Company Appraisal 3rd Ed.

Financial Strategy — Unit 6

The Open University

Publisher: The Open University, 2000, 71 pages

ISBN: 0-7492-9785-9

Keywords: Finance, MBA

Last modified: Sept. 11, 2022, 3:16 p.m.

There are a number of ways of doing this and I for one do believe that only a very small part of this has anything to do with financials. Then again, financials are important and it's good to have a well grounded foundation. So there we go. What can one do?

Value to Assets

Publilius Syrus pointed out 'A thing is worth whatever the buyer will pay for it.' and this in itself does depend on a lot of different factors. So what are a company's assets worth? You need to determine the book value and then move from there as you might want to put a slightly different valuation on assets than how they are presented on the balance sheet.

Book value will tell you how much the company is worth to the ordinary shareholders, meaning the value of the assets minus that of the liabilities to third parties. Some call it book value of equity, others shareholders' funds or net asset value. You can also look at that per share and if there are options that might be exercised, then this will increase the number of shares and hence the fully diluted book value per share will be lower.

In the end, the book value and assets held will be valued somewhere between the historic cost of assets and the current market value. You might need to adjust that.

Tangible assets are normally depreciated according to some estimates or revalued in case of land that does not wear out for example. In case market value goes below depreciated book value, these assets will be revalued to reflect market value in the books, even though this will never be accurate.

In some countries (e.g. USA, France, Germany), property is always inclueded at historic cost, leading to a book value potentially way below current value. In the UK, the move to include these assets at current value was done because sometimes companies were taken over and their assets sold at a profit. Now the true value of the assets is made clear to the market and not only to those people looking very very carefully. Return on assets shrinks then though and this means that some companies prefer to lease.

While most of the time interest on debt is an expense, some countries allow it to be capitalised for construction projects.

Intangible assets like R&D expenses and brand values are sometimes a very high value inside a company but are hard to value. The capitalisation of brands like Coca-Cola might give a clearer picture to the market value of the company. In the UK, you can capitalise brands if you bought them but not if you build them, bringing in the role of goodwill. This goodwill would be the difference of the price paid for a company and its book value and this difference can appear on the buying company's balance sheet.

With goodwill it is important if and how it needs to be written off. If this needs to be done against the income statement then the earnings per share will be reduced, making it less attractive to pay high goodwill at acquisition.

[This again shows that it is of major importance to look at the cash flow statement!!!]

Off-balance sheet items can be leases, pension assets or liabilities which can be mentioned in the notes only. Leasing can be seen as just another form of conventional debt. This lead to finance leases now needing to be included in the balance sheet if more than 90% of the value of the asset is paid during the lease period. Companies do need to disclose year by year changes in pension fund values. In Germany you need to remember that companies do quasi capitalise pension fund money on the balance sheet, meaning that when comparing them to non-Germany companies you need to find out which amounts of money really do belong to shareholders. Enron is a good case where off-balance sheet transactions hid too many things.

Calculate like this:

Book value of assets
+ Adjustment for replacement cost on inventory, plant and equipment
+ Overfunding of pension fund
+ Undervaluation of intangibles
= Adjusted book vlaue of assets
- Current liabilities
- Long-term liabilities
- Contingent legal liabilities
= Adjusted book value of equity

Market Multiples

This is another method of valueing a company and it is almost dead simple and makes comparison easy. You start with the market multiples of public companies, with large companies giving you a good idea and small companies a less good one. The problem is that the bid and ask spread in smaller companies is bigger as the market maker has a more difficult task to sell or buy back the trade after completion. [Boy are market makers fun things ;)]

There are some more comments to make though. Stock exchanges tell us that any price can also not be a 'fair market price', with a fair one implying at least the semi-strong form of efficient markets. In emerging markets, the quality of information available is also hard. Also, the market price implies that you can sell or buy the shares at this price, which also depends on the volume you are talking about. You will have a big problem buying 30% of Microsofts outstanding shares without the price going up ;) Last but not least, a share price is always quoted at a specific time, which can be different at any other.

Further factors influence a stock price:

  • Shareholder loyalty
  • Additional benefits
  • Employee loyalty
  • Premium for control
  • Fashion

Specific multiples include …

… Dividend yield ignored capital gains or loss. It is now seen that not paying dividends increases capital gains and vice versa, and dividends should only be paid if they can be better employed elsewhere by the shareholders.

… Price to book implies that investores are willing to pay x times the book value because of the growth potential. This is rather meaningless on its own but insightful when compared to other companies or over time or to an index.

… Tobin's Q is an interesting one being about whether to set up a company from scratch or buying one. It is calculated via (Market Captitalisation) / (Replacement cost of assets net of liabilities). If it is below 1, you better buy the company, and if it is over 1 you should do it yourself. Other people argue that with the increase of intangible assets, Tobin's Q can be above 1 on average, also for an entire market. [One might argue that with a lot of hope in the market you go above 1, when hope wains, you go low… really low.]

… The PE multiple is a calculated by (Share price) / Earnings per share = (Market capitalisation) / (Earnings for shareholders). The higher this ratio the more bullish the shareholders have to be about the company. A higher PE ratio is often attached to companies with a high quality of earnings, meaning a very steady flow of earnings and earnings growth. When comparing across countries take into account diffferences in their account standards, as well as different economic cycles. Also take into account atypical drops or rises in earnings as well as potential provisions.

