Chapter 20 - Business valuations and market efficiency

Question 1

Valuations of share in both public and private companies are needed for several purposes including what?

Answer 1

• to establish terms of takeovers and mergers
• to be able to make ‘buy and hold’ decisions
• to value companies entering the stock market
• establish values of shares held by retiring directors, which the articles of the company specify must be sold
• for fiscal purposes (CGT, Inheritance tax)
• divorce settlements

Question 2

How do we calculate the market capitalisation of public companies?

Answer 2

current share price x no. of shares in issue

Question 3

The real worth of a company will be known when?

Answer 3

once a purchase has been made after negotiation between the two parties

Question 4

The accounting equation states what?

Answer 4

Total assets = shareholders’ equity + liabilities
Therefore follows that:
Shareholders’ equity = total assets - liabilities

Question 5

What are the 3 alternative asset valuation bases?

Answer 5

• Book value
• Replacement
• Breakup value/ NRV

Question 6

What is the book value bases?

Answer 6

• value is largely a function of depreciation policy

Question 7

What is the replacement value bases?

Answer 7

Useful for the buyer. If the buyer wants to estimate the minimum price that would have to be paid to buy the assets and set up a similar business from scratch

Question 8

What is the breakup value/NRV?

Answer 8

Useful for the seller. Considers the amount they would receive if they were to liquidate the business as an alternative to selling the shares.
Useful for a buyer if their intention is to strip the assets and sell them

Question 9

What are some problems of asset-based valuations?

Answer 9

• asset based valuations do not value what is being purchased, i.e., the right to future earnings/cash flows of the company
• asset based valuations ignore intangible assets, such as goodwill

Question 10

What are advantages with asset-based valuations?

Answer 10

• the valuations are fairly readily available
• they provide a minimum value of the entity

Question 11

When are income/earnings based valuation methods particularly useful?

Answer 11

when valuing a majority shareholding

Question 12

What do income/earnings based valuation methods reflect?

Answer 12

that the investor has additional benefits of control, which means they have access to the earnings of the business, not just the dividends (as they can influence dividend policy)

Question 13

What is the PE ratio calculation?

Answer 13

Value per share = EPS x P/E ratio
Total value of equity = Total earnings x P/E ratio

Question 14

What are some disadvantages of the PE ratio valuation method?

Answer 14

• they are based on accounting profits rather than cash flows
• it is difficult to establish the relevant level of sustainable earnings

Question 15

What are some advantages of the PE ratio valuation method?

Answer 15

• They are commonly used and are well understood
• they are relevant for valuing a controlling interest in an entity

Question 16

What is the earnings yield method?

Answer 16

inverse of the PE ratio

Question 17

What is the calculation for the earnings yield method?

Answer 17

value per share = EPS / earnings yield
total value of equity = total earnings / earnings yield

Question 18

When incorporating constant growth in earnings what is the calculation?

Answer 18

Total value of equity = (earnings x (1-g)) / (earnings yield -g)

Question 19

What is the dividend valuation model used for?

Answer 19

used for valuing a minority shareholding in a company

Question 20

If dividends are growing what calculation will be used?

Answer 20

Po = Do (1+g) / (re -g)

Question 21

If dividends are constant what calculation will be used?

Answer 21

Po = D / re

Question 22

What are some strengths and weaknesses of the DVM?

Answer 22

• problems estimating a suture growth rate
• growth assumed to be zero or at a constant rate
• high sensitivity to changes in the assumptions used
• few advantages over earnings based methods for controlling interests

Question 23

What is the growth caluclation?

Answer 23

g = (Do / Dn) ^(1/n) - 1

Question 24

The value of equity is derived by what?

Answer 24

estimating the future annual free cash flows of the entity, and discounting these cash flows at an appropriate cost of capital

Question 25

What are free cash flows?

Answer 25

- operating cash flows excluding financing flows - deduct tax cash flows - add revenue from sales of assets - add cash flow benefit of synergies from the manager - deduct the cash flow for ongoing asset expenditure

Question 26

What are the steps for valuation?

