Spring 2022 End-of-year Exam on the Valuation of Companies- Finance, University of Missouri

Thoroughly preparing for the end-of-year exams is the only way to ensure you pass. Below is a blog providing special guidance on tackling exams on the valuation of a company. It includes six questions to help you learn how to take finance exams on this topic with ease. They can be used for revision for the same. We also have finance exam writers available 24/7 that you can pay to complete your exams.

Exam Question:

What are some of the considerations when using earning multiple or price earning ratio as a measure of valuation of a company?

Exam Solution

Earnings multiple/price-earnings ratio

"Earnings multiple' or 'price-earnings ratios' has become over the last 25 years a measure of valuation with which even infrequent stock market investors or observers are comfortable and familiar. However, some refinements in the way earnings are calculated and how the multiple is applied are necessary to ensure the earnings multiple concepts are as appropriate as possible in a particular case. The main considerations include:

How should ‘earnings' be defined?

Earnings for this purpose can most usefully be regarded as the profits of the company and its subsidiaries and associates after the deduction of the charges which rank ahead of the shareholders entitled to those earnings. Consequently, all interest charges owing to bankers or others should be deducted as these claims on the company's income and assets rank ahead of shareholders. Tax should also be deducted for this reason. If any proportion of income is attributable to outside shareholders of a subsidiary (for example if a subsidiary is not wholly owned by the company), this proportion, called 'minority interests' is also deducted. The above represents standard accounting treatment of 'earnings' as they would appear in an audited profit and loss statement in most countries, that is consolidated profit after interest, tax, and minority interests.

‘Attributable’ earnings

The principle is to match what is being valued with the earnings attributable to it or generated by it. If there are preference shares outstanding which are entitled to receive a certain dividend, this should be deducted from the earnings before the ordinary shares can be valued. If there are convertible securities outstanding which are likely to be converted, the interest should be added back to earnings (with appropriate adjustments for tax) and the earnings related to the enlarged number of shares in issue after conversion.

Recurrent earnings

If a multiple is applied to a particular year's earnings to calculate a valuation, the implication is that the elements included in the earnings will be present in each year's earnings for the foreseeable future. Profits or losses which are made from activities which are not part of the company's regular business such as the sale of a fixed asset used in the business, are separately listed in account under the heading extraordinary items. Such items should not be included in earnings to which the multiple is applied for valuation purpose.

Recurrent earnings imply that the business is a going concern. For this purposes reason, depreciation should not be added back to earnings, as it is in a cash flow calculation. It is assumed that regular reinvestment at the level of the depreciation charge will be required to ensure that the earnings are indeed recurrent.

Timing

Earnings are expressed over a single financial period, often a calendar year Trading conditions may not fall conveniently into annual patterns. If a company has made a loss of 5 in the first half of the year and a profit of 10 in the second half the accounts will show earnings of 5 for the whole year (10 for the second half s 5 for the first) In this case, other things being equal, the year-end profitability is running at the annual rate of 20. To Using the published figure of 5 for the basis of valuation is likely to be misleading.

Forecast as historic earnings

In assessing earnings, analysts will attempt to form as up-to-date a picture as possible. Past earnings are only of interest as a guide to the future. Reliable estimates and forecasts are much sought her. However, the degree of uncertainty in the estimates is likely to increase sharply beyond a few months in the future and the analysis will become more speculative.

Exam Question:

In using a multiple of earnings to value a company, it is critical to ensure that all the elements included in the profits being multiplied are in fact appropriately treated in this fashion. What are the Items which are not best treated in this manner?

Exam Solution:

INTEREST ON SURPLUS CASH DEPOSITS OR INVESTMENT INCOME ON FUNDS UNDER MANAGEMENT

Cash can hardly be worth more than its face value. If interest is earned at 10% on surplus cash of 100 and interest income included in earnings to a 15 times multiple is applied, cash of 100 will in effect be valued at 150 RENTS If a property is owned by a company but not for the moment used in its business, rent may be earned. In this case, it is preferable to value the surplus property separately and not include rentals in profits to which a multiple is applied. The multiple may bear no relationship to the capitalization rate.

FOREIGN EXCHANGE INCOME.

In times of unstable foreign exchange rates, a appropriate to the property company with an international range of business may make substantial gains or losses from the timing of payment for its purchases and conversion of its foreign exchange sales income. The company might argue that this is part and parcel of its regular activities. An analyst might well feel uncomfortable at putting a multiple on substantial foreign exchange gains (or losses) and risking distortion of the valuation. A better treatment is to exclude such items on the grounds that in the longer term gains and losses of this type will probably balance out.

INCOME FROM SALES OF ASSETS

Some asset-based companies regularly buy and sell major assets as well as utilize them in their business. Examples of industries where this is common practice is transportation (particularly shipping and airlines) and property development. The companies may argue that it is their regular involvement in a particular line of business that enables them to make sales of assets which outsiders could not achieve. Nevertheless, asset-based industries are often highly cyclical so that the reliability of such profits is hard to gauge. Differing accounting treatments by companies in the same industry complicate the picture, some including such profits (or losses) in earnings and others showing them as extraordinary items.

