VALUATION OF SHARES & BUSINESS

CHAPTER OBJECTIVES
At the end of the chapter you will be able to

Explain the reasons for a business and share valuation

Value a business using Net Asset Valuation Methods
Value a business using Earnings Methods: P/E Ratio, Dividend Yield,
etc
Apply the Dividend Valuation Method (DVM)
Compute the valuation of ordinary shares, preference shares and
bonds
Compute the valuation of a business using the super-profits method

INTRODUCTION
There are a number of different ways of putting a value on a business, or shares
or bonds and it is preferable to use several methods of valuation, and to compare
the values they produce.
REASONS FOF BUSINESS/SHARE VALUATION
Given quoted share prices on the Stock Exchange, why devise techniques for
estimating the value of a share? A share valuation will be necessary:
(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 unquoted 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
iii) Shares are sold
iv) Shares need to be valued for the purposes of taxation
v) Shares are pledged as collateral for a loan
For subsidiary companies, when the group's holding company is negotiating the
sale of the
subsidiary to a management buyout team or to an external buyer.
(d) For any company, where a shareholder wishes to dispose of his or her
holding. Some of the valuation methods we describe will be most appropriate if a
large or controlling interest is being sold. However even a small shareholding may
be a significant disposal, if the purchasers can increase their holding to a
controlling interest as a result of the acquisition.
(e) For any company, when the company is being broken up in a liquidation
situation or the company needs to obtain additional finance, or re-finance current
debt.

ASSET VALUATION BASES

The net assets valuation method can be used as one of many valuation
methods, or to provide a lower limit for the value of a company. By itself it is
unlikely to produce the most realistic value.

The Net Assets Valuation Basis

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

Example: Net Asset Valuation Method

The summary statement of financial position of Cactus is as follows.
Non-current assets
Land and buildings
Plant and machinery
Motor vehicles

$
160,000
80,000
20,000
260,000
20,000

Goodwill
Current assets
Inventory
Receivables
Short-term investments
Cash
Current liabilities
Payables
Taxation
Proposed ordinary dividend

80,000
60,000
15,000
5,000
160,000
60,000
20,000
20,000
(100,000)

12% bonds
Deferred taxation
NET ASSETS
Ordinary shares of $1
Reserves
4.9% preference shares of $1

60,000
340,000
(60,000)
(10,000)
270,000
80,000
140,000
220,000
50,000
270,000

REQUIRED:
Calculate the value of an ordinary share using the net assets basis of valuation

Solution
If the figures given for asset values are not questioned, the valuation would be as
follows.
$
$
Total value of assets less current liabilities
340,000
Less intangible asset (goodwill)
20,000
Total value of assets less current liabilities
320,000
Less: Preference shares
50,000
Bonds
60,000
Deferred taxation
10,000
120,000
Net asset value of equity
200,000

Number of ordinary shares

Value per share

80,000
$2.50

NET ASSET VALUATION BASES

There are several net asset valuation bases and the difficulty is in establishing the
asset values to use. Values ought to be realistic. The figure attached to an individual
asset may vary considerably depending on whether it is valued on a going concern
or a break-up basis.
Possibilities include:
Historic basis unlikely to give a realistic value as it is dependent upon the
business's depreciation and amortisation policy
Replacement basis if the assets are to be used on an on-going basis
Revaluation basis: if the business has a regular revaluation.
Realisable basis if the assets are to be sold, or the business as a whole broken
up. This won't be relevant if a minority shareholder is selling his stake, as the assets
will continue in the business's use
Break up or liquidation basis: if the assets of the business are to be broken up or
sold on a in a liquidation.
INCOME BASED VALUATION BASES
These methods are used to value ordinary shares using the earnings or income of a
company. The common methods are the Price/Earnings (P/E) ratio and the Earnings
Yield (E/Y) methods.
The P/E ratio (earnings) method of valuation
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 earnings
per share to a share's value.
Since P/E ratio = Market Value
EPS
Then market value per share = EPS x P/E ratio
Note: Earnings Per Share (EPS) = Profit /loss attributable to ordinary shareholders
Weighted average number of ordinary shares
A high P/E ratio may indicate:
(a) Expectations that the EPS will grow rapidly
A high price is being paid for future profit prospects. Many small but successful and
fast-growing companies are valued on the stock market on a high P/E ratio. Some
stocks (for example those of some internet companies in the late 1990s) have
reached high valuations before making any profits at all, on the strength of expected
future earnings.
(b) Security of earnings
A well-established low-risk company would be valued on a higher P/E ratio than a
similar company whose earnings are subject to greater uncertainty.
(c) Status

If a quoted company (the bidder) made a share-for-share takeover bid for an

unquoted company (the target), it would normally expect its own shares to be valued
on a higher P/E ratio than the target company's shares.
The Earnings Yield Valuation Method
Another income based valuation model is the earnings yield method.
Earnings yield (EY) =

