Approaches to Company

Valuation

Author: Yousif Eltom

SUN: 061413353

MEng Chemical Engineering

ABSTRACT

The different approaches to valuing a business are identified, and the main

approached are income approach, asset approach and market approach. The asset

approach estimates the equity of a business by identifying the assets and liabilities

of the company being valued. The methods include the super profits method, and

net assets basis. The income approach values a company based on its expected

cash flows, and includes the earnings based method, discounted cash flow

method, discounted dividend yield method, accounting rate of return and capital

asset pricing method.

1
INTRODUCTION

The approach taken by businesses when valuing a prospective company, or even

valuing themselves is critical these days. Various methods exist whereby

valuations may be achieved, however these methods yield different values

therefore companies and directors must be able to identify the options which are

most feasible for them, therefore employ systematic approach to arriving at their

valuations.

This paper will identify the various methods available to value a prospective

project, and identify any key advantages or shortcomings which may influence the

valuations attained.

According to Lonergan (2003, pg14) valuations of share are required for different

reasons, and based on these circumstances different methodologies will be

adapted. Some of the reasons for share valuations are:

- To assist a seller at which price to sell

- To assist a management buyout proposal

- To assist a purchaser in deciding how much to consider paying

- To determine a value according to a contractual agreement

Once identified, the adopted method may be further modified to tailor it to the

specific circumstance of valuation, thus providing a more accurate valuation.

2
VALUATION METHODS

There are three known valuation methods when it comes to valuation of a

company and its shares, these are:

o Asset Approach

o Income Approach

o Market approach

Within the methods listed, there are more specialist methods which can be applied

when valuing a company, there are broken down as below:

o Asset Approach

o Super Profits Method

o Net assets valuation

o Income Approach

o Earnings based method

o Discounted Cash Flow Method

o Discounted Dividend Yield Method

o Accounting Rate of Return

o Capital Asset Pricing Method

3
SUPER PROFITS METHOD

According to Kapoor et Bhushan(1996 pg 185) the super profits method denotes

the profit’s accrued by a firm above the normal profits earned by other firms in

the same industry.

uper rofits ctual rofits- ormal rofits

Here the normal profits are calculated by multiplying the rate of return by the

capital invested and dividing by 100.

rate of return
ormal rofits apital nvested

4
NET ASSETS VALUATION

The net assets valuation approach is a method used to value the equity of a

business. Sometimes referred to the adjusted book value approach, according to

Rezaee(2001,pg.206) this approach adjusts the tangible assets of a company from

book value to market value by valuing intangible assets such as goodwill and

subtracting liabilities. For companies with exceptionally high income, or may

have endured years or loss, this method is particularly useful.

GOODWILL

Goodwill is a type of intangible asset, which takes measure when the overall value

of a business is greater than that of its tangible and identifiable intangible assets.

During a merger or acquisition, the goodwill value can be determined by the

difference between the price paid for the acquisition, and the market value of the

assets less the liabilities.

oodwill umber of ears urchase uper rofit

5
EARNING BASED METHOD

The earnings based method is a commonly used method and according to Reuvid

et al(2007, p145) the earnings based method works by ascribing a value to the

business being assessed by comparing it with a similar business. The basis of this

method is to identify the maintainable earnings of a business and then applying a

price multiple. Although it may seem straightforward, the difficulties lie in

determining the underlying maintainable value of a business, and the multiple

factor to be applied.

The underlying value is essentially the net earnings accrued by the company, and

usually measured according to shares, earnings per share (EPS). This is deduced

by dividing the amount of earnings reported by a company by the outstanding

shares.

arnings eported
utstanding hares

The multiple factor to be used, also known as the price/earnings(p/e) ratio takes a

company’s stock price and divides it by the company’s last four quarters earnings.

p ompany s stock price per share

e ratio ompany s last four quarters earnings per share

Since the basis of this model is around the market in which the business is

operating in, it can provide a good indication on company valuation bases on a

‘going concern’ basis, in which the company is not at threat of liquidation.

6
Although this method is widely used, obtaining the p/e ratio is not always

accurate, therefore the p/e ratio of sector average is a reliable source to start.

