9.
Share and Business Valuation
A share price
is the amount at which a buyer and seller of a share ‘agree to do business’.
When a share is sold, both the buyer and the seller agree that the share has a
certain value. In other words, a
share price is its agreed trade value.
When a
company is ‘listed’, its shares are listed on the stock exchange and the
share price is set by the market makers, who are the traders of shares in the
stock market. If we wish to know
the price of shares of a ‘quoted’ or ‘listed’ company, we can look at a
price list in the daily newspaper.
When a
company is not ‘listed’ on a stock market (i.e., it is ‘unlisted’ or
‘unquoted’) there is no readily obtainable share price. Persons wishing to
sell or buy some shares in a private company which is unlisted on any market,
must therefore ‘invent’ a price at which they can agree to deal.
Further situations where private company shares have to be valued are:
(a)
when shares are
given away or inherited and must be valued for tax purposes;
(b)
Takeovers/mergers
where the consideration is in the form of shares in a private company;
(c)
New issues of
shares;
(d)
Giving security
for a loan in the form of shares.
When the
would-be seller and the would-be buyer of shares in an unquoted company begin to
negotiate a price for the shares, they will need to make some estimate of what
they ought to be worth. The problem
is to find a way of making an estimate of the shares’ value. There are several
different methods which can be used. Each
will provide a completely different value.
However, each different estimate of value will help the buyer or seller
of shares to judge the price (or range of prices) at which he will agree to
deal.
The
purpose of these notes is to look at the different methods of estimating a
share’s value when the share does not have a quoted market price.
Given
that a price for shares or for a business as a whole depends on negotiation
between buyer and seller, there may not seem to be any reason for trying to
calculate any valuation. However
the various techniques available for estimating what a business is worth do have
a useful purpose. They may not
establish what a buyer is willing to pay or what a seller should ask, but they
do indicate broadly the kind of figures which the parties can discuss.
This means that it is usual to carry out more than one calculations, and
then look at what different figures mean about a particular business.
There
are three methods that are used in estimating the value of a business:
1.
ASSET-BASED
METHOD.
2.
PROFIT-BASED
METHOD.
3.
CASH
FLOW METHOD
1
ASSET-BASED
METHODS
a) Book
Value Basis
The
most straightforward method of valuing a business on the basis of accounting
information is to look at the values of assets and liabilities as shown in the
balance sheet. Since the balance sheet shows the amount of the assets less
the liabilities as the capital, a simple assessment of a business would consider
the value of the net assets to be the same as the owner’s equity shown in the
balance sheet.
The
book value basis, or assets basis of valuation is often refined a little by
excluding goodwill, on the grounds that goodwill is normally written off as soon
as it is created, or very shortly afterwards.
Since this approach assumes that the business will continue to operate it
is also referred to as the going-concern method of valuation.
FORMULA:
¨
The book value
of all assets (fixed and current) minus the long-term liabilities (such as debenture stock) and
current liabilities of the business. If
there are any preference shares, these should also be treated as liabilities.
¨
The book value
of fixed assets is taken after subtracting depreciation – i.e., at their net
book value.
¨
Another way of
stating the book value of shares or business is the nominal value of shares plus
the book value of reserves (share capital plus
reserves) i.e. total owners’s equity
The value per
share is:
The total value of shares or business
Number of ordinary shares
Note
- Book
values also ignore the existence of assets not included in the balance sheet,
such as goodwill or development costs written off.
LECTURE QUESTION #1
The balance sheet of Nebraska Ltd. at 30 April 19x4 was:
$
$
Tangible
Fixed Assets
Land and Buildings
80,000
Plant and Machinery: Cost
60,000
Depreciation
35,000
25,000
105,000
Current
Assets
Stocks
12,000
Debtors
18,000
Cash at bank and in hand
5,000
35,000
Current
Liabilities
Trade Creditors
20,000
Net Current Assets
15,000
Total
Assets less Current Liabilities
120,000
Long-term
Liabilities
Debenture Loans
30,000
90,000
======
Capital
and Reserves
Called-up ordinary share capital @ $0.50 each
40,000
Preference share capital @ $0.20 each
20,000
Share premium account
10,000
Profit and Loss account 20,000
90,000
======
What is the value of the business and the book value per share?
b)
Replacement Cost
Basis
To make a more useful asset-based valuation, assets must be valued at
their replacement costs. Replacement
cost value is the cost that would be incurred if the assets of the business had
to be replaced at today’s prices, in their current condition.
