﻿ Valuation

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# Valuation

There are billions of shares traded daily on stock exchanges across the world. Typically, investors are looking to either buy equity shares or a firm’s debt, but their primary concern is the amount to pay for the shares or the debt. In this module, the valuation of securities will be explored, both in respect of how the initial valuation of a firm can be determined and how a fundamental investor can analyse this information for a more measured view.  Specifically, the value of a business is the combined value of the debt plus the value of the equity.

## Comparables Method

This method is based on the view that similar businesses will have similar multiples[1]. If market prices are efficient in that all the available information about a share is already incorporated into the price of that share, then this would be a reasonable assumption. If all information is incorporated into all shares, then the market would value similar businesses approximately the same.

## Calculation

This method of comparables or multiple comparison analysis takes a variety of measures from ‘comparable’ firms and calculates multiples of those measures. The average of these multiples is used to calculate the measure for the target firm to see how it compares to similar companies.

The table below shows how the method of comparables could be used to value Tesco using comparable firms. The comparable firms selected are Sainsbury and Wm Morrison and price to sales (P/S), price to earnings (P/E) and price to book (P/B) figures are calculated for these comparable businesses using their reported sales, earnings, book value in relation to the quoted market value.

 Company Sales Earnings Book Value Market Value P/S (market value / sales) P/E (market value / earnings) P/B (market value / book value) Sainsbury 33.7 0.690 25.8 7.1 0.21 10.3 0.28 Wm Morrison 21.7 0.407 11.6 6.8 0.31 16.7 0.59 Tesco 78.4 0.232 61.8 19.2 ? ? ? Average 0.26 13.5 0.44

All data in billions of dollars

All data taken from Forbes 2017 List of the world’s biggest public companies (Forbes Media LLC, 2017)

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The average of the comparable multiple is used to determine the target valuation. As seen in the table below, the average multiple for market value to sales is 0.26, this is multiplied by the sales income of Tesco to get a valuation of \$20.4 billion. This process is repeated using the appropriate average earnings and book value multiples against Tesco’s own earnings and book value and the three valuations are then added up and the average calculated.

 Average Multiple for Comparables Tesco’s Numbers Tesco’s Valuation Sales 0.26 X 78.4 = 20.4 Earnings 13.5 X 0.232 = 3.13 Book Value 0.44 X 61.8 = 27.2 Average Valuation 16.9

The above calculations indicate that the market value of Tesco is \$16.9 billion versus the stated value of \$19.2 billion. This is approximately a 12% variation in the valuations, but it could be considered that even if the valuation showed less variation this method intuitively feels a little simplistic for something that is influenced by so many factors.

• It is relatively easy and simple to calculate
• If the target investment is a private company with no comparable traded stock price, then this method will provide a base indicative figure to begin the investment analysis.

• There are also problems in the implementation of this method. It appears simplistic on the surface but in reality, identifying comparable companies is not as easy as it seems.
• If a comparable business has a loss, it leads to a negative P/E ratio which has no meaning and therefore cannot be used.

Multiples screening method is also explored in this module, which is an adaptation of the comparables method, but it uses screening to determine if a share is mispriced on the market.

An asset based valuation considers the value of the firm’s assets to determine its value and there are a variety of asset based calculations that can be made.

## Calculation

The first and simplest method is to value the business as the value of shareholders equity based on book values, i.e. total assets less total liabilities at values recognised in the balance sheet. To calculate the value of an individual share this amount should simply be divided by the total number of issued shares in the business.

However, the problem with this basic asset based valuation is that many assets are carried at amortized (depreciated) historical prices and therefore may not adequately reflect their true current value.

This leads to a more refined approach to an asset based valuation that takes account of the ‘fair’ value of the assets of the business. In this instance, the investor includes an uplift to increase assets, so they are more representative of the current market value at the time of investment.

Finally, there may be assets missing from the balance sheet such as brand, knowledge and managerial assets. These assets collectively tend to be classified under the banner of ‘goodwill’ and a goodwill reserve is often created on acquisition of one business by another which represents the difference between the balance sheet net assets at fair value and total price paid. This variation on the net asset valuation to account for goodwill is known as ‘the super profits’ method and it takes the net assets basis but then builds in an allowance for goodwill which is not reflected in the base net assets figure.

- The basic net asset method is very simple to understand and calculate

- The data is always available

- It does not take account of items that may not be included in the assets such as goodwill

- A simple book value approach to net asset valuation does not recognise that historic costs with depreciation applied is unlikely to match the real value precisely

# Methods Involving Forecasting

Two methods will be discussed this section. Those that value the cash flows to the investor i.e. the dividends and those that use the projections of the future profitability/cash flows of the business. Within the former approach, there are 2 methods that can be adopted. The first assumes that there is no growth in dividends and the second assumes growth in dividends.

Dividend models can be used for valuation as they represent a return that investors get from their investment in the form of cash flows and as such the investor can use the estimated return to calculate how much they may be willing to pay for the investment.

This basic method does not actually require forecasting as it assumes no growth in the amount of dividend paid. This method values the business based on the following formula:

Price of the share = dividend just paid / required return

The tables below provide an example of the various valuations that could arise from this method.

