b821 block3unit6 company valuation

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B821 FinancialStrategyBlock3 FinanceandInvestment

Unit6CompanyValuationPreparedbytheCourseTeam

Masters


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This publication forms part of an Open University course B821,FinancialStrategy. Details of this and other Open University courses can beobtained from the Student Registration and Enquiry Service, The Open University, PO Box 625, Milton Keynes, MK76YG, United Kingdom:tel. +44 (0)1908 653231, email [email protected] Alternatively,you mayvisit the Open Universitywebsite at http://www.open.ac.ukwhereyou can learn more about thewide range of coursesand packs offered at all levels by The Open University. To purchase a selection of Open University course materialsvisit http://www.ouw.co.uk, or contact Open UniversityWorldwide, MichaelYoung Building,Walton Hall, Milton Keynes MK76AA, United Kingdom for a brochure. tel. +44 (0)1908 858785; fax +44 (0)1908 858787;email [email protected]

The Open UniversityWalton Hall, Milton KeynesMK76AAFirst published 1998. Second edition 1999. Third edition 2000. Fourth edition 2003. Fifth edition 2006. Reprinted 2007.Copyright# 1998,1999, 2000, 2003, 2006, 2007 The Open UniversityAll rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by anymeans, electronic, mechanical, photocopying, recording or otherwise,withoutwritten permission from the publisher or a licence from theCopyright LicensingAgency Ltd. Details of such licences (for reprographic reproduction) may be obtained from the Copyright LicensingAgency Ltd of 90 Tottenham Court Road, LondonW1T 4LP.Open University course materials may also be made available in electronic formats for use by students of the University.All rights,including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed toThe Open University, or otherwise used by The Open University as permitted by applicable law.In using electronic course materials and their contentsyou agree thatyour usewill be solely for the purposes of following an Open Universitycourse of study or otherwise as licensed by The Open University or its assigns.Except as permitted aboveyou undertake not to copy, store in any medium (including electronic storage or use in awebsite), distribute,transmit or retransmit, broadcast, modify or show in public such electronic materials inwhole or in partwithout the priorwritten consent ofThe Open University or in accordancewith the Copyright, Designs and PatentsAct 1988.Edited and designed by The Open University.Typeset in India byAlden Prepress Services, Chennai.Printed and bound in the United Kingdom by Hobbs the Printers Limited, Brunel Road, Totton, Hampshire SO40 3WX.ISBN 0 7492132135.3
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C O N T E N T S 1 Introduction 52 Valuing the assets 9

2.1 Determining book value 102.2 Adjusting book value 13

Summary 203 Market multiples 21

3.1 Market value 213.2 Dividendyield 243.3 Price-to-book ratio 253.4 Tobins q 263.5 PE multiple 273.6 Price to cash flow 313.7 Enterprise value to EBITDA 353.8 Specific valuation ratios 373.9 Comparison of market multiples 37

Summary 444 Discounted cash flow 47

4.1 DCF valuation steps 49Summary 62

5 Valuation in context 635.1 Regulation 645.2 New issues 655.3. Privatisations 675.4. Mergers and acquisitions 745.5 Restructuring 83

Summary 90Summary and conclusions 91Answers to exercises 93Appendix Brokers report on De La Rue 97References and suggested reading 98Acknowledgements 99


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1 I N TR OD U C TI ON 1 INTRODUCTION

This unit looks at companyvaluation in the context of investment.Both investors in shares and companies seeking to makeacquisitions need to know how much a company isworth andhow much to pay for their investment. This unit outlines anumber ofways ofvaluing companies, using the techniquesyouhave come across in earlier units, andwill show how different

valuation techniques can be used in different contexts. Companyvaluation is a fascinating topic since it requires an understandingof financial analysis techniques in order to estimatevalue; foracquisitions, it also requires the negotiating and tactical skillsneeded to fix the price to be paid. This unit should thereforestrike a chordwithyou,whetheryou enjoy the numbercrunchingaspects of finance orwhetheryou prefer a more intuitive, or evenemotional, approach.In Unit 5,we considered investing in projects and how projectinvestment decisions should be taken. In Unit 6,we considerinvesting inwhole companies rather than individual projects.

Although the concept is much the same that is,you areinvesting in a stream of future cash flows the range oftechniques applied is even morevaried than for projects. Thisis because, for companies, there is often historical information inthe form of accounting data available,whereas for projects thereare often no existing assets or fiveyear histories to rely on.

Also, even if a company is starting up, aswas the casewithEurotunnel and Eurodisney, orwith biotechnology companies suchas British Biotech and Genentech, there are usually comparablecompanieswhich already have share prices and hencevaluationmultiples that can be used as a reference point.As the informationavailable on companies is so much richer, so the techniquesavailable forvaluing companies are morevaried.Aswe shall see,the techniques range from looking at thevalue of the balancesheet through to a fully fledged discounted cashflow analysis, as

well as the application of a simple profit or asset ratio.This unit also looks at thevaluation decision inherent in anyrefinancing. Companies are now bought and sold, taken intoprivate ownership and then made public again,with the financingstructure a key element in theirvaluation.

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ACTIVITY 1.1Try to thinkofcompanies thathavebeen in thenews recentlywherevaluationhasbeenakey issue.At the timeofwriting, in2005,Ican thinkof thefollowing:l

Thenew

issue

of

Google,

the

internet

search-engine

company.Sharesweresoldviaanauctionon theinternet.

l The takeoverof theMerseyDocksandHarbourBoardbased inLiverpool.This companywas thesubjectofcompetingbidsfromprivateequityfirms,seeking tobenefitfrombuying the companyand changing itsfinancialstructure.

UNIT 6 COMPANY VALUATION

A private equity firm is afund that buys and sellscompanies for profit. It isusually financed by largeinvestors.

Outline of Unit 6The first part of this unit discusses the differentvaluationapproaches that can be applied to estimate companyvalue and theattractiveness of any companyinvestment decision. Thevaluationapproacheswe shall use can be split into three main types,depending onwhich type of data is used as the basis forvaluation.1 Assetvalues,which use balancesheet data to estimatevalue

(Section 2).2 Market multiples,which use share prices to establish

comparative benchmarks forvalue (Section 3).3 Discounted cashflow techniques,which use forecast data to

estimate presentvalue (Section 4).We beginwith the traditional cautious accounting approach oflooking at thevalue of the assets to be acquired.We then considerthe role of market multiples (for example, the commonly usedPE ratio). Finally,we consider cashflow based techniques of

valuation, in particular operating free cashflow models,which arecloser to projectappraisal techniques. In order to do this,we usea discounted cashflow Excel spreadsheet specifically designedfor companyvaluation, calledVAL.As in earlier units,we shallconcentrate on Boots and De La Rue as our main corporate casestudies, althoughwe also consider thevaluation of othercompanies, publicsector organisations (in the regulatory andprivatisation contexts) and companies not listed on the major stockmarkets.

We have alreadycovered a numberof the techniques outlinedabove in earlier units,soyou should no longer find the mathematicsor formulaeyou come across daunting. This unit concentratesonthedifferences in the techniques used for companyvaluation fromthoseof financial analysis and ofprojectappraisal.That is not to saythat there arenooverlaps. For example, lenders may be lendinglong term andhence concernedwith the overallviability andvalue



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1 INTRODUCTION

ofanorganisation. Managers maybe consideringa makeorbuydecision in the sense that they are trying to choose betweenbuyinga company or making that companysproducts inhouse.The second part of the unit (Section 5) looks at the four mainsituations inwhich companyvaluations are typicallyrequired

regulation,

privatisation

and

new

issues,

mergers

and

acquisitions and corporate restructurings, includingventure capitaland going private.Asyouwill see, different methodologies arenormally applied in different situations.Valuation is an importantbut not exclusive part of the investmentappraisal process. Strategicissueswill need to be addressed, aswell as consideringwhetherthe appropriate financing is available.Aims of Unit 6By the end of this unityou should be:l familiarwith the three main methods of companyvaluation

bookvalue, market multiples and discounted cash flow;l able to appreciate the merits and disadvantages of each

technique;l able to decide on the most appropriate method or methods of

valuation according to the circumstances regulation, newissue, privatisation, takeover or restructuring.



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2V AL U I N G TH E AS SE TS 2 VALUING TH E ASSETS

Beforeweconsiderhowtovaluecompanies,letusconsiderexactlywhatwemeanbythetermvalue.AsPubliliusSyruspointedout,Athingisworthwhateverthebuyerwillpayforitandwhatthebuyerwillpaywilldependonanumberoffactors.

ACTIVITY 2.1Supposeyouarebuyingasecond-hand teddybearatauction.Whymightyoubeprepared topaymore thanyoumighthavetopay foranequivalentnewone?Supposenowyouareconsideringbuyingacompanywhichhasjustonemachine.Whymightyoubeprepared topaymore for thecompany than thecostofamachineofequivalentageandcondition?In thefirstcase,anumberoffactorscome intoplay.Theteddybearmighthaverarityvalue itmighthavebeenMargaretThatchers teddybearandhencebe collectable.Itmighthavesentimentalvalue toyou itbelonged toyourmotherbutnothavesentimentalvalueforanyoneelse.Itmightbe impossible tomake teddybearsof thisqualitytodayforexample, if itweremadefromsome rarefurnolongeravailableashuntingof theanimalconcerned isnolongerallowed.For thecompany,sentiment isunlikely toplayaroleunless theacquirer isan individualunaccountable tostakeholdersforwhomfinancialmotivespredominate.Ontheotherhand, themanagementof themachinecompanymaybeable toaddvalue to themachinesproduction inaway thatyourmanagementcannot.Settingupanewmachinefromscratchmay take timeand thepremium thecompany is likely tohave topayoverequivalentassetvalueisperhapsmore thanoffsetby the immediatesynergybenefits.Also,buying thecompanymaygiveyouaccess tothecustomerportfolioand to theassociatedcashflows.Such issuesmaybe relevant to thevaluationofascruffyoldteddybearand to thevaluationofacompany.Neverforget,evenwhenyouhavedetermined thevalue toyou, thedifferencebetween thevalueyouhaveplacedandwhatyouactuallyenduppayingmakesvaluationanartandnotascienceandmakesnegotiatingskillsparamount.