ASSOCIATES

If a company is accounted for as an associate, the attributable percentage of its earnings (rather than just dividends received) will be taken into the profits of the company holding the stake. Associated companies are defined as companies in which the holding company has a substantial interest (say a minimum of 20% of the equity) and some influence over management, evidenced for example by being able to appoint at least one board member. However, board membership may confer little control. The holding company has no access to the associate's cash flow which may be a weakness. There appears to be some merit in the verdict of a well-known City of London financier that associated company accounting is for the birds.

SALES AND EXPENSES NEAR YEAR END

By accelerating or delaying shipment of goods or completion of projects, management can adjust profits to some extent from one year to the next. Many types of indirect or non-variable costs can be deferred by management on a short-term basis, for example an advertising campaign, a branch-opening program or the hiring of additional administrative staff. It may well be legitimate to smooth profits to reflect underlying business trends but the analyst should beware of the effect on a single year's figures: If a business is highly geared, increases or decreases in interest costs will have a marked effect on profits before taxation. Consideration should be given in such cases to applying the multiple to earnings plus interest paid and then deducting the amount of the debt to reach the valuation.

The underlying principle behind the above adjustments is that the multiple of earnings method is most satisfactory where the earnings are recurrent earnings generated from continuing business activities. If the earnings figure is substantially influenced by net financial income such as interest and foreign exchange gains, rents and sales of non-current assets, distortions are inevitable.

Exam Question:

A company can be valued using its net assets. Using an example of a consolidated balance sheet, show how the valuation is achieved.

Exam Solution

The most obvious way to value a company is perhaps to value its assets and then subtract its liabilities as shown in the balance sheet. An example of a typical consolidated balance sheet laid out in vertical form is given below:

	$m
Fixed Assets
Land	25
Buildings	10
Machinery and Equipment	15 = 50
Associated Company	8
Investment	7
Current Assets
Stocks and Work-in-Progress	28
Accounts Receivable and Pre-Payments	13
Bank Balance and Deposits	20 = 61
Current Liabilities
Accounts Payable and Accrued Charges	15
Bank Loans and Overdrafts	20
Taxation	5
Proposed Dividend	5 = 45
Net Current Assets	16
Goodwill on Consolidation	5
Intangible Assets	5 = 26
Less: Deferred Liabilities
Long-Term Loans	25
Deferred Taxation	5 = 30
Minority Interests	13
Consolidated Net Assets	48
Consolidated Net Tangible Assets	38
Net Assets Per Share
(75 million shares in issue)	$0.64
Net Tangible Assets Per Share	$0.51

In carrying out a valuation on a net asset basis, each item must be examined critically. Most time will probably be spent on the fixed assets, typically the largest items in the balance sheet. If they have been owned by the group for a number of years, substantial differences may have arisen between book value and current market value.

Exam Question:

Using an example, explain the composite approach to valuation of a company.

Exam Solution:

If sufficient information is available, a composite approach to valuation is more satisfactory than taking an earnings multiple or net asset backing by itself. Where a group consists of a number of essentially different assets or businesses, it is preferable to look at each on an individual basis. This requires constructing a valuation on an unconsolidated rather than consolidated basis. In a large company, this may have to be taken further involving a valuation of each major category.

The main reason for building up a composite valuation on an unconsolidated basis is the different nature of businesses or assets which may be included in a group. Some businesses are able to make a considerable profit from a very low capital investment. They may require a high level of recurrent expenditure on, for example, advertising which is expensed year by year without an asset base being built up. A well-known brand name with immense commercial value does not appear on a balance sheet. Other assets may have a high book value but a relatively small income. For example, the more prime the location of a property, the lower its yield.

If a group consists of these two types of assets, a consolidated valuation will result in an under-estimate of the worth of the group. On a consolidated basis, the group may appear to be worth approximately the same, as if an earnings multiple and net asset backing is used. However, examined separately it will be readily apparent that the value is greater. An example of this principle would be as follows:

	$m
Land and Buildings	50
Plant and Machinery	5
Investments	10
Current Assets: Stock	30
Accounts Receivable	15
Cash	25 = 70
Current Liabilities: Creditors	15
Overdraft	15 = 30 40 105
Less; Long-Term Debt	10
Net Assets	95

For the latest financial year, the company reported earnings of $10 m and the current year's budget is for a small increase. A typical price earnings multiple for this industry is 8. On the face of it it would appear that a fair value for the above company is about $80-90 m representing an industry average multiple and a small discount on net assets. On further enquiry the following facts emerge

Land and buildings are factories only half occupied by the company itself. The remainder are vacant or rented to third parties.
Investment of $10 m consists half of an investment in a research and development company engaged in design work for the business and half of listed shares unrelated to the business.
Cash balances of $25 m are not utilized in the business but are managed separately by an investment adviser. There is no foreseeable requirement for additional working capital in the business.