Adjustments can also be made to this multiple by considering the circumstances

of the business

7
DISCOUNTED CASH FLOW METHOD

The discounted cash flow method, according to Damodaran (2002,pg12) is a

method by which the value of an asset is related to the present value of the future

cash flows associated with that asset. The fundamental correlation for this method

is :

t
t
r
t

here

resent alue

t ash low in period t

r discount rate

This model can be modified depending on what is being valued.

Equity Valuation

The value of equity is obtained by discounting the expected cash flows to equity

against the actual cost of equity.

to equityt
alue of quity t
k
t

here

to equityt xpected cash flow to equity, at time t

k cost of equity

8
This model takes into consideration the residual cash flows after meeting all

expenditures, and is adopted in the discounted dividend model whereby the value

of equity is modelled as the present value of future dividends.

Company Valuation

The value of a company can also be obtained by discounting the expected cash

flows to the company against the weighted average cost of capital (WACC). The

WACC is the cost of the different components of financing used by the company,

and weighted using their proportion of the market value.

to firmt
alue of ompany t
t

here

to firmt xpected cash flow to the company, at period t

eighted average cost of capital

The weighted average cost of capital can be summarised simply using the below

correlation:

n n

here

n ndividual costs of capital

n arket values of individual sources equity,debt,stocks etc.

otal market value of company

9
DISCOUNTED DIVIDEND YIELD METHOD

Discounted dividend models are an agglomeration of valuation models based on

the distribution of dividends to shareholders where dividend can be described as

‘cash flow’. Fundamentally, the purpose of this model is to value a stock, and

there are a variety of models which could be applied to model the distribution of

future company dividend payments. Pinto et al(2010, pg 85) state that the

forecasting of dividends in the indefinite future is not practical, therefore the

approach is simplified by applying growth patterns to the company.

For zero growth, i.e. an assets value is the present value of the future cash flow it

generates, we can model the below equation according to pinto et al (2010,pg 85)

t
t
r
t

Where = Present Value of assets at t

t ividends ash flow at time t

r iscount rate

The anticipation of zero growth is a very inaccurate observation, and a company

would expect growth over a period of time, therefore the equation is adjusted to

include growth. When the growth is at a constant known rate, the below can be

stated:

t t g

here g expected growth rate

10
 t g
t
r
t

g g g n
r r r rn

This model is known as the Gordon growth model, and according to Pinto et

all(2010, pg 97), was developed by Gordon and Shapiro in 1956, and adopted

further by Gordon (1962) whereby the assumption that dividends grow at a

constant rate is applied.

For many companies, it is more desirable to view dividends and earnings as a

function of multiple stages of growth since they will undergo different economic

cycles throughout the years and will trade shares regularly which will mean they

rate of growth will change. For instance, if a company would offer dividends with

constant growth for three years after which they continue to offer dividends equal

to that given during the three years into perpetuity, the constant growth and

perpetuity must be combined.

Perpetuity can be presented by the following formulae:

Combined with the Gordon growth model

g g g n
r r r rn

In this example, the present value of perpetuity discounts back two year, therefore

the perpetuity term requires a further three years discount.

g
g g r
arket rice per hare
r r r r

11
ACCOUNTING RATE OF RETURN

The accounting rate of return is a method which uses information available on a

financial statement to measure an estimated performance of a capital investment.

According to Needles et al (pg 1260) this method is an imprecise however easy

method to estimate performance of capital investment in which the annual profits

are divided by the average investment cost.

verage nnual et ncome

verage nvestment ost

For projects with time t, the average net income over that period should be taken

into consideration to account for fluctuation.

12
CAPITAL ASSET PRICING MODEL

The capital asset pricing model(CAPM) is a model used to estimate the cost of

equity capital. Pratt et al(2010, pg104) state that is one of the most widely used

models due to its association of market risk in the model. The market risk is

measured by a value known as beta, furthermore pratt et al(2010,pg 107) suggest

a linear correlation between a security’s equity risk premium and the security’s

beta.

i f m

Where

i xpected rate or return on security i

f ate of return on a risk-free security

measure of market risk

m quity isk remium

The equity risk premium, can be further defined as

m m f

Where

m market rate or return

f isk-free rate of return

13
CONCLUSION

Various methods exist for which a value may be applied to a company. These

methods vary in their approach, and the variables involved.