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Units 2 and 3 considered a number ofstakeholders, including suppliers, lenders andequity investors. Suppliers and lenders havedeveloped a number of techniques for assessingthe creditworthiness of enterprises,which mayrequire a full cashflow analysis, for example

whenthe

finance

is

specifically

linked

in

with

a

project. In this unit,we consider the point of

view of investors, primarily equity investors,althoughwe do look at other stakeholders inthe section on restructuring.As a result,weconsider thevalue of the firm or organisation as

awhole and deduct thevalue of any liabilities to lenders, minorityinterests, convertible debt holders and preference shareholders toobtain thevalue to existing ordinary shareholders.

D E T E R M I N I N G BO O K V ALUE 2 . 1 Determining bookvalue is centred around the balancesheetvalueof a company as presented in the latestAnnual Report.We lookfirst at the bookvalue given in the balance sheet and then look athowwe can adjust bookvalue in a number ofways in order to geta closer approximation of how muchwe might be prepared to pay.

Table2.1 Consolidatedbalancesheetof Bootsas at 31 March2004Notes Group

2004m

Group2003m

Parent2004m

Parent2003m

FixedassetsIntangible assetsTangible assetsInvestments

101112

281.51,499.4

74.7301.3

1,516.584.7

1,106.7

1,387.41,855.6 1,902.5 1,106.7 1,387.4

CurrentassetsStocksDebtors falling due withinone yearDebtors falling due aftermore than one yearInvestments and depositsCash at bank and in hand

13141415

690.8516.0165.9239.1110.5

638.6536.6114.0293.1203.4

1,205.3502.6223.0

4.6

275.024.5

1,722.3 1,785.7 1,930.9 304.1Creditors: Amounts fallingdue within one year 16 (1,135.3) (1,155.6) (455.2) (175.1)Netcurrentassets 587.0 630.1 1,475.7 129.0

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2 VALUING TH E ASSETS

Totalassets lesscurrentliabilities 2,442.6 2,532.6 2,582.4 1,516.4Creditors: Amounts falling dueafter more than one year 17 (382.9) (401.8) (869.6) (315.0)

Provisionsfor

liabilities

and

charges 20 (177.2) (160.9) Netassets 1,882.5 1,969.9 1,712.8 1,201.4Capitaland reservesCalled up share capitalShare premium accountRevaluation reserveCapital redemption reserveMerger reserveProfit and loss account

21, 222121212121

193.90.3

244.215.2310.8

1,116.9

203.5

260.35.6

310.81,189.2

193.90.3

15.2

1,503.4

203.5

5.6

992.3Equityshareholders funds 1,881.3 1,969.4 1,712.8 1,201.4Equityminority interests 1.2 0.5

1,882.5 1,969.9 1,712.8 1,201.4

Table 2.1 shows the consolidated balance sheet for Boots as at31 March 2004. In terms ofvaluation based on bookvalue, theprinciple here is that a company isworth to its ordinaryshareholders thevalue of its assets less thevalue of any liabilitiesto third parties. This is sometimes referred to as net assetvalue,shareholders funds or the bookvalue of the equity. FromTable 2.1,we can see that shareholders funds available for Bootsequity shareholderswere 1,881.3m at 31 March 2004. In a noteto the accounts,we are told that at theyear end therewere775.5 million allotted, called up and fullypaid shares in issue, giving a bookvalueper share of 1,881.3m/775.5m =2.426per share. In the same note, readers aretold that there are executive shareoptionschemes outstandingwhich, if all exercised,

would involve the issue of a further 0.1million shares. Ifwe assume that these areall exercised, thiswould increase thenumber of shares to 775.6 million giving

what is known as a fully diluted bookvalue per share of 2.425. This compareswith, at 31 March 2004, a Boots share price

You can access the 2004and later Boots annualreports, which will havethe notes to the accounts,on their investor website,www.boots-ir.comEquityshareholdersareknownascommonstockholdersintheUSA.Fullydilutedmeansthatwehaveassumedallpossiblesharesareissued.

of 6.20. Part of Boots current assets



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ACTIVITY 2.2Whatdoes thebookvalueofacompany represent?Does itrepresent:l the liquidationvalue of the assets less the liabilities;l the replacementcostof the assets less the liabilities;l themarketvalueof the assets less the liabilities;l thevalue of thebusiness as agoingconcern: that is, the

economicvalue of the assets less the liabilities;l thevalue of thebusiness to apotential purchaser: that is,

including synergybenefits;l the sunk cost: that is,howmuchhas alreadybeen

invested in thecompany?Bookvaluerepresentsamixtureofthese,ratherthanasingleoneofthem.Itincludessomeassetsathistoriccost,somewrittendowntoliquidationvalue,somewrittenuptocurrentvalue(forexample,property)andsomewrittendownovertheirestimatedusefullivesusingsomearbitrarydepreciationmethod.Dependingontheaccountingjurisdictionandonthetypeandageofassetsheldbyeachcompany,thebookvaluewillbesomewherealongthespectrumbetweenhistoriccostandcurrentmarketvalue.However,thebookvaluewillnotbeanestimateofeconomicvaluesince,inthemain,assetsarenotvaluedusingthepresentvalueofforecastfuturecashflows.Forexample,inthecaseofBoots,thefixedassetsownedbyBootsaresmallinrelationtorevenuesand,aswehaveseen,Bootsmarketvalueismuchhigherthanthebookvalueoftheassetsitmanages.


A sunk cost?



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AD JUS T IN G BOOKV A LUE 2 . 2 In this sectionwe look at how assetvalues in the accounts can beadjusted to offer a closer estimate of economicvalue than does theconventional bookvalue or net assetvalue of the company.

Tangible assets Tangible fixed assets are typically depreciated according toaccounting estimates of their expected useful lives. Land andbuildings may be depreciated over a period of, say, fortyyears

whereas plant and equipment may bewritten off over five ortenyears. However, if the marketvalue or realisablevalue of theassets is lower than the depreciated bookvalue, tangible assets aretypically included in the balance sheet at this lower marketvalue.Bookvalues of assets therefore give some clue to currentvalues,but not an accurate one as they do not, for example, fully takeaccount of inflation or obsolescence. If, however, the analyst hasmore detailed information on the type and age of assets than isavailable from the accounts, it is possible to adjust bookvalues offixed and, indeed, current assets to a closer estimate of current

value. It is easier to do this for a small company actively seeking apurchaser than for a large quoted company fending off a hostiletakeover bidwhereyouwill not be allowed access to the companybeforeyou buy it.

Depending on the accounting jurisdiction,property assets (that is, land and buildings)may be carried on the balance sheet eitherat historic cost or at recent marketvaluationand this choice can radically affect book

value. For example, in the United Kingdom,property owned by companies is oftenrevalued on a regular basis and included inthe accounts at close to currentvalues.Boots does this, asyou can see from theextract overleaf.Where properties are

valued by surveyors using estimates of

ItisrumouredthatwhenFordacquiredJaguarin1989afterahostiletakeoverbattle,FordmanagementhadashockwhenenteringtheJaguarcarfactory.WethoughtwewerebackinVictoriantimes,theyarereputedtohavesaid!


rentalincome,

they

can

be

considered

to

be

included at economicvalue (the presentvalue of future incomegenerated) rather than historic cost.

What value obsolete computers?



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Investmentpropertieswerevaluedonthebasisofexistingusevalueat31March2004bythegroupsownprofessionallyqualifiedstaff.Extract from Boots Annual Report for the year ended 31 March 2004

In some countries, such as the USA, France and Germany, propertyis always included at historic cost and this can lead to the book

value being much lower than the currentvalue.Interestingly, the impetus in the United Kingdom for the inclusionof property at currentvaluewas market driven. Many acquisitions inthe United Kingdoms takeover boom of the early 1970swere madebywouldbe asset stripperswho felt that company share pricesand balance sheets did not fully reflect thevalue of the underlyingassets. They made hostile bids for the companies and then strippedout and sold the assetswhosevalue had been hidden fromview.To protect their company from such asset strippers, managerssought to spell out to the market the truevalue of their propertyassets by including them not at historic cost, but at recent market

value. Revaluation also meant that companies could appear to offermore security to their bankers for loans, although this proved not tobe the casewhen property prices crashed in the late 1980s in theUnited Kingdom and in the late 1990s in the Far East. Revaluationofassets also has the effect of reducing one of the performancemeasures applied to companies, return on assets (or return oncapital

employed).

As

a

result,

some

companies

choose

to

lease

rather than own the properties they needed.Boots, for example, held land and buildingsvalued at 700.2m at31 March 2004, but during that financialyear also paid 182.2m tolease property. If they had owned the properties and had put themon the balance sheet, thevalue of land and buildingswould haveincreased by, say, 2,089.8m and thiswould have substantiallyreduced the ratios for the return on equity and the return oncapital employed.

Another fixed assetwhich may be included at other than historiccost is property under construction. Some countries allowcompanies to capitalise the interest they pay on debt related tothe construction, rather thanwrite it off as an expense.

