Valuations Lecture

1. Introduction

There are approximately 350 billion shares traded daily on stock exchanges across the world. Typically, investors are looking to either buy equity shares or a firm’s debt, but their primary concern is the amount to pay for the shares or the debt. Determination of the price to pay requires some form of valuation to be made.

The market is driven by information, but investors are faced with significant ‘noise’ in the space of valuation. Claims of overpriced shares, under-priced shares, trends driving inappropriate pricing and potential stock market ‘bubbles’, all provide different indications to an investor of the value of a potential investment and as such different investors take different approaches.

Some investors are intuitive and rely on their instincts when making an investment, others place their faith in the efficient market hypothesis to drive the correct valuation, but both the intuitive and the passive investor are unlikely to be as intelligently informed as a fundamental investor. This is an individual who effectively ‘inspects the goods’ a little further before buying.

For an effective inspection an analysts or investor will need to understand the business being reviewed, they must understand the competitive advantage that the business has and how the financial statements measure the success of the business and then, once all this is more clearly understood they will need to select a valuation method.

In the following sections the valuation of securities will be explored further, both in respect of how the initial valuation of a firm can be determined and how a fundamental investor can analyse this information further for a more measured view.

The valuation methods explored below can be divided into two main types and are as follows:

Type 1 - Methods that do not involve forecasting

• Comparables method
• Multiple screening method
• Asset-based valuation

Type 2 - Methods that involve forecasting

• Dividend models
• Discounted cash flow analysis

There is also a method that uses a combination of information, some that is static and some that requires forecasting and this will also be considered briefly.

2. Fundamentals - A Reminder

Before moving onto the calculations for each valuation method it is worth setting out a few of the fundamental principles to keep in mind throughout.

The value of a business is the combined value of the debt plus the value of the equity. In trying to understand a valuation, the investor is trying to determine the value of one or the other of these two things. Debt is set up with a known return and as such the value of debt is much easier to determine. It is the principal plus the interest on the principle until the claim is paid.

Equity on the other hand, is an uncertain return. Investors cannot guarantee the return on their investment and so determining the value of equity is a little harder. Equity should provide a return to the investor commensurate with the risk of holding that equity.

Determining the most appropriate required return is dependent upon many factors including the investor’s personal attitude to risk. There are several ways it can be established. There is an average market return calculated across the top 500 stocks which could be used, and this is the return that should be expected on a well-balanced portfolio. However, it will not be appropriate for an individual stock which must be considered in relation to its specific industry risk.

There is the industry average return which is a good indicator to use in understanding the value from an investment, but care must be taken when using this as there may be companies included within the industry that have very different operating models and this could skew the figure.

There is the individual required return or the company required return. The company required return is generally based on their cost of capital. This is the cost of the companies’ combined equity and debt. If a project or acquisition could not provide a return greater than or equal to the current cost of capital, then the return will be negative to the business. An individual may also have a cost of capital based on their own personal assets and debt structure.

A key aspect underlying acceptance of a valuation by an investor will be related to the individual’s belief or otherwise in the efficient market hypothesis and to what extent they believe the market is efficient.

3. Methods That Do Not Involve Forecasting

3.1. Comparables Method

This method is based on the view that similar businesses will have similar multiples[1]. If market prices are efficient in that all the available information about a share is already incorporated into the price of that share, then this would be a reasonable assumption. If all information is incorporated into all shares, then the market would value similar businesses approximately the same. 

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3.1.1. Calculation

This method of comparables or multiple comparison analysis takes a variety of measures from ‘comparable’ firms and calculates multiples of those measures. The average of these multiples is used to calculate the measure for the target firm to see how it compares to similar companies.

The table below shows how the method of comparables could be used to value Tesco using comparable firms to Tesco. The comparable firms selected are Sainsbury and Wm Morrison and price to sales (P/S), price to earnings (P/E) and price to book (P/B) figures are calculated for these comparable businesses using their reported sales, earnings, book value in relation to the quoted market value.