The asset approach methods estimates the value of equity held by a business by

investigating the assets and liabilities of the business at the time of valuation.

The income approach methods, estimate the value of a company by predicting

future cash flows, the basis of which is on a discount rate which is also a

projection.

These methods can be implemented, and factors applied to arrive at more accurate

valuations.

14
REFERENCES

Reuvid,J Floating Your Company:The Essential Guide to Going Public (3e)

(Kogan Page,2007 )

Barker, R. Determining Value: Valuation Models and financial Statements (1e)

(Pearson Education Limited, 2001)

Needles,B &Powers,M & Crosson , S. Principles of Accouting (1e) (Houghton

Mifflin Company, 2008)

Damodaran, A. Investment valuation: Tools and techniques for determining the

value of any asset (2e) (John Wiley & Sons,Inc, 2002)

Pratt,S. & Grabowski,R. Cost of Capital: Applications and Examples ( 4e) (John

Wiley & Sons,Inc, 2010)

Rezaee,Z. Financial Institutions, valuations, mergers, and acquisitions: the fair

value approach. (2e) (John Wiley & Sons,Inc, 2001)

Kapoor, N. & Bhushan,B. A Complete Course in ISC Accounting (6e) ( Pitambar

Publishing Company,2006)

Lonergan,W. The Valuation of Businesses, Shares and other Equity (4e)

(Allen&Unwin:Australia, 2003)

15
Valuation of Yolanda Ltd

Author: Yousif Eltom

SUN: 061413353

MEng Chemical Engineering

FOR THE ATTENTION OF THE CEO OF XAVIER PLC

EXECUTIVE SUMMARY

The valuation methods used arrive at values ranging from £366,600 and

£1,030,000 which suggest the board of directors of Yolanda ltd will only accept

an offer above this. The valuation methods used were with the expected rate of

return of 15% however the CAPM method arrived at an expected rate of return of

8%. This suggests that the actual valuation will exceed the £1,030,000 as

suggested by the net assets method.

Further to this, a revaluation of Yolanda ltd may be required using an expected

rate of return of 8% however this valuation will arrive at a higher value than those

reached by the 15% rate.

Following this, the recommendations to the board of directors of Xavier plc is not

to pursue acquisition of Yolanda ltd since the valuation of £1,030,000 is the

minimum shareholders of Yolanda ltd are willing to accept, and this valuation

does not consider the 8% rate of return.

1
1.0 VALUATION OF YOLANDA LTD APPLYING THE NET ASSETS

METHODS

1.1 SUPER PROFITS APPROACH

Yolanda ltd do not present a set fair rate of return on tangible assets, however

since investor in Yolanda ltd have received a rate of return on investment of 15%

in recent years, and both of Xavier’s hurdle rate and accounting rate of return are

set at 15%, it is a rational value to use as the fair rate of return.

olanda ltd’s financial statements show that the company’s net tangible assets are

currently valued at £1m.

Fair return on net tangible assets

The current earnings of Yolanda Ltd is £75,000 and for super profits to exist must

exceed the fair return on tangible assets, however this is not the case and the

current earnings of Yolanda Ltd are half of the fair return on tangible assets. This

means the super profits method cannot be applied.

2
1.2 NET ASSETS METHOD

inancial statements of olanda Ltd show that the company’s net tangible assets

are currently valued at £1m, additionally freehold land and buildings have an

estimated book value in excess of £150,000. The financial statement also shows

that Yolanda Ltd have liabilities in the form of debentures for £100,000 whereby a

premium of 20% is applicable upon redemption. Furthermore, the directors of

Yolanda Ltd estimate that there is about £100,000 available in goodwill in the

business, however since super profits do not exist this estimation can be nullified.

