Chapter-20 Business valuations and market efficiency
Valuing business and financial assets
Valuations of shares in both private and public companies are needed for several
purpose by investors including:
➢ To establish terms of takeovers and mergers
➢ To be able to make ‘buy and hold’ decisions in general
➢ To value companies entering the stock market
➢ To establish values of shares held by retiring directors which the article of
company specify must be sold
➢ For fiscal purposes
➢ Divorce settlements
Approaches to valuations- The three main approaches are:
➢ Asset-based: based on the tangible assets owned by the company
➢ Income/earnings based: based on the returns earned by the company
➢ Cash flow-based: based on the cash flows of the company
Market capitalisation- A firm’s market capitalisation is found by multiplying its
current share price by the number of shares in issue.
NB1- The share prices of companies on stock exchange move constantly in
response to supply and demand as they move on to market capitalisation.
NB2- The values calculated in this way do not necessarily reflect the actual
market value of companies as it shown when one company launches a takeover
bid for another and pays a premium over the pre-bid price.
The real worth of a company- The real worth of a company depends on the
viewpoints of the various parties:
➢ The various methods of valuation will often give widely different results
➢ It may be in the interest of the investor to argue that either a ‘high’ or
‘low’ value is appropriate
➢ The final figure will be matter for negotiation between the interested
parties.
1
Asset-based valuations
Measure Strengths Weaknesses
Book values Book values are relatively Historic cost value
easy to obtain
Net realisable value- ➢ Minimum acceptable ➢ Valuation problems
assume break-up basis to owners especially if quick
➢ Asset pricing sale
➢ Ignores goodwill
Replacement cost- going Maximum to be paid for ➢ Valuation problems-
concern assets by buyer similar assets for
comparison.
➢ Ignores goodwill
Types of asset-based measures-
1. Book value- This will normally be a meaningless figure in which it will be based
on historical costs. The fair value accounting in the book value of assets and
liabilities will be fair value and relevant for valuation purpose.
2. Break-up value- It will often be considerably lower than any other computed
value. It normally represents the minimum price that should be accepted for a
sale of a business as a going concern. Since if the income-based valuations give
lower figures than break-up value then, it is apparent that the owner would be
better off by ceasing to trade and selling off all the assets.
3. Replacement cost- This should provide a measure of the maximum amount
that any purchaser should pay for the whole business. It represents the total cost
of forming the business from scratch. However, a major element of any business
as a going concern is likely to be the goodwill.
Problems with the asset-based valuations
The fundamental weakness-
➢ Investors do not normally buy a company for its statement of financial
position assets but for the earnings/cash flows that all of its assets can
produce in the future.
➢ It should value what is being purchased i.e. the future income/cash flows.
Subsidiary weakness- The asset approach also ignores non-statement of
financial position intangible assets. e.g.-
➢ Highly-skilled workforce
2
➢ Strong management team
➢ Competitive positioning of the company’s products
It is quite common that non-statement of financial position assets are more
valuable than the statement of financial position assets, especially for service
organisation which may not hold many non-current assets at all.
When asset-based valuations are useful
1. Asset stripping- Asset valuation models are useful in the unusual situation
that a company is going to be purchased to be broken up and its assets sold off.
In a break-up situation, it would value the assets at their realisable value.
2. To set a minimum price in a takeover bid- Shareholders will be reluctant to
sell at a price less than the net asset valuation even if the prospect for income
growth is poor. A standard defensive tactic in a takeover battle is to revalue
statement of financial position assets to encourage a higher price. In going-
concern, the value of assets at their replacement cost.
3. To value property investment companies- The market value of investment
property has a close link to future cash flows and share values, i.e. discounted
rental income determines the value of property assets and thus the company.
Income/earnings-based methods
Income-based methods of valuation are of particular use when valuing a
majority shareholding:
➢ Ownership bestows additional benefits of control not reflected in the
dividend valuation model
➢ Majority shareholders can influence dividend policy and therefore are
more interested in earnings.
P/E ratio method- P/E ratios are quoted for all listed companies and calculated
as:
P/E ratio = Price per share/Earnings per share (EPS)
This can be used to value shares in unquoted companies are:
Value of company = Total earnings * P/E ratio
Value per share = EPS * P/E ratio
3
Problems with the P/E ratio valuation-
➢ It may be necessary to make an adjustment to the P/E ratio of the similar
company to make it more suitable.
➢ It can be difficult to estimate the maintainable or normal ongoing level of
earnings of the company valued.
➢ It may be necessary to adjust these earnings to obtain a maintainable
figure
➢ PE ratio is based upon historical accounting information whereas the
valuation should reflect future earnings prospects.
