Basic Business Valuation Principles

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Basic Business Valuation Principles
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Income Statement
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IAS 18

• Significant risks and rewards transferred
• Seller retains no control
• Revenue can be measured
• Economic benefits will probably flow to the
  seller
• Costs can be measured
• Stage of completion can be measured (applicable
  to services only).

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Problem of Revenue Recognition

• Warranties
• Premium
• Vouchers
• Subscriptions
• Loyalty reward
• Services guarantee

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Research and DevelopmentIAS 38

• Research phase -original and planned
  investigation undertaken with prospect of gaining
  new scientific or technical knowledge
• All of the costs associated should be written off
  as incurred

• Development phase the application of research
  findings or other knowledge to improve or
  substantially develop company products, services
  or processes
• Development costs must be capitalized if
• The project is technically feasible.
• There is an intention to complete the intangible
  asset and use or sell it.
• The enterprise has the ability to sue or sell the
  asset.
• It must be clear how the intangible can be used
  or how it could be sold.
• The company has adequate resources to complete
  the project.
• The expenditure associated with the intangible
  asset can be reliably measured.

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Foreign Exchange Gains

• Gains on trading transactions are reported as
  reductions in operating expenditures
• Gains on financing transactions are reported as
  part of finance charges.

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Government Grants

• Revenue grants treated as income when related
  expense is incurred
• Capital grants treated as deferred credit.

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Leasing Accounting Treatment

• Capital Leases immediate recognition of total
  sale value of assets under lease based on the
  revenue receivable

• Operating Lease recognizing rental receipts
  over lease term as profit

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Criteria for Finance Leases IAS 17

• Criteria
• Ownership is transferred at the end of the lease
  or
• There is a bargain purchase option
• Leases term is for the major part of the assets
  economic life
• Present value of minimum leases payments is
  substantially all of the fair value of the leased
  asset
• Assets are of a specialized nature
• Residual value fluctuations belong to the lessee
• Lessee can extend the lease at a below market
  rental

• Comment
• This would effectively be payment by installments
• If the asset can be bought below its fair value
  then it is a bargain
• Typically 75 of the assets life is the
  benchmark
• Fair value can be read as cash price.
  Substantially all normally equates to 90
• If only the lessee can use them its the lessees
  asset
• This would be an indicator of where the economic
  risks and rewards lie
• The secondary period brings the lessee closer to
  economic ownership

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All leases are a form of debt (irrespective of
accounting treatment)

• Add back the existing rental to EBIT (and adjust
  taxes if appropriate)
• Capitalize the rental as an obligation (debt) and
  an asset
• Charge interest on the debt
• Charge depreciation on the capitalized asset

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Signs of Trouble relating to Revenues

• Unexpected changes in revenues
• Increasing disparity between profit and cash
• Unexpected ballooning of accounts receivable
• Change in segment mix, especially unexpected
  and/or inconsistent with strategy
• Significant revenues or increasing proportion
  coming from a related party.

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Reference

• Nick Antill and Kenneth Lee,
• Company Valuation under IFRS Interpreting and
  Forecasting Accounts Using International
  Financial Reporting Standards,
• Harriman House, 2005

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Given Company A and Company B are identical in
all respects except that Company A owns its fixed
assets while Company B leases its fixed assets
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Different rates of return because of risk
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Valuation is different because risk is different
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Basic Principles in Business Valuation
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Value is Based on Prospects
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Operational decisions drive the price and margin
positioning of the companys products (services)

• Investment decisions involve the companys use of
  both current and capital assets.

Financial decisions determine the companys
financial leverage and dividend policy
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Factors to be considered in business valuation

• Nature and history of the business is it an
  asset holding company or an operating business?
  Is there any prior transactions?
• Industry and types of company Is it a growth
  business? Is the business cyclical/ what is the
  competition? What is the economic outlook that
  may affect the subject business?
• Level of Sales and profit margin
• Financial strength/ tangible asset backings
• Management strength and weakness
• Distribution networks
• Liability issues are there identifiable or
  contingent liabilities? Are there proposed
  changes in safety or environmental regulations
  that may affect the industry?

