.
Finally, Table 3.6 summarises research into the valuation ratios preferred by corporate financiers. Table 3.6
Method
Frequency of use of valuation methods

Mean score Standard deviation Percent responding (where 1 is almost never and 5 is almost always)
1 2 24 37 41 5 10 4 27 2 3 14 14 17 18 14 8 29 6 4 9 1 5 21 26 25 19 23 5 7 1 1 52 47 60 12 69
Historic book value Replacement cost asset value** Liquidation value (orderly sale)*** Price/EBIT Capitalisation of historic earnings* Capitalisation of forecast earnings Dividend yield Trading multiples of companies in the industry Exit (acquisition) multiples Acquisition premiums (to market price)
2.07 1.72 1.93 4.12 4.03 4.34 2.87 4.59
1.27 0.81 0.89 1.12 1.16 1.02 1.22 0.69
46 47 36 4 4 4 14 0
4.21 3.52
1.04 1.24
2 7
8 15
10 23
28 28
53 26
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Industry rule of thumb Discounted cash flow (DCF)***/ Internal rate of return (IRR) Real options**/ Other
3.07 3.85 3.01 1.58 2.59
1.12 1.08 1.24 0.81 1.74
11 2 14 57 50
14 11 19 32 0
43 24 33 7 14
20 28 20 2 14
12 35 14 1 22
*, ** and *** represent statistically significant differences between large and small firms at the 10%, 5% and 1% levels, respectively. , and represent statistically significant differences between merchant banks and stockbrokers at the 10%, 5% and 1% levels, respectively. Source: Ross Geddes, 1999
From Table 3.6 you can see that the two most popular valuation methods for corporate financiers valuing companies for purchase, for sale or for flotation on the stock market were capitalisation of forecast earnings and trading multiples of companies in the industry. The first valuation method is the PE ratio, but using next years rather than last years earnings. The second compares a company with similar companies using valuation metrics common to that industry or sector. In the end, the valuation tools they use are not that complex. In Section 4, though, we shall look at valuation using discounted cash flow (DCF). From Table 3.6, we can see that over one third (35%) of respondents almost always used DCF, with a further 52% using DCF frequently or quite frequently. Table 3.6 also shows that internal rate of return (IRR) is almost always used by 14% of respondents despite potential pitfalls such as the one described in Box 3.3.
BOX 3.3 THE PERILS OF IRR

Imagine an investment that requires a payment of $5,000 up front and then produces positive cash flows of $3,000 in years two to 10. At a 10 per cent discount rate, this project will have a positive net present value of just over $22,160 and an internal rate of return of 59 per cent. Now assume the investor can sell out at a fair value in year three, receiving $14,605 (the NPV of the cash flows in years four to 10). The projects overall NPV remains exactly the same. But the IRR more than doubles to 120 per cent, even though no extra value has been created. This is hardly news. But all too often, it creeps into practice: IRR is the private equity industrys main yardstick for judging performance, raising funds and rewarding managers. Indeed, the sector makes much of its superior 25 per cent returns. Yet as the example
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shows, such IRR-based numbers can be artificially boosted by extracting cash early through trade sales, listings or recapitalisations. Indeed, the theoretical investor could accept as little as $5,000 in year three, thereby destroying considerable shareholder value, and still trumpet an IRR of over 59 per cent. IRR calculations implicitly assume that interim cash flows are reinvested at the original IRR. It would be more realistic to assume, as NPV does, reinvestment at the cost of capital. Because it is intuitive and easy to calculate, IRR will remain popular. But it should not be used in isolation and investors should recognise its flaws. Investment Years 23
1 Hold 2 Sale at fair value 3 Sale below fair value -$5,000 -$5,000 $3,000pa $3,000pa
Sale Year 3
No $14,605
Years 410
$3,000pa 0
NPV
$11,161 $11,161
IRR
59% 120%
-$5,000
$3,000pa
$5,000
$3,944
60%
(Ogier, Rugman and Spicer, 2004, p. 180, quoted in Financial Times, 1 June 2005)
ACTIVITY 3.3
Why do you think corporate financiers prefer to use prospective earnings rather than historic earnings in their valuation. If floating a company, it will look cheaper (have a lower PE ratio) if prospective earnings are higher than historic earnings. Prospective earnings may also be a better indicator of the future.
SUMMARY
In this section, we have looked at a number of ratios which compare share prices with dividends, book value, profit or cash measures, and which allow comparison of companies across sectors, time and countries. Valuation ratios can be used to compare companies that are listed on stock markets and also allow the valuation of companies not listed by using the multiple derived for a comparable listed company.
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The main ratios considered were:
l l
dividend yield a measure of income;

price/book a measure of how much more (or less) than book
asset value is being paid; Tobins q if greater than 1, this deems buying companies through the stock market as more expensive than setting up companies from nothing; PE ratio the most common measure of valuation using a multiple of accounting earnings; price to cash flow a measure of valuation using cash flow, although the definition of cash flow can vary according to the analyst; enterprise value to EBITDA a valuation multiple for the enterprise as a whole and using a surrogate for operating cash flow before tax; enterprise value to sales a valuation multiple for the enterprise as a whole which is unaffected by accounting differences; sector-specific ratios valuation multiples based on a value driver for a specific sector.
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DISCOUNTED CASH FLOW
The attraction of market multiples is their availability and their simplicity. It is clear, however, that market multiples do not expressly take account of the time value of money and only crudely allow for differences in growth prospects at the earnings or cash-flow level. We saw in Unit 5 how net present value (NPV) as a decision-making tool for project appraisal is now common in major organisations. What is noteworthy is that discounted cash flow (DCF) has become almost as common in company valuation, as we saw from Table 3.6.
ACTIVITY 4.1
From your reading of Unit 5 and what you have read in Unit 6 so far, what do you think are the key differences between using DCF techniques for company valuation and using them for project appraisal? There are many differences, but two major ones spring to mind. First, if shares are traded on an efficient stock market, share prices should reflect the markets best estimate of their value. Thus, discounting the cash flows back to a share price should lead to a zero net present value, whereas, as you saw in Unit 5, managers regularly expect positive net present values from projects. Second, the information available on companies (particularly for outside investors) is often more complex than for projects and companies can be viewed as a collection of projects. Valuing companies is therefore more difficult than valuing projects, which is why a number of simplifying assumptions are often made. You will see in the spreadsheet VAL that the number of inputs is more limited than for CAPX, the project appraisal spreadsheet, despite the fact that there may be more zeros on the end of a numbers valuation in a company than in a project one!
In essence, however, the DCF approach to valuing companies is the same as the DCF approach to projects. There are two levels at which the DCF approach can be carried out the equity level and the enterprise level. The enterprise level is the level most commonly used. Before explaining these two methods in more detail, we summarise them in Table 4.1.
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Table 4.1
DCF techniques
Valuing the equity Discount the equity cash flows (dividends) by the cost of equity Valuing the enterprise Discount the after-tax operating cash flows by the WACC to obtain the overall value of the enterprise
Minority interests are the rights of outside shareholders of subsidiary companies of a group to a proportion of the Groups assets.
Value of equity = Enterprise value Debt Minority interests
Valuing the equity using DCF

As you saw in Unit 4, the present value of a share can be stated as the discounted present value of all the future dividends expected on a share. We considered, in Unit 4, the special case of constant growth in dividends, called the Gordon growth model, and used it not as a valuation tool, but as a means of determining the required rate of return on a share, also called the cost of equity. Valuing a company at the equity level seems logical for equity investors who are buying or selling a relatively small number of shares compared with the total number in issue. Investors have no control over capital structure (that is, how much debt and equity management choose to raise), nor over the dividend policy, even though they may vote on dividend policy at the annual general meeting. It would seem sensible, therefore, for the investor to value the cash flows he or she expects from a likely dividend policy and from the likely growth rate of dividends. Although this method has been relatively popular in the past, the more common approach now is to value companies at the enterprise level: that is, to value the company as funded by debt providers and equity providers. When this value is obtained, the part of the company belonging to debt holders is deducted, to leave the value belonging to the equity holders.
Valuing the enterprise using DCF

The enterprise-value approach to valuing a company consists of forecasting the future operating cash flows of the company, before financing cash flows (such as interest payments and dividends), but after taxes. These forecasted cash flows are discounted by the weighted average cost of capital (WACC) because the enterprise is financed by both debt and equity (and sometimes minority interests). The figure obtained for the present value is the enterprise value. To estimate how much the equity holders part is worth, the debt (and minority interests) must be subtracted from the enterprise value first.
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4.1
DCF VALUATION STEPS
The steps that need to be determined for the valuation of a company are described in Table 4.2. None of these should surprise you, as you have considered most of them in the context either of forecasting (Unit 3) or project appraisal (Unit 5). The only complexity is to link the accounts with the DCF forecasting technique, Step 6, which most valuation spreadsheets will do automatically. The DCF valuation technique can be used without regard to the impact on future income statements or balance sheets, although estimating future financial statements can prove a useful check against unrealistic cash-flow forecasts. Table 4.2
1
Steps in valuing a company using DCF
Determine time horizon for specific forecasts
Look at the economic and business cycle Consider positive and negative growth Consider period of comparative advantage
2 Forecast operating cash flows

Determine value drivers Estimate historic, current and future ratios Decide whether to treat cash and investments separately or to subtract from debt policy
Determine residual value
Decide on residual-value methodology Either estimate growth rate in perpetuity or decide on a valuation multiple to use for residual value
Estimate WACC
Estimate cost of equity Estimate cost of debt Estimate cost of other finance if any Determine target debt/equity ratio
You can refer back to Unit 4 to refresh your memory on how to estimate the WACC from the cost of equity and the cost of debt.
Discount cash flows
Determine enterprise value Deduct debt and minority interests, add back cash and investments (if appropriate) to determine equity value Conduct sensitivity analysis
Prepare related financial statements
If future financial statements are to be calculated, determine what to do with cash flows generated regarding capital structure and dividend policy
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Box 4.1 shows a real life example on how to use the DCF valuation using the same company TELCO, already valued using valuation multiples in Box 3.3.
BOX 4.1 TELCO S DCF VALUATION