Earnings yield- The earnings yield is simply the inverse of the P/E ratio:
Earnings yield = EPS/Price per share
It can be used to value the shares or market capitalisation of a company in exactly
the same way as the P/E ratio:
Value of company = Total earnings * 1/earnings yield
Value per share = EPS * 1/earnings yield
It can incorporate earnings growth into this method as follows:
Value of company = earnings * (1+g)/(earnings yield – g)
Cash flow-based methods
Valuing shares using the dividend valuation model (DVM)- This method can be
used for valuing minority shareholdings in a company. Since the calculation is
based on dividend paid something which minority shareholders are unable to
influence.
The value of the company/share is the present value (PV) of the expected future
dividends discounted at the shareholder’s required rate of return.
P0 = D/re
P0 = D0*(1+g)/re-g
Where:
P0 → shareholder’s required return
g → annual growth rate
P0 → value of company
4
D → Total dividend
Strength and weakness of the DVM- The model is theoretically sound and good
for valuing a non-controlling interest but:
➢ There may be problems estimating a future growth rate
➢ It assumes that growth will be constant in the future
➢ The model is highly sensitive to changes in its assumptions
➢ It assumes that the growth rate is lower than the shareholder’s required
return rate
➢ For controlling interests, it offers few advantages over the earnings
method
Discounted cash flow basis- This alternative cash flow-based method is used
when acquiring a majority shareholding since any buyer of a business is
obtaining a stream of future operating cash flows.
The maximum value of the business is: PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used.
Method:
1. Identify relevant free cash flows-
➢ Operating flows
➢ Add revenue from sale of assets
➢ Tax
➢ Deduction for ongoing asset expenditure
➢ Add synergies arising from any merger
2. Select a suitable time horizon
3. Calculate the PV over the horizon. This gives the value to all providers of
finance, i.e. equity + debt.
4. Deduct the value of debt to leave the value of equity.
Advantages-
➢ Theoretically the best method
➢ Can be used to value part of a company
5
Disadvantages-
➢ It relies on estimates of both cash flows and discount rates – may be
unavailable
➢ Difficult in choosing a time horizon
➢ Difficult in valuing a company’s worth beyond this period
➢ Assumes that the discount rate, tax and inflation rates are constant
Valuation post-takeover
It may be necessary to estimate the value of a company following a takeover of
another company. In this situation, when estimating the effect of the takeover
on the total value of the company and on the value per share it is important to
take into account:
1. Synergy- any synergy arising from the takeover would be expected to increase
the value of the company.
2. Method of financing the takeover- If cash is used to finance the takeover the
value of the company will be expected to fall by the amount of cash needed. If
shares are used to finance the takeover then the extra shares issued need to be
taken into account when calculating the value per share.
Valuation of debt and preference shares
These are summarised below:
Types of finance Market Value
Preference shares P0 = D/Kp
Irredeemable shares MV = I/r
Redeemable debt MV = PV of future interest and redemption receipts,
discounted at investor’s required returns
Where:
D → the constant annual preference dividend
P0 → ex-div market value of the shares
Kp → cost of preference share
I → annual interest starting in one year’s time
MV → market price of the debenture now (year 0) PV = present value
r → debt holder’s required return, expressed as a decimal
6
Convertible debt- The market value of a convertible is the higher of its value as
debt and its converted value. This is known as its formula value. The formula of
convertible debt is:
➢ Floor value = value of convertible bonds without the conversion option
➢ Conversion premium = market value – current conversion value
➢ Terminal value = higher redemption proceeds or the value of equity shares
received.
Market efficiency
The concept of market efficiency-
➢ An efficient market is one in which security prices fully reflect all available
information.
➢ In an efficient market, new information is rapidly and rationally
incorporated into share prices in an unbiased way.
Current position- In the sophisticated financial markets, there are:
➢ Cheap electronic communications.
➢ Large number of informed investors.
Conclusion- New information is rapidly incorporated into share prices.
Benefits of an efficient market-
1. Ensure investor confidence- Investors need to know that they will pay and
receive a fair price when they buy and sell shares. If shares are incorrectly priced,
many savers would refuse to invest and seriously reducing the availability of
funds and inhibiting growth. Investor confidence in the pricing efficiency is
essential.
2. Reflects director’s performance in the share price- The primary objective of
directors is the maximisation of shareholder wealth i.e. maximise the share
price. In implementing a positive net present value decision, directors can be
assured that the decision is based on the communication to the market which
result in an increased share price. It motivates directors to maximise share price
while providing an early warning system of potential problems.
The efficient market hypothesis (EMH)
➢ It states that security prices fully and fairly reflect all relevant information.
7
➢ It is not possible to consistently outperform the market by using any
information that the market already knowns, except through luck.
➢ The idea is that new information is quickly and efficiently incorporated
into asset prices at any point in time, so that old information cannot be
used to foretell future price movements.
➢ Three levels of efficiency are distinguished, depending on the type of
information available to the majority of investors and hence already
reflected in the share price.
