Company Valuation

Introduction

Company valuation can be done using a number of specific techniques. It requires an understanding of financial analysis techniques in order to estimate value and, for acquisitions, also requires negotiating and tactical skills needed to fix the price paid. The three main methods of company valuation are book value, market multiples and discounted cash flow and valuation is required for:

Regulation

Privatisation

New issues, mergers & acquisitions

Corporate restructuring including leveraged buy-outs

Book Value

To use book value we must first investigate the concept of value. Publilius Syrus pointed out that a thing is worth whatever the buyer will pay for it. And what the buyer will pay depends on a number of factors such as estimated value, rarity, sentimental value, and importantly in corporate issues control.

Determining Book Value

Book value is based around the balance sheet as presented in the latest annual report. We first need to look at the book value given in the balance sheet and then examine how we may want to adjust it to get a closer approximation of what we might be prepared to pay.

The principle of book-value based valuation is that a company is worth to its shareholders the value of its assets minus the value of its liabilities.

Book Value = Assets - Liabilities

This can also be referred to as shareholders funds

If we divide this by the number of fully paid-up shares in issue we get the book value per share.

If we divide this by the fully paid up shares plus all those outstanding in option schemes we get the fully diluted book value per share.

The book value does not represent a single view of a company but more a mixture of views. It includes some assets at historic cost, some written down due to liquidation value, some written up to current value (e.g. property) and some written down by an arbitrary depreciation method

Consequently, book value will be somewhere between historic cost and market value However, it will not be an estimate of economic value since generally there is no consideration of the PV of future cash flows

In order to get closer to an economic value we need to consider adjustments to book value by considering the tangible intangible and off-balance sheet items

Tangible Assets Tangible assets are usually depreciated according to accounting estimates of their useful lives. Land and buildings are not written off as they are not expected to wear out - but may represent prices paid 20 years ago. Indeed, in the USA, France and Germany property is always included at historic price, but in the UK it can be re-valued.

Plant and Equipment may be written off over 5 to 10 years. However, if it is estimated that the current market value is less than the depreciated value, then the lower market value is taken.

Property under construction can also be recorded at other than historic cost. In some countries, companies are allowed to capitalised the interest payments they pay on debt related to property construction indeed in the USA it is compulsory. Other countries write it off as an expense.

All these go to show that book values give some clue as to market values but not an accurate one.

Intangible Assets Intangible assets include expenditure on R&D, brand values, intellectual capital and goodwill.

Whilst R&D expenditure does not buy a tangible asset such as a factory, it can be said to be an investment in knowledge which may generate future revenues. This can be described as an intangible asset whose life is more than one year and, as a result, should be capitalised on the balance sheet and depreciated over its expected life, say five years. Whilst many countries do not encourage this, it is permitted in some counties, e.g the UK, under certain circumstances.

There is also an argument for capitalizing spending on other forms of knowledge, such as database systems or the expertise provided by staff. This is known as intellectual capital. However, there is the risk that these assets can walk away, unlike a factory.

The capitalization of brand names has also been the subject of much discussion. Some UK companies did this and one added £0.5bn to its balance sheet. Again different countries have different rules, and in the UK brands can be capitalized if it they are acquired on take-over but not if it they are built up from scratch.

Goodwill is classed as the difference between the price paid for a company and its book value, and may appear on the acquiring companys balance sheet. It arises from the fact that book values typically do not reflect their economic values, especially in high value-added firms such as accountants where book values may be low. Some countries allow the depreciation of goodwill whereas some require that it be amortised against income the latter making paying lots of goodwill a less attractive proposition as it reduces earnings per share. However, the point to note here is that an acquiring company may acquire a large amount of goodwill, which if capitalised, will increase book value substantially compared with a company that has grown organically.

Off Balance Sheet

Off balance sheet items can be leases, pension assets or liabilities, employee related liabilities and other contingent liabilities. It is important to examine the off-balance sheet liabilities to see how they affect book value.

So we have seen that book value needs to be adjusted to gain a closer estimate of economic value. However, in certain circumstances, economic value can be less than book value or net realisable value. Indeed what we are seeking it what economists call opportunity value, as explained in the diagram below.