TELCO is a true fixed and cellular telecom company that operates in Africa and was valued in 2002 when privatised. For confidentiality reasons the name has been changed. Three complementary valuation methods were used. Two of them focused on comparable company and transaction multiples (as already discussed in Box 3.3), whilst the third used discounted cash flow (DCF), as shown below. The DCF valuation of TELCO was carried out on the fixed-network business and the cellular businesses, and was built on the following assumptions:
l l
Time horizon retained: ten years of cash flows from 2002. Forecast revenues and costs: estimated according to international benchmarks and local features and summarised below.
900 800 700 Real USD millions 600 500 400 300 200 100 0 2002 2003 2004 2005 2006 2007 Year 2008 2009 2010 2011
Total telecoms revenue Includes interconnection and carriers services
Revenue from fixed
Revenue from cellular
Figure 4.1a
Total telecoms revenue
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700 600 Real USD millions 500 400 300 200 100
Breakdown of total cost fixed
0
2002 2003 2004 2005 2006 2007 Year 2008 2009 2010 2011
Depreciation
Operating expenses
Outpayment
Tax
Figure 4.1b
450 400 350 Real USD millions 300 250 200 150 100 50 0 2002
Breakdown of total cost fixed
Breakdown of total cost cellular
2003
2004
2005
2006
2007 Year
2008
2009
2010
2011
Depreciation
Operating expenses
Outpayment
Tax
Figure 4.1c
Breakdown of total cost cellular
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Examples of international benchmarks for network rollout were in this case: Value driver Assumption
As per the demand and revenue analysis $750 per line in 2001, consistent with international benchmarks of which labour and material costs are both 50% $105 million in remedial CAPEX over two years (20023) Assumed investment as per TELCO June 2000 corporate plan Cumulative CAPEX Assumed to be 3% of cumulative CAPEX each year
Local access network
Number of lines CAPEX per line
Remedial CAPEX Backbone transmission network Capitalised maintenance
Value driver
TACS network New subscribers
Assumption
No new subscribers on the TACS network after 2001 and thus no additional CAPEX GSM network rolled out according to the demand as projected in the demand and revenue analysis CAPEX per subscriber based on cumulative CAPEX around $800 with a capacity of 9000 subscribers in 2001 and $300 when the capacity reaches 1.5 millions Licence fee of $285 million assumed to be paid in cash in 2001
GSM network
Rollout
CAPEX per subscriber
GSM licence fee
Capitalised maintenance
l
Cumulative CAPEX
Assumed to be 3% of cumulative CAPEX each year
An estimated total investment of $105 million to achieve sustainable quality of the existing fixed network. The residual values for the fixed and cellular businesses: estimated using an estimated growth rate in perpetuity, where the growth rate retained for both TELCOs fixed line and cellular operations was 3.5% per annum.
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A WACC computed using the following formula:
WACC = Rd (1 TC )
where:
D E + Re V V
Rd is the pre-tax cost of debt capital. This is assumed to be equal to the return on US treasury bonds (considered a risk free rate of return Rf), plus the home country risk factor (Cr) and a corporate debt premium (Dp). The country risk factor reflects risks inherent to investing in different sovereign territories and can be attributed to variations in the degree of economic, political, financial and institutional stability in different countries. This was estimated taking into account the return on the countrys Central Bank Certificates over and above the return on US Treasury bonds as well as international benchmarks for sovereign risk. That is, Rd = Rf + Cr + Dp. Tc is the home country corporate tax rate. D and E are the values of the TELCOs debt and equity, respectively, and V is the sum of D and E. Re is the cost of equity capital and is derived from the Capital Asset Pricing Model (CAPM) and where
Re = Rf + Cr + e (RM Rf ),
Rf is the return on US Treasury bonds (considered a risk free investment). Cr is the country risk premium for overseas investors investing in the country be is the equity beta of TELCO RM is the return on a representative portfolio of equities. Input
Risk free rate Country risk premium Corporate debt premium Equity beta
Symbol
Rf Cr Dp be
Value
5% 12% 4% 1.60
Comment
Return on US Treasury bonds Incorporates risks inherent to home country Local money market information Based on international benchmarks re-levered to reflect TELCO capital structure Based on international studies
Equity market risk premium
MRP
6%
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Corporate tax rate Weight debt Weight equity Computations Return on debt, post tax nominal Return on equity, post tax nominal Outputs WACC, post tax nominal $
Tc Wd We
30% 57% 43%
Marginal tax rate Based on current financing structure Based on current financing structure
Rdat Reat
15% 25%
WACC
20%
From these assumptions were determined the enterprise and equity values for both business as shown below:
350 300 250 USD millions 200 150 100 50 0 Fixed Cellular
TELCO net present value (cashflows)
Cashflow 20022011 Terminal value
Figure 4.1d
TELCO net present value
Fixed
Due to discounted free cash flow 20022011 Due to discounted residual value (perpetual growth) Enterprise value Long-term liabilities Current liabilities/cash Equity value total (US$ millions) 274 296 570
Cellular
151 153 304
Combined
426 449 874 - 498 54 430
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A sensitivity analysis to WACC was conducted retaining a WACC range of 1921%, as illustrated below. Fixed Cellular Combined
WACC WACC WACC WACC WACC WACC 19% 21% 19% 21% 19% 21% Due to discounted free cash flow 20022011 Due to discounted terminal value (perpetual growth) Enterprise value Long-term liabilities Current liabilities/ cash Equity value 293 254 162 139 455 394
334
258
173
133
507
391
627
512
335
272
962 - 498 54 517
785 - 498 54 340
ACTIVITY 4.2
Load VAL, the blank DCF spreadsheet for company valuation, and VALBOOT, a completed valuation for Boots. While you are reading through the rest of Section 4, look at the spreadsheets as examples of the valuation process.
Determine time horizon for specific forecasts
Look a t the economic and business cycle

Many of the valuation spreadsheets you will come across automatically assume a specific forecasting period. The spreadsheet we provide, VAL, does the same, allowing you to forecast specifically for a fixed number of years ahead (in our case, ten years) and then requiring you to calculate what is known as a residual value or terminal value for all cash flows beyond that fixed time horizon. The ten-year assumption is designed to allow you to include at least one economic cycle in the specific forecasts. It is all too easy to forecast three to five years of rapid growth and then assume implicitly in the residual value that things can only get better!
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Consider positive and negative growth

In the late 1990s, at the height of the new economy boom, most companies were valued using DCF analysis. Part of the reason for the optimistic valuations derived and hence the number of deals that subsequently went sour was the failure to incorporate negative growth into the spreadsheet models. Growth was always assumed to be both large and positive. It was assumed that sales could never fall, only go up. In the stock market collapse of the early twenty-first century, these assumptions were proved wrong.
Consider period of competitive ad va ntag e

Also, consider how long the company is likely to generate aboveaverage performance, given any advantage it may have relative to the competition. For example, pharmaceutical companies can use the life of a patent since they will be able to charge higher prices over that period before competitors are allowed to provide substitutes. The choice of period for specific forecasts can be linked to the competitive advantage period, with standard returns thereafter.
Forecast operating cash flows
What drove the valuation when VW took over Rolls-Royce?
Determine value drivers

Before estimating a stream of future cash flows, analysts need to determine what are the key drivers of those expected cash flows. Different valuation software will concentrate on different value drivers, but there is general consensus that the following forecasts are key to future cash flows:
l l l l l
future sales operating profits capital expenditure net operating asset needs taxes.
Future sales can be estimated in detail, looking at the likely volume and price of each product over time, as well as taking into account the kind of sector analysis recommended by Porter (1985) and discussed in Unit 1. We assume that, before attempting a valuation, you will have carried out this kind of analysis and are aware, for example, of likely future inflation rates, economic growth rates,
forecasts for the sector and company-specific issues such as quality of product, operating capacity and so on. However, instead of forecasting absolute numbers directly to feed into the cash-flow forecasts, we prefer, as in Block 2, to concentrate on ratios. This enables us to look at previous ratios and current ratios for the company and make a subjective decision as to whether to extrapolate a historical average, accept that the status quo will be maintained or input our own growth rates based on specific expectations for the future. You can note the following value-driver ratios in the ValueDrivers sheet of the VAL spreadsheet:
l l l
Change in sales %. Net operating profit/sales % (or operating profit margin). Net operating assets/sales % (as sales increase, so will the required net operating assets). Operating cash/sales % (this allows you to deal with any excess cash as an investment). Sales/net property, plant and equipment and depreciation/net property, plant and equipment (the asset-turnover ratio will drive your capital expenditure assumption, in that the more sales you have the more capital expenditure you are assumed to carry out). The depreciation figure is assumed in VAL to equal maintenance CAPEX this is a simplifying assumption. Total capital expenditure is assumed to be the maintenance CAPEX plus new CAPEX. Taxes/net operating profit (or taxes/net profit before tax). This should be the corporate tax rate unless the company has a different rate, say, due to overseas allowances.
Estimate historic, current and f uture ratios

Having determined a suitable set of value drivers, such as the six above, which are those used in VAL, you should estimate the ratios for the ten years to residual value. The first sheet of VAL, ValueDrivers, allows you to input the appropriate data from the last five years of accounts of any company and it then automatically calculates the five-year historical average and latest ratios on which to base your forecasts. It also allows you to override the historical ratios with your own estimates. The sheet Free Cash Flow shows all cash-flow assumptions over ten years and estimates the relevant free cash flows for discounting by the WACC.
Decide on cash/investment policy

As was made clear in Unit 2, it is a good idea to separate the financial elements of working capital from the operating elements, in order to get a better picture of the enterprise in question. In most DCF valuation models for companies, however, it is usual to estimate future working-capital needs as one line, ignoring whether there is excess cash or debt for the operating activities. In VAL you
are offered the opportunity to split the operating and financial elements of working capital, so you should consider the following:
l l l
What is the required ratio for net operating assets to sales? What is the required ratio for operating cash to sales? If there is substantial short-term debt, should this form part of long-term debt and be included in the debt-capital estimate for WACC or should it be dealt with in net operating assets or cash? If there is short-term cash in excess of operating requirements, should this be included in investments that are dealt with separately or treated as an asset that generates income in the form of interest received?
These questions are important, for example, when considering De La Rue which, at the time of writing, had surplus cash of at least 85m.
EXERCISE 4.1
Which of the two proposals for dealing with excess cash would give a higher value for De La Rue?
Determine residual value
The aim here is to estimate the present value of a stream of cash flows from the year after the specific time horizon to perpetuity. The difference between projects and companies is that projects typically have finite lives and most companies do not, because it is assumed that companies will invest in new projects in future. Thus, what is sometimes known as the present value of future growth opportunities has to be estimated through the mechanism of the residual value. This is an extremely important part of DCF valuation since, particularly for growth companies such as Vodaphone or Google, the residual value often makes up a substantial element of present value.
Decide on residual-value methodology

There are a number of ways in which the residual value can be estimated, deriving mostly from the valuation methods we considered in Sections 2 and 3. For example, a pessimistic view might be that the residual value was equal to the liquidation value making the assumption that there are no future growth opportunities and that, once the specific value has been added, the company will be disbanded. Not surprisingly, this approach to residual value is not popular, with most companies being expected to continue at least at current levels rather than close down. The most common approach is to value the company at the end of the forecasting time horizon by some appropriate market multiple, most often the EV/EBITDA ratio. Current levels of EV/EBITDA can be considered for the sector or for the economy, but the analyst
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must take into account the fact that the company may be valued on a very different multiple in ten years time, perhaps due to lower growth forecasts, but also perhaps due to different economic fundamentals. In VAL, we allow the analyst to input an EV/EBITDA multiple derived from external sources.
Estimate growth rate in perpetui ty

Instead of using a market multiple, the analyst may wish to make a specific forecast for growth. This is rather difficult to do in practice since 10% per annum growth in perpetuity, for example, is clearly unrealistic. The convention is to assume a low growth rate, from 0% to 4%, and care must be taken to allow for an appropriate inflation rate in the growth-rate assumption. In VAL, we can assume a growth rate of 2% in perpetuity if the growth-rate alternative for residual value is chosen. This is approximately in line with current inflation rates, so effectively assumes zero real growth.
Estimate WACC
How to estimate the WACC was covered in detail in Unit 4 and you should re-read Section 4 of that unit if necessary. VAL has a separate worksheet, WACC, in which WACC is estimated.
Determine target debt/equity ratio

For this, analysts should assume a debt/equity ratio that is likely to be maintained over time. Some companies disclose their target gearing levels for example, at the oil company BP, senior managers make company presentations to analysts at which they disclose five-year targets for gearing. For others, you will have to look over time and see what has been achieved and what is likely to be achieved. Do not forget that the higher the target debt/equity ratio, the lower the WACC and hence the higher the valuation you will get. Target debt/equity ratios should not be so high that tax relief on interest is not available. Notice also that the cash flows ignore any flows to do with debt the choice of capital structure, including the amount of debt, is left to be input into the WACC. VAL allows a choice of the actual debt/equity ratio or a target debt/ equity ratio in the WACC calculation.
Discount cash flows
Determine enterpri se value