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Industry x Competitive Position Profitability

• Two things determine a company's
  profitability-the industry in which it competes
  and its strategic position in the industry
  (Michael E. Porter)

Michael E. Porter is a leading authority on
competitive strategy and the competitiveness and
economic development of nations, states, and
regions. He is the Bishop William Lawrence
University Professor, based at Harvard Business
School.
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Industry Analysis Competitive Strategy
Aims to establish a profitable and sustainable
position relative to industry competitors.
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5 competitive forces that determine industry
attractiveness through their collective effect on
prices, costs, and required investment
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• Entry of new competitors barriers of entry,
  economies of scale, product differentials, brand
  identity, capital requirements, access to
  distribution channels, switching cost to buyers,
  government policy, cost advantages.
• Threat of substitutes relative price and
  performance, switching costs to buyers
• Bargaining power of buyers buyer concentration,
  buyer volume, buyer information, available
  substitutes, switching costs, price sensitivity
• Bargaining power of suppliers differentiation
  of inputs, presence of substitute inputs,
  supplier concentration, importance of volume to
  supplier, threat of forward integration
• Rivalry among existing competitors industry
  growth, fixed-Variable costs, value added,
  product differences, brand identity, diversity of
  competitors, exit barriers, informational
  complexity

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Reference

• Michael E. Porter, Competitive Strategy The Core
  Concepts, Free Press, New York, 1985, 1998
• Michael E. Porter, Competitive Advantage, Free
  Press, New York, 1985

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The Need for Financial Statement Analysis
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Earnings quality is of paramount importance

• While accounts are prepared in accordance with
  the generally accepted accounting principles,
  distortion can arise because many of the entries
  are subject to management decision or discretions
  that may prove to be inaccurate or they may be
  misleading.
• The companys operations themselves are never
  completely smooth and often contain one-time
  events which may not recur in the future.

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Three goals of financial analysis and adjustment

• Understanding of the relationships existing in
  the profit and loss statement and the balance
  sheet, including trends over time, to assess the
  risk inherent in the business operations and the
  prospects for future performance.
• Comparison with similar businesses to assesses
  risk and value parameters.
• Adjustment of historical financial statements to
  estimate the economic abilities of and prospects
  for the business

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Hong Kong Financial Reporting Standards (HKFRS)

• Effective from 1 January 2005

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Effect of IFRS on Reported Earnings in HK

• IASBs shift
• Income Statement Balance Sheet
• Measure Assets and Liabilities with Fair
  Value
• More one-off items on Income Statement
• Change in Fair Value of Investment Properties on
  Income Statement
• Impairment of Goodwill

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Net Income Cannot be Taken at Face Value

• Recurring earnings
• Can be used in year-to-year comparison
• Can be used in calculating P/E ratio

• Transitory earnings
• Restructuring charges
• Acquisition expenses
• Asset sale gain/loss
• Realized Investment gain/loss
• Litigation charges
• Goodwill amortization
• Tax adjustment

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Financial Misreporting The Seven Shenanigans

• Recording revenue before it is earned
• Inventing revenue
• Boosting profits with nonrecurring items
• Shifting expenses to later periods
• Failing to disclose and/or record liabilities
• Shifting income to later periods
• Shifting expense to earlier periods

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Red flags warning of an impending decline in
earnings quality

• Adoption of less conservative accounting
  practices, such as using a longer life for
  depreciation purposes.
• One-time transactions to generate gains, such as
  tax deals or asset sales.
• Operating actions designed to accelerate the
  recognition earnings, such as speeding up
  shipments to customer.
• Inclusion of past profits in the current period.
• Early adoption of new accounting standards that
  boost earnings
• Reduction of managed costs, such as Research and
  Development, maintenance, or advertising.
• Not fully allowing for bad debts, warranty
  obligations, returns, and other future costs of
  current sales.
• An increasing receivables period, i.e. the time
  between the recording a sale and the subsequent
  collection cash from the customer.
• An increasing reliance upon sources of earning
  outside the companys core business.
• Capitalizing types of expenses that were
  previously recognized when they were incurred.
• A major acquisition with inadequate disclosure,
  making comparisons difficult.
• Write-off of investments soon after they are
  made.
• An increasing amount of financial leverage
• A slowdown in inventory turnover.