In other words, it is an assessment of what it would cost to replace the
individual assets with others of comparable quality.
With occasional exceptions, the replacement cost value of assets is a
reasonable estimate of their value to the business, on the assumption that the
business is going to continue its operations.
FORMULA
The total replacement value of
shares or business is:
¨
The replacement
cost value of all assets (fixed and current) minus the long-term liabilities (such as debenture stock) and
current liabilities of the business. If
there are any preference shares, these should also be treated as liabilities.
The value per
share is:
The total value of shares or business
Number of ordinary shares
Note
- This
basis recognizes the existence of goodwill since assets are usually revalued at
higher prices thus creating goodwill.
LECTURE QUESTION # 2
$
Land and Buildings
100,000
Plant and Machinery (with adjustments to allow for depreciation)
34,000
Stocks
13,000
What is the replacement value of the business and the replacement value
per share?
This valuation looks on a business as a collection of assets which may be
sold off piecemeal, with the owners receiving any residue after all other
contributors of finance have been reimbursed.
If the business has to close down, the assets shown in the balance sheet
will only fetch low, forced-sale prices.
This approach of assessing what a company would be worth in the event of
liquidation is sometimes referred to as a gone-concern valuation, in contrast to
the going-concern approach which assumes that the business will continue
trading.
FORMULA
The total break-up value of
shares or business is:
1
The break-up
value of all assets (fixed and current) or sales proceeds of the individual
assets minus the long-term liabilities
(such as debenture stock) and current liabilities of the business.
If there are any preference shares, these should also be treated as
liabilities. Less
2
Any costs of
liquidation.
The value per
share is:
Value of shares or business or value of ownership interest
Number of ordinary shares
It may be helpful to be aware that:
(a)
freehold land
and buildings should sell for their current market value;
(b)
plant,
machinery and other equipment will probably sell for less than their book value
because the costs of removal might be high and second-hand machines values might
be low;
(c)
stocks will
probably be sold off at a profit;
(d)
debtors should
pay up in full.
Note
- Do not forget to include any cash at the bank and in hand in the total
asset value.
Note
- The
Break-up value also ignores the existence of assets not included in the balance
sheet, such as goodwill or development costs written off.
LECTURE QUESTION # 3
Oklahoma Ltd’s summarized balance sheet at 31 May 19x4 was as follows:
$
$
Tangible Fixed Assets
Land and Buildings
70,000
Plant and Machinery
150,000
220,000
Current Assets
Stocks
40,000
Debtors
45,000
Cash at Bank and in hand
5,000
90,000
Current Liabilities
Bank Loans and overdrafts
25,000
Trade creditors
15,000
Net current assets
50,000
Total assets less current liabilities
270,000
Long-term liabilities
Debenture Loans
50,000
220,000
======
Capital and reserves
Called-up share capital (ordinary shares at $1 each)
100,000
Profit and Loss
120,000
220,000
======
If the company were put into liquidation, it’s plant and machinery
would realize $90,000 and the stocks $48,000.
A recent valuation of the land and buildings by a firm of surveyors put
their value at $180,000. Liquidation
expenses would be $6,000. What is
the liquidation value per share?
2
PROFIT-BASED METHODS
In
most cases comparisons related to profit are based on share price rather than a
price for the business as a whole, in contrast to the techniques based on assets
in the balance sheet. The main
methods used to look at business values on aspects of profit are:
¨
The
total value of share or business using the dividend basis is:
Total annual dividend
Dividend
yield
Where the dividend yield represents the yield of comparable or similar
companies, or the average dividend yield of comparable or similar companies.
¨
The
total value per share is:
The
total value of share or business
Number
of ordinary shares
Dividend Yield
¨
Dividend
Yield as a percentage is:
Dividend per share
Average
market price per share
¨
Dividend
per share is:
Number of ordinary shares
The dividend yield basis of valuation normally assumes that the expected
dividends from a share in the future will be a constant amount every year.
It is possible, however, that in an expanding company, shareholders can
look forward to a regular increase in the annual dividend year after year.
Where the dividend growth is expected, a dividend growth model (known as
Gordon’s model) can be applied to find a share valuation.