	Replacement Cost		Economic Value		Net Realisable Value

Market Multiples

Market multiples are ratios which are applied to companies book values, profits or cash flows in order to estimate value. The main ratios are:

- Price to Book

- Tobins q

- Price to Earnings (PE)

- Price to Cash Flow

- Enterprise Value to EBITDA

Market Value

The starting point for market multiples is the market values of companies whose shares are listed on a stock market. Public listed companies have a quoted share price and this gives an instant picture of a companys value. For large companies with very liquid stock this price will give an up to date valuation. For less liquid stock the price may be out of date on unrealistic for a larger than average trade.

However, it is interesting that the London stock exchange issues a caveat that share prices do not reflect the value of the company - but result from the actions and hopes of investors. It is important to examine what price means in the context of share value.

The stock exchange warns us that the price may not be a fair market price. A fair market price implies at least a semi-strong version of the Efficient Market Hypothesis (EMH). However, possible sources of inefficiency are manifold, e.g balance sheets may hide under or over valued assets, e.g Polly Peck. Also prior information on a takeover may exist to certain insiders and emerging markets may have poor quality publicly available information.

Market price also assumes that a buyer can be found to buy the share at the ask price. It also refers to a price for a small amount of shares where an extra premium would be required for control.

Also time affects price and a share price is a snapshot of the instantaneous price at a fixed point in time. The next minute faced with another trade a different set of factors may exist resulting in a different price.

Finally there may be other factors such as:

- shareholder loyalty, e.g. football clubs like Manchester United.

additional benefits to shareholders, e.g. discount prices

employee loyalty

a premium for control, the extra you need to pay

fashion, especially old economy vs new economy companies.

Dividend Yield

Dividend Yield is a measure of the income yield from a share and ignores the capital gain or loss element of return.

It is used to compare shares since the lower the dividend yield the greater must be the expectation of capital growth, all other things such as risk, being equal and at the market level it is a valuable relative valuation tool.

Also since Equity rate of return = next years dividend yield + forecast div growth rate.

E(r) = D₁/P_i + g

Thus if the expected dividend is 16p and the current price 449p and Cost of Equity is 12.75% the Dividend Growth Rate is 9.2%

Price to Book Ratio

The price to book is simply the ratio of the share price to the book value per share.

Market value of Share

Book Value per Share

If we use Boots as an example with a share price of £7.01 and book value per share of £1.79 we get a Price to Book ratio of 3.91 which implies that investors were willing to pay 3.91 times more than the book value for Boots shares because of the growth potential that went with them.

The ratio is meaningless on its own but it is useful when used in comparison with those of other companies in the sector, and with the multiples of comparable companies from other countries (with lots of caveats about book values resulting from differing accounting practices).

It is also useful to look how the multiple has changed over time to see if a re-rating has occurred and whether this was limited to the particular company or was typical for the sector or market as a whole.

Tobins Q

Tobins q can be thought of as a make or buy decision indicator and is defined as:

Market Capitalisation

Replacement cost of assets net of liabilities

In a perfectly efficient takeover market Tobins Q would always be 1.

If q > 1 its cheaper to start a company from scratch than to buy one

If q < 1 its cheaper to buy an existing company that to start one up from scratch.

In real life on the US S&P 500 Index since the 1950s Tobins q has risen steadily above 1 over the years. The Bears say that this just predicts a crash but the Bulls suggest that it could be expected to rise compared with that in the 1950/60s as more companies had greater intangible assets, such as intellectual capital.

PE Multiple

This is the most popular multiple for valuing companies whether at the share, company or market level. The PE Ratio is

= Share Price = Market Capitalization

EPS Earnings for Shareholders

In this way a company can be valued by multiplying its earnings by the appropriate PE multiple.

The attraction of the PE ratio is that it uses historical and current data to say something about the future. The higher the PE then the more the investor is prepared to pay and hence the more bullish he must be about the companys future.

However, it is also affected by the quality of earnings as the more volatile the expected future earnings, the less the investor is prepared to pay and hence a lower PE. e.g. Banking had an industry sector PE much lower then the 500 Share Index as they were seen to be more risky due to bad debt.

