FINANCIAL MANAGEMENT 3B
BSR3B01/FNM03B3
Unit 3: Valuations
Class Notes and Chapter 7
Unit 3:
Valuations
Class Example and Notes
Chapter 7 Equity valuation
FRAMEWORK FOR A VALUATION
1. Purpose, date, parties involved.
2. Instruments to be valued, size of interest/entire business
3. Valuation model to be used
a. Net asset value – Where zero or non-reasonable return on
assets is achieved;
b. Dividend Yield (Po = D/Re) - Non controlling interest, with
no growth expectation;
c. Dividend Growth (Po = D1/Re-g) - Non controlling interest,
with growth expectation;
d. Dividend Growth with control premium (Po = E1/Re-g +
premium) - Controlling interest, with growth expectation
(E=Earnings);
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FRAMEWORK FOR A VALUATION
– (CONT)
4.
5.
6.
7.
8.
e. Free cash flow (PV of future CF’s) - Controlling interest, with
fluctuating cash flows in horizon period;
f. Earnings Yield (Po = E/Re) – Controlling interest with
no/little growth expected.
Calculate sustainable earnings / free cash flow
Determine reasonable rate of return
Perform valuation
Do reasonability test
Recommendation and negotiating factors
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VALUATION METHODS
In principle the value of an asset is the net
present value of its expected future benefits
discounted at the investor’s required rate of
return.
Vp = OCF / r
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VALUATION OF MINORITY INTEREST
• LISTED SHARES
The stock exchange price is an indication of the minority
valuation of the share.
• UNLISTED SHARES
The investor is only entitled to a stream of dividends as he does
not have any control over the company (minority interest),
therefore we need PRESENT VALUE the expected dividend
flow.
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VALUATION OF MINORITY INTEREST
(CONT)
• NO GROWTH IN DIVIDENDS
Dividend return method
Value of shares = Expected sustainable future dividend
Reasonable rate of return
The above formula is the perpetuity/annuity formula applied to a
stream of dividends.
Remember, the dividends is all that a minority shareholder will be
entitled to. As a result to a minority shareholder, the share is only
worth the present value of the expected dividend flows.
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VALUATION OF MINORITY INTEREST
(CONT)
• GROWTH IN DIVIDENDS
GORDON’S GROWTH MODEL:
Value of share
= D1
Ke - g
Where:
D1= the expected dividend at the end of the year;
Ke = the required equity rate of return
g = the expected annual growth percentage of the dividends of the
company
The above is essentially the perpetuity formula, where the growth is
excluded from the “discounting return” due to the fact that that
portion of the required return is achieved through dividend growth.
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VALUATION OF MAJORITY INTEREST
The investor is in control of the company’s assets and
its dividend policy.
1. EARNINGS YIELD METHOD
Steps:
i.
Determine the maintainable income of the company (V)
ii. Determine a reasonable rate of return for the company (r)
iii. Capitalise the maintainable income (V) at a reasonable rate of
return (r), therefore: Value of share
=V
r
The earnings-yield method is the inverse of the price-earnings (PE)
ratio valuation method.
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VALUATION OF MAJORITY INTEREST
(CONT)
2. GORDON’S GROWTH MODEL
In situations where there is high growth in the earnings of a
company, Gordon’s model can be used.
i.
In such a case the expected earnings for the following year
must replace the expected dividend for the following year in the
formula.
ii. A further adjustment in the value is necessary if insufficient
provision has been made for goodwill or cost of control.
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VALUATION OF MAJORITY INTEREST
(CONT)
3. FREE CASH FLOW METHOD
The value of an asset is determined by the cash benefits (not
earnings) provided by the asset.
Where
i.
the company’s earnings differ greatly from its cash flow or
ii. great fluctuations in annual cash flows are expected, the free
cash flow method is more appropriate than the earnings yield
method.
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VALUATION OF MAJORITY INTEREST
(CONT)
The formula:
Value of the company's equity
= Cash flow before interest
WACC
Less: Value of debt
Cash flow before interest =
Sustainable earnings + amortisations and depreciation, adjusted
for working capital flows and capital flows
Note: Focus on class example provided
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VALUATION OF MAJORITY INTEREST
(CONT)
4. NET ASSET VALUE METHOD
• It is important to distinguish between the going concern value and
the liquidation value of an enterprise.
5.
GOING CONCERN VALUE
• If an enterprise is sold as a concern, the buyer will pay the going
concern value of the enterprise. The difference between this and
the liquidation value is often called goodwill.
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VALUATION OF MAJORITY INTEREST
(CONT)
6. LIQUIDATION VALUE
This is the net amount that the assets of the enterprise would
realise if an asset stripping action was to be performed, assets sold
individually and the debts settled.
To determine the liquidation value, provision must be made for the
following inter alia:
• writing off of intangible assets
• obsolete inventory
• bad debt and debt collection costs
• revaluation of assets
• the benefit of tax losses
• the tax effect resulting from the sale of assets
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VALUATION OF MAJORITY INTEREST
(CONT)
Liquidation values are used:
i.
ii.
when the enterprise does not make a reasonable return on its
assets; and
as a reasonability test after using other valuation methods.
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CLASS EXAMPLE…
Practical Example…..
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