 Sainsbury Morrison Average P/E P/E ratio 14.06% 15.27% 14.67% Dividend just paid by Tesco 1.16p per share (the last recorded dividend for Tesco was in 2015 although an interim has been declared for 2018)
 Investor Determined Overall Market Average for comparison selected companies Required Return 10% 11.69% 14.67% Price Per Share 11.6p 9.9p 7.9p

Note: The average annualized return of the S&P 500 Index was about 11.69% from 1973 - 2016.

P/E ratio data taken from Financial Times market data (The Financial Times Limited, 2017)

Applying this calculation to the valuation of a Tesco share returns an extremely low price of between 7.9p per share and 11.6p per share whereas in reality Tesco shares are currently trading in the region of £1.86 (186p) per share. Tesco have faced difficulties in recent years with significantly reduced profits and some failed diversified market attempts and they have been through a phase of restructuring and refocusing their business.  Consequently, their dividends have been extremely low since 2014. If the same calculation is performed using the 2014/15 dividend of 14.76p then at the average P/E rate the share price would be £1. Whilst this is significantly higher than the current calculation it still falls short of the traded price in 2014/15 which at one point reached a high of £2.51 per share.

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The estimate for growth can be made in a number of ways. Historic data can be used to estimate any year on year growth and then average it, overall market data could be used indicating trends, or experience by the investor using their portfolio dividend growth rate.

This method values the business based on the following formula:

Price of the share = dividend just paid x (1+growth rate) / discount rate - growth rate

Staying with our Tesco example, if we were to predict 5% per annum growth in the Tesco dividend with a discount rate of say, 10%, then Tesco share price would now be 24p as shown in the calculation below.

1.16p x (1 + 0.05) / 0.10 - 0.05 = 24p

If we were to use the 2014 dividend, then this figure becomes £3.10 which is huge variation. However, the difference between 1p dividend and 14p dividend with a growth assumption is significant.

• This method is useful in determining an investment using the investors personal required return.

• The methodology and therefore the result only takes account of one thing, dividend and in reality, the market and investors take many more factors into account when judging the worth of a business.

Discounted Cash Flow (DCF) Method

This method uses the estimated future cash flows arising from the business to determine the value of the business. The method uses free cash which is the cashflow from operations effectively resulting from operations less the cash used to make investments.

Calculation

The table below shows a calculation using the DCF method for firm XYZ Plc.

 2017 2018 2019 2020 2021 2022 Estimated Free Cash Flow from operations (£000’s) 3,000 3,250 3,690 4,000 4,106 Divided by: Discount rate at 10% 1.10 1.21 1.331 1.4641 1.6105 Present Value 2,727 2,686 2,772 2,732 2,550 Total Present Value to 2022 (£000’s) 13,467 Continuing Value[2] (£000’s) 87,047 PV of Continuing Value[3] (£000’s) 54,049 Firm Value (£000’s) 67,516 Shares Outstanding 2,000 Value per share (£) 33.76
• Cash flows are easy to think about as they are real and not affected by accounting rules.
• Net present value is a widely understood and used concept and it takes account of the time value of money.

• The calculations could be prone to error depending upon the assumptions made in respect of the rate of taxation and inflation when estimating the arising cash flows.
• It is difficult to determine the discount rate required. The discount rate is dependent upon the firm or individual making the valuation.
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# Hybrid - Forecasting and Non-Forecasting Data

There is a further valuation that may be applicable in certain circumstances and this is called the earn-out arrangement. It is a mixture of the net asset based model but also includes forecast earning.

This method provides a figure based on the net assets but then also adds onto it an expected return based on the immediate or near-term future profits. This could be for 3 years or potentially longer, but the objective is to keep the forecasting to a time horizon that offers a little more certainty.

This has the advantage of ensuring that the price does not pay for earnings that never materialise as it keeps the estimates a little nearer on the time horizon which gives more certainty to the estimates. It is normally applied when the current owners/directors are going to be kept on to run the business. This then provides an incentive for them to continue to be motivated to get the best return for the company.

Bibliography

ACCA, 2012. SA Technical: Business Valuations. [Online]
Available at: http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf
[Accessed 9 April 2017].

Brealey, R. A., Myers, S. C. & Allen, F., 2006. Corporate Finance. 8th ed. New York: McGraw-Hill / Irwin.

Forbes Media LLC, 2017. Forbes: The Workds Biggest Public Companies. [Online]
[Accessed 28 October 2017].

Helfert, E. A., 1997. Techniques of Financial Analysis. 9th ed. s.l.:Irwin.

The Financial Times Limited, 2017. Financial Times. [Online]
Available at: https://markets.ft.com/data/equities/tearsheet/summary?s=TSCO:LSE
[Accessed 28 October 2017].

[1] A multiple is a representation of a business benefit such as earnings or sales into a single value

[2] Continuing value = 4,106 x 1.05 / 1.10 - 1.05 = 87,047

[3] PV of continuing value = 87,047 / 1.6105 = 54,049