£
Assets
Fixed Assets (cost less depreciation) £850,000
Net Current Assets £150,000
Freehold and Buildings £150,000
Total Assets £1,150,000
Liabilities
Debentures £100,000
Premium on Debentures £20,000
Total Liabilities £120,000
Net Asset Value of Equity £1,030,000

Based on the information available to Xavier plc regarding olanda Ltd’s

financial statements and the judgement taken with regards to the discarding of the

goodwill value applied to Yolanda Ltd by its board of directors, a value of

£1,030,000 can be attached to Yolanda Ltd.

3
2.0 VALUATION OF YOLANDA LTD APPLYING THE INCOME

BASED METHODS

2.1 EARNINGS BASED METHOD

As a commonly used method, the earnings based method utilises the earning

values of preceding years to determine the value of its shares.

The figures presented to Xavier plc regarding the earnings of Yolanda Ltd for the

previous five years are:

Year Earnings
2005 £47,000
2006 £51,000
2007 £59,000
2008 £68,000
2009 £75,000
Since Yolanda Ltd has authorised share capital of 200,000 ordinary shares at £1

each, the earnings per share ratio can be deduced.

Year Earnings Earnings Per Share(EPS)

2005 £47,000

2006 £51,000

2007 £59,000

2008 £68,000

2009 £75,000

Mean
£60,000
Average

4
A price to earnings ratio (p/e) is not listed for Yolanda Ltd therefore a suitable

alternative must be sought. Since the p/e ratio of three similar companies is given,

a mean average can be deduced.

Company p/e ratio

Ashraf plc 15

Bronagh plc 8

Conrad plc 12

Mean average

This average value can be rounded up to 12, which is also the mean p/e ratio for

the industrial sector in which Yolanda Ltd operates in therefore is a plausible

value to use. Furthermore, Conrad plc is a company with the same level of gearing

as Yolanda Ltd and has a p/e ratio of 12 which reinforces the use of 12 as the p/e

ratio.

he company’s stock price per share of olanda Ltd can now be evaluated by

applying the following equation:

ompany s stock price per share

p
e ratio ompany s last four quarters earnings per share

The introduction of the number of ordinary shares authorised by Yolanda Ltd

enables Xavier plc to value all the share capital.

Earnings Per Share(EPS) Stock Price Per Share Share Capital

2005
Year 64,000

5
2006
,000
2007
,000
2008
,000
2009
,000
Mean
Average
,000

ADJUSTMENTS TO SHARE CAPITAL

Since Yolanda Ltd is an unlisted company there is inherently a higher risk

involved, and according to Corriera et al(2007, page 6-20) a discount for lack of

marketability(DLOM) must be applied of between 25% - 45%1.

Discount to be applied

Currently the share price for Xavier plc is listed at 320p and the most recent

financial statement shows the the earnings per share to be 20p, from this we know

that the p/e ratio for Xavier is 16. Since Xavier plc is a well-known UK company,

it is foreseeable that Yolanda Ltd can be operated according to the standards set

by Xavier plc thus increasing the value of Yolanda plc; this will be by a fraction

of 16/12.

Just taking into consideration the lowest, highest and mean share capitals the

below can be deduced:

1
Corriera,C & Flynn,D, &Uliana, E, & Wormald,M. Financial Management (Juta and
Company,2007)

6
 Stock Price Per Share Capital Discounted Share New Share Capital

Share Capital
Year

p , , .
Low . p p , ,
64,000 ,

High . p p p ,
, .
,000
,

p p p ,
Mean , .
Average ,000 , ,
,

By applying the earnings based method, a share capital between £366,600 and

£780,000 can be justified depending on adjustments.

2.2 DISCOUNTED CASH FLOW METHOD

The discounted cash flow method cannot be implemented due to insufficient

information. Due to the information presented to Xavier plc regarding the cash

flows of Yolanda ltd, and not knowing the rate at which Yolanda ltd is expected to

grow means no accurate value can reached using the discounted cash flow

method.

7
2.3 DISCOUNTED DIVIDEND MODEL

The board of directors at Yolanda Ltd and Xavier plc hold differing expectations

when to comes to the distribution of dividends , however it will be dependent on

whether a takeover is successful or not.