This is:
|
|
D1 --------------------- r -g |
|
V = |
|
|
|
V is the share's value
D1 is the dividend payment
expected in one year’s time;
r is the dividend yield expected by the shareholder (expressed as a
percentage);
g is the expected annual rate of dividend growth (expressed as a
percentage).
California Ltd. is a private company which has paid a regular total
annual dividend of $24,000 on its 100,000 ordinary shares.
A prospective buyer of some of the share capital of California Ltd. considers that the dividend yield from an investment of this type should
be 12%.
What value should be place on a share of California Ltd. by the dividend
yield method?
¨
The
total value of share or business using the earnings basis is:
Earnings yield
¨
The
total value per share is:
The
total value of share or business
Number
of ordinary shares
Earnings Yield
¨
Earnings
Yield as a percentage is:
Earnings
per share
Average
market price per share
¨
Earnings
per share is:
Total annual Earnings
Number of ordinary shares
Suppose
for example that a shareholder in Nevada Ltd. wants to decide a price at which
he will sell his shares. He thinks
that an earnings yield of 15% is appropriate; in other words he thinks that a
shareholder of Nevada Ltd. should expect an earnings yield of 15% on his shares.
This is
another method that uses annual earnings as a basis for reaching a share
valuation. A price/earnings ratio
is quite simply the ratio of a share’s price to its annual earnings.
The P/E ratio is calculated for listed companies, and relates the market
price of a company’s share capital to its most recently reported earnings.
The market price of a share is found in the daily newspaper and the value
of earnings per share, which is based on profits after tax, must be given in the
published accounts of listed companies. The P/E may be calculated as follows:
Total value of all shares =
Market value of shares
Total Earnings
Earnings per share
An unlisted company can therefore be valued by multiplying its earnings
by the P/E ratio of a similar, but listed, company.
FORMULA:
¨
Total
value of the business:
Total earnings x P/E ratio
¨
Value
per share
Earnings per share x P/E ratio
Suppose
that New Mexico Ltd. is an unlisted company which last year made earnings of
$30,000. The company has 100,000
ordinary shares in issue. If Dakota
plc has offered to buy the entire share capital of New Mexico Ltd. on a
price/earnings multiple of 5, what would be the offer price per share?
·
It represents, for the
seller, the minimum value at which the transaction should take place, especially
if pessimistic valuations are applied to the assets.(In reference to the example
used, no offer to acquire the company at less than $3 per share is acceptable
since it is assumed that at least this sum would be received on liquidation. The
buyer has a bargain if the vendor is ignorant of the break-up value of the
company and accepts less than $3 per share, a possibility exploited by 'asset
strippers' who after acquisition, sell off the assets to realize a profit.'
Cons
·
This approach ignores
the possibility that the assets together may be worth more than the sum of their
individual values because of the particular manner in which the company uses
them.
·
The values placed on
the assets are estimates. The sale value of premises and plant and machinery can
only truly be ascertained in an actual sale.
·
Other consequential
costs are often ignored. These include redundancy payments and liabilities for
breach of contract.
·
It ignores the
existence of any goodwill
2.
Book
Value -
Pro
·
The figures are
factual
Cons
·
The historical cost of
an asset is the amount paid for it at the time of acquisition and this is not
relevant to a current valuation.
·
Due to errors when
estimating the lives of fixed assets, it is common for firms to have in their
books items which are fully depreciated, but are still providing useful service,
and so must have a value greater than zero.
·
It ignores the
existence of any goodwill
3.
Replacement Cost -
Pro
·
It serves as a more
useful asset-based valuation as it gives the
maximum price the buyer will pay. This is evident in the case where the
potential buyer has the alternative of purchasing a collection of identical
assets.
Con
·
It ignores the
existence of goodwill ( However a more favourable valuation method is achieved
if goodwill is considered)
4.
Earnings Yield and Price/Earnings (P/E) Ratio Valuation
Pros
·
It is simple to
calculate
Cons
·
The future earnings is
an estimate which is unlikely to prove accurate
·
Using the earnings
yield and P/E ratio of only one similar company may not always be
representative; therefore the average for a number of similar companies should
be used if possible
5.
Dividend Yield Valuation -
Pros
·
It is simple to
calculate
Cons
·
It is sometimes based
on past dividends, and these may not be representative of future expectations,
which should help determine the current price.
·
Using the dividends
yield of only one similar company may not always be representative; therefore
the average for a number of similar companies should be used