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## Department of Financial Management

University of Jaffna
FMG 3235 Strategic Financial Management
Date: 28.05.2012 Lecturer: Miss. S. Sivasubramaniam
Learning outcomes:
Define the term valuation of business.
Identify the reasons for the business valuation of the organization.
Calculate the value of shares by using different possible methods.

Introduction
An accurate, defensible business valuation plays a critical role in many business situations.
This can be an indispensable tool in establishing prices, justifying positions to stockholders
and satisfying governmental concerns in the course of corporate mergers, acquisitions,
refinancing and restructuring. Business Valuation is defined as a process used to determine
the value of a business, company or corporation by a process of estimation regarding the
companys present and future outlook.

The business valuation is necessary for many reasons. They are,
A. For quoted companies
When there is a takeover bid and the offer price is an estimated fair value in excess
of the current market price of the shares.

B. For un quoted companies, when:
(i) The company wishes to go public and must fix an issue price for its shares;
(ii) There is a scheme of merger, and a value of shares for each company involved
in the merger must be assessed.
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(iii) Shares are sold
(iv) Shares need to be valued for the purpose of taxation.
(v) Shares are pledged as collateral for a loan;

C. For subsidiary companies, when the groups holding is negotiating the sale of the

Methods of Valuing Shares
The following methods are used for valuing shares,
1. The earning method (P/E ratio method)
2. The accounting return method
3. The net assets method
4. The dividend yield method
5. The super profit method
6. DCF-based valuations.

The Earning Method (P/E ratio method)
This is a common method of valuing a controlling interest in a company, where the owner
can decide on dividend and retentions policy. The P/E ratio relates earning per share to a
shares value.
The P/E ratio =

Market value per share = EPS* P/E ratio

The P/E ratio can be used to make an earning-based valuation of shares. This is done by
deciding a suitable P/E ratio and multiplying this by the EPS for the shares, which are being
valued.

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For example:
Spider plc is considering the takeover of an unquoted company, Fly Ltd.Spiders shares are
quoted on the stock Exchange at a price of Rs. 3.20 and since the most recent published EPS
of the company is 20 cents, the companys P/E ratio is 16. Fly Ltd is a company with 100,000
shares and current earnings of Rs. 50,000, 50 cents per share. How might Spider plc decide
on an offer price?

The Accounting Rate of Return (ARR) method
The accounting rate of return of return will be required from the company whose shares are to
be valued. It is therefore distinct from the P/E ratio method, which is concerned with the
market rate of return required.
The following formula should be used.
Value =

For example:
Champers Ltd is considering acquiring Hall ltd. At present Hall Ltd is earning, on average,
Rs. 480,000 after tax. The directors of Chambers ltd feel that after reorganization, this figure
could be increased to Rs. 600 000. All the companies in the chambers group are expected to
yield a post-tax accounting return of 15% on capital employed. What should Hall Ltd be
valued at?

The Net assets Method
Using this method of valuation, the value of share in a particular class is equal to the net
tangible assets attributable to that class, divided by the number of shares in the class.
Intangible assets (including goodwill) should be excluded, unless they have a market value
(for example patents and copyrights, which could be sold).

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For example:
The summary balance sheet of J amuna Ltd is as follows.
Fixed assets Rs Rs Rs
Land and Buildings 160 000
Plant and machinery 80 000
Motor vehicles 20 000
260 000
Goodwill 20 000

Current assets

Stocks 80 000
Debtors 60 000
Short-term investments 15 000
Cash 5 000
160 000
Current liabilities
Creditors 60 000
Taxation 20 000
Proposed ordinary dividend 2 000 (100 000) 60 000
340 000
12% debentures (60 000)
Deferred taxation (10 000)
270 000

Ordinary shares of Rs 1 80 000
Reserves 140 000
220 000
4.9% preference shares of Rs1 50 000
270 000
What is the value of an ordinary share using the net assets basis of valuation?

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The Dividend Yield Method
The dividend yield method of share valuation is suitable for the valuation of small
shareholdings in unquoted companies. It is based on the principle that small shareholdings are
mainly interested in dividends, since they cannot control decisions affecting the companys
profits and earnings.
The simplest dividend capitalization technique is based on the assumption that the level of
dividends in the future will be constant. A dividend yield valuation would be:
Value =

%

It may be possible to use expected future dividends for a share valuation and to predict
dividend growth. The dividend growth model for share valuation can be expressed as follows,
P
o =
( )
( )

Where
P
o
- Current market value ex dividend
d
o
- Current dividend
g - Expected annual growth in dividend, so (1+g) is the expected dividend next year
r - Return required
For example:
A company expects to pay no dividends in year 1,2 or 3, but a dividend of 7.8 cents per share
each year from the year 4 in perpetuity. Value its shares on a dividend yield basis, assuming a
required yield of 12%.

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The Super-profits Method
This method starts by applying a fair return to the net tangible assets and comparing the
result with the expected profits. Any excess of profits (super-profits) is used to calculate
goodwill. The goodwill is normally taken as a fixed number of years super-profits. The
goodwill is then added to the value of the target companys tangible assets to arrive a value
For example: Light Ltd has net tangible assets of Rs. 120 000 and present earnings of Rs 20
000. Doppler Ltd wants to takeover Light ltd and considers that a fair return for this type of
industry is 12%, and decides to value Light Ltd taking goodwill at three years super-profits.
Discounted future profits Method
This method of share valuation may be appropriate when one company intends to buy the
assets of another company and to make further investments in order to improve profits in the
future.
For example: Dal Ltd wishes to make a bid for Tadpole Ltd makes after-tax profits of Rs.40
000 a year. Dal Ltd believes that if further money is spent on additional investments, the
after-tax cash flows (ignoring the purchase consideration)
Year Cash flow (net of tax)
Rs
0 (100 000)
1 (80 000)
2 60 000
3 100 000
4 150 000
5 150 000

The after-tax cost of capital of Dal Ltd is 15% and the company expects all its investments to
pay back, in discounted terms, within five years.
What is the maximum price that the company should be willing to pay for the shares of