All data in billions of dollars

All data taken from Forbes 2017 List of the world’s biggest public companies (Forbes Media LLC, 2017)

The average of the comparable multiple is then used to determine the target valuation. In the table below, it can be seen that the average multiple for market value to sales is 0.26 and so this is multiplied by the sales income of Tesco to get a valuation of $20.4 billion. This is repeated using the appropriate average earnings and book value multiples against Tesco’s own earnings and book value and the three valuations are then added up and the average calculated.

The above calculations indicate that the market value of Tesco is $16.9 billion versus the stated value of $19.2 billion. This is approx. 12% variation in the valuations, but it could be considered that even if the valuation showed less variation this method intuitively feels a little simplistic for something that is influenced by so many factors.

3.1.2. Advantages and Disadvantages

The key advantage to this method is that it is relatively easy and inexpensive. Furthermore, if the target investment is a private company with no comparable traded stock price, then this method will provide a base indicative figure to begin the investment analysis.

However, the disadvantages outweigh the advantages considerably when comparing traded stocks.

There are also problems in the implementation of this method. It appears simplistic on the surface but in reality, identifying comparable companies is not as easy as it seems. In our example, it feels right that Sainsbury and Wm Morrison are compared to Tesco but, the operating models of these businesses are very different. Sometimes an industry that appears to be in the same business can have a range of diverse activities that affect the multiple (ACCA, 2012).  Wm Morrison for example, do not do the expanded range of retail that the other two companies do and tends to focus mainly on food alone and Tesco may be viewed as being a UK supermarket but actually earns significant revenues overseas and in non-grocery items (ACCA, 2012). All these differences in operations will impact the multiple.

Another limitation with this method is that earnings include non-cash items such as depreciation and earnings can include very different values even in apparently comparable industries as a result of accounting treatments applicable in different countries or even in the choices of treatment adopted of by businesses in the same jurisdiction. 

A final problem occurs when a comparable business has a loss as a negative P/E ratio has no meaning and as such cannot be used.

3.2. Multiples Screening Method

This method is an adaptation of the comparables method, but it uses screening to determine if a share is mispriced on the market. This will only be used by investors who do not believe in market efficiency as belief in market efficiency means that it is not possible for a share to be mispriced.

3.2.1. Calculation

Unlike the comparables method that uses the average of a multiple to calculate the multiple for the target investment, multiple screening does not require calculations but a straightforward ranking and review.

In order to perform multiples screening, a suitable multiple must be identified. This choice can be varied but includes the most commonly adopted; price-earnings (P/E) and price-book (P/B). Stocks are then ranked based on the multiple selected. Stocks with the highest ranking are sold as it is considered that these are overvalued. It is assumed that this will be apparent at some future point in time and the price will fall to a correct valuation hence, the return should be made while they are still priced high. Stocks at the lowest ranking should be bought as these are currently under-priced and so represent a bargain.

3.2.2. Advantages and Disadvantages

The advantages are similar to those for the comparables methods. The method is simple and a cost-effective means of analysing investor choices. No matter what method is used to value an investment, there is always an element of judgement to be applied and if the right comparison companies and measures are selected then this method can provide useful information about relative value of investments.

For those who do not believe in the efficient market hypothesis, it should also be noted that the activity of a share can be a precursor to changes in the price of the share as the amount of activity can alter perception as to the value. Since investors tend to use the same common multiples in some form as part of their investment, the screening of stocks for mispricing can ultimately be self-fulfilling if enough investors make the same assumptions, i.e. excessive selling will drive down the price or excessive buying can drive it up.

There are many reasons that this happens. At the very basic level the economic dynamics of supply and demand are likely to impact the price as prices are lower when the supply is copious although if the efficient market hypothesis holds true then share price should not be impacted by such movements.