Most spreadsheets, including VAL, calculate the present value of the cash flows for you. The present value is equal to the value of the enterprise, which belongs to all providers of long-term capital. In most cases, we consider these to be long-term debt providers, equity investors and preference and convertible shareholders. Minority interests can be included if significant. The results of the valuation are shown in the Valuation Worksheet of VAL. Enterprise value will include any investments such as cash mountains that
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you have deemed appropriate to treat separately as investments from the operating cash flows.
Determine equity value

VAL will estimate equity value provided you input the amount of debt, other non-equity capital and minority interests. The equity value is shown below the enterprise value, in the Valuation Worksheet of VAL. Equity value is calculated as enterprise value less total debt, minority interests and other equity. Dividing the equity value by the number of shares in issue gives the value per share, which can then be compared with the current share price. You can then decide whether the market value is too high or too low compared with your own valuation. The Valuation Worksheet of the VAL software also allows you to use the value of the share price that you obtained to estimate an implied P/E ratio, implied price-to-book ratio and implied EV/EBITDA ratio. These multiples allow you to compare the valuation result with other companies, sectors and markets and help to place the DCF valuation in context.
Conduct sensitivity analysis

Any valuation exercise should include a sensitivity analysis. It is key in any valuation (as we also emphasised for project appraisal) to identify which variables or value drivers affect value most. Is it, for example, the profit margin, the capital expenditure, the residualvalue assumption or the choice of WACC? No analyst will offer just one value without discussion. For example, Box 3.2 showed how analysts derived a range of values for TELCO. The point of valuing companies using the DCF approach is to identify the important numbers and assumptions and then to consider what happens if the forecasts are wrong either way. By changing inputs to the estimates for cash flow and WACC in VAL, you can study the effect of the changes on your estimated value. You can do this using the three sensitivity analysis sheets in VAL, the Sensitivity Input, Sensitivity Output and Sensitivity Summary.
Prepare related financial statements
Commercial valuation software packages typically include future balance sheets and income statements based on the cash-flow forecasts as part of the output on valuation. To do this, however, assumptions have to be made concerning the future cash flows generated. For example, in order to be consistent with the assumed constant target debt/equity ratio embedded in the WACC calculation, the software may assume a constant debt/equity ratio over time. If there is insufficient cash in any one period, the model will assume that debt or equity finance is raised according to the debt/equity-ratio constraint. Excess cash, on the other hand, is assumed paid out as dividends (or share repurchases). The De La Rue approach of building a cash mountain is disallowed! In our VAL spreadsheet, we do not estimate future accounting
statements, but be careful to think about the future cash flow, capital structure and dividend policy that you estimate to be likely to occur.
ACTIVITY 4.3
Use VAL to estimate a value as at 2004 for De La Rue. Input the required accounting data for De la Rue from the OUFS spreadsheet. Input also the estimates for the cost of debt, cost of equity and the debt/equity ratio derived in Unit 4. Making appropriate forecasts, estimate a value as at 2004 for De La Rue. Compare this with the then share price of 3.19. Would you have bought the shares at that time and, from your perspective, given todays share price, would you have been right? Compare your DCF models estimate with the DCF valuation of De La Rue on CD-ROM2 saved as VALDLR.
The DCF valuation method is widely used by companies and their advisers when making acquisition or divestment decisions, by venture capitalists and, increasingly, by equity analysts. Although theoretically more accurate than simple multiples or adjusted book value, DCF estimation is, however, only as good as the numbers put into the spreadsheet. It is difficult, when faced with a set of rising cash flows over time, to be clear where you are making assumptions that are unrealistic (say, in strategic or economic terms) and where you are being pessimistic. As an analyst, you will need to have a good sense for the numbers and the behaviour of revenues and costs for the sector, company or country you are examining. This means studying a sector closely as equity analysts do and using your common sense.
EXERCISE 4.2
You have been asked to value a start-up cable company which is expected to have heavy capital expenditure over the next five years and not to make a profit before Year 10. Try to think of at least three possible pitfalls in valuing this company using a traditional DCF approach.
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SUMMARY
In this section, we have discussed how companies, as well as
projects, can be valued using discounted cash-flow (DCF)
techniques, either at the equity level (by discounting expected
dividends by the cost of equity) or at the enterprise level
(discounting after-tax operating cash flows by the WACC).
The six steps in discounted cash-flow valuation were outlined:
l l l l l l
determine time horizon for specific forecasts;

forecast operating cash flows;
determine residual value;
estimate WACC;
discount cash flows;
prepare related financial statements.
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5 VALUATION IN CONTEXT
VALUATION IN CONTEXT
In this section we shall look at the context of valuation. As you will have gathered by now, after having looked at a number of valuation methods, the value you get will partly depend on the method you use and partly on the numbers you use. Another factor, though, is the purpose for which you are valuing a company. For example, are you a buyer or a seller? You will not be surprised to learn that sellers typically arrive at larger valuations for the same company than do buyers. Perhaps you are in the process of making a competitive tender for a company? Your bid will have to take account of the likely bids of the competition as well as on the value you have derived. The value of a company may be very different to two different bidders. This is for two reasons. First, one bidder may be intending to change the financial structure reduce the WACC whereas the other is not. Lowering the WACC will increase the value. In recent years, leveraged buyout specialists and private equity bidders have used aggressive debt levels to outbid the competition. Another reason why you might attach more value to a company than someone else is to do with synergy benefit. In other words, the combination of your company with the company you are bidding for is expected to have greater cost savings, higher sales or lower inventories than would be the case for other bidders. In this section we shall look at the valuation context in a number of specific circumstances:
l l l l l
regulation; new issues; privatisations; mergers and acquisitions; corporate restructuring.
Eastern Electricity, the company that was the subject of the videoprogramme, Changing Values, was valued in the context of being a regulated nationalised company, as a privatised company, as an acquisition target, as a new issue and as a company with a different financing structure.
ACTIVITY 5.1
Watch the video-programme, Changing Values, which charts the history of one company from nationalised industry, through privatisation, takeover and restructuring. This video
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highlights the main valuation techniques you have encountered in this unit and the main contexts in which valuation is important. You may be surprised at how valuations of the same profit-generating assets can vary over time leaving plenty of opportunity for investors to make or lose substantial amounts of money.
5.1
REGULATION
Eastern Electricity was originally part of the United Kingdoms state-owned electricity industry and, as such, was regulated as a monopoly. Since the state-owned sector was the sole provider of electricity in the United Kingdom, in theory it could charge what it wanted, subject to competition from other nationalised industries such as gas. Utilities such as Eastern Electricity are regulated all over the world, regardless of whether they form part of the public or state-owned sector or are owned by private investors. As the video shows, the traditional way for United Kingdom nationalised utilities to be regulated was for their return on assets to be monitored, with assets defined in terms of current costs. This meant that the fact that certain assets went up in value as a result of inflation would be taken into account in determining notional book value. However, allowance was also made for depreciation of assets which, although long lived, did not necessarily last for ever. Return on assets was a key performance measure and book value a key valuation input into that. Utilities such as Eastern Electricity and British Telecom are still regulated now that they are, or form part of, listed companies. Although the regulatory emphasis, in the United Kingdom at least, has shifted towards controlling prices charged and away from return on assets or return on capital employed, these ratios are still important. For example, British Telecom and its regulator OFTEL have clashed on whether development expenditure should be treated as an intangible asset and capitalised on the balance sheet, thus allowing British Telecom a larger capital base on which to earn a return, or simply deducted from profits as an expense.
BOX 5.1 INTANGIBLE ASSETS

Intangible capital is defined as the sum of identifiable, non-monetary assets without physical substance that:
l
are used in the production of or supply of goods or services or for administrative purposes and are expected to be used during more than one period.
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In the case of BT, the focus is on intangible capital generated in BT Group Research and Development. This relates in particular to product research and development, and platform and computer systems development. In the absence of market values, the value of such intangible capital can be assessed by capitalising the associated expenditures. These assets should be added to BTs tangible capital and BT should be allowed to recover its cost and earn a return on its full capital employed. The main reasons for this are:
l
Product research and development and platform and systems development represent an investment. Substantial costs are incurred today in order to achieve future benefits that cover cost and yield a return on investment. Intangible capital adds to the share value of a firm on which shareholders require a return. OFTEL recognises the relevance of technological improvement to achieve efficiency gains, improve quality, and widen the range of choice available to the customer. OFTEL will only be able to provide signals for efficient entry into and exit from the market for interconnection services if it includes intangible assets in its return base.
Pricing of Telecommunications from 1997 BTs response to OFTELs Consultative Document of December 1995 BTs Cost of Capital, Annex I, February 1996
ACTIVITY 5.2
Investigate a regulated company, whether state or privately owned, in which you have an interest and determine whether measures such as return on assets or ROCE are used in controlling its activities. Given the difficulties of estimating current or replacement value for many utilities assets, United Kingdom regulators such as OFWAT (the water industry regulator) place more emphasis currently on price caps than on returns on assets. See, for example, ofwat.gov.uk
5.2
NEW ISSUES
When a company comes to the stock market for the first time, such a new issue is called a flotation or a primary issue or an initial public offering (IPO): any subsequent equity issue is called a secondary equity offering (SEO).The traditional way in which new issues were managed in the United Kingdom was that the shares were offered at a fixed price based on a valuation of the company
as a going concern. Under this system, however, the issue price was typically below the valuation in order to ensure that the new issue was a success. The level of success was judged by how much the new issue was oversubscribed that is, by how much demand exceeded supply. The price was agreed between the issuing company, the bank(s) underwriting (guaranteeing) the success of the issue, and the broker(s) to the issue who advised on market sentiment. In recent years, US practices have become the norm for new issues in most countries. Under the US system, prices are not fixed in advance of the issue date. Instead, banks managing the issue obtain indications of interest from investors, called book building or book running (and for big issues this can be on a global basis), and fix the price at the last minute according to demand. It is argued that this method is better for the issuing company since shares are issued at a higher price and fewer shares have to be issued in order to obtain the same proceeds from the sale. However, the book-building system relies heavily on marketing and the typical total charges, including marketing commissions, for even a large issue worth hundreds of millions of dollars, amount to around 5% of the gross proceeds. Each stock market has certain criteria which companies have to satisfy before they can be listed. Listing typically entails additional requirements on companies, over and above those embodied in legislation. For example, companies listed on the London Stock Exchange are required to issue interim reports (for the first six months of the financial year) in addition to the annual report, whereas unlisted companies are required only to file annual accounts. In the USA, companies listed on the New York Stock Exchange are required to report results quarterly this requirement can be off-putting for those companies whose management and financial accounting systems are not up to it! Other listing requirements are concerned with the size and profitability of companies and with their track record. They may also require at least a minimum percentage of the equity to be held outside ownermanagers hands in order to be sure of sufficient trading and hence liquidity in the shares. Major stock exchanges may require five years of audited accounts showing profits before they will allow a listing. In recent years, however, many stock exchanges have developed special markets or deliberately encouraged start-up companies to list on their exchanges. Thus, biotechnology companies, for example, with no profits and little in the way of assets have been able to issue shares on markets such as NASDAQ in the USA or AIM in the United Kingdom that have less onerous listing requirements.
Note that the returns are calculated from the end of day one of issue, excluding any new issue underpricing.
Although new shares are often issued at a discount to the value at which they subsequently trade, one of the more interesting areas of finance research is what is known as the new equity puzzle (see, for example, Loughran and Ritter, 1995). These authors found that new issues in the US between 1970 and 1990 a long period
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encompassing both bull and bear markets had been poor long-term investments. This applied to both primary (IPO) and secondary (SEO) issues of shares. They calculated that investors would have had to put 44% more money in issuing companies than non-issuing companies (with similar characteristics) to have the same wealth five years later. More recently, this has been tied in with broker research on new issues, which has been found to be over-optimistic. Analysts then, over the next few years after a new issue, revise these over-optimistic forecasts down to more realistic levels.
Indeed, in 2002, Merrill Lynch paid a fine of $100 million dollars in compensation for having published buy recommendations during the stock market bubble of the late 1990s. Their buy recommendations were for issues promoted by Merrill Lynch which their own analysts privately believed were worthless. Other research firms in the USA faced similar fines.
ACTIVITY 5.3
For an interesting example of a new issue, look at the press cuttings in the Course Reader on the Google IPO, which used an innovative new issue procedure when it was floated in 2004. Note how valuation was difficult both during the IPO and after, given the fact that Google had been in existence for only a few years and that future growth in sales and profits were difficult to estimate. Note also how enormous profits could be made in the short term. Would this have been true over a longer period? Look at the Google share price today. Were the optimists or the pessimists right? For an update on new issue overvaluation, visit the Jay Ritter home page, which has some of the latest research on new issues.
5.3
PRIVATISATIONS
A major source of new issues has come from the privatisation of state-owned companies and the demutualisation of companies previously owned by their members, such as building societies. Privatisation is the transfer of state-owned assets or enterprises from governmental to private ownership and control. One of the main reasons for the United Kingdom governments privatisation programme was that many United Kingdom utilities needed to replace an ageing infrastructure. For example, Eastern Electricity had a long track record of low profits, as it had been attempting to offer services at low cost to consumers rather than maximising
Building societies is the UK term for mortgage banks, or what Americans call savings and loans.
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value for the government. If it had remained part of the government sector, it would have had to raise debt which formed part of government borrowing. Privatisation has the advantage of effectively reducing public-sector debt and at the same time allowing utilities to raise both debt and equity finance to fund capital expenditure. Valuation of these utilities depends very much on the terms on which they were privatised: that is, on the regulatory regime they were given in which to operate in the private sector and on the opportunity to cut costs and increase revenues in changing technological environments. For example, the restrictions imposed on several utilities limited price rises to the rate of inflation less a percentage figure determined by the state regulator, which in the case of BT was the telecommunications regulator, OFTEL. This encouraged utilities such as BT to cut costs since there were, in general, no clawbacks of any profits made by increased efficiencies. The new-issue valuations applied to the early United Kingdom privatisations were based on the political need to be seen as successes and on their sheer size. They also reflected the fact that there was little experience in the United Kingdom of valuing utilities, as, until the 1980s privatisation programme, utilities had not been listed on the stock exchange since before the Second World War. For these reasons, the traditional fixed-price flotation method was adopted in most cases, leading to substantial underpricing of the shares on issue. This could be seen when the share prices rose within a day of listing to premiums of sometimes more than 100% over the issue prices. However, Railtrack, privatised in 1996 at 3.90 per share and whose shares rose to 17 at their peak, subsequently had its shares suspended at 2.80 when it went into administration on 7 October 2001.
BOX 5.2 THE STATE ELECTRICITY UTILITY IN THE UNITED KINGDOM

