Nature & purpose of Valuations
There are occasions when a business may decide to value a whole or part of the business for example when:
- One company buys another (takeover) or two companies merge
- Company wishes to go public and must fix and issue price
- Shares are sold
- Management Buy Out (MBO)
- Shares need to be valued for tax purposes
- Company needs to refinance current debt
There are three valuation approaches available to businesses including asset based, income based and cash flow based models. Note that these valuation methods are subjective and only a rough guide rather than a final estimation of the business value because a number of other things require consideration such as:
- Negotiating power of buyer or seller
- Urgency to buy or sell
Asset Valuation Bases
The Net Asset valuation is a method that often provides lower limits for valuing a company and is unlikely to be realistic because it ignores intangible assets such as Goodwill.
It is calculated as follows:
Net Tangible Assets divided by number of shares.
For a PLC it would be: calculate net assets as above (include preference shares as debt) and divide by the number of ordinary shares in issue.
Note that this excludes intangible assets unless they have a market value such as patents and copyrights which can be sold.
Income Based Valuation
The Income (profit) based valuation consists of the P/E ratio and Earnings yield.
The P/E ratio (Earnings) method is used for determining the value of a whole business or a large proportion of shares. The method can help inform shareholder dividend and retention policies. The formula is:
P/E ratio = Market Value Divided by earnings per share (EPS)
The Earnings yield valuation method is the inverse of the P/E ratio and is used to value shares and market capitalisation. Calculate using the formula:
Earnings Yield = EPS divided by Market price per share x 100%
Cash Flow Based Valuation Models
Dividend Valuation Model
The dividend valuation model is a share valuation method based upon dividends. The model either assumes constant dividends or constant growth. The annual income stream for a share is the expected dividends every year in perpetuity.
Discounted Cash Flow
Discounted cash flow basis is used to value a company’s assets by taking into account future free cash flow projections and discounting them to arrive at a present value. Future cash flows would include further investments made in order to improve cash flows in the future.
Valuation of debt
The valuation of debt method includes irredeemable, redeemable debt and preference shares. When calculating the value of debt, note that several things need to be considered:
- Debt is always quoted in £100 nominal units, or shares
- The interest on debt is stated as a percentage of the nominal value
- Debt can be quoted in % or as a value, eg 97% or £97 both mean that £100 nominal value of debt is worth £97 market value.
- Ex-interest prices should be used for any calculations