Interestiscapitalisedontangiblefixedassetsincourseofconstructionordevelopment.Thecapitalisationrateapplieddependsonwhethertheconstructionisfinancedbyspecificborrowings(basedonactualinterestrate)orwhetheritisfinancedbygeneralborrowings(basedontheweightedaveragerateofnon-specificborrowings).Extract from Boots Annual Report for the year ended 31 March 2004


International FinancialReporting Standards(IFRS), applicable to EUlisted companies forfinance years startingafter 1 Jan 2005, allowfair value for property aswell as historic cost. Thiswill mean a major changefor the asset values andreturn on capital ratios forFrench and Germancompanies, for example.In addition, IFRSrequirements onaccounting for leases willhave the effect of placingsome leased property onthe balance sheet whichwas previously offbalance sheet, as at present for companiessuch as Boots.

In this example, we havecapitalised the leases byassuming they are to bepaid over twenty years.The present value of182.2m paid each yearfor twenty years anddiscounted at an assumedcost of debt of 6% gives2,089.8m. If you needto revise this formula,seeVitalStatistics,Section 4.2.2.

http:///reader/full/%E3%B2%AC089.8mhttp:///reader/full/%E3%B2%AC089.8m


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Indeed, in the USA and some other countries the capitalisation ofinterest is a requirement.Intangible assets In the 1980s, another balancesheet item came under scrutiny bythe asset strippers, in this case intangible assets. Examples ofintangible assets include expenditure on research and development,brandvalues, intellectual capital and goodwill.Research and development (R&D) expenditure does not buy atangible asset, such as a ship or factory, but represents cash spenton a knowledge basewhich may generate future revenues. It canbe argued, however, that R&D does create an intangible asset

whose life is more than oneyear and, as a result, should becapitalised on the balance sheet and depreciated over its expectedlife of, say, fiveyears. Most countries do not allow or encouragethe capitalisation of R&D although, under IFRS for example,development activities (rather than pure R&D) can be capitalisedif future economic benefits can be linked to them. Thesedevelopment activitieswill then be amortised (depreciated) inthe income statement over their expected economic life.There is alsosomeargument forcapitalising spendingon otherformsof knowledge, as in databasesystemswithin consultancyfirms or expertise providedbyprofessional employees in investmentbanks. This is knownas intellectual capitaland firmssuch asScandia, a Swedish insurancecompany, have pioneered approachesto

the

valuation

of

intellectual

capital

for

inclusion

in

the

balance

sheet. There is, however, always the possibility that these types ofasset canchoose towalkaway, in contrast to ships or factories!

Another type of intangible asset overwhich there has beencontroversy is brand names for example,whether or not tocapitalise thevalue of the Coca Cola brand or theAmazon.combrand on their respective balance sheets. Some United Kingdomcompanies did do this in the 1980s,with firms such as Rank HovisMcDougall, a food manufacturer, putting brandvalues of 0.5bnon the balance sheet.Again, the methods used forvaluing brandsare linked to forecast cash flows related to the brands and henceto economicvalue. So capitalisation of brandswill give a closerapproximation to marketvalue thanwould the exclusion of thebrands. Current accounting policy in this area is somewhatconfused: for example, under IFRS, brands can currently becapitalised if they have been acquired through the purchase ofa company, but not if they have been built up from scratch. Thispoints up the major difficulty in using bookvalues to comparecompanies across countries and sectors the role of goodwill.The intangible asset goodwill arises as a result of the fact thatbookvalues of companies typically do not reflect their economic

values. Hence the prices paid for companies, especially highvalueadded firms such as advertising agencies and consultingfirms, typically far exceed their bookvalues. The difference



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between the price paid for a company and its bookvalue is knownas goodwill and may appear on the acquiring companys balancesheet. In some cases, thevalue or realisable goodwill may evenexceed thevalue of the acquiring companys shareholders funds,if acquisitions have featured large in a companys strategy.Under

IFRS,

goodwill

is

capitalised

in

the

balance

sheet

as

an

intangible asset. If, as is likely in the case of a brand name, itsexpected economic life is more than twentyyears, itwill not beamortised in the sameway as, for example, development activities.Instead, the company concerned is required to conduct an annualimpairment test: if the estimated value in use or salevalue isbelow the carryingvalue in the balance sheet, the balancesheet

value must bewritten down and the difference put through theincome statement.The main point to note here is that companieswhich makesubstantial acquisitions, particularly in growth businesses,willacquire goodwillwhich, if capitalised,will increase bookvaluesubstantially relative to a company, in the same sector, that hasgrown organically.In the case of Boots, goodwill acquired had beenwritten offagainst reserves to thevalue of 394.3m by 31 March 2004. If thishad been capitalised, equity shareholders funds at that datewouldhave been 2,275.6m instead of 1,881.3m.Off-balance sheet i tems

Wehaveseenhow fixedassetsand intangibleassetscanbeunderstatedoroverstated in thebalancesheet.Anotherpossiblearea

where thevalueofshareholders fundscanmislead is itsexclusion,bydefinition,ofwhatareknownasoff-balancesheet items.Thesecanbe leases,pensionassetsor liabilities,employeerelated liabilitiesandothercontingent liabilitieswhichmaybementioned in thenotes to theaccounts(or not,dependingonwhethermanagersviewthemasmaterialat thedateof theaccounts).Leasing represents a form of secured lending for asset investmentand can beviewed as an alternative to conventional debt. One ofthe early advantages of leaseswas that assets acquired under leaseand the associated leases themselves (since the assetsweretechnically owned by the lessor rather than the lessee or user) didnot need to be included in the balance sheet. Companies seekingto reduce disclosed levels of debt often chose leasing as a meansof doing this. In the early 2000s, companies such as FranceTelecom did thisvia sale and leaseback of some of their properties.

Although finance leaseswhere essentially all of the risks and therewards incident to ownership remainwith the lessee are nowrequired under IFRS to be on balance sheet, there is still scope forsome leases to be off balance sheet.Pension fund surpluses or deficits, the difference between thepresentvalue of the pension funds assets and the presentvalue ofthe pension funds liabilities, can be substantial relative to corporate


This is a simpleexplanation of a complexarea. For furtherinformation see the IASBwebsite, www.iasb.org.

Sale and leasebackinvolves selling a propertyand leasing it as a tenant.The company stilloccupies the property.
http:///reader/full/%E3%B1%AC881.3mhttp:///reader/full/www.iasb.orghttp:///reader/full/%E3%B1%AC881.3mhttp:///reader/full/www.iasb.org


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profits. For example, as at 31 December 2003, itwas estimated thatthe aggregate deficit of Europes top fifty companies alonewasE4,287 million. Under IAS 19, companies are required to disclosepension fund actuarial gains and losses. They can do thisimmediately and avoid having to put them through the incomestatement, instead disclosing them in the Statement of RecognisedIncome and Expense (SORIE). This is to allow the companies tocontinue accounting for pensions in the sameway as they arerequired to do under FRS 17.Alternatively, they can defer some ofthe gains or losses, but must do sovia the income statement. Giventhe size andvolatility of actuarial gains and losses relative toincome, net pension fund assets or liabilities have to be taken intoaccount in any estimate of adjusted bookvalue. Box 2.1 gives theexample of how ICIs pension fund deficit has affected thevaluethat potential bidders for the company place on the company.Otherassetsor liabilitieswhichmaybeoffbalancesheetcan includeliabilitiesthatmustbepaidtoemployees,suchashealthcarebenefits intheUSA,thegrantingofsharestodirectorsorstaffbelowcostandredundancypaymentstodirectorsandemployees,whichmayneedtobemade intheeventofarestructuringor takeover.Contingent (possible) liabilitieswhich are off balance sheet can alsoinclude pollution costs or likely lawsuit costs, such as thosecurrently in progress against the tobacco industry, or the costs ofrectifying the mistakes madewhen selling personal pensions in theUnited Kingdom during the early 1990s.

BOX 2.1UNITED KINGDOM PENSION DEFICITSWhen is a United Kingdom pension deficit a poison pill? For mostprivate equity groups, scouring all sectors for somewhere to housetheir cash, a deficit can be an unfortunate deal-breaker.The first reason is that size matters. Some oft-mooted targets sportdeficits that would put off even the bravest private equity house.ICIs 1bn FRS 17 deficit, for example, is a third of its marketcapitalisation. A second problem is the difficulty of quantifying theliability. In ICIs case, analysts routinely use only a proportion ofthe deficit in their valuation models. Private equity houses, likethe life assurers which could potentially take the liability off thecompanys books altogether, would be more likely to apply apremium to the deficit.Another challenge is that small changes to the discount rate orassumed longevity make huge differences to deficits, particularlywhen they are as large and as mature as ICIs. Finally, in a hostileapproach, trustees are not required to open the books, which canmake the risks impossible to value.Nor is valuation the only issue. Private equity firms like to showtheir investments a clean pair of heels after a few years. But



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new legislation means that, even once the business has been sold,if the purchaser is unable to honour the pension promises, theformer owner may be held responsible. Moreover, in most casespension fund trustees or the actuaries to the trustees control thelevel of contributions into the fund. If they believe the companyscovenants would worsen in the event of a buyout, they candemand increased or one-off payments from the company, as wellas requiring the deficit to be moved up the creditor queue. Suchproblems scuppered Permiras approach to WH Smith last year, aswell as Philip Greens putative move on Marks and Spencer. Whileit is not impossible to imagine a trade buyer being interested inICI, the characteristics of its pension fund make a private equitybid seem out of the question.(FinancialTimes, 6 June 2005)

Tables 2.2 and 2.3 give an example of how an adjusted bookvaluemight be determined.