In 1989, the United Kingdom government decided to privatise the electricity sector through an offer of shares to the investment community, with special emphasis on distribution of shares to customer stakeholders. The electricity industry included both the generation and distribution of electrical power. The transmission system, known as the National Grid, which consisted of a country wide network wiring of the industry, was broken up into various parts. Nuclear Electricity, deemed to be the most problematic of the constituent parts to privatise because of the unknown size of the decommissioning costs, was held back from the main privatisation initiative and privatised in 1996. The generating activities were split into two companies and the distribution activity split into ten regional distributors that each held a monopoly regional franchise
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for electricity distribution in a defined area and jointly retained ownership in the National Grid. One of these, Eastern Electricity plc, is the company featured in the video, Changing Values. The share issue of the twelve regional electricity distributors (RECs) in 1990 was co-ordinated by Kleinwort Benson, as advisers to the United Kingdom government. They offered the shares for sale as agents of the government. Individual investors were invited to subscribe for shares at a price of 2.40, with the balance of shares being distributed among institutional investors after priority allocations to, for example, customers. The issue was popular, being over-subscribed ten times, and the companies were then free to compete in their markets as they chose. As part of the restructuring process, each REC was equipped with a working capital facility provided by a syndicate of banks to allow it to manage its own affairs on flotation and separation. The assets used for power generation were ageing and interest was being shown in generation using more economical gas-fired power stations. It was hoped that the liberalisation of the electricity markets would encourage greater competition and benefit the consumer in the longer term through lower prices. Valuing the RECs posed an interesting challenge for the government and its advisers. When it was a part of the nationalised sector, Eastern Electricity had been valued in terms of the asset base at its disposal and judged on return on capital employed. On privatisation, however, the pricing reflected the way other low-growth, steady income utilities were valued and the price was determined on required dividend yield. After the privatisation, the share price of Eastern Electricity rose significantly as it became known as one of the more aggressively run distribution companies. It diversified into other activities such as gas distribution, which it used for electricity generation, developing projects where it was able to purchase the power output. In common with several other RECs, Eastern Electricity repurchased 19.95% of its own shares through the market in 1994. This decision was based on the cash surplus existing at the time and the dearth of other attractive investment opportunities. It also offered a way of enhancing the returns for those shareholders who remained. Eventually it attracted the attention of the Hanson Group, which launched a takeover bid in 1995 at some 9.75 per share, valuing the total group at 2.5bn, or 2.7bn after adjustment for debt and the subsequent sale of its share of the National Grid. The level of this bid represented a multiple of over four times the issue price in less than six years and was thought to be indicative of a valuation based on the discounted worth of future revenues, in particular future earnings. After acquisition, emphasis switched to cash flow. The demerger by Hanson of Eastern Electricity together with another Hanson company, Peabody Coal, as The Energy Group in 1996, at a share price of 5.25 or total value of 3.6bn, reflected an enhanced perception of the cash flow generating power of the entity. In 1998, this group was the subject of two bids from US
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utilities, both keen to add value by refinancing to include more debt and hence reduce the weighted average cost of capital and increase the enterprise value. The Eastern Electricity story offers us the opportunity to look at a business that has been valued a number of times with views from different stakeholder over a comparatively short period of time. We have summarised the valuations in Table 5.1. It also offers an insight into how analysts, expert in their field, can take a long time to change their attitude and method of valuation of companies, as shown in the following Lex column article from the Financial Times (Box 5.3).
Table 5.1
Date
Pre-1990 1990 1995 1996 1998
Reason for valuation

Nationalised Privatisation Takeover Demerger Subject of bids
Valuation method
Asset-related Dividend yield PE ratio Cash flow DCF using WACC
Equity value
n/a 0.65bn 2.5bn 3.6bn (including Peabody Coal) 4.5bn
BOX 5.3 VALUING UTILITIES

Here is a puzzle for efficient-market theorists: why, in the face of plenty of evidence, do so many investors cling to the traditional method of valuing Britains utilities on yields? Theory, of course, says yields can be as good a guide to value as any other. By definition, a company is worth the sum of all the dividends it will ever pay; a yield valuation which gets a stocks dividend growth potential right, as well as the risks, will be spot on. But in practice, largely as a result of under-gearing and high levels of dividend cover, valuations based on current pay-out levels have consistently underestimated utilities potential to shovel out cash a point bidders have not been slow to spot. In time, yield-based valuations will be easier to get right when utilities have finally got their balance sheets in order and run out
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of scope to outsmart their regulators and the shares will look more like bonds. The fact remains, however, that Britains utilities are mostly a long way from that. What should investors do in the meantime? The best answer is to pay more attention to balance sheets and cash flow. In practice, this means looking at cash flow interest cover, enterprise value to cash flow multiples and taking the trouble to run full-blown discounted cash flow models. This kind of analysis is no Holy Grail; it is tricky, for instance, to allow for the occasional enthusiasm of regulators and governments to get their own hands on investors cash. And utilities may themselves waste it. But cash flow projections do at least give investors a basic yardstick against which to judge a utilitys future dividend-paying potential. So even if investors are too fond of yields to part with them, they would still have a better chance of getting them right.
Some other United Kingdom privatisations were simply the sale of shares in companies that had previously been quoted, but had been rescued by past governments for economic or strategic reasons. An example of this was the privatisation of Rolls Royce (the aero-engine manufacturer, not the car builder). In such cases, the valuation methods used could reflect the fact that the company had previously been run on a commercial, profit-making basis and could therefore be compared with similar companies trading on the stock market.
Banks selling the newly issued Rolls Royce shares approached Middle Eastern investors and were happy to find a substantial number of people keen to buy the shares. It was only later that the investors realised that they were investing in aero-engines and not luxury cars. What price sophisticated valuation techniques!
From the 1990s onwards, there was a move towards privatisation in many countries around the world, encouraged by international bodies such as the International Monetary Fund (IMF). Different governments have chosen different means of moving their stateowned departments or organisations into the private sector, not all of them involving new issues. For example, after the reunification of Germany, East German companies were privatised by means of trade sale to other companies, often with an auction process involving two rounds of sealed bids. This preference for trade sale was because many companies were not profitable and needed capital investment and management skills that could only be
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provided by other companies and not by a diffuse body of shareholders. The Czech government chose to give vouchers to its taxpayers, which they either used to buy shares in specific companies or gave to specially created investment companies to choose and manage the investments on their behalf. This privatisation route was chosen because many of the companies for sale were too small to warrant individual privatisation. The New Zealand government sold some of its enterprises to foreign-based companies that had expertise in overseas investment.
BOX 5.4 THE ASMARA BREWERY

In February 1997, the government of Eritrea, through its National Agency for the Supervision and Privatisation of Public Enterprises (NASPPE) invited bids for the total acquisition of the Asmara Brewery. The invitation was issued as advertisements in a number of national and international newspapers and journals. The bid documents could be obtained for a notional fee of about US$13 by application to the office of NASPPE in Asmara, Eritreas capital city. The non-refundable fee for the documents was a device to cover photocopying and printing costs and to act as an initial deterrent to non-serious applicants. The invitation to bid set out a timetable and made clear that NASPPE had an ultimate veto. It described in some detail which assets were for sale and the terms, including issues relating to payments by the government for terminating staff contract (all staff contracts were to be terminated and staff might then be re-hired by the new owner) and the government policy of selling enterprises without debts or other encumbrances. Bidders were requested to submit a bid bond for a certain percentage of the price offered together with their bid, and the bonds would be released within sixty days of the opening date. Again, this device of an irrevocable bank guarantee in favour of NASPPE, in the form of the bid bond, was used to deter casual bidders. The successful bidder had fifteen days to conduct an audit (or due diligence) of the operation and forty-five days to complete a purchase agreement. This speed was necessary to ensure that the deal preserved the commercial interests of the company and gave the workforce fast and clear information about their future.
The trade-sale route employed by the government of Eritrea is not uncommon for enterprises where there is going to be a need for the introduction of new management and/or significant capital investment. It also shows some sensitivity to problems in some earlier privatisations in other countries: overstaffed state enterprises, where the foreign purchaser could not cut the workforce, or a high cost base. An asset sale allows the new purchaser to start with a clean sheet and to capitalise the new venture as appropriate. Part of the vetting procedure for the privatisation of the Asmara
Asmara
brewery included an assessment of a five-year projection for the enterprise under its new ownership, so the future as well as the present was taken into account. There was, however, no requirement that projections had to be achieved, merely that they seemed achievable. Privatised companies have included telecommunications, electricity and road companies and have been sold to investors around the world. One of the major consequences of this globalisation of equity issues has been a trend towards standard methods of valuation, notably market multiples such as EV/EBITDA and discounted cash flow. This was the case with the privatisation of TELCO which you came across in Boxes 3.2 and 4.1. Privatisation is still taking place in a number of countries. For example, Box 5.5 discusses some of the issues involved surrounding the proposed privatisation of the Hong Kong Airport Authority in 2004 . It highlights some of the complex issues when considering the value of the privatisation to taxpayers.
BOX 5.5 PROPOSED PRIVATISATION OF THE HONG KONG AIRPORT AUTHORITY

