SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS

1801
OVERVIEW
Objective
To estimate the value of one share or of a companys equity in total.
To be familiar with all ratios commonly used in business analysis.




BUSINESS
VALUATION
BUSINESS
VALUATIONAND
RATIO ANALYSIS
RATIO
ANALYSIS
Reasons for business valuation
Nature of valuation
Asset based valuations
Earnings based valuations
Dividend based valuation
Profitability
Liquidity
Efficiency
Gearing
Investor ratios



SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1802
1 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
IPOs;
To value shares in a private company for tax/legal purposes;
To value subsidiaries/divisions for possible disposal.
2 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

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1803
3 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;
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1804
4 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 markets 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 =
Share Per Earnings
share ordinary per price Market

Earnings per Share (EPS) =
shares ordinary issued of Number
dividends preference and tax after Profit

Therefore:
Ordinary share price = P/E ratio EPS

This can be used for valuing the shares in an unquoted company.
Step 1 Select the P/E ratio of a similar quoted company.
Step 2 Adjust downwards to reflect the additional risk of an unquoted company and the
non-marketability of unquoted shares.
Step 3 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 =
share per price Market
EPS
100
Therefore:
Ordinary share price =
Yield Earnings
EPS


SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1805

Example 1

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 260,000
Less Corporation tax (120,000)

________
Profit after taxation 140,000
Less Preference dividend 20,000
Ordinary dividend 36,000

______
(56,000)

________

Retained profit for year 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

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1806
5 DIVIDEND BASED METHODS OF VALUATION
5.1 Dividend yield
Dividend yield =
share pre price Market
share per Dividend
100
Therefore share price =
yield Dividend
share per Dividend

Step 1 Determine the dividend for the unquoted company
Step 2 Choose a published dividend yield for a similar quoted company
Step 3 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 under-
valuation
It also has little relevance for valuing a majority shareholding as such an investor has the
ability to change the dividend policy.

Example 2

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

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1807
5.2 Dividend Valuation Model
If dividends are expected to remain constant e.g. on preference shares:
Po =
re
D

Where P
0
= todays 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 =
g re
g) (1 D0

+
=
g re
D1

where D
o
= most recent dividend
D
1
= dividend in one year
g = growth rate

Step 1 Determine current dividend and estimated growth rate
Step 2 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.
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1808

Example 3

Claygrow Ltd is a company which manufactures flower pots. The following
data are available.
Current dividend 25c per share
Required return on equities in this risk class 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

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1809
6 RATIO ANALYSIS
6.1 Profitability ratios
Gross profit margin = 100
Sales
profit Gross

Operating profit margin = 100
Sales
tax and interest before Profit

Return on Capital Employed (ROCE) = 100
s liabilitie current - non + funds rs' Shareholde
tax and interest before Profit

Return on Equity (ROE) = 100
funds rs' shareholde Ordinary
dividends preference - tax after Profit


6.2 Liquidity ratios
Current ratio =
s liabilitie Current
assets Current

Quick or acid test ratio =
s liabilitie Current
inventory assets Current

6.3 Efficiency/activity ratios

Accounts receivable days = 365
sales credit Annual
receivable accounts Average

Accounts payable days = 365
purchases credit Annual
payable accounts Average

Inventory days = 365
sales of cost Annual
inventory Average

Cash conversion cycle = inventory days + receivables days payables days
Total asset turnover =
assets Total
Sales

Fixed asset turnover =
assets Fixed
Sales

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1810
6.4 Gearing/Risk ratios
Financial gearing:
Debt to equity = 100
reserves Capital
s liabilitie current - Non

+

Debt to total capital = 100
employed Capital
s liabilitie current - Non

gearing can also be referred to as leverage
Operational gearing:
100
costs operating Variable
costs operating Fixed
or 100
costs operating Total
costs operating Fixed

Interest cover =
expense Interest
tax and interest before Profit

Cash flow coverage =
expense Interest
operations from generated Cash

6.5 Investor ratios
Earnings per ordinary share (EPS)
issue in shares ordinary of number average Weighted
dividends preference - tax after Profit
=
Diluted EPS should also be calculated where a company has a complex capital structure that
includes Potentially Dilutive Securities (PDSs). These are securities in issue which involve
an obligation to issue shares in the future e.g. convertible debt, warrants.
Diluted EPS =
g outstandin s PDS' shares ordinary average Weighted
s adjustment PDS dividends preference - tax after Profit