At the next level, the buying or selling of stock provides an indicator to the market. This could be of a potential new trend or an indication that something is wrong that other investors may be unaware of. In reality, buying and selling based on screening is not because of any identified issues or opportunities but merely a decision based on related multiples. 

However, there are significantly more disadvantages to the screening method. As with the comparables method, it does not take account of differences in the operations of businesses which may be slight but in the long term could make the difference to the overall value of the business. It is also a snapshot at a point in time and therefore does not consider the future changes that may impact a business.

Finally, this method cannot be used to value an investment in a business that does not currently have a traded share price.

3.3 Asset Based

An asset based valuation considers the value of the firm’s assets to determine its value and there are a variety of asset based calculations that can be made.

3.3.1. Calculation

The first and simplest method is to value the business as the value of shareholders equity based on book values, i.e. total assets less total liabilities at values recognised in the balance sheet. To calculate the value of an individual share this amount should simply be divided by the total number of issued shares in the business.

However, the problem with this basic asset based valuation is that many assets are carried at amortized (depreciated) historical prices and therefore may not adequately reflect their true current value.

This leads to a more refined approach to an asset based valuation that takes account of the ‘fair’ value of the assets of the business. In this instance, the investor or analyst includes an uplift to increase assets, so they are more representative of the current market value at the time of investment.

Finally, there may be assets missing from the balance sheet such as brand, knowledge and managerial assets. These assets collectively tend to be classified under the banner of ‘goodwill’ and a goodwill reserve is often created on acquisition of one business by another which represents the difference between the balance sheet net assets at fair value and total price paid. This variation on the net asset valuation to account for goodwill is known as ‘the super profits’ method and it takes the net assets basis but then builds in an allowance for goodwill which is not reflected in the base net assets figure.

3.3.2. Advantages and Disadvantages

This basic net asset method is very simple to understand and calculate as the data is always available, but it does not take account of items that may not be included in the assets such as goodwill (Livens, 1986). Neither does a simple book value approach to net asset valuation recognise that historic costs with depreciation applied is unlikely to match the real value precisely (ACCA, 2012).

The method also does not take account of any future prospects or improvements in the business as it values the business on the balance sheet which is a static representation at a point in time. It is also worth remembering that a business that is marketing itself for sale (or is the target of an acquisition) can potentially manipulate the value of assets on the balance sheet to try to increase the value and as such the price paid.

If the model is adjusted to one based on ‘super profits’ then the validity of this price depends upon the determination of the normal investment return percentage and the good will multiplier. The value of goodwill is very hard to measure and meet the GAAP ‘reliability’ criterion despite the fact that businesses inevitably have an element of brand or customer loyalty or managerial excellence that undoubtedly has a value. This value will likely be very subjective.

A model adjusted for ‘fair’ value may also be flawed if the market value assumed was correct. This can happen if the market for the asset is imperfect or the value placed on the asset at market value is not representative of the value of the asset to the business.

Finally, the sum of all the assets may still not equal the value of the business as synergy in the use of assets can lead to the sum being greater than the parts.

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4. Methods Involving Forecasting

The second type of valuation that will be considered are those based on forecasting. There are two key methods included in this section. Those that value the cash flows to the investor i.e. the dividends and those that use the projections of the future profitability/cash flows of the business. Within the former approach there are 2 methods that can be adopted. The first assumes that there is no growth in dividends and the second assumes growth in dividends.

Dividend Models

Dividend models can be used for valuation as they represent a return that investors get from their investment in the form of cash flows and as such the investor can use the estimated return to calculate how much they may be willing to pay for the investment.

Calculation (no growth)

This basic method does not actually require forecasting as it assumes no growth in the amount of dividend paid. This method values the business based on the following formula:

Price of the share = dividend just paid / required return

The tables below provide an example of the various valuations that could arise from this method.

Note: The average annualized return of the S&P 500 Index was about 11.69% from 1973 - 2016.