However, underanother accounting procedure ...

Table2.2 SaltandPepperplcbalancesheetYear-end 31 December mLong-termassetsProperty, plant and equipment 135.3Intangibles 63.1Other assets 24.8Total long-termassets 223.2CurrentassetsCash and marketable securities 17.4Accounts receivable 70.4



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Inventory 38.1Other current assets 16.1Totalcurrentassets 142.0Total

assets

365.2

Current liabilitiesAccounts payable 48.3Other current liabilities 32.3Totalcurrent liabilities 80.6Long-term liabilitiesandequityLong-term debt 115.2Long-term creditors 13.4Equity (23.5 million shares of 1 nominal value)and reserves 156.0Total long-term liabilitiesandequity 284.6Total liabilitiesandequity 365.2

Net assets (equity) . m156 0Book value = = = 6 64 .

Number of shares .23 5mm

Table2.3 SaltandPepperplcadjusted bookvalueAdjusted book value mBook value of assets 365.2+ Adjustment for replacement cost on inventory, plant

and equipment 50.0+ Overfunding of pension fund 4.8+ Undervaluation of intangibles 50.0= Adjusted book value of assets 470.0 Current liabilities (80.6) Long-term liabilities (128.6) Contingent legal liabilities (24.0)= Adjusted book value of equity 236.8



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Adjusted book value of equityyAdjusted book value per share =

Number of shares236.8 m

=23.5m


= .10 08Uptonow,wehavebeenunclearonexactlywhichvalueweareseekingtodetermine.Wehavenotedthatbookvalueneedstobeadjustedtoobtainacloserestimateofeconomicvalue.Incertaincircumstances,however,economicvaluecanbelessthanbookvalueornetrealisablevalue.Figure2.1helpstoputthealternativedefinitionsofvalueincontext:whenbuyingabusiness,weareseeking

whateconomistssuchasCoase(1937)termedopportunityvalue.

Opportunity value

lower of

Economic value Net realisable value

higher ofReplacement cost

Figure2.1 Definitions of value (Gregory, 1992)

EXERCISE 2.1Lookat theconsolidatedbalancesheet in theDeLaRue2004AnnualReport.Suggestways inwhichyou think thebookvaluecouldbeadjusted to reflectopportunityvaluebetter.

S UM M AR Y In this section,we have looked at the bookvalue of a companyfrom the perspective of thevalue of the balance sheet to equityshareholders and have considered how this bookvalue might beadjusted to take into account:l more recentvaluations for current and fixed assets;l intangible assets, including R&D, intellectual capital, brand

names and goodwill;l offbalancesheet items, such as leases, pension funds and

contingent liabilities.



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3 MARKET MULTIPLES

3M A R K ET M U LTI P LES InSection3,weshallconsider themainratiosthatareapplied toacompanysbookvalue,profitsorcash flows inorder toestimate its

value.Theratiosweshallconsiderareprice tobook,Tobinsq,price toearnings(orPE),price tocash flowandenterprisevalue toEBITDA.Theattractionofusingsimplemultiples tovalueacompanyisclear themathematics iseasyandmultiplescanbecomparedacrosscompanies,sectorsandcountries. It isreassuring toknow that

youhavepaid ten timesprofitwhenyourcompetitorpaideleventimes,or thatyouhavesoldacompany for twice itsbookvalue

when thegoingrate is1.8 times.Ifacompany isunlistedandhasnoshareprice, themarketmultipleforasimilarquotedcompanycanbeused,but if thecompany isalreadyquoted, theremaybenoneed toapplyamultiple fromanothercompany.Themarketvalueof thecompanyssharesgivesaclearstatementofvalue.

For a revision ofenterprise value andEBITDA, see theGlossary, Block 2 andOUFS.

M AR K E T V A LUE 3 . 1 The starting point for determining market multiples is the market

values of companieswhose shares are listed and hence quoted ona stock market.A publicly listed company, onewith shares listedon a stock exchange, has its share price quoted by market makers

whose job it is to provide a market in shares. This gives an instantpicture of a companysvalue.Asyou know, the marketvalue ofa company may be derived by multiplying the share price by thenumber of shares in issue. In the case of Boots, at 31 March2004, this gave a market capitalisation or marketvalue of6.206 775.5 million = 4,808m or 4.808bn. For large companiestraded on the major exchanges the share pricewill represent aprice atwhich the shareswerevery recently traded andwilltherefore give an uptodatevaluation. For less frequently tradedshares, in closely held companies or traded on emerging stockmarkets, the price may be somewhat out of date or may not berealistic for a larger than average trade. Less liquid stockswill have

wider spreads between the bid and offer prices to reflect their lackof liquidity making it more difficult for traders or market makersto sell on or buy back the shares.It is important to note thewarning of stock exchange authoritiesabout their role in reporting market prices. The following is theLondon Stock Exchangesversion:

WedesiretostateauthoritativelythatStockExchangequotationsarenotrelateddirectlytothevalueofacompanys assets, or to the amountofitsprofits,andconsequentlythesequotations,nomatter

Bidandofferpricesarethepricesatwhichyoucansell(bid)andbuy(offer)sharesonthestockmarket.Theofferpriceishigherthanthebidpricetoallowthetraderaprofitmargin.Market makers earn aliving by buying andselling shares, makingtheir profit from thebid/offer spread.



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whatdatemaybechosenforreferences,cannotformafairandequitablebasisforcompensation.TheStockExchangemaybelikenedtoascientificrecordinginstrumentwhichregisters,notitsownactionsandopinions,buttheactionsandopinionsofprivateandinstitutionalinvestorsallover thecountryand,indeed,theworld.Theseactionsandopinionsaretheresultofhope,fear,guesswork,intelligenceorotherwise,goodorbadinvestmentpolicy,andmanyotherconsiderations. Thequotationsthatresultdefinitelydonotrepresentavaluationofacompanybyreference toitsassetandearningpotential.

(London Stock Exchange)

Withthiscautioninmind,weshouldmakeadditionalcommentsaboutthetermprice,sinceitisimportanttounderstandwhichpriceisrelevantinthecontextofsharevalue.First, the Stock Exchanges caution is essentiallywarning us that theshare price given may not be a fair market price.A fair marketprice implies at least a semistrong form of efficient market(as

described

in

more

detail

in

Unit

1),

where

prices

reflect

all

publicly available information about a company andwhere theprice quickly adjusts to any new relevant information. Possiblesources of inefficiency are manifold. One example thatwe havealready mentioned in Section 2 of this unit is that balance sheetsmay hide undervalued or overvalued assets or liabilities, not all of

whichwill necessarily be clear to equity analysts. Enron,when itfiled for bankruptcy in 2001,was seen after the event to have alow bookvalue due to the existence of substantial offbalance-sheet liabilities.Although some of these liabilities could have beendeduced from a close study of the accounts, thiswas apparentlynot done before the company failed.Another example of



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3 MARKET MULTIPLES

inefficiency iswhere someone has prior information, say, on atakeover bid for a company,which is not publicly available. One ofthe risks of investing in emerging markets is that the quality ofpublicly available information may be poor and there maywell berelevant inside information not available to, say, overseas investors.Second,

the

term

market

price

refers

to

the

publicly

quoted

price

of

ashare.This implies that theshare ismarketableand thataninvestorcanalwaysbe foundwho iswilling tobuy theshareat thequoted askingor offerprice,orsell itat thequoted bidprice.Italsorefers to theprice forarelativelysmallnumberofshares.

Anyonewishing toacquirea largeorcontrollingstakemightwellhave topayapremiumover thequotedshareprice.Similarly,anyonewishing tosella largestakemighthave tosellatadiscount.Third, there is a time element affecting share prices. The shareprice is quoted at a single point in time, for a specific transaction

with a specific market maker. The next minute,when facedwitha different trade, this market maker or another may quote adifferent price. The essentially temporary nature of quoted marketprices makes marketvaluation rathervolatile. For example, theprice of a large firm such as Boots canvary by 5% in a day and,indeed, shares do so quite regularly. Prices of shares of smallcompanies or companies in avolatile sector, such as that of theinternet shares, can easily move by 20% or 30% in a single day.This may be to dowith new information,which is fundamental tothe company, or simply to dowith supply and demandconsiderations for this particular share or company.Finally, there may be factors other than the future prospects of acompany that affect the relationship between price and economic

value. Specific examples include:

While such shares caneasily be moved by 30%in a day if the newinformation is importantenough, this does notmean such largemovements arecommonplace!


l Shareholder loyalty for example, ownership of shares ina football club, such as Manchester United. Shareholdersphysically demonstrated their unwillingness to sell to USfinancier, Malcolm Glazer, in 2005.

l Additionalbenefits toshareholders for example, the Isle ofWight Ferry Company fought off a hostile takeover bid becauseof the threat to shareholders concessionary pricing on fares.

Also, preference shareholders of P&O, also the subject oftakeover bids, get discounts on ferry crossings.l Employee loyalty an example is the community and trade

protest that supported Pilkingtonwhen facing a hostile bid fromBTR. In this case, the share pricewas raised sufficiently to deterthe predator.

l Apremiumfor control for example, Forte (now swallowedup by Granada) paid a premium for the small number ofvotingshares in the Savoy Hotel Group (comparedwith the price paidfor the nonvoting shares) in order to acquire control.

l Fashion for example, the late 1990s preference fornew economy internet and technology shares instead ofold economy companies such as Boots or De La Rue.


