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Valuation of equity is important to both individuals and businesses in Hong Kong. Strong economic growth in China has led to unprecedented numbers of mergers and acquisitions of listed companies in recent years. There are 3 types of valuation methods: market-based methods, cash-based methods and asset-based methods.
Valuation of equity is important to both individuals and businesses in Hong Kong. Strong economic growth in China has led to unprecedented numbers of mergers and acquisitions of listed companies in recent years. There are 3 types of valuation methods: market-based methods, cash-based methods and asset-based methods.
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Valuation of equity is important to both individuals and businesses in Hong Kong. Strong economic growth in China has led to unprecedented numbers of mergers and acquisitions of listed companies in recent years. There are 3 types of valuation methods: market-based methods, cash-based methods and asset-based methods.
Droits d'auteur :
Attribution Non-Commercial (BY-NC)
Formats disponibles
Téléchargez comme PDF, TXT ou lisez en ligne sur Scribd
individuals and businesses in Hong Kong because of the numerous market participants. According to a research 1 performed by the Hong Kong Exchanges and Clearing Limited in 2009, 35.1% of the Hong Kong adult population (or 2,069,000 individuals) were retail investors in stocks. On the other hand, the strong economic growth in China has led to unprecedented numbers of mergers and acquisitions of listed companies in recent years. One of the objectives of business valuations is simple, the search for undervalued shares. If a share is trading under its intrinsic value, an ordinary investor would make a buy decision with the hope that the currently undervalued shares would reflect its real value sometime in the future. Unfortunately, valuation of equity is not an exact science. It is instead an art because it is an exercise of incorporating not only factual data but also personal judgements. For example, when the dot-com bubble swept 1 http://www.hkex.com.hk/eng/stat/research/Documents/RIS2009.pdf Hong Kong in 2002, a blue-chip company, with HK$7.7 billion loss in the year ended 31 Dec 2002, had attained its peak share price at HK$140 in February 2002 but then decreased to around HK$2 in December 2009. Why were some investors willing to pay HK$140 to buy the shares which then had more than 98% fall in share price? What made the investors judge that HK$140 was a fair price in 2002? The reason was in large extent due to the unexplainable judgement. Some investors were too optimistic that they paid too much for the overvalued shares. The personal judgements are seriously affected by the market atmosphere, personality of investors, bargaining skills of the acquirer and the acquiree, etc. Practically, there are 3 types of valuation methods: Market-based methods, cash-based methods and asset-based methods. Market-based This method uses price-earnings ratio (PE method), market capitalisation, etc. PE method may be the most commonly used valuation technique for listed shares in reality because the information needed in the PE method (i.e. prices and earnings) is easily obtainable. In additions, the calculations are easy as shown in Example 1. For unlisted companies, the use of PE may be difficult because information about share prices is not readily available due to low marketability of the shares. PE Ratio = Price per Share Earnings per Share Value of Equity = Profit after Tax x Suitable PE Ratio Even different companies in the same industry do not have the same PE ratio because those companies are different in growth potential, management efficiency, etc. A high PE ratio means investors are willing to pay high amounts to acquire its share with compared to other companies which have the same amount of earnings. VALUATIONS OF SHARES RELEVANT TO PAPERS F9 AND P4 PAGE 12 LEARNING CENTRE NEWS UPDATE SPRING 2011 2 http://www.hkex.com.hk/eng/stat/smstat/mthbull/rpt_price_earning_ratio_main_0910.htm 3 http://www.hkex.com.hk/eng/stat/smstat/mthbull/rpt_price_earning_ratio_main_1010.htm Example 1 ABC Co is considering to make a bid for the entire equity capital of XYZ Co, a firm which has a PE ratio of 9 and earnings of $390m. ABC Co has a PE of 13 and earnings of $693m, and it is thought that $125m of synergistic savings will be made as a consequence of the takeover. The PE of the combined company is expected to be 12. In this case, the minimum value acceptable to XYZs shareholders: = 9 x $390m = $3,510m The maximum amount which ABC is willing to pay: = Value of the combined entity Value of ABC = [12 x ($390m + $693m + $125m)] (13 x $693m) = $5,487m The final acquisition consideration will be somewhere between $3,510m and $5,487m depending on the negotiation results of ABC and XYZ. From Example 1, we can see that the calculation of equity values using PE ratio is easy, but this method does have some theoretical weaknesses: It is based on accounting earnings which are subject to manipulation and affected by the choices of accounting policies. In additions, some non-recurring extraordinary transactions may distort the PE ratio. The estimation of the combined PE ratio is highly subjective. Why is it 12? Why cant it be 11, 13, or anything else? Adjustments to PE ratio is also a subjective exercise. For example, a private company should have lower PE ratio compared to a listed competitor of similar size and growth because of its worse marketability. However, there is no universal rule regarding the exact discount to be applied to the private company. PE ratio is not applicable to loss making companies. PE ratio is a volatile measure. For example, the PE ratio of Hang Seng Index in Hong Kong could be as low as 6.83 2
in November 2008 and then increased to 16.58 3 in October 2010. It highly depends on the market atmosphere! A more practical weakness of PE ratio is that there is no universal decision rule under the method of PE ratio. A low PE ratio indicates a cheap share, but it does PAGE 13 LEARNING CENTRE Example 2 Today is 1 Jan 2010. DEF Ltd has earned $1 per share. Its policy is to retain 75% of its profits for future expansion. The return on equity is 20%. What is the theoretical value per share if the dividend will stay constant for the next 5 years and then grow by 5% p.a. to perpetuity? D0= $1 x (1 75%) = $0.25 Present value of dividends for the next 5 years = $0.25 x 2.991 4 = $0.748 Present value of dividends from Year 6 and onwards = _____________________________________________________________________________________________________________________________________________________________________________________ ______________________________________________________________________________________________________________________________ x $0.25 (1+5%) 1 20% - 5% (1+20%) 5 = $0.703 The theoretical share price = $0.748 + $0.703 = $1.451 From Example 2, we can see that the amount of equity values highly depend on the assumptions which are subjective. Other weaknesses of this model are as follows Even a minor change in investors expectation of growth rates can cause a major change in share price. It is almost not possible to estimate the growth rate of the dividends in perpetuity. Some investors use the long term average growth rate of dividend, but this is only applicable to those well established companies with historically stable dividend policy. Some companies never pay dividends. Cost of equity is usually calculated by the Capital Asset Pricing Model (CAPM) which does not give a perfectly correct cost of equity. Asset-based The traditional asset based valuation method is to take as a starting point the value of all the firms assets less any liabilities. Asset values used can be: Book value the book value of assets can easily be found from the financial statements. However, it is unlikely that book values (which are based on historical cost accounting principles) will be a reliable indicator of current market values. Replacement cost The buyer of a business will be interested in the replacement cost, since this represents the alternative cost of setting up a similar business from scratch (organic growth versus acquisition). This in theory is a very suitable value for asset, but it is not easy to identify such assets in practice. Net realisable value the seller of a business will usually see the net realisable value of assets as the minimum acceptable price in negotiations. 4 2.991 is extracted from the annuity table not necessarily lead to a buy decision. Here is a recent example. From 2003 to 2007 when Hong Kong enjoyed a very bullish ride in the stock market, some international banks listed in Hong Kong were trading at very low PE ratios. Many people purchased their seemingly cheap shares because, according to the belief of value investing, those international banks with low PE ratios will finally enjoy high PE ratios when the market discovered their real values. Sadly, the whole bullish boom was over and those banks had only increased for less than the market average. Finally, the financial tsunami due to sub-prime mortgages in the US swept the world in 2008 and those international banks, being hard hit by the problem, had their shares fallen much more serious than the market average. This story tells us that a low PE ratio comes with reasons. This may be due to a team of poor management. Similarly, there may be some hidden problems known to a small portion of investors but not yet commonly covered in the media and agreed by the public. When the hidden problems become obvious, those cheap shares can become even cheaper. In conclusion, the investor merely using PE ratio as an evaluation tool for investing very often falls into value traps. It is worth using a comprehensive list of tools in order to assess whether a particular company is a real cheap deal. In reality, finding a undervalued share takes a lot more work than just reviewing its PE ratio. Cash-based A very simple idea behind the cash-based valuation is that the value of a share is the present value of the expected future dividends discounted at the shareholders required rate of return. In theory, it sounds sensible. A very common formula is as follows:
P = _____________________________________________________________________________________________________________________ Do (1+g) Ke - g P = Value of the shares D0 = Dividend per share today g = growth rate of dividend Ke = Cost of equity PAGE 14 LEARNING CENTRE NEWS UPDATE SPRING 2011 From example 3, we can see that the current share price is trading at a premium of $0.305 to its theoretical value. Why is that? A major flaw with this valuation method Example 3 The following is the statement of financial position of Happy Ltd as at 31 Dec 2009 $ Non-current asset (carrying value) 450,000 Net current asset 100,000 550,000 Share capital ($0.5 par) 200,000 Retained earnings 250,000 6% loan note 100,000 550,000 You also notice that: Loan note are redeemable at a premium of 2%. Current market value of freehold property exceeds book value by $30,000. All assets, other than property, are estimated to be realisable at their book values. The current market share price of the company is $1.5. What is the theoretical value of the share price of Happy Ltd as at 31 Dec 2009? Net asset value = $550,000 + $30,000 $100,000 x (1 + 2%) = $478,000 Theoretical value per share = $478,000 400,000 shares = $1.195 is that it does not take account of intangible assets which are defined as the assets that have no physical substance like, for example, goodwill, brand name, a competent management team, etc. Intangible assets, though not easily observable and measurable, affect values of shares in a positive way. If these items were not considered in the valuation, the values of shares would become understated. As a result, this method is not well applicable to companies in, for example, the retail industry of luxurious brands where the intangible brand names account for a big deal of its success. It is not surprising to see their shares are trading at high premium to the net asset values. Some investors purchase shares which are trading at discount to its net asset values in an attempt to wait for the true net asset values being reflected in the share price. Similar to a low PE ratio, a discount to net asset values comes with reasons. Unless you can change the operations of the companies, the true net asset values may never be incorporated into the share price. As a result, individual investors do not find this valuation method useful. However, some institutional investors are specialised in using this valuation method to gain unbelievably huge sum of profits. After they have identified a company with potentially valuable assets but not efficiently managed by the current management, they purchase its shares in secret without pushing the share prices up. As soon as they have accumulated enough shares, they will try to gain management board representation and force the existing management to implement strategies that can realise the real values of the potential assets. So who should use this valuation method? If you are confident that you can influence or change the existing management in order to take control of the potential asset by selling or implement your desired strategies, you should adopt this valuation method. Of course, the cost of searching for such companies may be so high that the potential profit is outweighed. Conclusion After the discussions above, it becomes understandable that why valuation is not an exact science. It is a highly subjective exercise in that personal judgements need to be considered. It is also a comprehensive process in that it cannot be possibly well completed with just a few valuation tools. So what can an investor do to obtain a more accurate valuation? In theory, the more information an investor has, the more he understands about a firm. As a result, his valuation should lead to a more accurate result. Paradoxically, this is not true in practice, evidenced by the fact that even financial conglomerate makes wrong investment decisions. From the irregular failures of investment veteran, it is not odd to conclude that there is just no simple or best way to obtain accurate valuations and make correct investment decisions. Ted Chan lecturer Kaplan Hong Kong PAGE 15 LEARNING CENTRE