➢ The forms of efficiency are cumulative so that if the market is semi-strong
form it is also weak form.
Types of efficiency
1. Market inefficiency-
➢ An inefficient market is one in which the value of securities is not always
an accurate reflection of the available information.
➢ Market may also operate inefficiently.
➢ In an inefficient market, some securities will be overpriced and others will
be under-priced which means some investors can make excess returns
while others can lose more than warranted by their level of risk exposure.
2. Weak form efficiency-
Information- In a weak form efficient market, share prices reflect information
about all past price movements. Past movements don’t help in identifying
positive NPV trading strategies.
Evidence- Share price follow a random walk-
➢ There are no patterns or trends
➢ Prices rise or fall depending on whether the next piece of news is good or
bad
➢ Tests show that only 0.1% of a share price change on one day can be
predicted from knowledge of the change on the previous day.
Conclusion- The stock market is weak form efficient and so:
➢ Future price movements cannot be predicted from past price movements
➢ Chartism/technical analysis cannot help make a consistent gain on the
market.
8
3. Semi-strong form efficiency-
Information- In a semi-strong form efficiency markets the share price
incorporates all past information and all publicly-available information.
Evidence- Share prices react very quickly to any new information being released:
➢ Rise in response to breaking good news
➢ Fall in response to breaking bad news
Conclusion- The stock market is semi-strong form efficient are:
➢ Fundamental analysis – examining publicly – available information – will
not provide opportunities to consistently beat the market.
➢ Only those trading in the first few minutes after the news breaks can beat
the market
➢ Since the published information includes past share prices a semi-strong
form efficient market is also weaky efficient.
4. Strong form efficiency-
Information- In a strongly efficient market, the share price incorporates all
information whether public or private including information that is as yet
unpublished.
Evidence- Insiders have access to unpublished information. If the market was
strong form-
➢ The share price wouldn’t move e.g.- news broke about a takeover, as it
would have moved when the initial decision was made in it.
➢ There would be no need to ban ‘insider dealing’ as insiders couldn’t make
money by trading before news become public – it is banned because they
do.
Conclusion- The stock market is not strong form efficient and so:
➢ Insider dealers have been fined and imprisoned for making money trading
in shares before the news affecting them went public
➢ The stock exchange encourages quick release of new information to
prevent insider trading opportunities
➢ Insiders are forbidden from trading in their shares at crucial times
The market paradox- The market paradox is that, for markets to be efficient,
investors have to believe that they are inefficient. If they believed them to be
9
efficient, they would not buy or sell shares, thereby slowing the dissemination
of information into market prices.
Behavioural finance- Behavioural finance may be-
1. Herding- Herding or "herd mentality" may be explained by:
➢ the desire to conform and not to act differently from others
➢ individual investors lacking the confidence to make their own judgements,
believing that a large group of other investors cannot be wrong.
2. Stock market bubble- If many investors follow a herd instinct to buy shares in
a certain sector, a significant price rise for shares in that sector can lead to a stock
market bubble.
3. Noise traders- "Noise traders'' are investors who do not base buy/sell
decisions on rational analysis. Noise traders generally have poor timing, follow
trends and over-react to good and bad news.
4. Loss aversion- Loss aversion means that some investors:
➢ avoid investments with the risk of making losses, even though expected
value analysis suggests that, in the long term, they will make significant
capital gains;
➢ prefer to invest in companies that look likely to make stable, but low,
profits, rather than those that may make higher profits in some years but
possibly losses in others.
5. Momentum effect- The “momentum effect" in stock markets can create
optimism which increases willingness to invest in companies that show
prospects for growth. If a momentum effect exists, it is likely to lengthen a period
of stock market boom.
Practical considerations in the valuation of shares and business
1. Marketability and liquidity of shares- Shares in unquoted companies are not
traded via the stock market, and this lack of marketability reduces their value
relative to shares in quoted companies.
Furthermore, unquoted companies are not required to comply with stock
market listing rules or corporate governance codes, increasing their perceived
risk and further depressing their value.
10
Even shares in quoted companies can suffer from a lack of marketability when
there are periods of "thin trading".
2. Available Information- Potential investors generally have plenty of publicly
available information when deciding whether to buy/sell quoted shares.
However, much less information may be available for unquoted companies
because they may not be required to publish accounts and are also unlikely to
be watched by analysts or news agencies.
This leads to "asymmetry of information" between the managers and potential
investors in unquoted companies. The resulting uncertainty leads to investors
potentially undervaluing the shares.
3. Equilibrium prices- The market does show sudden price fluctuations that
cannot be explained simply by the information being newly released. If a share
price is highly volatile, then it is considered not in equilibrium.
Prices used to provide data for the valuation of unlisted shares need to be in
equilibrium if meaningful values are to be obtained.
11