24/104


Despite these caveats, itwould be foolish to look a gift horse inthe mouth and ignore the share price as an estimate ofvalue.Given the number of analysts studying publicly quoted shares as afulltime occupation, surely their combined expertise must enablethem to get close to the economicvalue of a particular firm?Asweshall see later, complexities arise, as they did during the lifetime ofEastern Electricity,when there are differences of opinion on theappropriatevaluation method andwhen there is a takeover in theoffing, implying a possible premium for control. This explainswhyEastern Electricitysvaluevaried so much over its relatively shortlife as a company in the private sector.

We now consider a number of ratioswhich can be applied to acompany to obtain an estimate of itsvalue. One reason for sodoing might be that the company is not publicly quoted and so hasno share price to provide an indicator ofvalue.Instead, a ratio based on a similar listed company or on a sectoraverage can be used tovalue the private company.Alternatively,ratios can be used to compare companies in the same sector or tocompare stock markets in different countries. This is called relative

valuation. CompanyA may be seen to be cheap relative toCompany B or Market C expensive to Market D.

Note that we can applyratios or multiples toindividual shares or to thecompany as a whole.

D I V I D E N D Y I EL D 3 . 2 The first market multiple, dividendyield, is a measure of theincomeyield from a share. It is the dividend per share divided bythe share price. Traditionally, investorswere interested in thedividendyield for tax and income purposes highrate taxpayerspreferred low dividendpaying shares and income seekers preferredhigh dividendpaying shares. Investors now prefer to concentrateon total return, rather than just the dividend. Total return can bethought of as the dividend received plus any capital gain or loss ondisposal.Anotherway of looking at total return is to considerdividendyield and dividend growth.We saw in Unit 4 that one

way of estimating the expected equity rate of return,via thedividendvaluation model,was to estimate nextyears dividend

yieldand

the

forecast

dividend

growth

rate.

Thiswas expressed as

DE Ri = 1 +g( ) Pi

We can rearrange this equation to giveg= ( ) DiE Ri Pi

In thisway,we can seewhat level of dividend growth,g, the sharewill have to offer to achieve a particular expected return. Forexample, if an investorwants 12% return on a sharewith adividendyield nextyear of 3%, future dividendswill have to grow



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3 MARKET MULTIPLES

anaverageof9%ayear toachievethis.If inflationisexpectedtobeanaverageof4%ayear,thisimpliesabout5%realgrowth.Itisuptotheinvestortodecideifthisispossibleforthisparticularcompany.

EXERCISE 3.1CalculatethedividendyieldofDeLaRuegivenasharepriceof3.19andassumingthattheexpecteddividendpersharenextyear,D1,willbe16p.Givenacostofequitycapitalof11.5%(fromUnit4),whatwouldbethe impliedexpecteddividendgrowthrate?

P R I C E - T O - BO O K R AT I O 3 . 3 The pricetobook ratio is simply the ratio of the share price to thebookvalue per share or, at the company level, the ratio of themarketvalue of the equity to the bookvalue of shareholdersfunds. For example, in the case of Boots, using the 31 March 2004share price of 6.20 per share and given a bookvalue of 2.425per share:

6.20Price-to-book = 2 56= .

2.425

Thisimpliesthatinvestorswereatthattimewillingtopay2.56timesthebookvalueforBootssharesbecauseofthegrowthpotential

whichwentwiththem.Whatdoes2.56timesthebookvalueactuallymean?Wellitismeaninglessonitsown.WhatitcanbeusedforistocompareBootswithappropriateUnitedKingdomcompanies,withthesectorinwhichBootsoperatesandwithcomparablecompaniesfromothercountrieswithmanycaveatsrelatingtothedifficultiesofcomparingbookvaluesofcompaniesoperatingunderdifferentaccountingregimes(orevenchoosingdifferentmethodsofaccountingwithinthesameaccountingregime).ItcanalsobecomparedwithBootspricetobookratioovertime.Ayearearlier,forexample,thepricetobookratiowas2.2comparedwith2.6.ThisimplieswhatisknownasareratingofBoots.Wasthisageneralphenomenonacrossallshares?Forexample,didthepricetobookratiofortheFTSEAllShareIndexorFTSE100ShareIndex(ofwhichBootsisaconstituent)increaseasmuch,orwasthisareratingofBootsrelativetothemarket?Furtherinvestigationisneeded.Soalthoughthepricetobookratioisdifficulttointerpretjustsayingthatinvestorsarepreparedtopayover21=2 timesbookvalueisinsufficientmakingacomparisonwithhistory,withothercompanies,withthesectorandwiththemarketprovidesaframeworkfordiscussingBootsvalue.The pricetobook ratio can also be applied to chemists retailingcompanies that do not have a market price. For example, supposea company in the same sector as Boots had shareholders funds



26/104


(bookvalue) of 100m.Applying the Boots pricetobook ratiowould give it avaluation of 256m. This may not be the bestestimate of opportunityvalue, but it is at least a starting point.Remember that adjustments could be made to bookvalues to makethe two companies bookvalues comparable by, say, dealing ina consistentwaywith properties and goodwill. For example, ifwecapitalised the operating leases for Boots aswe did in Section 2,the adjusted bookvaluewould be 3971.1m or 3971.1m/775.5m =5.12 per share. The pricetobook ratiowould then fall to6.20/5.12 = 1.21.

T O BI NS Q3 . 4 The pricetobook ratio is also discussed in the context of stockmarket levelswhen it is referred to asTobinsq. The precisedefinition of Tobinsq is

Market capitalisationTobins q =

Replacement cost of assets nnet of liabilities

Number of shares in issue Market price of the share=

Replacement cost of assets net of liabilitiess

Notice that the denominator has been adjusted to reflectreplacement cost of fixed and current assets rather than historiccost. This is because Tobinsq is based on the idea that stockmarkets, if the takeover market for companieswere efficient,wouldoperate at a Tobinsq of 1. If Tobinsqwere greater than 1,managers seeking to set up a project from scratch and consideringthe alternative of buying a company already running the equivalentassets,would choose to set up from scratch as the cheaper option.If, however, Tobinsqwere less than 1, itwould be cheaper toacquire a company rather than start from scratch. Thiswouldhappen until priceswent up to make Tobinsq equal to 1 again.

2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

1900 1920 1940 1960 1980 2000

Year

Figure3.1 Tobinsq for the US market from 1900 to 2003



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3 MARKET MULTIPLES

Ifwe consider Tobinsq,which is shown in Figure 3.1 for the USmarket from 1900 to 2003,we can see that itwas unusually highin the 1990s. Even if markets are not efficient in the sense thatTobinsq is always exactly 1,we should have expected that prices

would fallwhen Tobinsq reached the heady levels it did in thelate 1990s. Bears of the market at that time used Tobinsq as areason to predict an imminent crash. Bulls of the market arguedthat Tobinsqwould have been expected to rise over time as,comparedwith the 1950s and 1960s, the index reflected companies

with fewer tangible assets and more intangible assets, such asintellectual capital, than in the past (for example, Microsoft asopposed to US Steel) and these intangible assetswere not includedin balance sheets and hence in determining Tobinsq.

ACTIVITY 3.1Looking

at

Figure

3.1,

what

has

happened

to

the

US

stock

market since the timeofwriting?Were thebullsor thebearsright in theirunderstandingof the relevanceofTobinsq?FromFigure3.1,wecansee thatTobinsqdid indeedfallback tomoreusual levelsafter themarketdeclinesof2000to2002.Currently, themarketdoesnot lookparticularlycheapor dearaccording toTobinsq.

P E M UL T I P L E 3 . 5 The most popular multiple forvaluing companieswhether at theshare, company or market level is theprice-to-earnings ratio orPE ratio. This is simply

Share price Market capitalisati onoPE ratio = =

Earnings per share Earning for shareholders

In thisway, any company can bevalued by multiplying its earningsby the appropriate PE multiple.As for the pricetobook ratio, butmore

so,

PE

ratios

are

calculated

for

companies,

sectors,

markets,

and over time, oftenwith little attention paid to the accountingdifferenceswhich distort earnings and hence PE ratios.The attraction of the PE ratio is that it uses historical and currentdata to say something about the future. The higher the PE ratio, themore the investor is prepared to pay and hence the more bullishhe or she must be about the companys future. For example, thehigher the expected growth rate in earnings, the higher the PEratio. However, the PE ratio is also affected bywhat is knownrather poetically as the quality of earnings. The riskier or more

volatile the expected future earnings stream, the less the investorwill be prepared to pay and hence the lower the PE ratio.A classicexample of this is the banking sector in the United Kingdom and inother countries. In the United Kingdom, in 1990, the FTSEActuaries

Earnings per share isearnings for equityshareholders divided bythe number of shares inissue.



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industry sector PE for bankingwas 6.24, comparedwith an averagePE ratio for the nonfinancial shares of 10.77. ByJune 2005, banks

were doing relatively better, trading on a PE ratio of 12.34comparedwith a nonfinancial PE ratio of 15.73 (see Table 3.1).

Another problemwith the PE ratio is the definition of earningsper

share

that

is

used

in

its

calculation.

For

example,

in

the

US,

the

PE ratio on the top 500 shares, measured by the S&P 500 index,

was 30 inJune 2003.After adjusting for pension costs and the costof executive stock options, the adjusted PE ratiowas over 50,making the US market look much more expensive.

PE ratios are notcalculated for companieswith negative earnings.You will therefore neversee a negative PE ratio!

