Business valuation

Question 1

2 advantages of using the revaluation of net assets method to value a company

Answer 1

• Assets are more certain than predicted income so using this approach relies less on subjective factors than other valuation methods.
• Although much of this approach is based on historic cost, it does at least take into account the latest asset values.

Question 2

Disadvantage of using the revaluation of net assets method to value a company

Answer 2

This approach tends to undervalue a company as the value of intangibles and digital assets not included on the balance sheet are missed.

Question 3

4 advantages of using the price / earnings ratio method to value a company

Answer 3

• The price / earnings ratio is relatively easy to calculate
• Can provide particularly useful insights for investors with controlling interests.
• The PE multiple can be used to directly compare with other companies.
• This is an income-based measure, which is advantageous versus the asset-based approach.

Question 4

5 disadvantages of using the price / earnings ratio method to value a company

Answer 4

• If earnings have been erratic, then the latest earning figures may be misleading.
• Accounting policies can be used to manipulate earnings figures.
• Can be challenging to find appropriately similar listed companies to apply the PE.
• Not always reasonable to take the industry average as the company may be dissimilar to other firms in the industry.
• Private company valuations need to be adjusted downwards to reflect the lack of marketability, but this adjustment is subjective.

Question 5

2 advantages of using the dividend valuation model to value a company

Answer 5

• This method is useful for valuing minority interests as the investor cannot control dividend policy. Therefore, investors’ income will depend on the dividends likely to be paid out and so this is useful information.
• This is an income-based measure, which is advantageous versus the asset-based approach.

Question 6

10 disadvantages of using the dividend valuation model to value a company

Answer 6

T - Assumes dividends are only paid once a year.

E - Estimates of dividend growth rates tend to be based on historic patterns rather than the actual future facing the firm and its likely future earnings, consideration of which might produce more meaningful cost of equity calculations.

N- For non-listed companies, the valuation needs to be adjusted downwards to reflect the lack of marketability.

G - Assumes dividends do not grow or grow at a constant rate. The former is unrealistic and the latter may be realistic in the long term, but dividend payments are subject to short-term fluctuations, which undermines calculations of the cost of equity.

A - It may not always be reasonable to take the industry average as the company may be dissimilar to other firms in the industry.

P - Assumes that share prices are constant, which is clearly not the case.

S - Assumes that share prices are constant, which is clearly not the case.

D - Can be difficult to find similar listed companies in practice.

V - Assumes that shares have value because of their dividends, which isn’t always true. Some firms have a deliberate policy of no or low dividend payments, which would render any valuations using the methodology unrealistic.

M - Assumes that a perfect market is operating to ensure that the share price is the present value of the future dividends discounted at Ke. In reality, this will only be true if the shares and debentures are listed.

Question 7

Advantage of using the present value of future cash flows to value a company

Answer 7

Valuing a firm by discounting its expected future cash flows is theoretically the best approach compared with earnings, which can be manipulated and assets, which don’t focus on income generated.

Question 8

2 disadvantages of using the present value of future cash flows to value a company

Answer 8

• It may be difficult to estimate future cash flows as they are in perpetuity.
• The relevant discount rate, future cash profits and future tax rates are estimates and open to subjectivity.

Question 9

Validity of growth rates used in dividend valuation models

Answer 9

• If the growth rate is based on historic data, it would be more accurate to look to future dividends.
• Earnings retention model could have been used (g = br)

Question 10

Formula for valuation using P/E ratio

Answer 10

Price = earnings x PE ratio

Or

Price = EBITDA x EBITDA multiple - MV of debt + cash

Question 11

Formula for dividend yield valuation

Answer 11

market price of the share = dividend per share / dividend yield