A consultation document on the partial privatization of Hong Kong airport authority was released by Hong Kong Economic Development and Labor Bureau Monday. Outlining 21 preliminary proposals for public comment, the document deals with regulatory issues in six main areas, namely, the relationship between Hong Kong SAR government and a partially privatized authority, the authoritys business case and valuation, economic regulation, land use, competition and scope of business, and impact on companies and workers at the airport. Following the recent capital
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restructuring, the paper said the governments equity capital in the authority stands at about HK$30.7 billion (US$4 billion). Its return on equity is low especially in the context of a commercial enterprise. In order for the market to ascribe a value to the authority comparable to the SAR governments equity investment, the authority needs to demonstrate to potential investors that it will be able to achieve a commercial return within a reasonable timeframe. The paper said this is a choice between trying to preserve taxpayers investment by increasing airport charges in the next few years, or keeping airport charges more competitive at the risk of diminishing taxpayers investment in the authority. Concerns have been expressed by some stakeholders that the authority would be privileged over other developers or other private enterprises given the land it holds and its status as the operator of Hong Kong International Airport, which may give rise to unfair competition or anticompetitive practices.
(Financial Times, 23 November 2004)
5.4
MERGERS AND ACQUISITIONS
A merger is the result of two or more companies (or indeed other economic entities, such as trade unions, housing associations, charities) of similar scale coming together to form a single entity. Mergers require the consent of all the entities concerned since they cease to exist as separate entities on merger, becoming, instead, a single merged entity. An acquisition is the result of the assumption of the assets or the business of an economic entity by another, where the acquired entity usually survives as a separate operation, perhaps a fullyowned subsidiary of the acquirer. Takeover is simply another word for acquisition. Note that, unlike mergers, acquisitions do not always have to be accepted by managers. If there are voting shareholders, for a listed company, or voting policyholders, for a mutual insurance company, the company or entity can be sold over the heads of the existing management. Managers may fight off a takeover bid, even though it represents value for shareholders, because they are reluctant to lose control. Until recently, the most common form of combination for companies was full or partial takeover of one company by another. Although the term mergers and acquisitions (often shortened to M&A) had been used for decades, many people had never seen a true corporate merger. The late 1990s, however, changed all that with huge mergers, such as those between two Swiss pharmaceutical companies, Sandoz and Ciba-Geigy, to form Novartis; between two United Kingdom drinks companies, Grand Metropolitan and Guinness, to form Diageo; between two accounting partnerships, Coopers & Lybrand and Price Waterhouse, to form PricewaterhouseCoopers; and the $166bn merger of
There is more on the possible conflicts between managers and shareholders in Unit 10.
Citibank and Travelers Group to form Citigroup, a financial services company with 100 million corporate and retail customers in over 100 countries. The common theme behind all these mergers was that, as markets have become global, so companies need to have sufficient size to operate in this larger marketplace. The less publicised rationale was cost savings from removal of duplication in a number of product areas, countries and central services operations. The non-corporate sector has also seen recent mergers with consolidation in the law profession, in the housing-association and building-society sectors, in trade unions and in health trusts. The economic rationale for a merger or acquisition is that A + B combined will be worth more than A on its own and B on its own. There are a number of possible reasons for this phenomenon, known as synergy, which can come from benefits derived from vertical integration, horizontal integration, technology, process or brand capture, improved management, cost savings through economies of scale, critical mass and so on. A further motive for mergers, popular in the 1970s and 1980s, was the opposite reason to synergy diversification. This was the time when tobacco companies diversified into food manufacturing and car companies went into insurance. What was not appreciated at the time was that, since shareholders can diversify by buying shares in different sectors, there is no need for companies to do it for them. In Box 5.6 overleaf, the demise of Hanson, one of the largest United Kingdom conglomerates is discussed. Financial motives for mergers and acquisitions are also relevant. In the 1980s, acquirers attempted to enhance earnings per share by acquiring companies with lower PE ratios. Provided investors applied the same PE ratio to the larger entity as they had to the acquirer in other words, provided that they were fooled value was added as if by magic! In the 1990s, a main motive for takeovers was to add value through increasing the debtequity ratio and thereby reducing the WACC. The same cash flows, discounted by a lower WACC, became worth more. As a result, there was a boom in what were then known as leveraged buyouts. Private investment vehicles, using bank loans or bonds to provide the debt, took publicly listed companies private. In the twenty-first century, the trend is for private-equity and venture-capital funds to acquire companies and enhance value through better management and more cost-effective financing.
ACTIVITY 5.4
Read Box 5.6, Big can still be beautiful, on conglomerates and, in particular, on Hanson. Note how the attitude towards conglomerates has changed over time. What mistakes was Hanson perceived to have made? Note that EVA, referred to in this article, is discussed in detail in Unit 10.
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BOX 5.6 BIG CAN STILL BE BEAUTIFUL

Today brings the formal dissolution of Hanson, one of the most prominent conglomerates of recent times. The spin-off of the various parts of its empire, such as Imperial Tobacco, will doubtless fuel a familiar debate. In todays competitive climate, we are told, companies need to be focused. Conglomerates have had their day. But there is a growing consensus among academics, analysts and managers that this argument is becoming sterile. Focus and diversity can both work, provided the circumstances are right. If the break-up of Hanson proves a point, it is about companies of Hansons peculiar type, not diversified corporations as a class. The case for diversity can be made in two ways. First, experience shows that old-established corporations such as General Electric or 3M of the US can invest across a huge range of businesses and add value for their owners. Second, there are several big conglomerates today which make a great deal of money from acquisitions, as Hanson did in its heyday. But instead of being conventional corporations they are privately run investments specialists such as Kohlberg Kravis Roberts (KKR). There is no doubt that Hanson, in its latter years, lost its way. It was not alone. According to a recent study from NatWest Securities, the stockbrokers, almost all the United Kingdom conglomerates, including BTR, have been systematically destroying value since around 1990. The study analyses the companies by the increasingly popular US-derived measure of Economic Value Added (EVA). In essence, this looks at the spread between the return on capital invested in the business including equity and its cost. According to NatWest Securities, the sector has produced an average 8 per cent net return on capital in the past six years, compared with an 11 per cent cost of capital. Thus, it has been frittering away its capital base at around 3 per cent a year. Hanson, because of the break-up, is not included in the calculation. But according to the studys authors, its record is much the same. In part, the EVA approach exposes the illusory nature of acquisition accounting. For many years, acquisitive conglomerates used provisions and other tricks of the accounting trade to boost earnings. If shareholders are to learn anything from Hanson, the NatWest study remarks, it is that creation of value and earnings enhancement are not the same thing. Thus, while the United Kingdom conglomerates reported rising earnings, value was being destroyed.
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There were two main reasons for this. First, the companies typically paid too much for acquisitions in the late 1980s. Second, they relied too heavily on equity to pay for them. One of the most decisive factors in the rise of companies such as Hanson and BTR was the wealth of cheap acquisition opportunities in the mid 1980s. Hanson, for instance, was able to buy large chunks of the US conglomerate SCM and the tobacco-based Imperial Group for little or nothing in 198586, since the purchase price was recouped within months by selling off other parts of the business. In the usual market fashion, this opportunity cancelled itself out. Other providers of capital spotted the gap, and acquisition prices rose. But the conglomerates carried on buying. BTR bought the engineering group Hawker Siddeley; Hanson bought Consolidated Goldfields and Beazer, the housebuilder. They destroyed value accordingly. To be fair, they were not unique. Another company which made its fortune through windfall acquisition in the mid-1980s was Guinness, with the purchase of Distillers, the Scotch whisky group. It then went on to more expensive purchases later in the decade, such as the Spanish brewer Cruzcampo; and as its chairman finally confessed last week, it damaged shareholder value in the process. But the conglomerates were unusual in relying so heavily on equity as an apparently cheap and risk-free means of payment. Mr Andrew Arends, an acquisition manager with Hanson in the 1980s, says this was particularly true of the late Lord (Gordon) White, Hansons co-founder. It was a psychological thing Gordon got stuck into, Mr Arends says. He was influenced by the US conglomerates in the 1960s. He always had in mind the concept of cheap paper. The contrast with todays successful acquisition specialists could not be more acute. Mr Arends points to the example of Mr Warren Buffett, the US portfolio investor whose company, Berkshire Hathaway, is a conglomerate in all but name. Throughout his career, Mr Buffett has regarded Berkshire Hathaways equity as a precious commodity, not to be given away under any circumstances. Or take the leveraged buyout specialists such as KKR or Clayton, Dubilier & Rice. Their approach is to make acquisitions for debt, thus using debt payments as a stick to force managers into maximising cash flow. At the same time, equity is reserved for the funds investors, and as a carrot to reward managers. This is the heart of the argument against conglomerates such as Hanson and BTR: if they cannot find a continuous supply of cheap companies to buy, they cannot hope to add value to their existing subsidiaries either.
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There is one final flaw in companies like Hanson, and it can prove fatal. If cheap acquisitions can indeed be found, the way to secure value for shareholders is by re-packaging the bits and selling them on again. But it is in the nature of managers to prefer buying things to selling them: that is, to build empires. In a remarkably prescient article from 1987 (reprinted by Goold and Luchs), Professor Michael Porter of Harvard University reflected on the dismal tendency of old-style US conglomerates to destroy value over the previous 35 years. He pointed to Hanson, then at its peak with the triumphant acquisition of Imperial Group, as one of a successful new breed of restructurers. However, he added a warning. Its too early to tell, he wrote, whether Hanson will adhere to the last tenet of restructuring selling turned-around units once the results are clear. If it succumbs to the allure of bigness, Hanson may take the course of the failed US conglomerates. Hanson, of course, did not follow that advice. Eventually, it became too big to survive: and todays break-up is the result.
(Financial Times, 5 November 1996)
Weve finally tracked down the parent company of that Siberian outfit that went bust owing us a fortune its us!
Hanson is perceived to have made several errors. First, Hanson, confused earnings enhancement with value creation. The emphasis today is on adding positive net present value of cash flows rather than concentrating on maximising earnings per share. Second, Hanson held on to too many of the acquisitions it made. Todays private equity investors and venture capitalists treat companies as commodities to be bought and sold at a profit. Finally, Hanson relied on its own shares (paper) to make acquisitions. Again, the trend now is to finance as much as possible with low-cost debt. With interest rates today at near fifty-year lows, too much equity in the structure will lead to a high WACC and reduce the number of profitable acquisition opportunities.
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If there are synergy benefits to a merger or takeover, whether economic, strategic, or purely financial, these should be quantified and included in the valuation. For example, cost savings of 100m a year for five years can be discounted using the WACC to provide a net present value. Alternatively, if the acquirer has access to a lower WACC, the acquiree will be worth more, even if there are no cost savings. The value of a company as a stand-alone concern is likely to be different from its value as a subsidiary or merged entity. In addition, the bidding process for a company will also affect the price. For example, a company may be put up for sale because a large company had decided that it no longer wants to be in the business of a subsidiary. The advisers to the selling company will put together an offering memorandum, giving financial and other details on the company to be sold. Potential bidders can then put in a non-binding bid. This first-stage process will identify serious purchasers and weed out the rest. The second stage gives potential bidders access to more information, but they then have to put in sealed bids. This part of the process requires bidders to think not only of the stand-alone value of the target company and of the value to them, but also of the value to the competing bidders. Competitive bids such as these and also hostile bids via the stock market should be just high enough to see off the competition, but not so high as to give the seller all the synergy benefits. Once a bid has been accepted, the buyer signs a letter of intent to purchase, subject to what is known as due diligence. This is where financial advisers, such as accountants, go into the target company and check that there are no hidden problems. The final contract signed between buyer and seller will try to deal with any problems, such as contingent liabilities, unpaid debts and so on. The purchase price may even be in several elements, with later payments linked to performance. An alternative valuation process takes place when companies are acquired on the stock market. Bids can either be agreed or hostile. If agreed, this means that the directors of the target company have approved both the potential acquirer and the price to be paid for the shares. If hostile, the would-be acquirers make a direct approach to shareholders, by-passing the directors. It is unusual for directors to agree to a bid immediately, since directors have a duty to extract the best possible price for shareholders, even if they believe that the company should be sold. They may try to encourage a second bidder, to raise the value of the offer. Directors do not always manage to do this though. A 19bn bid for Abbey (previously Abbey National, a United Kingdom retail bank) in 2001 by Lloyds TSB was vetoed as being anti-competitive. Directors then agreed an approximately 9bn bid with Banco Santander, a Spanish bank (see Box 5.7). Hopes of a counter-bidder failed to materialise and the takeover went ahead in 2004.
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BOX 5.7 THE BATTLE FOR ABBEY