Table3.1 United Kingdom Sector PE Ratios as at 24 June 2005



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ACTIVITY 3.2LookatTable3.1whichshows sectorPE ratiosand find theindustrialorcommercial sectorswith the threehighestandthree lowestPE ratios.Try toexplain thedifferences in termsofqualityofearningsandearningsgrowthpotential.Thesectorswith the threehighestPE ratiosareInformationTechnologyHardware,ElectronicandElectricalEquipmentandInvestmentCompanies.For thefirst twoof these,highPEratiosareprobablydue to lowearningsandhighgrowthprospects.Investmentcompaniesarevaluedon theirassetvalue (investments)rather than theirearnings.Thesectorswith the three lowestPEratiosareSteelandOtherMetals,ConstructionandBuildingMaterialsandForestryandPaper.All threeof thesesectorsarebasicorcommodity industrieswith relatively lowgrowthprospects.

PE ratios enable relative comparisons across time, acrosscompanies, across sectors and across countries.A company can beconsidered cheap or dear according to its relative PE ratio.How are PE ratios used invaluation?The calculation technique is simple. For example,when RollsRoycewas privatised, the closest comparable company, British

Aerospace,was trading on a PE multiple of 11. Rolls Royces sharepricewas based on a multiple of 10 times its earnings to make itrelatively cheap comparedwith BritishAerospace.Another examplecould be the pricing of an unquoted company in a takeoverwherethe sector PE is 15 on average. The exitPE the PE ratio impliedin the sale price might be 13, perhaps to reflect lower growthprospects than the sector average.

A number of factors should be taken into account to ensure thatthe comparisons among between companies arevalid. For example:l the accounting methods used by each company to calculate

earnings might be different for instance, one company mightrecord R&D as an expense, the other capitalise it;

l the financialyearends might be different (although in somecountries this is not allowed) so that the earnings of eachcompany relate to different parts of the seasonal cycle;

l one company may have experienced an atypical drop inearnings,whichwould have the effect of artificially boosting thePE ratio;

Ifwe consider Boots, Table 3.2 gives the companys incomestatement for theyear ended 31 March 2004. Taking the earningsper share figure of 52.9p and a share price of 6.20,we obtain aPE of 6.20/0.529 = 11.72.

3 MARKET MULTIPLES

Glamour stocks typicallyhave high PE ratios.Louis Vuitton MoetHennessy (LVMH) is onesuch share, on a PE ratioof over 30 in 2005.



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Table3.2 Bootsincomestatement year-end 31 March2004Notes 2004

m 2003mTurnoverContinuing operations excludingacquisitions 5,326.4- 5,087.5234.9Turnover from continuing operationsDiscontinued operation 5,326.4(1.4) 5,322.4(2.2)Total turnover 1 5,325.0 5,320.3OperatingprofitContinuing operations excludingacquisitions 551.2- 532.322.5Operating profit from continuingoperationsDiscontinued operation

551.2(1.1)

554.8(1304)

Totaloperatingprofit 2 550.1 441.6Profit/(loss)ondisposaloffixedassetsProvisionon lossonclosureofoperationsLoss on disposal of business

333

32.53.9-

5.1(34.5)

(123.2)Profitonordinaryactivitiesbefore interestNet interest

15

586.5(5.5)

389.0103.2

Profitonordinaryactivitiesbefore taxationTax on profit on ordinary activities 6

581.0(167.7)

492.4(191.9)

Profitonordinaryactivitiesafter taxationEquity minority interests

413.3(0.7)

300.5(0.5)

Profit for the financialyearattributable toshareholdersDividends 8

412.6(226.3)

300.0(230.7)

(Loss)/profit retained 21 186.3 69.3Earningspershare 9 52.9p 35.8p

EXERCISE 3.2UsingaDeLaRuesharepriceof3.19and theannual reportfor2004orOUFS todetermine2004earnings,calculate thePE ratio forDeLaRue. If theSupportServices sectorPE ratiowas then21.61,commentonDeLaRuesPE ratio relative tothatof itssectorat that time.



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P R I C E T O C AS H FLOW3 . 6 The third ratio that can be used to determinevalue is the ratio ofprice to cash flow. This ratio is problematic in that there are, as

you saw in Unit 3, many definitions of cash flow. If, however,youare using the ratio in the context of the share price (which is thenumerator in this ratio), the cash flow figure in the denominatorshould be the cash flow available to shareholders.Thus,we can define the ratio of price to cash flow to be

3 MARKET MULTIPLES

There is a problem withthe choice of earningsfigures similar to that forthe PE ratio.

Price to cash flow = Share price = Market caapitalisationCash flow per share Cash flow

whereCash flow = Operating cash flow + Other income + Interest

received Interest payable TaxationCash flow = Operating profit + Depreciation Capital expenditure +Other Income Net interest payable Changes in

working capital TaxationIn Table 3.3,which gives an analysis of Boots cash flow for thefiveyears 20002004,we can observe the annual cash flows plusestimates ofwhat the moneywas used for. The table has beendrawn up using the definition of cash flow from the equationabove that available to shareholders.

This definition of cashflow does not tie in withany of the definitions inUnit 2: it is yet anothervariation on a theme, butis important as we shalluse it to value companies.


Table3.3 Boots cash-flowanalysis Comparative analysis of cash flow and change in debt

Mar-04 Mar-03 Mar-02 Mar-01 Mar-00Operating profit beforeexceptional items 551.2 590.4 625.5 603.1 573.3Depreciation 136.7 162.8 163.4 159.9 154.4Capital expenditure (42.3) (24.1) (102.2) (405.0) (221.0)Other income 32.5 5.1 (6.0) 3.2 12.9Net interest received/(paid)

(22.6) 103.4 13.2 1.1 5.9Change in workingcapital 134.1 (136.0) (207.7) 156.5 (295.8)Taxation (167.7) (192.7) (191.2) (158.8) (154.4)

Netcash flowavailableto shareholders* 621.9 508.9 295.0 360.0 75.3Exceptional gain/loss (32.4) (157.7) (22.4) 0.0 0.0


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Disposals &acquisitions (2.2) 386.8 (21.1) (42.7) 6.7Dividends paid (229.1) (238.3) (234.5) (224.0) (216.3)Shares repurchased (264.6) (455.2) (45.9) 0.0 (95.4)Shares issued 0.3 0.1 0.7 8.8 0.5Fundsavailable/(needed) fordebt 93.9 44.6 (28.2) 102.1 (229.2)Net actual changein debt (91.6) (45.0) 36.1 (102.4) 223.0*Using the definition of cash flow given inSection 3.6

Asat

31

March

2004,

Boots

has

a

share

price

of

6.195

and

775.5 million issued shares, but Boots had a share repurchaseprogramme,which meant that 38.3 million shares had been boughtback (and cancelled) during the period. Using the derived cashflowfigureforyear2004of621.9m,equivalentto621.9m/775.5m=80.19ppershare,weobtainapricetocashflowratioof

Boots pricetocashflow ratio = Share price/Cash flow pershare

= 619.5/80.19= 7.72

On the other hand, ifwe decide that the cash flow should beattributed to the shares outstanding at the beginning of theyear,since the repurchase scheme is ause of the cash flow attributableto shareholders, thenwe get a derived cash flow per share of621.9m/813.9m = 76.42p per share and a pricetocashflow ratio of

Boots pricetocashflow ratio = 619.5/76.42= 8.11

Note that a fair case can be made for either method, since thecashflow figure is based onwhatwent on throughout theyear, butthe share price is appropriate for the number of shares outstandingat the time (31 March 2004). It is, though, important to beconsistentwith the method chosen through theyears of analysis.

http:///reader/full/%E3%B6%B21.9mhttp:///reader/full/%E3%B6%B21.9m


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3 MARKET MULTIPLES

Similar calculations for theyears 2000-2003 give pricetocashflowratios of

2003 9.382002 20.502001 15.662000 65.25

This example demonstrates the difficulties of using a pricetocash-flow multiple as avaluation measure. Cash flow after taxes, interestand capital expenditure in particular mayvarywidely fromyeartoyear and hence give misleadingvaluations for companies.In contrast, earnings are smoother than cash flows, becauseaccounting rules require standard depreciation policies and thematching of revenues and costs as far as possible. This makes thePE multiple more stable over time than the pricetocashflowmultiple.

A second disadvantage of the ratio of price to cash flow is thatdifferent analysts use different definitions of cash flow in the ratio.

You have seen in Section 2 of Unit 3 a number of differentdefinitions for example, free cash flow and operating free cashflow and these are only some of awide number of possibledefinitions. In practice, the Unit 3 definition of free cash flow,

which uses depreciation as a surrogate for capital expenditure anddeducts changes in net operating assets orworking capital, is oftenused as a measure of cash flow for shareholders.Currently, many analysts define cash flow for this ratio to besimplyearningsplusdepreciation(thatis,beforecapitalexpenditureandincreasesinnetoperatingassets).Thereasonforthisisthatitiseasytocalculateandthenumbersareusuallyavailableforcomparison,whatevertheaccountingregulatoryframework.Itisclearly,however,nothinglikeoperatingfreecashflow.FromTable3.3,theearningsplusdepreciationdefinitionwouldgiveacashflowfortheyear2004of687.9mandapricetocashflowratioof6.97(usingyearendnumberofshares)or7.31(usingyearstartnumberofshares).Cashflowvaluation can be important, however, in the context oftakeovers,

especially

leveraged

buyouts.

In

such

situations,

though,

it is likely to beoperating cash flow that is important, because thegearing (and thus interest payable and taxable profits)will besignificantly different after a buyout than before.The main conclusion on pricetocashflow ratios seems tobe beware! Checkyour definitions. In this course,we have stuckto the definitions recommended in theFinancialTimes andoutlined in Box 3.1 overleaf. The hope is that, over time, analysts,managers, accountants and investorswill come to agree a standardset of definitions making everyones life much easier. (The termamortisation, as used here, relates to the depreciation ofintangibles.)