P/E ratio data taken from Financial Times market data (The Financial Times Limited, 2017)

Applying this calculation to the valuation of a Tesco share returns an extremely low price of between 7.9p per share and 11.6p per share whereas in reality Tesco shares are currently trading in the region of £1.86 (186p) per share. Tesco have faced difficulties in recent years with significantly reduced profits and some failed diversified market attempts and they have been through a phase of restructuring and refocusing their business.  As a consequence, their dividends have been extremely low since 2014. If the same calculation is performed using the 2014/15 dividend of 14.76p then at the average P/E rate the share price would be £1. Whilst this is significantly higher than the current calculation it still falls short of the traded price in 2014/15 which at one point reached a high of £2.51 per share.

Calculation (with growth)

An alternative to the above model is to incorporate some expectation of growth in the dividend. The estimate for growth can be made in a number of ways. Historic data can be used to estimate any year on year growth and then average it, overall market data could be used indicating trends, or experience by the investor using their portfolio dividend growth rate. Alternatively, an investor can simply go with their ‘gut’ feel or they may have a specific growth requirement in mind.

This method values the business based on the following formula:

Price of the share = dividend just paid x (1+growth rate) / discount rate - growth rate

Staying with our Tesco example, if we were to predict 5% per annum growth in the Tesco dividend with a discount rate of say, 10%, then Tesco share price would now be 24p as shown in the calculation below.

1.16p x (1 + 0.05) / 0.10 - 0.05 = 24p

If we were to use the 2014 dividend, then this figure becomes £3.10 which is huge variation. However, the difference between 1p dividend and 14p dividend with a growth assumption is significant.

Advantages and Disadvantages

This method is useful in determining an investment using the investors personal required return however, if using the average P/E ratio from similar businesses care needs to be taken in the selection of these businesses. The example above also considers the average return for the market as a whole although this could be too high or too low in relation to the risk associated with the specific industry or firm that is being considered.

There are several other issues that arise with this method. Firstly, the methodology and therefore the result only takes account of one thing, dividend and in reality, it is clear that the market and investors take many more factors into account when judging the worth of a business. The no growth model could be considered unrealistic, but the growth model is assuming a constant rate of growth which could be an equally flawed assumption.

Another key issue in respect of using dividends as the basis for valuation is that some consider dividends to be irrelevant and investors will not care whether their return comes from dividends or capital growth and as such basing a valuation purely on this may not be the most appropriate basis (Brealey, et al., 2006). 

Discounted Cash Flow (DCF) Method

This method uses the estimated future cash flows arising from the business to determine the value of the business. The method should use free cash which is the cashflow from operations effectively resulting from operations less the cash used to make investments.

Calculation

The table below shows a calculation using the DCF method in practice for firm XYZ Plc.

Advantages and Disadvantages

There are several advantages to this methodology. In the first instance, cash flows are easy to think about as they are real and not affected by accounting treatment and rules. Net present value is a widely understood and used concept and it takes account of the time value of money.

This method is similar in principle to the dividend models considered but whereas the dividend model only looks at the cash returned to the investor this model considers the entirety of the cash generated by the business and as such considers the wider value of the business.

The cashflows of the business can be used to pay dividends or retained in a business to support growth but either way the entirety of the cashflows offer a return to the investor whether by dividend or capital growth and as such this method addresses a key flaw in the dividend method.

Other disadvantages include the fact that the calculations could be prone to error depending upon the assumptions made in respect of the rate of taxation and inflation when estimating the arising cash flows. It is also difficult to determine the discount rate required. The discount rate is dependent upon the firm or individual making the valuation.

5. Hybrid - Forecasting and Non-Forecasting Data

There is a further valuation that may be applicable in certain circumstances and this is called the earn-out arrangement. It is a mixture of the net asset based model but also includes forecast earning.