Board of directors of Yolanda Ltd profile

The board of directors at Yolanda Ltd expect to pay a dividend next year of 80p

per share, rising over the following two years at a compound rate of 10% p.a. and

remaining constant in perpetuity thereafter.

With 100,000 shares available at 80p per share, the total is £80,000 and with an

annual profit of £75,000 for 2009 should be treated cautiously.

In recent years, investors in Yolanda Ltd have received a 15% rate of return on

investement.

t g
t
r
t

. . .
. . .
. .
The perpetuity is calculated and then discounted back,

g . .
r .
.
r .

. . .

For 100,000 shares this equates to . , ,

8
Board of directors of Xavier plc profile

The board of directors at Xavier plc state that the do not into to pay dividends

with the first three year of successful acquisition of Yolanda ltd. Following this

period, they intend to pay dividends of 120p per share in year four, with a rise in

compound rate of 10% p.a. until year 6 and remaining constant thereafter. Xavier

plc currently operate a policy whereby the hurdle rate is 15% when evaluating

potential projects.

The perpetuity value is calculated as below:

r r

. . .
. . .
. .

And then discounted as below:

r
r

. .
.
.
.

. . .

With 100,000 ordinary shares available, this amounts to

£615,510 is the present value of the future dividends to Xavier plc.

9
A minimum valuation of Yolanda, according to the requirements of the Yolanda

board of directors is £624,060 and this is the least value shareholders will accept

should an approach be made to buy their shares. However, this valuation is only

feasible should Yolanda plc manage to generate profits of £80,000 in the next

year.

10
2.4 ACCOUNTING RATE OF RETURN

As a simple method to establish the maximum value a company would attach to a

prospective company they wish to take over, the accounting rate of return could

be applied to value Yolanda ltd.

Companies in the Xavier group are required to yield an accounting rate of return

of 15%, and the board of directors of Yolanda ltd estimate that the investment by

Xavier plc will lead to Yolanda ltd accruing earnings of £90,000 in the twelve

months following the investment.

,
,

Should the required accounting rate of return be achievable and the projected

earnings accurate, the value of £600,000 can be attached to Yolanda ltd.

11
3.0 ESTIMATION OF EXPECTED RATE OF RETURN

3.1 CAPITAL ASSET PRICING MODEL

The capital asset pricing model (CAPM) method is a suitable method to estimate

the expected rate of return for the investment.

A suitable beta value is required for Yolanda ltd to be able to estimate the

expected rate of return. Conrad plc is a company which operates with the same

level of gearing as Yolanda plc, therefore the risk associated is similar and it is

feasible to apply the same beta value as Conrad plc.

Currently a risk-free return of 2% is achievable from the UK treasury Gilts, and

an average stock market return is estimated at 6%.

Combining the following equations :

i f m

m m f

The following equation is deduced.

i f m f

i . -

The CAPM method presents an expected rate of return of 8%, which is

significantly lower than the rate of return which investors in Yolanda Ltd have

received in recent years of 15%. Furthermore, it is also lower than the 15%

hurdle rate set by the Xavier group when evaluating potential projects.

12
4.0 CONCLUSION

The various methods applied arrived at different valuations of Yolanda ltd, and

these are summarised below:

Net Assets Method £1,030,000

Earnings Based Method Between £366,600 and £780,000

Discounted Dividend Method

Accounting Rate of Return

Yolanda Ltd currently possess assets values at £1,030,000 therefore a valuation

below this means the company would be undervalued. Further to this, the CAPM

method arrived at an expected rate of return of 8% which is significantly lower

than the rate of return investors have been receiving in recent years. Revaluation

using the 8% rate of return will yield different values.

Since this is the case, the recommendations to the board of Xavier plc is not to

pursue acquisition of Yolanda ltd since the minimum value the shareholders will

accept is £1,030,000 and the calculated rate of return is significantly lower than

the anticipated expected rate of return, which in turn means the valuation using

this rate of return will be exceptionally higher, and although this can possibly

yield more profit in the future by eliminating competition, it is not Xavier plc’s

interest to acquire Yolanda ltd following these valuations.

13