Companies can also be compared to a relative PE. e.g Rolls Royce on privatisation was compared with Bae which was the most comparable company, trading on a PE of 11. Rolls Royces share price was based on a PE of 10, thus making it cheap compared with BAe.

However, when comparing PEs we must take care of the following:

- Different accounting methods may have been used to calculate earnings. E,g is R&D capitalized or treated as an expense.

- FY ends may be different and so earnings may relate to different parts of the economic cycle.

- One company may have experienced an atypical drop in earnings which would have artificially boosted its PE.

- Tax minimization through provisions against earnings may artificially boost PE.

Price to Cash Flow

Price to Cash Flow is defined as

Share Price or Market Capitalisation

Cash Flow per Share Cash Flow

Where Cash Flow =

Operating Cash Flow (or Operating Profit + Depreciation Capital Expenditure)

+ Other Income

+ Interest Received

- Interest Payable

- Taxation

The main difficulty in using this ratio is that cash flow after taxes, interest and capital expenditure may vary from year to year and hence give misleading valuations for companies. Earnings on the other hand, due to accounting rules, are smoother than cash flows. This makes the PE multiple much more stable than the Price to Cash Flow multiple.

Also many different analysts use different definitions of cash flow and many prefer the simple earnings plus depreciation nothing like free cash flow.

The main conclusion is beware and check the definition of cash flow used.

Enterprise Value to EBITDA

B821 Mind-Map Peter Warburton

EV/EBITDA is growing in popularity as a valuation tool for companies and it is different from the other multiple in that it considers the value of the whole entity not just the equity.

It uses values for profit before interest & tax and so is independent of financing choice. These profits are also before depreciation and amortization - so EBITDA is not equivalent to cash flow as its is before depreciation or Capex.

EV is defined as:

Market Value of Equity + Book Value Net Debt + Market Value of any preference shares or convertibles plus minority interest

A strength of EV/EBITDA is that is tends to be more stable than other price to cash flows measures. Its main attractions also include its independence of capital structure, as well as its freedom from any distortions due to differences in depreciation policies between companies. This independence of tax and accounting differences enables comparison of companies across national boundaries and has been of particular use in the valuation of privatised utilities worldwide. e.g. Deutsche Telecom which was compared with BT.

Specific Valuation Ratios

There are also some ratios which are specific to sectors. e.g passenger yield, sales/m2, no of subscriber multiples etc.)

Discounted Cash Flow

The attraction of market multiples is their availability and their simplicity. However, they do not expressly take account of the time value of money and only crudely allow for differences in earnings or cash flow growth. Whilst DCF has traditionally been used as a project evaluation tool, it has now become almost common for company valuation.

DCF for company valuation is very similar to project evaluation except that it must be conducted at two levels: the equity level and the enterprise level. There are two main differences however:

- If shares are traded on an efficient market then the shares prices should reflects the markets best estimate for of value. Thus discounting shares back to a share price should give a zero NPV, whereas managers regularly expect positive NPVs from projects.

- Valuing companies is much more difficult than valuing projects due to the complexity of the information available. Consequently, a number of simplifying assumptions are normally made.

Equity Level Valuation

The value of a share can be said to be the discounted present value of all the future dividends expected on a share. Valuing a company at the equity level would seem logical for equity investors who are buying a few number of shares compared with all those in issue. Such investors have no control over the capital structure, dividend policy and even though they may vote they are effectively disempowered compared with the large institutional shareholders.

It would therefore seem sensible to value the cash flows expected from a likely dividend policy and likely dividend growth after taking account of debt interest. We do this by using the cost of equity as the discount factor.

Whilst this has been popular in the past the more common approach is now to value the company at the enterprise level.

Enterprise Level Valuation

Enterprise level valuation considers the cash inflows before financing, but after tax, and discounts them using the after-tax discount rate typically the WACC. The PV of these cash flows is equivalent to the enterprise value of the company; the value of the equity is determined by subtracting the value of the debt and minority interests.

DCF Valuation Steps

The DCF valuation is widely used by companies and their advisers when making acquisition or divestment decisions. It is also used by venture capitalists and increasingly by equity analysts. However, whist theoretically more accurate than simple multiples or adjusted book value, it is only as good as the numbers put in. It is difficult to know if you are making assumptions which are unrealistic or are being pessimistic. To help you need to study the sector closely and use your common sense.