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BOX 3.1CASH FLOWCash is King. Though the phrase is a clich, the notion thatinvestors ought to be looking at a companys cash flow rather thanmerely

its

accounting

profits

is

valid.

The

only

snag

is

that

defining

cash flow is slippery. Different companies stockbrokers andconsultants calculate it in different ways.Some semantic tidying-up is needed. The starting point should berecognition that there is no correct definition of cash flow,justas there is no single measure of profit. Butjust as investorsdistinguish between operating profit, pre-tax profit and earnings,it is important to be precise about which sort of cash flow one istalking about. Below are the definitions Lex proposes to use.EBITDA: earnings before interest, tax, depreciation andamortisation has caught on as a valuation tool, especially for

judging the relative attractiveness of companies in the sameindustries across borders for example, European telephonecompanies. Typically, ratios of sales or enterprise value (marketcapitalisation plus debt) to EBITDA are calculated. The appeal isthat these measures strip out the different depreciation, capitalstructures and tax regimes in different countries.Closely allied to EBITDA is operating cash flow. The onlydifference is that adjustments are made for changes in workingcapital. Operating cash flow is the top line of United Kingdomcash-flow statements, where it is described as cash flow fromoperations

. While working capital changes can be important in anysingle year, they tend to even out over time. So for trend analysis,

EBITDA is normally a better measure.But, EBITDA is not a Holy Grail, precisely because it is calculatedbefore many of the costs business has to bear. Most important iscapital expenditure. Without investment, companies would wither onthe vine. The snag is that for most companies, only a portion ofthe CAPEX is required to maintain the business while the rest isused for expansion. Ideally, companies would give a breakdown;but, in practice, they do not. That means that estimates ofmaintenance CAPEX the investment needed to maintain thevalue of the companys assets is subjective though not worthless.Of course tax is also a cost to business and certainly if one wantsto discount cash flows to calculate net present value, one needs totake it into account. For this purpose the best measure is operatingfree cash flow: operating cash flow minus CAPEX and tax (butbefore interest). Discounting such cash flows by a companys cost of capital will give its enterprise value from which net debt needsto be deducted to calculate the value of the equity. Sometimes,though, one is interested simply in how much cash is left over forshareholders in which case interest should also be subtracted.This free cash flow is the amount available for paying dividends,cutting debt, and making acquisitions.



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At other times it is useful to think of dividends as given andsubtract them to give residual cash flow. This number, which isoften negative, is the cash available for repaying debt andacquisitions. It is not very useful for valuation purposes, but in

judging how much debt and dividends a company can support, itis invaluable.(FinancialTimes, 27 December 1997)

E N T E R P R I S EV ALU E T O EBITDA3 . 7As mentioned in Box 3.1, a ratio that has become popular relativelyrecently as avaluation tool for companies is enterprisevalue (EV)to EBITDA. This ratio is different in several respects from PE orpricetocash flow ratios. First, it considers thevalue of theenterprise as awhole, not merely the equity element. The profits itmeasures are the profits before interest and tax and hence areindependent of financing choice. Interest payments are clearlyaffected by the amount of debt finance and corporate tax paymentsare also affected since debt interest typically attracts corporate taxrelief. Profits before both taxes and interest are not affected by thefinancing choice. The second characteristic of the ratio is that theprofits considered are also before depreciation and amortisation.This means that EBITDA is not equivalent to cash flow, sinceit is before capital expenditure or its accounting surrogate,depreciation. Thus, companieswithvery different capitalexpenditure programmeswill not be seen to be different using thisratio. The main advantage of this ratio, however, is its stabilitywesaw howvolatile the cashflow ratio could be.Enterprisevalue is typically defined to be the marketvalue of theequity plus the marketvalue of net debt plus the marketvalue ofany preference shares or convertibles plus minority interests. Theidea is to include any longterm capital provided by all types ofinvestors. The equity element is easy to calculate and preferenceshares may also have a market price. However,when prices are notavailable, analysts often proxy the marketvaluewith the book

value. They certainly do this for the net debt element of enterprisevalue.You may bewonderingwhatwe mean by net debt. Theidea here is to include only debt that represents longterm capitalto the business. Determining the debt element of the enterprise

valuewill involve a decision as towhether any shortterm debtshould be included andwhether cash should be netted off. In thecase of De La Rue, in 2004,with a longterm cash mountain, such cash should not be netted off itwas an asset, because itwasexpected that itwould be invested in the business, and notnegative

capital.

Turning

to

Boots

and

using

the

figures

from



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Table 2.1, aswell as the notes to the accounts,we have thefollowing calculation for enterprisevalue at 31 March 2004

EV = Marketvalue of equity + Bookvalue net debt= 775.5m6 6.20 + 331.6m longterm borrowings +

156.5m shortterm borrowings 110.5m cash= 5,195.7m

Note that, in this example,we have excluded trade creditors andnettedoff cash (deeming these to be part of shortterm financing).Thus, the enterprisevalue of Boots at 31 March 2004was 5195.7m.Ifwe now turn to Table 3.2,we find that the EBITDA for Boots fortheyear ended 31 March 2004was 586.5m of total operatingprofit before tax, interest and exceptional items, plus 128.8m ofdepreciation to give an EBITDA of 715.3m. Thus for Boots at31 March 2004

EV/EBITDA = 5,195.7m/715.3m= 7.26

The equivalent figures at 31 March 2003would have beenEV = 4,313.14m + 361.1m + 186.9m 203.4m

= 4,657.74mEBITDA = 534.2m

EV/EBITDA = 8.7Asyou can see the EV/EBITDA tends to be more stable than thepricetocashflow ratio.In the bull market of the late 1990s, some analysts looked not atprofits or cash flow or even EBITDA, but at revenues andcalculated the EV/sales ratio. This ratiowas particularly usefulduring the internet bubble forvaluing companies such asAmazon.com, since such companies often had negative cash flows andnegative earnings. The higher the EV/sales ratio, the higher theexpected operating margin or the greater the growth expectationsfor a particular company.In summary, the main attractions of the EV/EBITDA ratio are itsstability and its independence from capital structure, aswell as itsfreedom from any distortions due to differences in depreciationpolicies between companies. This independence of tax andaccounting differences enables comparison of companies acrossnational boundaries and has been of particular use in thevaluationof privatised utilitiesworldwide. These utilities have hadverydifferent capital and asset structures, according to their level ofmodernity andwhich governmentwas responsible for privatisation.EV/EBITDA helped, for example, in thevaluation of TELCO in 2002(see Box 3.2), since comparison could be madewith quoted

http:///reader/full/%E3%B5%B195.7mhttp:///reader/full/%E3%B7%B15.3mhttp:///reader/full/%E3%B7%B15.3mhttp:///reader/full/%E3%B5%B195.7m


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companies such as British Telecom, even though it had a differentgearing ratio and a different asset base.

S P E C I F I C V AL UAT IO N R AT I O S 3 . 8 Finally, there are a number of specificvalue drivers that are used incertain sectors asvaluation tools and for comparisons. They arebased on the idea that profit and cash flow depend on a key driver

which can form part of avaluation ratio. For example,supermarkets may bevalued on a per square metre basis, mobilephone companies on a multiple of the number of subscribers(see Box 3.2), and fundmanagement companies on a percentage ofthevalue of the funds under management.

Valuedrivers

are

key

factors that affect value:for example, the numberof bank branches of aretail bank or the amountof funds both in termsof value and the actualnumber undermanagement for a fundmanagement company.

EXERCISE 3.3Thinkofpossiblevaluedriversandhencevaluationmultiplesfor:(a) fashion boutiques(b)advertising agencies(c)airlines.

C O M P AR I S O N OF M AR K E T M UL T I P L E S

3 . 9 So farwe have described each of the key market ratioswhich areused invaluation. Thesewere dividendyield, price to book,Tobinsq, PE ratio, price to cash flow, EV/EBITDA, EV/sales, andsectorspecific ratios. Table 3.4 summarises the pros and cons ofeachvaluation multiple.Table3.4 Prosandconsof valuationmultiples

Pros ConsNetassetvalue Easy to calculate. It comesstraight from the accounts.

Useful for specialsituations such ascompanies that dealpredominantly in easilyvalued fixed assets.

Relies on accounting valueand not economic value.Accounting standards indifferent countries canvary.Accounts are often out ofdate and subjective as tovaluation. How much valuein a fire-sale? What aboutpossible tax payments ina fire-sale?



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Tobinsq Has economic rationale. Still dependent onUseful for valuation accounting values, albeitof markets. adjusted.Tries to adjust historicvalues.

Comparisons over timemay be biased bychanges in types ofcompany included instock market indices.

PE ratio Commonly used ratio. If earnings erratic,Easy to calculate. PE ratio should be

normalised.Doesnt fully take accountof the time value ofmoney.Sensitive to accountingstandards.Investment requirementsare overlooked.

Price to Takes investment into Confusion over definitioncash flow account. of cash flow.

Represents real Ignores time value ofcash belonging to money.shareholders. Can be variable over

time.EV/EBITDA Commonly used ratio. Ignores capital

More stable than expenditure requirements.cash flow. Ignores differences in taxAllows companies withdifferent financial

rates betweencompanies.

structures to be In calculating EV, thecompared.Allows internationalcomparisons.

book value is often usedas a proxy for the marketvalue of debt which maydistort comparisons.Ignores time value ofmoney.

EV/sales Commonly used ratio Ignores value toespecially in countries shareholders, taxes,where earnings are not capital structure.meaningful numbers. Doesnt fully take accountEnables accounting of time value of money.distortions to beminimised.

Sector- Commonly used for May mask importantspecific valuation purposes, differences betweenratios especially in acquisitions. companies.