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Further Reference

• Howard Schilit, Financial Shenanigans, 2nd
  Edition, McGraw-Hill, New York, 2002
• Martin Fridson and Fernando Alvarez, Financial
  Statement Analysis A Practitioners Guide, 3rd
  Edition, Wiley, New York, 2002

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Common Size Analysis

• A technique that enables Valuer to determine the
  component makeup of a companys balance sheet and
  income statement in relation to a critical
  component (total assts or total sales).
• When this technique is used in conjunction with a
  balance sheet, all balance sheet items will be
  represented as a percentage of net sales or
  revenues.
• As the name of the method goes, common size
  analysis can be used to compare companies of
  different sizes.

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Common-size analysis can either be vertical or
horizontal

• In vertical analysis for a given year, all
  balance sheet items are expressed as a percentage
  of total assets and all income statement items as
  a percentage of net sales.
• Horizontal analysis develops trends in balance
  sheet or income statement percentages over time.
  A particular year is designated the base year and
  percentage changes in subsequent years are
  computed.

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Financial Ratio Analysis
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Earning power the Return of Equity

• ROE
• net profit margin x asset turnover x equity
  multiplier
• Net Income x Sales x Assets
• Sales Assets Equity (Book Value)
• (the DuPont formula)

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Other financial ratios

• Liquidity ratios demonstrate the companys
  ability to meet its current (short-term)
  obligations.
• Current Raito Current assets
• Current liabilities
• Quick Ratio Current Assets Inventories
• (Acid-Test) Current Liabilities

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Other financial ratios

• Asset Management or Activity Ratios measures how
  effectively a company manages its assets.
• Accounts Receivable Turnover Sales
  
• Accounts Receivable
• or Average Collection Period (Days)
  365
• Accounts Receivable Turnover
• Inventory Turnover Cost of Goods Sold
• Inventories
• or Average Days Inventory 365
  
• Inventory Turnover
• A slow (low) inventory turnover means a long
  average holding period. It would put a strain on
  the companys liquidity and may indicate obsolete
  or otherwise undesirable inventory. A too fast
  (high) inventory turnover may indicate that sales
  are being lost due to insufficient inventory on
  hand.

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Other financial ratios

• Cash Conversion Cycle
• Days in inventory Days in accounts receivable
  Days in accounts payable
• The cash conversion cycle is a rough measure of
  the time it takes for a companys operations to
  produce cash, beginning with the initial
  inventory investment.
• Working Capital Turnover Sales
• Working Capital
• If a companys current ratio, accounts receivable
  collection period, and inventory turnover remain
  constant as sales go up, the working capital must
  rise, because the company will have to carry more
  receivables and inventory to support the
  increased sales level. A high ratio of sales to
  net working capital results from a favourable
  turnover of accounts receivable and inventory and
  indicates efficient use of current assets. But a
  high sales-to-net-working-capital ratio also can
  indicate risk arising from possibly inadequate
  short-term liquidity.

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Other financial ratios

• Debt Management Ratios
• Cash Flow Coverage
• Cash Flow from Operations
• Total Debt
• Interest Coverage
• Earnings before Interest and Tax (EBIT)
• Interest Expense

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Further Reference

• Krishna G. Palepu, Paul M. Healy, and Victor L.
  Bernard, Business Analysis Valuation Using
  Financial Statements, 3rd Edition, South-Western
  College Publishing, 2003

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Further Adjustments

• Non-operating Items
• Redundant assets
• Depreciation
• Management Compensation and Perquisites
• Occupancy Costs
• Discretionary items

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Financial statement adjustments are made for the
purpose of assisting the Valuer in reaching a
valuation conclusion.

• Adjustments made should be fully described and
  supported.
• If the Valuer is acting as a consultant to either
  the buyer or seller in a proposed transaction,
  the adjustments should be understood by the
  client.