A composite valuation of the business would be as follows:

Earnings = 10

Less: Income from rentals and surplus cash = (2)

= 8

Business valued on 8 times multiple = 64

Surplus land and buildings at valuation = 25

Surplus investment at market value = 5

Surplus cash after allowing for a $5 m contingency = 20

Total valuation = 114

As compared with initial valuation = 80-90

The composite method is likely to place the highest on the group. It is most relevant where there is at least a possibility that the group might be broken up and sold to realize full value for each independent unit. When a hostile bid reaches this level, the directors of the target company have to consider whether it is in the shareholders' interests to continue to resist.

Exam Question:

What are some of the methods that can be used for the valuation of a company?

Exam Solution:

Dividends

The dividend paid on an ordinary share divided by the share price and expressed as a percentage is called the 'dividend yield'. It is normally expressed gross, without taking any account of the recipient's tax position. Income-conscious investors may place a high weight on annual income received although they would acknowledge that capital gain is also part of the total return equation. Companies which pay out almost all earnings as dividend may be valued on this basis alone. Of course, as dividends and earnings are virtually identical in this case, valuation on the basis of dividends is also an earnings valuation.

In some markets, the stock exchange authorities will pay particular attention to the amount of dividend paid. They regard this as a more concrete return than the more speculative nature of capital gains. The fact that the company is able to pay out a substantial cash dividend is taken as a reliable test of strength.

Cash flow

Using cash flow as a basis for valuation is essentially similar to using earnings or dividends. However, as the format of analysis based on cash flows involves setting out figures for a significant number of years ahead, the analyst is forced to spell out assumptions on such matters as capital investment and working capital requirements, inflation and timing of tax payments. In addition, risk can be incorporated more systematically by using expected values for the various components of cash flow rather than single point estimates. A computer model can be constructed by assigning probability distributions to each variable. A large number of possible outcomes are then calculated to produce a probability distribution of valuation estimates.

The snag of carrying out such a valuation in the context of corporate finance transactions is that there is rarely sufficient reliable data about a company and its many variable features to make the numerous assumptions required for the analysis. If general assumptions are made concerning estimated flows, little is gained by using the cash flow method. The net cash flow for an average year begins to look like an adjusted figure for estimated earnings. If it is assumed that cash flows continue indefinitely, the discount rate begins to look like a reflection of the multiple.

Relatively simple businesses owning a single major capital asset such as a hotel. quarry or mine may be usefully assessed by the cash flow method. The nature of the investment in such a company is quite close to a capital investment in its major asset. The discounted cash flow method has for a considerable period of time been widely used in industry to make decisions about capital investments.

Exam Question:

What are the factors influencing the pricing of a company?

Exam Solution

Flotation

In flotation, pricing is chiefly based on comparison. An investor has a choice between buying a large number of existing shares or the new one which is being floated. Although novelty can have some appeal, investor inertia and a sentiment of "better the devil you know' may prevail unless there is a tangible incentive. The pricing of a flotation is therefore normally pitched at a discount to the ratings of the most comparable companies. The ratings of comparable companies themselves of course are influenced by fundamental factors such as price earnings ratio, net asset backing and dividend yield. However, setting the price is effectively at one stage removed from these fundamentals. It must also be remembered in a flotation or any other market exercise that the average investor is buying only a small number of shares and no premium for control or access to underlying assets is appropriate.

Rights issues

As rights issues are made by definition to a company's existing shareholders, the question of pricing is not so sensitive. Most markets will have a standard approach to pricing which again is based on the principle of a discount. In this case, the discount is not so much related to comparable companies as to the price of the company's own shares. Some incentive must be given to shareholders to take up the rights issue rather than simply buying more shares in the market which is a quicker and more convenient process. It is unlikely that fundamentals will be very relevant to the pricing discount itself, although of course they may have a significant bearing on whether to proceed with the rights issue in the first place.

Placings

As in the case of a rights issue, markets normally have their own standard discounts which apply to a placing of shares to investors other than existing shareholders. In this instance, the position of the existing shareholders is highly relevant. They will wish to see the shares placed as close to market price as possible so that share price does not come under pressure. They will also be concerned if their attributable earnings or assets per share are likely to be significantly diluted.

Takeovers

In launching a takeover particularly if it is contested, some premium over market price is required if the bid is not to fall flat on its face. It is also helpful if it can be demonstrated that shareholders of the target company will receive an increase in their income. If it is possible to offer them an increase in asset and earnings backing, this will also be of some effect particularly as it deprives the defense of a major argument.

At this stage, however, valuation becomes relevant. If the price for success is too high and exceeds the valuation on a theoretical basis, the board of the bidding company must consider whether they should withdraw from the fray. In this connection it is useful to set limits in advance, even if they are somewhat flexible. On the other side of the table, the board of the defending company must consider whether they should accept an offer at this level. Even if it could be successfully resisted, is it really in the shareholders' interests to continue the struggle?