Shares in Abbey National and prospective buyer Banco Santander both rose yesterday amid mounting City support for a counter-bid from a British institution. HBoS has said it is considering whether a combination with Abbey would be in the interests of its shareholders. A bid would also be likely to renew Lloyds TSBs interest in Abbey despite the Competition Commissions decision to block its pounds 19 billion approach in 2001. One fund manager said that HBoS could bid up to 650p for Abbey, a 17pc premium to Santanders current offer, and still achieve the necessary returns and synergies to make a deal pay, although shareholders would be likely to balk at such a price. At yesterdays prices Santanders offer was worth 560p or 8.27 billion compared with Abbeys closing price of 586p, up 6p, which values the company at 8.65 billion. HBoS is not expected to declare its hand until after Santander publishes its offer document next month. HBoS was created after the merger of former building society Halifax with Bank of Scotland. HBoS chief executive James Crosby won cost and revenue savings of 807m from the deal. Analysts believe the HBoS management would be best placed among United Kingdom banks to achieve similar savings from a deal with Abbey. A United Kingdom bank would be able to double the 450m cost savings targeted by Santander because of overlap in branches and jobs but would be likely to face the ire of unions and politicians if it imposed large-scale job losses and branch cuts. Santander, as an overseas concern, does not face competition issues in the United Kingdom and the EU authorities have fasttracked the bid. However, with more than a third of the United Kingdom mortgage market, an HBoS bid for Abbey would face a referral with the resultant inquiry likely to last for at least six months. Shareholder Legal & General has said it would welcome a British company coming forward with an offer for Abbey and that consolidation should be allowed by the Competition Commission given the intense competition in the mortgage market. Isis fund manager Jamie Hopper said he believed that HBoS would not need to offer a substantial premium over Santanders bid because of the advantages to Abbeys shareholders of being paid in United Kingdom paper. They would have to increase the cash element of the offer, but if they could do that then the deal would stack up, he said.
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Analysts believe HBoS will attempt to break up the deal with a bid of between 600 and 650p. Abbey has said it is committed to a merger with Santander and the Spanish bank has indicated that it will offer incentives to the sizeable corps of Abbey retail shareholders who have held the stock since demutualisation.
(The Daily Telegraph, 18 August 2004)
In a hostile bid, making an appropriate valuation is more difficult than in competitive tendering. In a hostile bid, the target has a share price which, in an efficient market, should reflect its value as a stand-alone company. However, rumours of potential takeovers may already be in the price and these will have to be excluded. In contrast, the synergy benefits can be added to the share price to give the maximum amount the bidder can afford to pay. Therefore Maximum price to be paid = Current share price Any bid premium already in share price + Synergy benefits A bidder has to take account of whether the bid is likely to be immediately successful or not. If the initial bid is too low, this could draw in other bidders and may lose the target. If too high, the synergy benefits will be wasted. One thing is certain: the bidder will have to pay a premium to the current share price to tempt shareholders to accept. Bid premiums can go as high as 50% or more in a bull market. The M&A business involves negotiation skills as well as valuation skills. An additional factor to consider is the method of payment. Paying equity for a company is, given the cost of equity, an expensive means of payment. It also has the effect of transferring some of the synergy benefits to the selling shareholders. They, too, will benefit in any future growth. The use of debt is now more common, for a number of reasons. First, interest rates have been very low which, with the tax advantage of debt, allows a very low WACC and hence high valuation. Second, debt has the advantage that it can be secured on the assets of the business to be acquired and secured debt is even cheaper than unsecured debt. Third, buying and selling companies has become easier. This has led to an increase in private-equity and venture-capital firms, using money raised from institutional or large private investors, seeking high returns from leveraged deals. These firms do not usually have listed shares that can be used as payment for companies. Instead, they use their own funds, plus bank debt, to buy the companies they intend to sell at a profit in a few years time.
Clearly, issues other than valuation can affect the success or failure of a merger, as was the case with the abortive Smith Kline Beecham/Glaxo Wellcome merger announced in 1998. This foundered on an argument about who got what senior management job. The merger, however, did finally take place in September 2000.
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There is a substantial academic literature on whether or not mergers and acquisitions add value for the shareholders concerned. A large number of studies have been carried out in a wide range of countries and the overall results are that there are synergy benefits in other words A + B is worth more than A and B alone. However, the shareholders who benefit are more likely to be the selling shareholders than those of the acquirers. For example, Hanson ended up paying 9.75 for Eastern Electricity shares which were trading at 7.00 on the last day of trading before the announcement of the bid.
ACTIVITY 5.5
Read the article in the Course Reader on cross-border M&A by Simon London of the Financial Times, which reports on research that highlights the potential advantages of crossborder mergers and acquisitions, but also on the difficulties companies encounter in adding value, even for the selling shareholders.
Given the weight of evidence against the benefits of takeovers, why do companies persist in making acquisitions? There is some evidence (see, for example, Brealey and Myers, 2005, p. 966) of the existence of merger waves or cycles. In this pattern, companies grow because of economic booms and market expansion. A point is then reached where growth expectations of investors can no longer be met solely from organic growth of products or services. Companies may also be benefiting from strong cash flows at this stage of the cycle and further investment in projects may not yield the required rate of return. At this point, companies consider either a major expansion in the same sector, or a new one, and adopt the merger or acquisition route. Once started, the size of the acquisitions or mergers has to increase continually in order to satisfy investors required rates of return. The company then reaches a size and diversity of businesses which makes both analysis and cost savings difficult to achieve. It then becomes a break-up candidate, until the merger wave begins all over again. Merger waves are therefore fuelled by easy debt (if funded by debt), rising equity markets (making acquirers equity stretch further) and periods of economic growth. One aspect of mergers and acquisitions is the way in which the participating organisations are valued. Market multiples are popular since they allow comparison with recent purchases in the same sector; book value is not, unless the company has few growth prospects. Nowadays, the overriding valuation method is DCF, either by the company making the acquisition or their advisers. DCF allows the potential bidder to determine the (maximum) acquisition price and hence the premium to the current price it can pay. It also determines the value and impact of any synergies arising from the deal. The main impetus for the DCF approach has
come from US investment banks and this has overtaken the traditional United Kingdom bank approach of preferring the simpler market multiples. DCF approaches have radically affected the way analysts have to value shares listed on stock markets. They can no longer be valued simply as going concerns, they must also be valued using DCF as possible takeover targets (and size is no hindrance, given the availability of debt finance) or as merger candidates. It could also be argued that the greater emphasis of management on adding value and on global strategy has increased merger and acquisition activity, not only in traditionally active stock markets such as the USA and the United Kingdom, but also in Europe and Asia.
ACTIVITY 5.6
In Section 4, you used VAL to value De La Rue as a going concern using discounted cash-flow analysis. How would you alter your DCF valuation of De La Rue if you were a potential bidder or an investor scenting a potential bid? The main issues would be whether the bidder had any synergy benefits, such as country overlaps or improved management. More likely is the ability to use De La Rues excess cash for positive NPV investment or to lower the cost of capital through the use of more debt. For example, you can rerun VAL to estimate how much value a reduction of 1% in cost of capital could add.
5.5
RESTRUCTURING
In this final part of Section 5, we look at valuation in the more general context of restructuring. Behind such moves lies the idea of releasing value back to shareholders. For example, we saw in Unit 4 that share repurchases and altering the debtequity ratio could affect value. There are, however, ways in which altering the ownership of companies can add value. For example, conglomerates, as we have already seen in this section, may have difficulty in maximising shareholder value. This can be because different elements of a company will be valued differently (due to different growth prospects, levels of profitability). Shareholder value may be maximised by spinning off an under-valued subsidiary or breaking up the conglomerate altogether. For example, ICI, after an unsuccessful approach by Hanson, sold off its more highly valued subsidiaries, remaining with the core chemical businesses. Shares in ICI were exchanged for shares in Zeneca plc, the pharmaceutical subsidiary, and a remaining share in ICI plc, representing a claim on the balance of the ICI assets. Another example is the mobile phone operator, Orange, which was bought in 2000 for 25bn by France Telecom from Vodaphone, who had acquired it as part of its own acquisition of the German group, Mannesmann. Orange
had only recently been sold to Mannesmann by the Hong Kong group, Hutchison Whampoa and Vodaphone only acquired EU regulatory approval to buy Mannesmann by agreeing to sell Orange. An alternative to companies restructuring is for financiers to do it for them. Leveraged buyouts first became popular in the 1980s. A bank, or specialist company, uses its own finance, plus bank debt, or bond finance, to fund the buyout and then refinance the deal or sell the company on to realise a profit. Today, equity funds and the financing expertise for such deals are provided by venture-capital firms (for start-ups) or private-equity firms (for existing companies). Private-equity firms are pro-active. They analyse sectors and companies looking for suitable restructuring candidates. No company is safe, however large. Box 5.8 shows how fluid the market in corporate restructuring has become and how strategically motivated and financially motivated bidders compete for companies.
BOX 5.8 THE RESTRUCTURING PLAYERS

