ACCA paper f9 financial management study materials F9FM session18 d08

SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS OVERVIEW Objective To estimate the value of one share or of a company’s equity in total To be familiar with all ratios commonly used in business analysis BUSINESS VALUATIONAND RATIO ANALYSIS BUSINESS VALUATION Reasons for business valuation Nature of valuation Asset based valuations Earnings based valuations Dividend based valuation RATIO ANALYSIS Profitability Liquidity Efficiency Gearing Investor ratios 1801 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS REASONS FOR BUSINESS VALUATION To determine the value of a private company e.g for a Management Buy Out (MBO) team; To determine the maximum price to pay when acquiring a listed company e.g in a merger or takeover - note that the quoted share price is only relevant for taking a minority shareholding; To aid in decisions on buying/selling shares in private companies; To place a value on companies entering the stock market i.e Initial Public Offerings – IPO’s; To value shares in a private company for tax/legal purposes; To value subsidiaries/divisions for possible disposal NATURE OF BUSINESS VALUATION When a business is valued it is not a precise exercise and there is often no unique answer to the question of what it is worth e.g the value to the existing owner may be significantly different to the value to a potential buyer There are a variety of different methods of valuing businesses which may produce different overall values These can be used to determine a range of prices The relevant range of values is: the minimum price the current owner is likely to accept; the maximum price the bidder is likely to pay The final price will result from negotiations between the parties In the following sections the following methods of valuation will be considered: asset based valuations earnings based valuations dividend based valuations 1802 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS ASSET BASED VALUATION METHODS 3.1 Net Book Value (NBV) Simply uses the balance sheet equation i.e Equity = assets - liabilities Problems: balance sheet values are often based upon historical cost rather than market values; net book value of assets depends on depreciation policy; many key assets are not recorded on the statement of financial position e.g internally generated goodwill For the above reasons a valuation based upon balance sheet net assets is not likely to be reliable 3.2 Net Realisable Value (NRV) This estimates the liquidation value of the business Equity = estimated net realisable value of assets - liabilities This may represent the minimum price that might be acceptable to the present owner of the business Problems: estimating the NRV of assets for which there is no active market e.g a specialist item of equipment ; ignores unrecorded assets such as internally generated goodwill; 3.3 Replacement cost This can be viewed as the cost of setting up an identical business from nothing Equity = estimated depreciated replacement cost of net assets This may represent the maximum price a buyer might be prepared to pay Problems: technological change means it is often difficult to find comparable assets for the purposes of valuation ; ignores unrecorded assets; 1803 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS EARNINGS BASED VALUATION METHODS 4.1 Price/Earnings Ratios The published P/E ratio of a quoted company takes into account the expected growth rate of that company i.e it reflects the market’s expectations for the business Using published P/E ratios as a basis for valuing unquoted companies may indicate an acceptable price to the seller of the shares Price/Earnings (P/E) ratio = Market price per ordinary share Earnings Per Share Earnings per Share (EPS) = Profit after tax and preference dividends Number of issued ordinary shares = P/E ratio × EPS Therefore: Ordinary share price This can be used for valuing the shares in an unquoted company Step Select the P/E ratio of a similar quoted company Step Adjust downwards to reflect the additional risk of an unquoted company and the non-marketability of unquoted shares Step Determine the maintainable earnings to use for EPS 4.2 Earnings Yield Earnings yield is simply the reciprocal of the P/E ratio Earnings Yield = EPS × 100 Market price per share = EPS Earnings Yield Therefore: Ordinary share price 1804 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS Example You are given the following information regarding Accrington Ltd, an unquoted company (a) Issued ordinary share capital is 400,000 25c shares (b) Extract from income statement for the year ended 31 July 19X4 Profit before taxation Less Corporation tax Profit after taxation Less Preference dividend Ordinary dividend Retained profit for year $ 20,000 36,000 $ 260,000 (120,000) 140,000 (56,000) 84,000 (c) The P/E ratio applicable to a similar type of business (suitable for an unquoted company) is 12.5 Required: Value 200,000 ordinary