… Price to cash flow should be calculated by on (Share price) / (Cash flow per share) where:

Cash flow = Operating cash flow + Other Income + Interest received - Interest payable - Taxation

Cash flow can be very volatile in relation to earnings though, as there is no depreciation for example.

… Enterprise value (EV) to EBITDA looks at the entire enterprise and kind of at a cash flow before capital expenditure. EV is normally defined as market value of both debt and equity and preference shares or convertibles minus minority interests. You need to decide whether to include short term debt, meaning as to whether to consider it funding or a temporary thing. EV/EBITDA tends to be more stable than price to cash flow. The higher the number the higher the exptected margin and the expected growth. It is also attractive because it is independent on the capital structure and depreciation policies.

Discounted cash flow

Shares traded on the stock market should reflect the value of the company, meaning that discounting the future cash flows to the share price should lead to a zero net present value. [Sounds good doesn't it? ;)]

You can either do it at an equity level, meaning dividends, or the enterprise level. You need to take into account cash flows before financing but after taxes discounting them typically by the WACC. You then subtract the value of debt and minority interests from that value. The OUBS gives you a spread sheet to try to work through all of this and they suggest several steps:

  1. Determine the time horizon for your forecast
    • Look at economic and business cycle
    • Consider positive and negative growth
    • Consider the time of above-average returns
  2. Forecast operating cash flows
    • Determine value drivers (e.g. change in sales, NOP/sales, sales/NPPE, …:)
    • Estimate historc, current and future ratios
    • Decide on cash/investment policy
  3. Determine residual value
    • Decide on value methodology (eg. EV/EBIDTA ratio in the future, or growth in perpetuity)
  4. Estimate the WACC including the determination of debt/equity ratio.
  5. Discount the cash flows
    • Determine enterprise value
    • Determine equity value
    • Conduct sensitivity analysis
  6. Potentially prepare related financial statements.

Valuation in context

Sometimes valuation is very critical. A closer look is taken at them here…

… Regulation will have an effect with some companies as to how to value the company, for example in cases of previously state-owned companies that have now gone public and still have a quasi monopoly that needs to be regulated.

… New issues (flotation or primary issues are when a company goes public the first time) can be done in several ways. For example a price might be fixed before the new issue based on the value of the company as a going concern or a little below that. A new method mostly used in the US is called book building and is about managing the indications of interest by investors to get the highest price. Fees in the US can be as high as 5% of gross proceeds. It is also argued that return for investors on new issues will be not so high in the long term, partly as analysts will be over-optimistic in their forecasts, especially if their company has some hand in the offereing ;)

… Privatisations
The valuation here very much depends on the terms of just that privatisation, including the regulatory environment and targets they are set or restrictions imposed. BT in the UK had to limit price rises to the cost of inflation -x%. Anther option than an issue is used in Germany a lot, being a trade sale. This means that the company is auctioned off to a private company which will provide both money and management. Another example would be Deutsche Telekom, issuing 600 million shares in a book building method with two-thirds earmarked for German investors.

… Mergers and Acquisitions mostly really have been partial of full take-overs with real mergers only coming in the late 1990s. The idea was in global markets you need to have a given size. A+B is worth more than A and B on its own. The valuation is even more important in an acquisition though, because this decides who gets the benefit, kind of. Earlier equity was common in a buy, but now debt is more common because it is generally cheaper and might even be tax deductible. Lots of take-overs fail though, but they are still done, partly because organic growth has reached its limit.

… Restructuring is about the idea of releasing value back to shareholders. If the underlying assets are believed to be worth more than the market valuation of the company, then a leveraged buyout (LBO) backed by financiers can take-over the company and split it up. Another form is the management buyout (MBO) or management buy-in (MBI) or the hybrid transaction of new and old management being called BIMBO.

  1. Introduction
    • Outline of Unit 6
    • Aims and objectives of the unit
  2. Valuing the Assets
    • 2.1 Determining Book Value
    • 2.2 Adjusting Book Value
      • (i) Tangible assets
      • (ii) Intangible assets
      • (iii) Off-balance sheet items
  3. Market Multiples
    • 3.1 Market Value
    • 3.2 Dividend Yield
    • 3.3 Price to Book Ratio
    • 3.4 Tobin’s q
    • 3.5 PE Multiple
    • 3.6 Price to Cash Flow
    • 3.7 Enterprise Value (EV) to EBITDA
    • 3.8 Specific Valuation Ratios
  4. Discounted Cash Flow
      • Valuing the equity using DCF
    • 4.1 DCF Valuation Steps
      1. Determine time horizon for specific forecasts
        • Look at economic and business cycle
        • Consider positive and negative growth
        • Consider period of comparative advantage
      2. Forecast operating cash flows
        • Determine value drivers
        • Estimate historic, current and future ratios
        • Decide on cash/investment policy
      3. Determine residual value
        • Decide on residual value methodology
        • Estimate growth rate in perpetuity
      4. Estimate WACC
        • Determine target debt/equity ratio
      5. Discount cash flows
        • Determine enterprise value
        • Determine equity value
        • Conduct sensitivity analysis
      6. Prepare related financial statements
  5. Valuation in Context
    • 5.1 Regulation
    • 5.2 New Issues
    • 5.3 Privatisations
    • 5.4 Mergers and Acquisitions
    • 5.5 Restructuring
      • Management buyouts


Company Appraisal

Reviewed by Roland Buresund

Decent ****** (6 out of 10)

Last modified: May 21, 2007, 2:56 a.m.

MBA material, what do you expect?


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