Valuing company shares
| by Peter Atrill 14 Jul 2005 Diploma in Financial Management Relevant to Subject Area 3 |
|
In practice, it may be necessary to value shares for a variety of reasons. These can include:
- takeovers and mergers
- management buyouts
- taxation
- liquidations
- stock exchange flotations.
In this article, we take a look at some of the more important methods of company share valuation and discuss their strengths and weaknesses.
The main approaches to valuation
In theory, the value of a company share can be defined either in terms of the current value of the assets held or the future cash flows generated from those assets. In a world of perfect information and perfect certainty, company share valuation would pose few problems. However, in the real world, measurement and forecasting problems conspire to make the valuation process difficult. Various valuation methods have been developed over the years to deal with these problems, but they can often produce quite different results.
The methods employed to value a company share can be divided into three broad categories. These are:
- methods based on the value of the company's assets
- methods which use stock market information
- methods which are based on future cash flows.
Asset-based methods
These methods attempt to value a company's share by reference to the value of the assets held by the company. The simplest method is to use the balance sheet values of the assets held. The balance sheet or net book value approach will determine the value of a company's ordinary share (Vo) as follows:
Vo = |
Total assets at balance sheet values - total liabilities |
| Number of ordinary shares issued |
Where the company has preference shares in issue, these must also be deducted (at their book value) from the total assets in order to obtain the net book value of an ordinary share.
This method has the advantage that the valuation process is straightforward and the data is easy to obtain. However, the balance sheet value or net book value of a share is likely to represent a conservative value. This is because certain intangible assets such as goodwill and brand names may not be recorded on the balance sheet and will, therefore, be ignored for the purposes of valuation. In addition, those assets which are shown on the balance sheet are usually recorded at their historic cost (less any depreciation to date where relevant), and this figure may be below their current market values. During a period of inflation, the current market values of assets held will normally exceed the historic cost figures recorded on the balance sheet.
When a share value based on balance sheet values is calculated, it is often done to obtain a minimum value for a share. This figure can then be compared with a market value figure in order to measure the 'downside' risk associated with making an investment in the company. Where the market value is close to the balance sheet value, the level of investment risk is usually assumed to be small. However, that is not to imply that the share values of companies do not, at times, fall below their balance sheet or net book values. There is evidence to suggest that many companies will, at some point in their history, have a market value per share which is below their net book value.
A more useful approach to share valuation is to use the current market value of assets held by a company. Current market values can be expressed either in terms of net realisable values or replacement costs. Valuation models can use both, depending on the circumstances and/or on the purpose of the valuation.
The liquidation basis will value the assets held by the company according to the net realisable values (that is, the selling price less any costs of selling) which could be obtained on an orderly liquidation of the company. The liquidation value per share can be calculated by adjusting the formula above as follows:
Vo = |
Total assets at net realisable values - total liabilities |
| Number of shares issued |
This valuation method is, however, likely to produce a conservative value because it fails to take account of the value of the business as a going concern. Usually, the going concern value of the business as a whole will be higher than the sum of the individual values of the assets when sold on a piecemeal basis.
Employing realisable values can pose a number of problems. It is important to recognise that the net realisable value of an asset can vary considerably according to the circumstances of the sale. The realisable value of an asset in a hurried sale, for example, may be considerably below what could be obtained in an orderly, managed sale. Determining hypothetical realisable values can also be difficult. Where the asset is unique, it may be particularly hard to place a reliable value on the item.
Replacement cost can also be used as an indicator of the market value of the assets held by a business. The value of a company's ordinary share, based on replacement cost, will be calculated as follows:
Vo = |
Total assets at replacement cost - total liabilities |
| Number of shares issued |
The replacement cost approach will take account of tangible assets such as plant, fixtures, stock etc, as well as intangibles such as goodwill and brands. When this is done, the figure will represent an upper limit for the market value of assets held. Determining the replacement cost of assets, particularly intangibles however, can be difficult.
Stock market methods
Where a company is listed on the stock exchange, the economic value of its shares may be reflected in the quoted share price. However, the stock exchange warns investors against placing too much reliance on share price as a reflection of the underlying value of the company. It points out that the share price is determined by the actions and opinions of private and institutional investors which: '...are the result of hope, fear, guesswork, intelligence, or otherwise, good or bad investment policy, and many other considerations.' (International Stock Exchange).