EPS
Market price per share

x 100

This method is effectively a variation on the P/E method (the EY being the reciprocal
of the P/E ratio), using an appropriate earnings yield effectively as a discount rate to
value the earnings:
Market value = Earnings
EY
Exactly the same guidelines apply to this method as for the P/E method. Note that
where high growth is envisaged, the EY will be low, as current earnings will be low
relative to a market price that has built in future earnings growth.
We can incorporate earnings growth into this method in the same way as the
dividend growth model as follows.
Market value = Earnings (1 + g)
(K - g)
EXAMPLE:
A company has the following results.
2011
$m
6.0

Profit after tax

2012
$m
6.2

2013
$m
6.3

2014
$m
6.3

The company's cost of capital is 12%.

REQUIRED
Calculate the value of the company based on the present value of expected
earnings.
SOLUTION
Market value = Earnings (1 + g)
(K - g)
Earnings = $6.3m
Ke

= 12%
6.3

=3

- 1 = 0,0164 or 1,64%
6.0

Market value = 6.3 x 1.0164

0.12 - 0.0164
= $61.81m
The Dividend Valuation Model
The dividend valuation model is based on the theory that an equilibrium price for any
share (or bond) on a stock market is the future expected stream of income from the
security discounted at a suitable cost of capital
Equilibrium market price is thus a present value of a future expected income stream.
The annual income stream for a share is the expected dividend every year in
perpetuity.
The basic dividend-based formula for the market value of shares is expressed in the
dividend valuation model as follows:
D0 (1 + g)2

D0 (1 + g)
MV (ex div) =

+
(1 + Ke)

(1 + Ke)2

D0 (1 + g)
+.. =
Ke - g

D1
=
Ke - g

Where D0 = Current year's dividend

g = Growth rate in earnings and dividends
D0 (1 + g) = Expected dividend in one year's time (D1)
ke = Shareholders' required rate of return
P0 = Market value excluding any dividend currently payable
EXAMPLE

Target paid a dividend of $250,000 this year. The current return to shareholders of
companies in the same industry as Target is 12%, although it is expected that an
additional risk premium of 2% will be applicable to Target, being a smaller and
unquoted company. Compute the expected valuation of Target, if:
(a) The current level of dividend is expected to continue into the foreseeable future or
(b) The dividend is expected to grow at a rate of 4% pa into the foreseeable future
(c) The dividend is expected to grow at a 3% rate for three years and 2% afterwards.

THE SUPER PROFITS METHOD

The Statement of Financial Position of Q Ltd on 31 December 2010 was as follows:
ASSETS
Tangible Non Current Assets
Goodwill
Net Current Assets

$
4 500 000
750 000
1 750 000
7 000 000

EQUITY & LIABILITIES

Ordinary Share Capital of $1.00 each
General Reserve
Retained Profits

4 000 000
1 650 000
1 350 000
7 000 000

The net profits after tax for the next 5 years are expected as follows:
31/12/2011
31/12/2012
31/12/2013
31/12/2014
31/12/2015

$
1 700 000
3 150 000
2 200 000
2 450 000
2 680 000

A fair return on the business is estimated at 25%

REQUIRED:
Calculate the value of the ordinary shares using the super profits method.
Super Profits
Capital Employed
Less Goodwill
Adjusted Net Worth

$
7 000 000
750 000
6 250 000

Fair return on adjusted net worth (25% x 6 250 000) =

1 562 500

Average annual profits [(1 700 000 + 3 150 000 + 2 200 000
+ 2 450 000 + 2 680 000)]
= 12 180 000 =
2 436 000
5
Super Profits = Average annual profits - Fair return on adjusted net worth
= (2 436 000 1 562 500) = 873 500
Super Profits year ended 31/12/11
Super Profits year ended 31/12/12: (3/4 x 873 500) =

$
873 500
655 125

Super Profits year ended 31/12/13: (2/4 x 873 500) =

Super Profits year ended 31/12/14: (1/4 x 873 500) =
Super Profits year ended 31/12/15:
Present Value of Super Profits (at 25% discount rate)
31/12/11: 873 500 x 0.8000 =
698 800.00
31/12/12: 655 125 x 0.6400 =
419 280.00
31/12/13: 436 750 x 0.5120 =
223 616.00
31/12/14: 218 375 x 0.4096 =
89 446.40
Present Value of Super Profits
1 431 142.40
Present Value of Ordinary Shares
= Present Value of Super Profits + Adjusted Net Worth
= 1 431 142.40 + 6 250 000
= 7 681 142.40
Value per Ordinary Share:
= Present Value of Ordinary Shares
No. of Ordinary Shares in issue
= $7 681 142.40
4 000 000
= $1.92

436 750
218 375
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