Private equity has had the run of the mergers and acquisitions playground for more than three years. Trade buyers, which dominated the field during the dotcom boom by using their highly-valued stock as acquisition currency, were suddenly forced to retreat and clean up their balance sheets, bloated with debt from exuberant deals. But now, armed with cash and confidence, chief executives are ready to spend again and are playing private equity firms at their own game. Indeed, the volume of trade sales across Europe is running at its highest level since 2000, according to Dealogic, the global data provider. So far this year, there have been Dollars 228bn (Pounds 125bn) of such deals in Europe higher than all of last year. Corporate confidence, corporate liquidity and corporate appetite for deals is back, says Simon Warshaw, co-head of United Kingdom investment banking at UBS. The balance of purchasing activity is changing. An important part of that is investors being prepared to support the right deals, he adds. Recent and running auctions provide clear evidence of this trend. Last week, T&F Informa beat five financial buyers including IIR Holdings, the worlds largest provider of trade conferences and exhibitions; in January RR Donnelley & Sons, the biggest US printing company, also pipped several buyout houses to the post in the race to acquire Astron Group, a privately-owned United Kingdom print and mail provider.
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Three trade bidders are competing in the final round of the auction for HP Foods, which is being sold by Danone. They are New Yorkbased McCormick, the worlds largest spice company; Premier Foods and Associated British Foods, the United Kingdom food groups. In theory, trade buyers should be able to outbid their financial rivals, largely because they can combine the target with their existing operations and reap synergies, typically unavailable to private equity owners, thereby justifying a high takeover premium. The relative competitiveness between trade and financial buyers is being dictated by the availability of operating synergies for trade buyers versus access to financing synergies from private equity buyers. However, this is being further complicated by the fact that private equity is increasingly acquiring as trade buyers, as they look to expand their portfolio companies, says Piers de Montfort, head of United Kingdom and Ireland investment banking at CSFB. Blackstone and Terra Firma, for example, last year made platform acquisitions known as buy-and-build in the industry in the cinema sector, adding larger acquisitions later to build dominant UK market share. Blackstone repeated this model in the healthcare sector, first buying Southern Cross Healthcare and later adding NHP nursing homes. Trade buyers are also becoming more sophisticated about participating in and winning auctions. Private equity firms, renowned for being M&A savvy because of the sheer volume of deals they do, can conduct due diligence and pull together the financing for a deal without the need for market or shareholder approval. But now, the strategic buyers have proved more adept at pricing and risk. T&F Informa, for example, is believed to have paid only a tiny premium less than 2 per cent more than the private equity under-bidders. The cost of financing, despite last months credit downgrade of General Motors and Ford, is still cheap, particularly in the senior debt market, which is awash with liquidity. In a low interest rate environment, investors are less concerned about the cost of servicing debt. The public equity markets now tolerate and, even encourage, higher levels of debt, says Brian Magnus, at Morgan Stanley. The re-emergence of trade bidders is not all bad news for private equity. Trade buyers can be a threat on the buy side, but they provide private equity with a lot of advantages on the sell side, says William Maltby, at Deutsche Bank. During the recent bear market, private equity increasingly sold assets to each other because a dearth of strategic buyers.
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Now, though, their options have widened. CVC Capital, for instance, is selling Kwik-Fit, the car-parts chain, and has attracted interest from both trade and financial buyers. Bridgestone, the worlds largest tyremaker, has teamed up with Mitsubishi Corporation of Japan, is considered one of the strongest in the auction because of the synergies available to it. Although few yet believe that trade buyers are showing signs of profligacy, it is in the nature of such deals that it will be a while before investors can properly test how prudent they have been. For now, those same investors who have tolerated acquisitions by the companies they own, can only hope that the mistakes of the last wave of corporate deals, which peaked in 2000, will not be repeated.
Another reason for a change in ownership can be to do with the capital structure. After the market crash in 2000, many companies found that they had too much debt and were forced into a fire sale of some of their subsidiaries in order pay back debt. This was the case in the telecommunications sector, which had overexpanded. France Telecom suffered as it had paid cash (using debt) to buy companies, not wishing to dilute the French governments shareholding in France Telecom. Vivendi Universal, the French utility that was transformed into a new economy stock by its then chief executive, M. Messier, was also aggressively restructured with substantial sales required to pay off astronomically high debt as can be seen in Box 5.9.
BOX 5.9 VU TO SELL 12BN EURO ASSETS OVER 18 MONTHS

Jean-Rene Fourtou, chairman of Franco-US media group Vivendi Universal (VU), has said that the liquidity problems of his group will be resolved soon. The group recently obtained a 3bn-euro credit line but has a debt of 17.3bn euros. Its cash flow is expected to be negative 849m euros at the end of the year. Mr Fourtou believes that the value of VUs assets is higher than its debt. VU will sell assets worth 12bn euros over the next 18 months, including 5bn euros worth by March 2003. The priority is to reduce losses and relaunch Canal+, the French pay-TV company. The VU chairman has denied that VU is about to sell its services group Vivendi Environment or alter its stake in telecoms group Cegetel.
(Le Monde, 27 September 2002)
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ACTIVITY 5.7
What do you think is the impact of a fire sale on valuation? In practice, announcing that you wish to sell subsidiaries because you are in financial difficulties gives the buyers the upper hand when it comes to how much they are prepared to offer. In 1997, Barclays Bank announced that it wished to sell its investment bank, BZW. It had had ambitions to be a global investment bank, but had failed to make headway in the US market. The CEO of Barclays breaking all the rules of deal-making announced the sale publicly, thus sending its staff scurrying to headhunters and giving the eventual buyer, CSFB, greater bargaining power (The Economist, 18 November 2000).
Management buyouts
Another form of restructuring is that of a management buyout, when the management of a subsidiary offers to buy the subsidiary from the group. In such cases, the deals are highly leveraged because managers do not have substantial assets. An existing management team purchasing an entity is known as a management buyout (MBO), a new team coming in with financial backing is a management buy-in (MBI). MBOs and their related transactions are generated by such circumstances as:
l
a chief executive who owns a private company and wishes to retire (for example, Moulinex); a listed company that is underperforming, also known as taking the company private (for example, Virgin); a company put into liquidation with the receivers selling it to the managers (for example, Leyland DAF); a group seeking to divest itself of an underperforming operation or of a subsidiary no longer deemed an appropriate business to be in after a strategic appraisal (for example, Inns Company).
Often the management will not have sufficient personal wealth to buy the entity from their own resources, so they will seek the assistance of venture capitalists, or specialist buyout fund managers. In return for a share in the company, these providers of funds will put up the greater part of the money for the purchase, while holding a lower portion of the equity. This allows the management to have an incentive to generate positive results while sharing in the rewards as enhanced equity holders. The managers are encouraged to put in as much as they can afford, often borrowing substantially in a personal capacity to increase their individual shareholdings. They are highly motivated to see that the operation
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succeeds, even though in the scale of things they may be the smallest investors. In valuation terms, however, there may be a conflict of interest. For example, if managers have formed part of a large group and been aware of the possibility of making an MBO, they may well be tempted to make the accounting numbers look poor before approaching the board with an offer. Just as there is a paramount need for a robust financial plan in merger and acquisition activity, so too in MBO activity, the plan should be tested to ensure all possibilities are considered. Very often, MBOs focus on cost-cutting as a source of improved performance, but experienced fund managers will know that there is a balance to be struck between the cost paring and reinvestment needs. Many celebrated MBOs that ran into trouble did so because investment was underestimated, as a result of lack of foresight concerning industry changes. Getting the industry analysis right cannot be underestimated, as Box 5.10 shows.
BOX 5.10 INVESTING TO KEEP FLYING

Airclaims provides aviation loss-adjusting and consultancy services. Its customers include aerospace manufacturers, aircraft operators, insurers and financiers. The business was owned jointly by British Aviation Insurance Co Limited and La Reunion Aerienne, which together represented 34 British and French insurance companies. But as Derek Hammond-Giles, chief executive, explains, after 9/11 the companies which owned the British half decided that aviation was too risky and by February 2003, they no longer had any involvement in aviation insurance. When 50 per cent of your shareholders pull out, you either have to replace them with another group, or go in dependent, says Mr Hammond-Giles. If we had been owned by just one group, we would receive no business or instructions from anybody else. The view was taken that there should be a management buyout (MBO) and we were asked to put our hat in the ring. The management team was given six weeks to table a proposal. With no experience in private funding, they approached Baker Tilly, an accountancy firm that specialises in medium-sized companies. which advised getting half the funds from Lloyds TSB, the firms bankers. The team subsequently learned that, during that six-week period, an approach had been received from a management buy-in team. When the buyout details were tabled, the shareholders felt obliged to conduct a public auction and Lexicon, an independent corporate finance advisory firm, was appointed to oversee it. The private equity winner was Lloyds Development Capital (LDC), part of the Lloyds TSB group, which has a Dollars 7bn aviation asset base. It wasnt just the money, says Mr Hammond-Giles. We were influenced by other factors, as we were going to have an ongoing relationship.
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Putting a bid together wasnt difficult, says Mr Hammond-Giles. We were a 40-year-old company in a 70- year-old industry. We were a good solid business, our management team had been around for ten years and we had a good track record. Aviation is still a bit sexy, so people get fairly excited about it. Some private equity companies specifically look for service providers who are top of their sector and they viewed us as being top of our sector. The biggest problem was that the entire process took 18 months. This was initially because of the auction process. If we could have done a straight MBO it would have been quicker and cheaper for the shareholders, he says. They felt they had a public duty to go to auction, which I understand, but I think that it cost them a lot of money. The other headache was the amount of due diligence required. Although a small company, Airclaims has offices and subsidiaries around the world. Independent reviews were conducted of the companys research and development and its pension scheme. The process was expected to take four weeks, but it eventually took 14. Patience is definitely a virtue and you have to stay objective, says Mr Hammond-Giles. Over a period of time, the ebb and flow of negotiations and discussions is quite deleterious to management and it is very hard to run a business at the same time. You have to be determined to keep your eye on the ball. Although the deal took longer than expected, raising finance was straightforward. A lot of interest was shown because we had a very firm signal from our current bankers that our credit was good, concludes Mr Hammond-Giles. We had genuine prospects for the future, which helped the private equity companies to fund the rest. People do not stop travelling, and while they continue to do so we have a future.
(Financial Times, 17 May 2005)
After a buyout, a company is not listed on a stock exchange. This means that financiers, with a time horizon of no more than, say, five years to getting a return, will look to a flotation or a trade sale to crystallise their expected profit.
ACTIVITY 5.8
Listen to Audio Programme, Venture Capital, in which a panel of venture capitalists and managers discuss how they work in practice, from start-up situations to quite large management or leveraged buyouts. Also, read the venturecapital case study, Sciona, in the Course Reader.
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SUMMARY
In this section we looked in more detail at four types of situation
in which company valuation plays a major role. These were:
l l l l
regulation;
new issues and privatisations;
mergers and acquisitions;
restructurings, including management buyouts.
Our aim was to show how valuation is carried out in practice. In

the section on regulation, we saw how book value was a major
input in estimating return on capital employed for regulated sectors.
In new issues and privatisations, we saw how market multiples
played a major role and how global privatisations, managed by US
investment banks, have introduced new multiples based on
enterprise value and on cash flow. In the section on mergers and
acquisitions, we found that discounted cash flow was the major
valuation approach, although it would appear that any cash flows
generated from synergies are paid to the sellers rather than retained
by the bidders. Finally, we considered the pressures on companies
to restructure and to add value through divestments such as
management buyouts.
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SUMMARY AND CONCLUSIONS
SUMMARY AND CONCLUSIONS