Nevertheless, in the UK, there is a considerable body of evidence which suggests that share prices do react quickly and in an unbiased manner to new information which becomes publicly available and so, in that sense, the stock market can be described as efficient. As information is fully absorbed in share prices it can be argued that, until new information becomes available, shares are 'correctly' valued. The efficiency of the stock market is largely due to the efforts of investment analysts who closely monitor listed companies in an attempt to identify undervalued shares. The activities of these analysts ensure that undervalued shares do not stay undervalued for very long as they will advise clients to buy.
Despite the activities of investment analysts, there may still be a number of reasons why, in practice, the quoted share price of a company may not reflect its economic value. It may be that, for example, not all relevant information is available to investment analysts and others in order for them to make an informed judgement on the true economic value of a business. In some cases, share prices may reflect non-economic considerations. The shares of a football club, for example, may be in demand as a result of loyalty to the club rather than for any future returns from the investment.
The quoted share price of a company is more likely to be most appropriate for marginal transactions, that is, where a small proportion of the shares are being purchased or sold. Where this is not the case, such as when an attempt is being made to gain control of the company, the quoted share price may be less reliable. In the circumstances mentioned, a premium may have to be paid to existing shareholders in order to ensure that a sufficient number of shares can be acquired.
It is possible to use stock market information and ratios to help value the shares of an unlisted company. The first step in this process is to find a listed company within the same industry that has similar risk and growth characteristics to the unlisted company whose shares you wish to value. Stock market ratios relating to the listed company can then be applied to the unlisted company in order to derive a share value. Two ratios which can be used in this way are the price earnings (P/E) ratio and the dividend yield ratio.
The P/E ratio relates the current share price to the current earnings of the company.
P/E ratio = |
Market value per share |
| Earnings per share |
The P/E ratio reflects the market view of the likely future growth in earnings and the quality of those earnings: the higher the P/E ratio, the more highly the future prospects of the company are viewed by the market. The equation above can be rearranged so that:
Market value per share (Vo) =
P/E ratio x earnings per share
The P/E ratio of the listed company can be applied to the earnings of the unlisted company in order to derive a share value. Using the rearranged equation above, the value of an ordinary share of the unlisted company is calculated as follows:
Vo = P/E ratio of similar listed company x
Earnings per share (of unlisted company)
Although the calculations are fairly simple, this valuation approach should not be viewed as a mechanical exercise. Care must be taken to ensure that differences between the two companies do not invalidate the valuation process. As you may have guessed, a potential problem with this method is finding a listed company with similar risk and growth characteristics to the company you wish to value. Other differences, such as differences in accounting policies and accounting year ends between the two companies, can lead to problems when applying the P/E ratio to the earnings of the unlisted company.
An unlisted company may adopt different policies on such matters as directors' remuneration, which will require adjustment before applying the P/E ratio. Finally, shares in unlisted companies are less marketable than those of similar listed companies and this should be taken into account. Usually, a discount is applied to the share value derived by using the above equation, although determining an appropriate discount figure can also be a problem.
The dividend yield ratio offers another approach to valuing the shares of an unlisted company. This ratio relates the cash return from dividends to the current market value per share and is calculated as follows:
Dividend yield = Gross dividend per share x 100
Market value per share
The dividend yield can be calculated for shares listed on the stock exchange as both the market value per share and gross dividend per share will normally be known. However, for unlisted companies, the market value per share is not normally known and therefore cannot normally be applied. The equation can be expressed in terms of the market value per share by rearranging as follows:
Market value per share (Vo) =
Gross dividend per share x 100
Dividend yield
This re-arranged equation can be used to value the shares of an unlisted company. For this purpose, the gross dividend per share of the unlisted company, whose shares are to be valued, and the dividend yield of a similar listed company is used in the equation.
This approach to share valuation, however, has a number of weaknesses. Once again, we are faced with the problem of finding a similar listed company as a basis for valuation. We must also recognise that dividend policies may vary considerably between listed and unlisted companies. Unlisted companies, for example, are likely to be under less pressure to distribute profits in the form of dividends than listed companies. Dividends represent only part of the earnings stream of a company and to value a company's shares on this basis may be misleading. The valuation obtained will be largely a function of the dividend policy adopted by the company (which is at the discretion of management) rather than the earnings generated.