shares in Accrington Ltd on an earnings basis Solution 1805 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS DIVIDEND BASED METHODS OF VALUATION 5.1 Dividend yield Dividend yield = Dividend per share × 100 Market price pre share Therefore share price = Dividend per share Dividend yield Step Determine the dividend for the unquoted company Step Choose a published dividend yield for a similar quoted company Step Adjust this dividend yield upwards to reflect the greater risk of an unquoted company and the non-marketability of unquoted company shares This method fails to take growth in to account and therefore can lead to an undervaluation It also has little relevance for valuing a majority shareholding as such an investor has the ability to change the dividend policy Example An individual is considering the purchase of 2,000 shares in G Ltd G Ltd has 50,000 shares in issue and the latest dividend payment was 12 cents per share G Ltd is similar in type of business, size and gearing to H plc H plc has a published dividend yield of 10% Required” Suggest a price that the individual might pay for the 2,000 shares in G Ltd Solution 1806 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS 5.2 Dividend Valuation Model If dividends are expected to remain constant e.g on preference shares: Po = D re Where P0 = today’s share price D = dividend per share re = required return of equity investors If dividends are forecast to grow at a constant rate in perpetuity Po = where D0(1 + g) re − g = D1 re − g Do = most recent dividend D1 = dividend in one year g = growth rate Step Determine current dividend and estimated growth rate Step Determine the required return − for example by using the Capital Asset Pricing Model (CAPM) on a similar quoted company and then adjusting upwards to reflect greater risk/lack of marketability of unquoted shares Problems: determining growth rate of dividends; determining appropriate required return for unquoted company; little relevance for valuing a majority shareholding as such an investor has the ability to change the dividend policy 1807 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS Example Claygrow Ltd is a company which manufactures flower pots The following data are available Current dividend Required return on equities in this risk class 25c per share 20% Required: Value one share in Claygrow Ltd under the following circumstances (i) No growth in dividends (ii) Constant dividend growth of 5% per annum (iii) Constant dividends for five years and then growth of 5% per annum to perpetuity (iv) Constant dividends for five years and then sale of the share for $2.00 Solution 1808 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS RATIO ANALYSIS 6.1 Profitability ratios Gross profit margin = Gross profit × 100 Sales Operating profit margin = Profit before interest and tax × 100 Sales Return on Capital Employed (ROCE) = Profit before interest and tax × 100 Shareholders' funds + non - current liabilities Return on Equity (ROE) = Profit after tax - preference dividends × 100 Ordinary shareholders' funds 6.2 Liquidity ratios Current ratio = Current assets Current liabilities Quick or acid test ratio = Current assets − inventory Current liabilities 6.3 Efficiency/activity ratios Accounts receivable days = Average accounts receivable × 365 Annual credit sales Accounts payable days = Average accounts payable × 365 Annual credit purchases Inventory days = Average inventory × 365 Annual cost of sales Cash conversion cycle = inventory days + receivables days – payables days Total asset turnover = Sales Total assets Fixed asset turnover = Sales Fixed assets 1809 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS 6.4 Gearing/Risk ratios Financial gearing: Debt to equity = Non - current liabilities × 100 Capital + reserves Debt to total capital = Non - current liabilitie s × 100 Capital employed gearing can also be referred to as leverage Operational gearing: Fixed operating costs Fixed operating costs × 100 × 100 or Variable operating costs Total operating costs Profit before interest and tax Interest expense Interest cover = Cash flow coverage = 6.5 Cash generated from operations Interest expense Investor ratios Earnings per ordinary share (EPS) = Profit after tax - preference dividends Weighted average number of ordinary shares in issue Diluted EPS should also be calculated where a company has a complex capital structure that includes Potentially Dilutive Securities (PDS’s) These are securities in issue which involve an obligation to issue shares in the future e.g convertible debt, warrants Diluted EPS = Profit after tax - preference dividends + PDS adjustments Weighted average ordinary shares + PDS' s outstanding Dividend cover = Profit ater tax - preference dividend Ordinary dividend Dividend payout ratio = Ordinary dividend Profit after tax - preference dividend Dividend yield = Dividend per ordinary share × 100 Ordinary share price Price earnings ratio (P/E ratio) = 1810 Ordinary