The aim of this unit was to introduce you to the techniques and
applications of company valuation. This differs from project
appraisal in that it is often more complex in principle, since
companies can be viewed as collections of projects, and the
techniques used vary from simplistic market multiples to more
sophisticated discounted cash-flow techniques.
Section 2 considered the role of book value in valuation and
showed how the shareholders funds figure on the standard balance
sheet could be adjusted to reflect a value closer to economic value
by revaluing tangible assets, considering how to capitalise
intangible assets such as R&D, intellectual capital, brand names and
goodwill, and by considering off-balance-sheet items such as
operating leases, pensions and contingent liabilities.
The third section looked at market multiples such as dividend yield,
price to book, Tobins q, PE ratio, price to cash flow,
EV/EBITDA and sector-specific ratios. We considered the pros and
cons of each ratio in a valuation context.
Section 4 followed the six steps that should be considered when
doing a DCF analysis on a company. These were:
l l l l l l
determine the time horizon for specific forecasts;

forecast operating cash flows;
determine residual value;
estimate WACC;
discount cash flows;
prepare related financial statements.
The main point to note here is that no one valuation method is

always better than another. The disadvantages of book value and
market multiples are clear enough. Although technically and
theoretically superior, DCF values can vary according to the
assumptions put in, making DCF values more contentious in certain
situations. DCF, however, is the only technique appropriate for
growth stocks, for which negative earnings and cash flows, and
small book values, make any other method inappropriate.
The final section looked in more detail at four types of situation
in which company valuation is required. These were regulation,
new issues and privatisations, mergers and acquisitions, and
restructurings (including management buyouts).
After having studied this unit, you should now be:
l
familiar with the three main types of method of company valuation: book value, market multiples and discounted cash flow;
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able to appreciate the merits and disadvantages of each technique; able to decide on the most appropriate method or methods of valuation according to circumstance: for example, regulation, new issue, privatisation, takeover or restructuring.
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ANSWERS TO EXERCISES
EXERCISE 2.1
Possible adjustments to the book value of De La Rue at 31 March 2004 could include the following. Tangible assets Note 10 to the accounts shows that freehold properties were included in the balance sheet at 1989 values or cost. More information is needed, but these values could well need adjusting to reflect current realisable value. Similarly, adjustments might be needed to plant and machinery values. Investments Note 11 to the accounts shows that the market value of listed investments is higher than book value and that investments in related companies are in at book value, which is also lower than market value. If these were to be valued at current realisable value, adjustments would be needed. Stocks Note 12 states that the replacement cost of stocks is not materially different from the amounts in the accounts. However, the realisable value might be lower. Provisions Notes 15 and 19 discusses deferred tax and potential tax liabilities. The purpose of estimating the adjusted book value becomes important here (for example, takeover, liquidation and so on) as the tax liability may be different in each case.
EXERCISE 3.1
From Unit 4, Section 3.3, we know that
E( R i ) =
D1 +g Pi
where E(Ri) = the expected return on the share (or cost of equity), D1 is next years dividend, Pi the current share price and g the expected growth rate for dividends. For De La Rue,
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we know D1 = 16p and Pi = 319p. If we assume E(Ri) = 11.5% (or 0.115) we can write
0.115 =
16 +g 319
= 0.0502 +
g

g = 0.115 0.0502
= 0.0648
This gives g = 6.48%, which rounds to 6.5%.
EXERCISE 3.2
The 2003/04 earning per share figure was 6.8p. With a share price of 319p, the PE ratio is 319/6.8 = 46.9, much higher than the PE ratio for the Support Services sector of 21.61. De La Rues high PE ratio can be explained either by unusually low 2004 earnings (2003 earnings per share were negative, but 2002 earnings were much higher) or by higher growth prospects, given the international nature of De La Rues activities and 2003s disappointing results.
EXERCISE 3.3
For fashion boutiques, a crucial value driver might be the frontage of the shop in metres rather than the overall size; for advertising agencies, it might be the value of billings; for airlines, it could be the number of hubs at airports. Examples of valuation multiples would therefore be a multiple of frontage for boutiques, a multiple of billings for advertising agencies and a multiple of revenues from airport hubs.
EXERCISE 3.4
(a) Dividend yield 14.2/3.19 = 4.45% (b) Price to book 3.10/(214/183.07) = 2.7 (c) PE Ratio 319/6.8 = 46.9
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(d) Price to free cash flow 3.19/(101.2/183.07) = 5.77 NOTE: We have taken Operating Cashflow of 101.2 in denominator. You will have noticed from reading of Unit 6 section 3.6 that there could be different definitions of cashflow. So you will find variations in the price to free cashflow figures in OUFSDLR. We are changing this here because the present printed version of the answers uses 28.9 for cashflow and 183.7 for number of shares. These do not correspond to De La Rue figures for 2004 as you can see in the OUFSDLR. (e) EV/EBITDA EV = 546.4 m EBIDTDA = 80.4 m
EV/EBITDA = 546.4/80.4 = 6.8
(f) EV/Sales 546.4/682.5 = 0.80 NOTE: Sales value was not correct. Youll find correct figure in OUFSDLR or 2004 Annual Report for De La Rue (g) EV/total assets 546.4/540.9 = 1.01
EXERCISE 4.1
Treating cash as an investment that is worth book value implicitly assumes that De La Rue is achieving zero NPV from investing in cash. If, for example, it were paid back to shareholders or the firm acquired and the cash paid out this would be a fair assumption. From the investors point of view, however, De La Rue has a WACC of over 11% (see Unit 4) and is investing in cash yielding (after tax) no more than 3 or 4% at most most definitely a negative NPV. This could mean that the measured WACC already allows for the cash which has been held for some time and the hurdle rate should in fact be increased for risky projects to compensate. The more generous valuation will come from treating cash as an investment.
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EXERCISE 4.2
There are many possible pitfalls including the following.
l
It is likely that all the positive present value will come from the residual-value calculation if you restrict the forecasted time horizon to ten years, making estimation errors very likely. The company is not going to be paying tax for at least ten years and probably longer. Using an after-tax cost of debt in the WACC or after-tax cost flows for Years 1 to 10 would be wrong. It is unlikely that the company will use debt finance in the early years, but will do so later. It is unlikely to have a stable debt/equity ratio.
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APPENDIX BROKERS REPORT ON DE LA RUE
APPENDIX BROKERS REPORT ON DE LA RUE
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REFERENCES AND SUGGESTED READING

Brealey, R. A. and Myers, S. C. (2005) Principles of Corporate Finance, (8th edn), London, McGraw-Hill. Carnes, A. T., Black, E. L. and Jandik, T. (2001) The long-term success of cross-border mergers and acquisitions. Working Paper, accessible from the Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf ?abstract_id=270288 Coase, R. H. (1937) The nature of the firm, Economica, reprinted in Readings in Price Theory, American Economic Association, Irwin, New York, 1952. Copeland, T., Koller, T. and Mullin, J. (2000) Valuation: Measuring and Managing the Value of Companies, 3rd edn, New York, John Wiley. Danbolt, J. (2005) Cross-border acquisitions into the UK an analysis of target company returns, Working Paper, University of Glasgow. Gregory, A. (1992) Valuing Companies: Analysing Business Worth, Woodhead-Faulkner. Gregory, A. (1997) An examination of the long run performance of UK acquiring firms, Journal of Business Finance and Accounting, vol. 24, no. 7, pp. 9711002. Gregory, A. (2001) Strategic Valuation of Companies, (2nd edn), Financial Times/Prentice Hall. Jensen, M. C. (2004) The agency costs of overvalued equity and the current state of corporate finance, European Financial Management, vol. 10, no. 4, pp. 54965. Loughran, T. and Ritter, J. R. (1995) The new issues puzzle, Journal of Finance, vol. 50, no. 1, pp. 2351. Ogier, T., Rugman, J. and Spicer, L. (2004) The Real Cost of Capital: A Business Field Guide to Better Financial Decisions, London, Financial Times/Prentice Hall. Porter, M.E. (1985) Competitive Strategy: Creating and Sustaining Superior Performance, New York, The Free Press. Ritter, J. R. home page currently http://bear.cba.ufl.edu/ritter/ for material on IPOs. Ross Geddes, H. (1999) Valuation methods employed by UK corporate financiers, unpublished paper, University of Greenwich.
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ACKNOWLEDGEMENTS
ACKNOWLEDGEMENTS
Grateful acknowledgement is made to the following sources:
Text
Box 2.1: The Lex Column, UK pensions deficits, Financial Times, 6 June 2005, Financial Times Syndication; Table 3.1: FTSE Actuaries Share Indices, Financial Times, 25 June 2005, FTSE International 2004; Box 3.1: Cash flow, Financial Times, 27 December 1997, Financial Times Syndication; Box 3.3: Ogier, R. and Rugman, J., Internal rate of return, Financial Times, 1 June 2000, Financial Times Syndication; Box 5.3: The Lex Column, Valuing utilities, Financial Times, 17 April 1996, Financial Times Syndication; Box 5.5: HK seeks consultation on privatising of airport authority, Financial Times, 23 November 2004, China Daily; Box 5.6: Jackson, T., Big can still be beautiful, Financial Times, 1 October 1996, Financial Times Syndication; Box 5.7: Moore, J., The battle for Abbey, The Daily Telegraph, 18 August 2004, Telegraph Group Limited; Box 5.8: Saigol, L. and Smith, P., Trade purchases and mergers are back in fashion, Financial Times, 11 June 2005, Financial Times Syndication; Box 5.10: Newing, R., Investing to keep on flying, Financial Times, 17 May 2005, Financial Times Syndication.
Tables
Table 3.6: Geddes, H. R. (1999) Valuation Methods Employed by UK Corporate Financiers, University of Greenwich.
Figures
Figure 2.1: Gregory, A. (1992) Valuing Companies: Analysing Business Worth, Woodhead-Faulkner Publisher Limited, by permission of Prentice-Hall; Figure 3.1: Tobins Q, www.ratings.standardpoor.com, Standard & Poors.
Illustrations
Page 11: # Photodisc; Page 12: # 1990 S. Gross; Page 18: # Dana Fradon; Page 29: Courtesy of Red Rooster PR; Page 56: # Volkwagen Press; Page 56: # Rolls-Royce Motor Cars Limited; Page 73: Maurice Harvey The Hutchinson Library; Page 78: Noel Ford/PricewaterhouseCoopers.
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B821 Financial Strategy Block 3 Finance and Investment

Prepared by the Course Team

UNIT 6 COMPANY VALUATION

UNIT 6 COMPANY VALUATION

2 VALUING THE ASSETS

VALUING THE ASSETS

UNIT 6 COMPANY VALUATION

DETERMINING BOOK VALUE

Fixed assets Intangible assets Tangible assets Investments

2 VALUING THE ASSETS

2,582.4 (869.6) 1,712.8 193.9 0.3 15.2 1,503.4 1,712.8 1,712.8

1,516.4 (315.0) 1,201.4 203.5 5.6 992.3 1,201.4 1,201.4

UNIT 6 COMPANY VALUATION

2 VALUING THE ASSETS

ADJUSTING BOOK VALUE

UNIT 6 COMPANY VALUATION

2 VALUING THE ASSETS

UNIT 6 COMPANY VALUATION

Off-balance sheet items

2 VALUING THE ASSETS

BOX 2.1 UNITED KINGDOM PENSION DEFICITS

UNIT 6 COMPANY VALUATION

However, under another accounting procedure ...

Salt and Pepper plc balance sheet

135.3 63.1 24.8 223.2

2 VALUING THE ASSETS

38.1 16.1 142.0 365.2

48.3 32.3 80.6

115.2 13.4 156.0 284.6 365.2

Net assets (equity) 156.0 m = = 6.64 m Number of shares 23.5m

Salt and Pepper plc adjusted book value

Adjusted book value

UNIT 6 COMPANY VALUATION

Adjusted book value per share =

Adjusted book value of equity Number of shares 236.8 m = 23.5m = 10.08

Net realisable value

Definitions of value (Gregory, 1992)

UNIT 6 COMPANY VALUATION

UNIT 6 COMPANY VALUATION

We can rearrange this equation to give

6.20 = 2.56 2.425

UNIT 6 COMPANY VALUATION

Tobins q for the US market from 1900 to 2003

UNIT 6 COMPANY VALUATION

United Kingdom Sector PE Ratios as at 24 June 2005

UNIT 6 COMPANY VALUATION

Boots income statement year-end 31 March 2004

PRICE TO CASH FLOW

Price to cash flow =

Comparative analysis of cash flow and change in debt Mar-04

Net cash flow available to shareholders* Exceptional gain/loss

UNIT 6 COMPANY VALUATION

(2.2) (229.1) (264.6) 0.3 93.9 (91.6)

386.8 (238.3) (455.2) 0.1 44.6 (45.0)

(21.1) (234.5) (45.9) 0.7 (28.2) 36.1

(42.7) (224.0) 0.0 8.8 102.1 (102.4)

6.7 (216.3) (95.4) 0.5 (229.2) 223.0

*Using the definition of cash flow given in Section 3.6

UNIT 6 COMPANY VALUATION

BOX 3.1 CASH FLOW

UNIT 6 COMPANY VALUATION

SPECIFIC VALUATION RATIOS

COMPARISON OF MARKET MULTIPLES

UNIT 6 COMPANY VALUATION