Valuation in Context

There are four situations in which valuation is critical:

Regulation

New issues and Privatisation

Mergers & Acquisitions

Corporate restructuring including LBOs.

Regulation

Utilities, such as electricity generators and telephone providers, are regulated the world over whether they form part of the private or public sector. The traditional way this was done in the UK was based on their return on assets, with assets defined in terms of current costs. Whilst emphasis has now generally shifted to controlling prices charged, ROA is still important. Indeed, BT has clashed with it regulator OFTEL over whether development expenditure should be treated as an intangible asset thus giving BT a bigger asset base on which it can then make a bigger return, or simply deducted from profits as an expense.

New Issues

In a flotation or primary issues the offered share price was historically set below the valuation to encourage a successful launch. The level of success was defined by how much the issue was oversubscribed. More recently the US practice of book building has become common and the prices are not fixed in advance of the issue date. It is argued that this method is better for the issuing company since shares are issued at a higher price and thus fewer shares need to be issued to obtain the same proceeds. However, the process is costly and can account for 5% of the gross proceeds. Furthermore, public listing requires compliance with certain stock market criteria that include frequent reporting to the market and liquidity/profitability requirements. Many stock markets also require 5 years of audited accounts showing profits before they will allow a listing. This created parallel stock exchanges such as NASDAQ that dont have formal listing requirements.

Whilst new shares are often issued at a discount to the value at which they subsequently trade there is the New Equity Puzzle to consider. It was found that new US issues between 1970-90 had been consistently poor long-term performers. This was thought top be tied to over-optimistic brokers reports (because they were scared of or indeed were working for the issuing banks but using Chinese Walls). Consequently, over the first years of trading these over-optimistic forecasts were revised down in the face of reality and the share prices fell.

Privatisation

Privatisation is the sale of state-owned assets or enterprises from governmental or parastatal ownership to private ownership and control. In the UK, utilities were amongst the first to be privatised. One of the main reasons for this privatisation was need to invest large sums in ageing infrastructure and if they had remained under government control then governmental borrowing would have had to increase.

The new issue valuations applied to these privatisations were based on the need for them to be a success. Also there was limited experience of valuing utilities and so a fixed price flotation method was chosen. This resulted in a substantial under pricing of the shares on offer and some prices rose by more than 100% within a day of listing.

However, other valuation methods were used in other privatisations. E.g. Rolls-Royce was compared with other similar companies in it sector in order to determine a valuation.

Despite the move towards privatisations on many countries, not all followed the IPO route. e.g After the reunification of Germany, the East German utilities were sold by means of a trade sale to other companies as experienced management and capital investment was needed.

A new issue boom has also come from the privatisation of utilities in Brazil, Russia, Portugal, Italy and Malaysia and shares have been sold to investors around the world. One of the major consequences of this globalisation of equity issues has been a trend towards standard methods of valuation, notably market multiples such as EV/EBITDA and DCF.

Mergers & Acquisitions

Mergers are the result of two or more companies of similar scale coming together to form a single entity. They require the consent of all the parties concerned as they cease to exist in their own right on merger.

Acquisitions are the result of the assumption of the assets or the business of an economic entity by another. Take-over is another word for it. Unlike mergers, takeovers do not have to be agreed by the managers indeed they may fight off a takeover bid even though it represents value for shareholders, as they are reluctant to lose control.

Historically, the most common form of combination was a full or partial take-over of one company by another. This changed in the 1990s with the huge mergers between entities like pharmaceuticals and accounting partnerships etc. The common theme behind all these mergers was that a global market place needed companies of sufficient size to compete in them. However, the less-publicized rationale was cost savings from the removal of duplication in product areas, countries and central service operations.

The economic rational behind mergers is the synergy effects that can be realised.

However, there are also financial motives that were relevant.

- 1980s: Acquires attempted to enhance earnings by acquiring a lower P/E ratio firm which then enhances their own.

-- This is achieved by EPS bootstrapping, from which Hanson was famous.

As a high PE ratio implies expectations of high growth prospects. By taking over a firm with a lower PE ratio the overall new EPS can be improved. However, this is just an arithmetic factor but if the market doesnt realize then the PE may not be market down.