Cash flow methods
The cash returns from holding a share take the form of dividends received. Using an economic concept of value, it is possible to view the value of a share in terms of the stream of future dividends which are received. The value of a share will be the discounted value of the future dividends received and can be shown as:
| Vo = | d1 |
+ |
d2 |
+ |
..... |
dn |
| (1 + r) | (1 + r)2 | (1 + r)n |
Where:
d = the dividend received in periods 1 to n
r = the required rate of return on
the share
Although this model is theoretically appealing, there are practical problems in forecasting future dividend payments and in calculating the required rate of return on the share. The first problem arises because dividends tend to fluctuate over time. If, however, dividends can be assumed to remain constant over time, the discounted dividend model can be reduced to:
| Vo = | d1 |
| r |
Where d1 = the dividend received at the end of period 1
The assumption of constant dividends, however, may not be very realistic as many companies attempt to increase their dividends to shareholders over time.
Where companies increase their dividends at a constant rate of growth, the discounted dividend model can be simplified to:
| Vo = | d1 |
| (r - g) |
Where: g = the constant growth rate in dividends.
Sometimes, an attempt may be made to forecast dividend payments for the next few years of the company's life. After this time horizon, forecasting may become too difficult and so a constant growth rate may be assumed for the remaining period. Although avoiding one problem, this approach creates another problem of deciding on an appropriate growth rate to use.
The use of dividends as a basis for valuation can create difficulties because of their discretionary nature. Different companies will adopt different dividend payout policies. In some cases, no dividends may be declared by a company for a considerable period. There are, for example, high-growth companies which prefer to plough back profits into the company rather than make dividends.
Another approach to share valuation is to value the free cash flows which are generated by a company over time. The free cash flows represent the cash flows available to lenders and shareholders after any new investment in assets: they are equivalent to the net cash inflow from operations after deducting tax paid and cash for additional investment. Thus free cash flows can be derived as follows:
£ |
|
| Cash received from sales | x |
| - Cash operating expenses | (x) |
| - Tax paid | (x) |
| - Cash for investment | (x) |
| Free cash flows | x |
In order to value shares using free cash flows, we have to discount the future free cash flows over time using the cost of capital. The process is similar, therefore, to the NPV calculations undertaken when appraising investment opportunities. The present value of the cash flows, after deducting amounts owing to lenders, will represent that portion of the free cash flows which accrue to the equity shareholders. Hence, the value of an ordinary share will be:
| Vo = | Present value of future free cash flows - debt |
No. of ordinary shares issued |
The free cash flow approach represents a number of practical problems. One major problem is that of accurate forecasting. Sometimes, free cash flows may be forecast over a manageable time horizon, say five years, and then a terminal value substituted for free cash flows arising beyond that period in order to deal with this. However, determining the terminal value is, in itself, a problem - and an important one - as it may be a significant proportion of the total cash flows. Another approach to the forecasting problem is to assume a constant growth rate over time, just as we did with dividends earlier. The value of the business as a whole (Vb) would be:
| Vb = | c1 |
r - g |
Where:
c = free cash flows in the following
year
r = the cost of capital
g = the constant rate of growth in
free cash flows.
Once again, the value of any debt would have to be deducted from the figure obtained from this calculation in order to derive the value of equity shares.
We can see that the discretionary policies of management concerning investments can have a major influence on the free cash flow figure calculated. In practice, free cash flows are likely to fluctuate considerably between periods. Unlike earnings, management has no incentive to smooth out cash flows over time. For valuation purposes, however, it may be useful to smooth out cash flow fluctuations between periods in order to establish trends over time.
Which method should be used?
When deciding on the appropriate valuation model to employ, it is important to consider the purpose for which shares are being valued. Different valuation models can be appropriate for different circumstances. For example, an 'asset stripper' (that is, someone who wishes to acquire a company with a view to selling off its assets) would probably be most interested in the liquidation basis of valuation. However, a financial adviser to a new company being floated on the stock market may rely heavily on the P/E ratio method. We saw earlier that this approach takes account of share values of similar companies already listed on the stock exchange.
In many cases, it is appropriate to use more than one method of valuation. Where share valuations are used as basis for negotiation, different methods can be used to help set boundaries within which an agreed share value will be determined. This agreed figure will usually be influenced by various factors including the negotiating skills and the relative bargaining position of the parties.
Summary
In this article, we have examined some of the more important methods of share valuation. We have seen that all of the methods have their limitations and so it is often useful to rely on more than one method when seeking to establish the value of a share.
Peter Atrill is examiner for Module B of the Diploma in Financial Management