Allow companies whose Doesnt fully take accountearnings may be of the time value ofmeaningless to be money.compared. Considers only one valueGives reference points driver.within a sector.Allows feed-in to conceptof value drivers.



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Eachanalyst,manager,investorandaccountantwillusedifferentratiosindifferentcontextsandweshalldiscussthisingreaterdepthinSection5.Asexamples,weshowyouacasestudyusingEV/EBITDAandspecificvaluationratios(seeBox3.2)andanextractfromabrokersreportonDeLaRuereproducedastheAppendixinthisunit,butwhichyouhavealreadyseenintheAppendixofUnit3.Theseexampleswillgiveyouafeelforhowanalystsuseratiostodecidewhetheraparticularshareisagoodbuyornot.

BOX 3.2WHEN TO USE EV/EBITDA AND SPECIFIC VALUATION RATIOS: COMPANY ANDTRANSACTION MULTIPLES VALUATIONS An investment banker would always use multiple methods to valuea company to get a range of estimates, which may differ from theprice the company will be sold at because of the likely competitionduring the bidding process, financial constraints of potentialacquirers and different companies valuation for each acquirereach potential acquirer has its own expected synergies with thecompany, as well as different estimates of the country risk, whetherthey are familiar or not with the market context.The example of TELCO, a true fixed and cellular telecomcompany that operates in Africa and was valued, when it wasprivatised, in 2002, was chosen to illustrate the use of specificvaluation ratios e.g. comparable company and transaction multiplevaluations. For confidentiality reasons the name has beenchanged.MethodologyComparable company multiples:l The comparable company valuation is based on comparable

company multiples. TELCO is a fixed-line and mobile player;pure cellular, pure fixed and both fixed/mobile listed telecomcompanies as close as possible to TELCO in terms ofbusiness, size, geographic presence, profitability and financialstructure were sampled.

l The following industry standard financial benchmarks wereretained: Enterprise value (EV)/sales EV/EBITDA, EV/subscribers.

l The above data multiples were then calculated from brokersbusiness forecasts and applied to TELCOs forecasts in order toestimate the enterprise and equity values, as though TELCOwas a listed company. (TELCOs forecasts were those providedin the DCF valuation see Box 4.1.)

l Pure fixed and pure cellular companies were used to perform asum-of-the-parts valuation. The sum-of-the-parts method is



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based on the addition of TELCOs fixed-line and mobilebusinesses separate valuations obtained with, respectively, purefixed company multiples and pure mobile company multiples.

l Both fixed and mobile players constituted the sample calledfixed/mobile comparables.

Only two transactions

Multiples used:

EV/Population

EV/Fixed lines

Sum-of-the-parts* Fixed/Mobile

Pure fixed + puremobile companies

EV/EBITD

EV/Sales

EV/Cellularsubscribers

Both fixed/mobilecompanies

*Sum-of-the-parts valuation values each part of the company separatelyand adds up the results to get a value for the whole

Comparable transactionvaluation

Comparable companyvaluation

Comparable multiples valuation

Multiples used: Multiples used:

EV/EBITD

EV/Sales

Multiples applied to TELCOs forecastsfrom 2002 to 2006

Comparable transaction multiples:l Comparable transactions of both fixed and mobile operators

during the 2000/2001 period were examined and a comparabletransaction valuation was determined from them.

l Only two transactions were directly comparable to the TELCOstransaction: Privatisation of the Tanzanian incumbent telecoms operator(TTCL) in March 2001. Privatisation of the Ugandan incumbent telecoms operator

(Utel) in May 2000.Valuation synthesisFollowing the above mentioned methodology, TELCOs enterprisevalue was estimated at between $611 million and $908 million, withan average of $750 million. Therefore, considering a net financial



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debt of $444 million, TELCOs equity value was estimated to beclose to $315 million.Enterprise value Equity value

In USD million500 1000 1500 2000 400 600 800

Sum-of-the-parts

Fixed/mobile comparable

Fixed/mobile transactions

Retained range

732 1009

611 908

819 1250

611 908

0 1000

Sum-of-the-parts

Fixed/mobile comparable

Fixed/mobile transactions

Retained range

288 565

167 464

375 806

167 464

In USD million

Table3.5liststhekeyratiosgeneratedbythebrokerforDeLaRueintheirinvestmentreport.Notehowbrokerscalculatepastyearsmultiplesandforecastfutureyearsmultiplies.

Table3.5 KeydataforDe La Rue2004a 2005e 2006e 2007e

Turnover (m) 682.5 658.1 674.4 701.6Pre-tax profit (m) 58.7 55.9 62.9 68EPS (p) 24.2 22.3 26.93 30.4DPS (p) 14.2 15.05 15.8 16.59Dividend yield (%) 4.1 4.4 4.6 4.8PE 16.1 15.8 EV/EBITDA 5.4 7 6.4 5.9ROE (%) 3.1 Source:Merrill Lyncha = actual, e = estimateEPS earnings per shareDPS dividend per sharePEPE ratioEV/EBITDA enterprise value to earnings before interest, tax, depreciation and amortisationROE return on equity



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Industry rule of thumb 3.07 1.12 11 14 43 20 12Discounted cash flow(DCF)***/ 3.85 1.08 2 11 24 28 35Internal rate of return (IRR) 3.01 1.24 14 19 33 20 14Real options**/ 1.58 0.81 57 32 7 2 1Other 2.59 1.74 50 0 14 14 22*, ** and *** represent statistically significant differences between large and small firms at the10%, 5% and 1% levels, respectively., and represent statistically significant differences betweenmerchant banks andstockbrokers at the 10%, 5% and 1% levels, respectively.Source:RossGeddes, 1999

From Table 3.6you can see that the two most popularvaluationmethods for corporate financiersvaluing companies for purchase,for sale or for flotation on the stock marketwere capitalisation offorecast earnings and trading multiples of companies in theindustry. The firstvaluation method is the PE ratio, but using next

years rather than lastyears earnings. The second compares acompanywith similar companies usingvaluation metrics commonto that industry or sector. In the end, thevaluation tools they useare not that complex. In Section 4, though,we shall look at

valuation using discounted cash flow (DCF). From Table 3.6,wecan see that over one third (35%) of respondents almost alwaysused DCF,with a further 52% using DCF frequently or quitefrequently. Table 3.6 also shows that internal rate of return (IRR) isalmost always used by 14% of respondents despite potential pitfallssuch as the one described in Box 3.3.

BOX 3.3THE PERILS OF IRR Imagineaninvestmentthatrequiresapaymentof$5,000upfrontand

then

produces

positive

cash

flows

of

$3,000

in

years

two

to

10.

At a 10 per cent discount rate, this project will have a positive netpresent value ofjust over $22,160 and an internal rate of return of59 per cent.Now assume the investor can sell out at a fair value in year three,receiving $14,605 (the NPV of the cash flows in years four to 10).The projects overall NPV remains exactly the same. But the IRRmore than doubles to 120 per cent, even though no extra valuehas been created.This is hardly news. But all too often, it creeps into practice: IRR isthe private equity industrys main yardstick forjudging performance,raising funds and rewarding managers. Indeed, the sector makesmuch of its superior 25 per cent returns. Yet as the example



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shows, such IRR-based numbers can be artificially boosted byextracting cash early through trade sales, listings orrecapitalisations. Indeed, the theoretical investor could accept aslittle as $5,000 in year three, thereby destroying considerableshareholder value, and still trumpet an IRR of over 59 per cent.IRR calculations implicitly assume that interim cash flows arereinvested at the original IRR. It would be more realistic toassume, as NPV does, reinvestment at the cost of capital.Because it is intuitive and easy to calculate, IRR will remainpopular. But it should not be used in isolation and investors shouldrecognise its flaws.

Investment Years23 SaleYear 3 Years410 NPV IRR

1 Hold -$5,000 $3,000pa No $3,000pa $11,161 59%2 Sale

at fairvalue

-$5,000 $3,000pa $14,605 0 $11,161 120%

3 Salebelowfairvalue

-$5,000 $3,000pa $5,000 0 $3,944 60%

(Ogier, Rugman and Spicer, 2004, p. 180, quoted inFinancialTimes,1 June 2005)

ACTIVITY 3.3Whydoyouthinkcorporatefinanciersprefertouseprospectiveearningsratherthanhistoricearningsintheirvaluation.Iffloatingacompany, itwill lookcheaper(havea lowerPEratio) ifprospectiveearningsarehigher thanhistoricearnings.Prospectiveearningsmayalsobeabetterindicatorof thefuture.

S UM M AR Y In this section,we have looked at a number of ratioswhichcompare share priceswith dividends, bookvalue, profit or cashmeasures, andwhich allow comparison of companies acrosssectors, time and countries.Valuation ratios can be used tocompare companies that are listed on stock markets and also allowthevaluation of companies not listed by using the multiple derivedfor a comparable listed company.



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4D I SC OU N TED C A SH F L O W 4 DISCOUNTED CASH FLOW

The attraction of market multiples is their availability and theirsimplicity. It is clear, however, that market multiples do notexpressly take account of the timevalue of money and onlycrudely allow for differences in growth prospects at the earnings orcashflow level.We saw in Unit 5 how net presentvalue (NPV) asa decisionmaking tool for project appraisal is now common inmajor organisations.What is noteworthy is that discounted cashflow (DCF) has become almost as common in companyvaluation,aswe saw from Table 3.6.

ACTIVITY 4.1Fromyour readingofUnit5andwhatyouhave read inUnit6so far,whatdoyou thinkare thekeydifferencesbetweenusingDCF techniques fo

b821 block3unit6 company valuation

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