share price EPS SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS Earnings yield = EPS × 100 Ordinary share price Total Shareholder Return (TSR) = Year - end share price + dividends × 100 Share price at start of year Example Cathcart Inc Statement of financial position at 31 December 200X Non - current assets Cost less depreciation Current assets Inventory Receivables Cash $000 $000 2,200 400 500 100 _ 1,000 _ 3,200 _ Equity Ordinary shares ($1 par) Retained earnings 1,000 800 Non-current liabilities 10% bond Preferred shares (10%) ($1 par) Current liabilities Payables Income tax 600 200 400 200 _ 600 _ 3,200 _ 1811 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS Cathcart Inc Income statement for the year ended 31 December 200X Turnover Cost of sales $000 $000 3,000 (2,400) _ Gross profit Operating expenses 600 (200) _ Profit before interest and tax Interest 400 (60) _ Profit before tax Income tax 340 (180) _ Profit after tax 160 _ Dividends Ordinary Preference Current quoted price of $1 ordinary shares in Cathcart Inc Required: Calculate each of the following ratios for Cathcart Inc: (a) Gross profit margin (b) Operating profit margin (c) Return on capital employed 1812 125 20 $1.40 _ SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS (d) Return on equity (e) Current ratio (f) Acid test ratio (g) Receivables days (h) Total asset turnover (i) Fixed asset turnover (j) Proportion of debt finance (k) Interest cover (l) Earnings per ordinary share 1813 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS (m) Dividend cover (n) Dividend yield (o) Price earnings ratio Key points Business valuation is not a science – different analysts use different techniques You need to enter the exam with a range of methods at your disposal and choose the most relevant depending what data is available and whether you are required to value a minority stake or a business in total Ratio analysis is also a subjective area – different analysts calculate ratios in slightly different ways If the exam question does not define exactly how a certain ratio should be calculated then state your definition, show your workings and be consistent between companies/years Often it is the change in ratios which is more relevant than their absolute level FOCUS You should now be able to: prepare and justify a range of prices for valuing a business in a variety of different circumstances; calculate and interpret all key ratios for a business 1814 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS EXAMPLE SOLUTIONS Solution Valuation of 200,000 shares = 200,000 × P/E ratio × EPS = 200,000 × 12.5 × = $750,000 = Dividend Dividend yield (140,000 − 20,000) 400,000 Solution Share price Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of unquoted company - say 13% (subjective) Share value Estimated value of 2,000 shares = 12 0.13 = 92 cents per share = $1840 Solution 0.25 0.2 (i) Constant dividend Po = (ii) Constant growth in dividend Po = (iii) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 = $0.748 = $1.25 0.25 (1.05) (0.2 − 0.05) = $1.75 plus Present value of growing dividend from year onwards 0.25 (1.05) × (0.20 − 0.05) 1.2 = $0.703 _ $1.451 _ (iv) Present value of five years’ dividend of $0.25 pa = $0.25 × 2.991 $0.748 $0.804 Present value of $2.00 in five years’ time = $2.00 × 1.2 _ $1.552 _ 1815 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS Solution (a) (b) (c) (d) (e) (f) (g) (h) (i) 1816 Gross profit margin = 600 × 100 ,000 = 20% = 400 × 100 ,000 = 13.3% Operating profit margin Return on capital employed = 400 × 100 = 15.4% 1,000 + 200 + 800 + 600 = 160 - 20 × 100 = 7.8% 1800 = 1,000 600 = 1.67: = 600 600 = 1: = 500 × 365 3,000 = = 3,000 3,200 = 0.94 = 3,000 2,200 = 1.4 Return on equity Current ratio Acid test ratio Receivables days Total asset turnover Fixed asset turnover 61 days SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS (j) Proportion of debt finance = 800 × 100 1800 = 44.4% = 800 × 100 = 800 + 1800 30.8% = Profit before interest and tax Interest charge = 400 60 OR (k) (l) (m) (n) (o) Interest cover = 6.67 Earnings per ordinary share = 160 − 20 1,000 = = 160 - 20 = 125 1.1 = Dividend per ordinary share × 100 Ordinary share price = 12.5 cents $1.40 = Share price EPS = 140 14 14 cents Dividend cover Dividend yield Price earnings ratio = = 8.9% 10 1817 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS 1818 ... RATIO ANALYSIS REASONS FOR BUSINESS VALUATION To determine the value of a private company e.g for a Management Buy Out (MBO) team; To determine the maximum price to pay when acquiring a listed company... of assets depends on depreciation policy; many key assets are not recorded on the statement of financial position e.g internally generated goodwill For the above reasons a valuation based upon... Sales Fixed assets 1809 SESSION 18 – BUSINESS VALUATION AND RATIO ANALYSIS 6.4 Gearing/Risk ratios Financial gearing: Debt to equity = Non - current liabilities × 100 Capital + reserves Debt to total