Answer 26

- identify free cash flows - select a suitable time horizon - calculate the PV over this time period - if valuing equity only, deduct the value of the debt to give the equity value

Question 27

what are some advantages of the discounted cash flows basis?

Answer 27

- theoretically the best method - can be used to value all or part of a company

Question 28

what are some disadvantages of the discounted cash flows basis?

Answer 28

- relies on estimates of cash flows and discount rates - difficulty in choosing a time horizon - difficult in valuing a company's worth beyond this time horizon - assumes that discount rates, tax and inflation rates are constant over the period

Question 29

What is the calculation for preference shares Po?

Answer 29

D/Kp

Question 30

What is the calculation for irredeemable debt MV?

Answer 30

I/kd

Question 31

What is the calculation for redeemable debt MV?

Answer 31

PV of future interest and redemption receipts discounted at investors required return rate

Question 32

What is the floor value?

Answer 32

the market value as calculated if you ignore the conversion option and use only the interest and redemption cash flows

Question 33

What is the conversion premium?

Answer 33

this is the difference between the current market value of the loan note and the current market value of the shares that the loan note could eventually be converted into

Question 34

What is the floor value equal to?

Answer 34

market value without the conversion option

Question 35

What is the conversion premium equal to?

Answer 35

market value of loan note - current conversion value of shares

Question 36

What is an efficient market?

Answer 36

one in which security prices fully reflect all available information. New information is rapidly and rationally incorporated into share prices in an unbiased way

Question 37

Fairly priced shares ensure what?

Answer 37

investor confidence and reflect director performance

Question 38

What are the 3 forms of efficiency?

Answer 38

- Weak - Semi strong - strong

Question 39

What is weak form efficiency?

Answer 39

- share prices reflect information about all past price movements. Past movements do not help investors in identifying positive NPV trading strategies

Question 40

What is the evidence for a weak form efficiency?

Answer 40

Share prices follow a random walk: - no patterns or trends - prices rise or fall depending on whether the next piece of news is good or bad - very little of a share price movement on one day can be predicted from knowledge of the change on the previous day

Question 41

What is the conclusion for the stock market in regards to a weak form efficiency?

Answer 41

- future price movements cannot be predicted from past price movements - chartism/technical analysis cannot help make consistent gains on the market

Question 42

What is a semi-strong form efficiency?

Answer 42

- share prices incorporate all past info and all publicly-available info. Incorporates weak form market efficiency

Question 43

What evidence is there for a semi-strong form efficiency?

Answer 43

Share prices react within 5-10 minutes of any new info being released: - rising in response to good news - falling in response to bad news

Question 44

What is the conclusion for the stock market that is semi-strong form efficient?

Answer 44

- fundamental analysis - examining publicly-available info will not provide opportunities to consistently beat the market - only those trading in the first few minutes after the new breaks can beat the market

Question 45

What is a strong form efficiency?

Answer 45

share prices incorporate all info, whether public or private, including which is as yet unpublished

Question 46

What evidence is there of a strong form efficiency?

Answer 46

- insiders (directors e.g.,) have access to unpublished info. - share prices would not move with breaking news, as they would have already reacted before the news became public - there would be no need to ban 'insider dealings' as insiders would not be able to beat the market

Question 47

What is the conclusion for strong form efficiency?

Answer 47

- not strong form efficient; therefore max level of efficiency is semi-strong - insider dealing is banned - the stock exchange encourages the release of new info quickly preventing insider dealing opps - insiders are forbidden from dealing in their shares at crucial times

Question 48

Why do investors make seemingly irrational decisions when buying and selling?

Answer 48

- market paradox - herding - stock market bubble - noise traders - loss aversion - momentum effect

Question 49

What are the practical considerations associated with valuing a company?

Answer 49

- marketability and liquidity of shares - available info - equilibrium prices