- 1990s: A major motive was adding value through improved financing, usually through increased leverage.

This came from the realization that many conglomerates were systematically destroying shareholder value as the creation of value and earnings enhancement was not the same.

The two main reasons or this were that too much was paid for acquisitions in the late 1980s and too much reliance had been placed on equity to pay for them.

As the market realized that companies were being broken up and sold for profit, acquisition price rose to account for this inherent value. But the conglomerates kept on buying. Destroying more value as they went.

Todays successful acquisition specialists understand the value of their equity and do not give it away lightly, e.g. Berkshire Hathaway. Indeed many buy-out specialists make acquisitions through debt, thus using the increased interest payments as a stick with which to beat management into maximizing cash flow. At the same time, equity is used as a carrot to reward managers to succeed.

Another motive for acquisitions popular in the 1970s and 1980s was the diversification of risk through the acquisition of unrelated activities. However, this was an inefficient was to reduce risk when investors can do it themselves by holding diversified portfolios.

When valuing mergers or takeovers then any synergy benefits should in theory be quantified and put into the valuation but this raises the question who will benefit from the increased value. Studies have shown that it is the acquiring firm that gets the most and thus other factors apart from valuation become important. Indeed cultural issues and, as in the case of the failed SKB/Galxo merger, who takes the senior management roles can become paramount.

But is it worth all the effort? Many studies in the UK and US where the market for corporate control is the strongest suggest no and Higson showed that bidders showed value losses in the two years subsequent to takeovers. This tends to suggest that acquirers rarely manage to avoid paying the selling company shareholders for any synergy benefits they may acquire.

So why do companies acquire?

Merger waves: as the economic cycle prevents further organic growth.

Excess cash reserves and no internal projects to spend them on, thus turn to expansion.

Fuelled by easy debt and rising equity markets

How are they valued in practice?

- Market multiples are popular since they allow comparisons with recent purchases in the same sector.

Book value is not popular unless the company has few growth prospects.

- Overriding method is DCF as it allows the potential bidder to determine the maximum acquisition price and hence the premium to the current price it can pay, and also the value and impact of any expected synergies.

This has changed the way that shares now have to be valued - depending on the point of view:

As going concern

As takeover targets

As merger candidates

Restructuring

The restructuring boom of the 1980s was based on the idea of releasing value back to shareholders.

For many conglomerates the perceived value of the shares as reflected in the share price does not reflect the true worth (our shares are undervalued!) of the underlying cash flow streams. This is due to the difficulty of releasing sensitive divisional information to the market (and hence competitors) thus creating information asymmetry.

This offers an opportunity to an investor who takes the view that the realizable value of the assets/operations is greater than that indicated by the stock market. If he can get the support of financial backers he can attempt a takeover and subsequent break up of the company. This is called a leveraged buyout (LBO).

LBOs were big in 1988 but have now declined because most companies re-structure internally before raiders knock on the door.

In addition to realising shareholder value, restructuring can be used to:

Incentivise management through EVA.

Financial engineering via share repurchase or finance mix alterations.

External improvements through acquisitions/disposals to consolidate a core sector.

Closing the value gap can be seen in the diagram below.

Management Buyouts

MBOs and BIMBOs are generated by circumstances such as:

CEO who owns a private company and wants to retire. e.g. Moulinex

Listed company with under performing shares going private by buying back its shares e.g Virgin

An organization in liquidation being sold to its managers e.g Leyland

A group seeking to divest itself of under performing or inappropriate business.

MBOs imply high gearing so stable cash flows are preferable. Often management will have insufficient personal wealth to buy the entity from their own resources and so will seek the assistance of venture capitalists. In return for a share of the company they will put up the most of the money but managers are normally required to put in funds themselves even by borrowing in a personal capacity to motivate them to success.

It is paramount to have a strong business plan and all possibilities should be tested and a balance needs to be struck between cost-cutting investment for the future.

During the period of buyout the shares are no longer listed on the market. However venture capitalists will want an exit strategy and will normally want to be repaid within 5 to 7 years. This can be accomplished by either a trade sale or re-floatation.