+
+

Dividend cover =
dividend Ordinary
dividend preference - tax ater Profit

Dividend payout ratio =
dividend preference - after tax Profit
dividend Ordinary

Dividend yield = 100
price share Ordinary
share ordinary per Dividend

Price earnings ratio (P/E ratio) =
EPS
price share Ordinary

SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1811
Earnings yield =
price share Ordinary
EPS
100
Total Shareholder Return (TSR) =
year of start at price Share
dividends price share end - Year +
100
Example 4

Cathcart Inc
Statement of financial position at 31 December 200X
$000 $000
Non - current assets
Cost less depreciation 2,200
Current assets
Inventory 400
Receivables 500
Cash 100
_____
1,000

_____
3,200

_____
Equity
Ordinary shares ($1 par) 1,000
Retained earnings 800

Non-current liabilities
10% bond 600
Preferred shares (10%) ($1 par) 200

Current liabilities
Payables 400
Income tax 200

_____
600

_____

3,200

_____



SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1812

Cathcart Inc
Income statement for the year ended 31 December 200X
$000 $000
Turnover 3,000
Cost of sales (2,400)

_____

Gross profit 600
Operating expenses (200)

_____

Profit before interest and tax 400
Interest (60)

_____

Profit before tax 340
Income tax (180)

_____

Profit after tax 160

_____

Dividends
Ordinary 125
Preference 20


Current quoted price of $1 ordinary shares in Cathcart Inc $1.40

_____



Required:
Calculate each of the following ratios for Cathcart Inc:
(a) Gross profit margin


(b) Operating profit margin


(c) Return on capital employed


SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1813
(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


SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1814
(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.
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1815
EXAMPLE SOLUTIONS
Solution 1
Valuation of 200,000 shares = 200,000 P/E ratio EPS
= 200,000 12.5
400,000
20,000) (140,000

= $750,000
Solution 2
Share price =
yield Dividend
Dividend

Dividend yield to be adjusted upwards to reflect greater risk and non-marketability of
unquoted company - say 13% (subjective)
Share value =
13 . 0
12

= 92 cents per share.
Estimated value of 2,000 shares = $1840
Solution 3
(i) Constant dividend Po =
0.2
0.25
= $1.25
(ii) Constant growth in dividend Po =
0.05) (0.2
(1.05) 0.25

= $1.75

(iii) Present value of five years dividend of $0.25 pa = $0.25 2.991 =
$0.748
plus
Present value of growing dividend from year 6 onwards

0.05) (0.20
(1.05) 0.25

1.2
1

5
= $0.703

_______
$1.451

_______

(iv) Present value of five years dividend of $0.25 pa = $0.25 2.991 $0.748
Present value of $2.00 in five years time = $2.00
1.2
1

5
$0.804

_______

$1.552

_______
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1816
Solution 4
(a) Gross profit margin
= 100
000 , 3
600
= 20%
(b) Operating profit margin
= 100
000 , 3
400
= 13.3%
(c) Return on capital employed
= 100
600 800 200 000 , 1
400

+ + +
= 15.4%

(d) Return on equity
= 100
1800
20 - 160
= 7.8%
(e) Current ratio
=
600
1,000
= 1.67: 1
(f) Acid test ratio
=
600
600
= 1: 1
(g) Receivables days
= 365
3,000
500
= 61 days
(h) Total asset turnover
=
3,200
3,000
= 0.94
(i) Fixed asset turnover
=
2,200
3,000
= 1.4
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1817
(j) Proportion of debt finance
= 100
1800
800
= 44.4%
OR
= 100
1800 800
800

+
= 30.8%
(k) Interest cover =
charge Interest
tax and interest before Profit

=
60
400
= 6.67
(l) Earnings per ordinary share
=
1,000
20 160
= 14 cents
(m) Dividend cover
=
125
20 - 160
= 1.1
(n) Dividend yield = 100
price share Ordinary
share ordinary per Dividend

=
$1.40
cents 12.5
= 8.9%
(o) Price earnings ratio =
EPS
price Share


=
14
140
= 10
SESSION 18 BUSINESS VALUATION AND RATIO ANALYSIS
1818