This method provides a figure based on the net assets but then also adds onto it an expected return based on the immediate or near-term future profits. This could be for 3 years or potentially longer, but the objective is to keep the forecasting to a time horizon that offers a little more certainty.

This has the advantage of ensuring that the price does not pay for earnings that never materialise as it keeps the estimates a little nearer on the time horizon which gives more certainty to the estimates. It is normally applied when the current owners/directors are going to be kept on to run the business. This then provides an incentive for them to continue to be motivated to get the best return for the company.

6. Valuation Summary

There are a few different approaches that can be taken to the valuation of a business or individual stock.

One approach, screening, simply takes indicators of business performance and compares them to other businesses in the same industry. This can either be done with the indicators as they are or the indicators for the other businesses can be averaged and used for comparison purposes.

The comparables approach uses the performance indicators of other businesses to calculate the value of the target business.

The actual net assets of the business can be used to value a business. The net asset value can be adjusted for ‘fair’ value and other missing assets defined as goodwill to provide a more appropriate current value for the business.

Alternatively, forecasting methods can be adopted. This can either be in the form of valuing the dividend returns from the business, with or without growth estimates, or forecasting future cashflows.

Finally, a combination of the value of the assets and the future value to be generated by the business could be determined.

Each of the methods will give a different answer to the value of the business and it is up to the fundamental investor to look at all of these and balance the calculated values with further analysis of the business. This further analysis should consider all the other factors such as the current market conditions, the economic climate and the competition.  It should include an understanding of the wider industry to give context. Each method has advantages and disadvantages but if the fundamental investor takes some account of these other factors then this will modify their view of the value i.e. if the investor knows that the comparable companies are similar but not identical then some value can be added or deducted, metaphorically, when considering the investment to compensate for this. 

7. Conclusion

Valuations for business can vary widely depending upon the basis used. The net asset method purely based on the balance sheet generally tends to give the lowest overall valuation but once an element of return is added to the balance sheet asset value as in the super profit method of calculation the valuation increases slightly and then again in the earn out which is based on a more even mix of assets and future earnings. The highest valuations generally arise based purely on earnings with the P/E, dividend and DCF methods.

The higher valuations that take account of future potential of the business appear more appropriate as the net asset basis takes no account of the value that those assets can generate or the effort that has gone into building a valuable brand or customer base.

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In conclusion, the most appropriate price probably lies somewhere in between the highest and the lowest. If the valuation is to consider the acquisition of a business the any valuation calculated is only the starting point for negotiations to begin. If the valuation sis for an investor looking to invest in a specific stock then, only the investor can make the decision about whether they are comfortable with the market price of the share given their analysis or whether they will look for a different share   that better meets their criterion.

Recommended Textbooks

Livens, L., 1986. Share Valuation Handbook. 1st ed. London: Fourmat Publishing.

Penman, S. H., 2007. Financial Statement Analysis and Security Valuation. 3rd ed. New York: McGraw-Hill/Irwin.

Ross, S. A., Westerfield, R. W. & Jordan, B. D., 2014. Essentials of Corporate Finance. 8th ed. New York: McGraw-Hill/Irwin.

References

ACCA, 2012. SA Technical: Business Valuations. [Online]
Available at: http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf
[Accessed 9 April 2017].

Brealey, R. A., Myers, S. C. & Allen, F., 2006. Corporate Finance. 8th ed. New York: McGraw-Hill / Irwin.

Forbes Media LLC, 2017. Forbes: The Workds Biggest Public Companies. [Online]
Available at: https://www.forbes.com/global2000/list/#header:marketValue_sortreverse:true_industry:Food%20Retail
[Accessed 28 October 2017].

Helfert, E. A., 1997. Techniques of Financial Analysis. 9th ed. s.l.:Irwin.

The Financial Times Limited, 2017. Financial Times. [Online]
Available at: https://markets.ft.com/data/equities/tearsheet/summary?s=TSCO:LSE
[Accessed 28 October 2017].

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