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Financial Statement Forecasting
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, the careful estimates of security analysts
(based on industry studies, plant visits, etc.)
do little better than those that would be
obtained by simple extrapolation of past trends,

• Burton G. Malkiel,
• A Random Walk Down Wall Street, W.W. Norton
  Company,
• Revised and Updated Edition, 2003

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Example

• The Park Company runs a retail chain.
• It started its operation 3 years ago by opening
  on average 3 new stores per year.
• After this 3-year growth, Park Company plans to
  just open 2 more new stores in the coming four
  years only.
• The opening costs for a new store, excluding
  fixed assets, are approximately 35,000.
• It appears that a new store takes one year to
  mature.
• Park Company has shown the following results from
  operations

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Unscrupulous Projection
Year
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Suggested answer
Analysis Year 1 3 immature stores produced
30 Year 2 3 mature stores and 3 immature
stores produced 90 i.e. 3 mature stores
produced 60 Year 3 6 mature stores and 3
immature stores produced 150 i.e. 6 mature
stores produced 120 Year 4 9 mature stores and
2 immature stores will produce 180 20
200
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If Park Company opens no new store in Year 5
Year 5 11 mature stores will produce 220 Year
6 If no new store come forth, the net income
before tax will still be 220 assuming
everything remains the same
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Actual Performance
Year
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Product Life Cycle
Sales
Maturity
Decline
Expansion
Development
Product Life Cycle
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Percent-of-sales method

• Once the sales have been forecasted, the Valuer
  should try to develop a pro forma income
  statement and balance sheet.
• The most commonly used technique is the
  percent-of-sales method, which is to express
  income statement and balance sheet items as a
  percentage of future sales.
• This method is viable when variable costs as well
  as most current assets and liabilities vary
  directly with sales.

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The percent-of-sales method follows a simple
three-step process

• Forecast the future periods sales.
• Determine which financial statement items have
  varied directly with sales in the past. This will
  be a good indication of whether those same
  accounts will vary with sales in the future.
• Forecast all income statement and balance sheet
  items that vary directly with sales. Obtain
  independent forecasts of those items that do not
  vary with sales.

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Typical Forecasting Techniques for Financial
Variables
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Forecasting growth

• The above shows the forecasted sales of a
  business for eight years.
• The eight-year period is called the explicit
  forecast period, with the eighth year being the
  forecast horizon.
• The initial forecasted growth rate is 10, but
  high growth attracts competition and eventually
  the market becomes saturated.
• Therefore, population growth and inflation
  determine the long-term sustainable growth rate
  for most companies that have no international
  market sales.

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Then, the forecasted financial statement of the
coming year is presented as follows
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Business Valuation Approaches
The concepts, processes, and methods applied in
the valuation of businesses are the same as those
for other types of valuations
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Asset-based business valuation approach

• The asset-based approach should be considered in
  valuations of controlling interests in business
  entities that involve one or more of the
  following
• An investment or holding business, such as a
  property business or a farming business
• A business valued on a basis other than as a
  going concern

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Asset-based business valuation approach (contd)

• Like the cost approach in the valuation of real
  property, the asset-based approach should not be
  the sole valuation approach used in assignments
  relating to operating businesses appraised as
  going concerns because it cannot be easily
  applied to intangible assets.
• This approach is generally considered to be a
  floor value for a company being valued as a
  going concern.

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Asset-based business valuation approach (contd)

• For this reason, the asset-based approach is
  generally not used for the following types of
  business valuation assignments
• Service businesses
• Asset-light businesses
• Operating companies with intangible value
• Minority interest, which have no control over he
  sale of the assets (because the minority
  shareholder does not have the ability to
  liquidate the assets.)

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Income approach to business valuation
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(Direct) capitalization of income

• A representative income level is divided by a
  capitalization rate or multiplied by an income
  multiple to convert the income into value.
• This method is most appropriate to valuation of a
  business that is not too asset intensive.

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(Direct) capitalization of income (contd)

• Income can be a variety of definitions of income
  and cash flow. Some of the more common
  definitions include
• Net income after tax
• Net income before taxes (pretax income)
• Cash flow (gross or net)
• Debt-free income
• Debt-free cash flow (gross or net)
• Earnings before interest and taxes (EBIT)
• Earnings before depreciation, interest and taxes
  (EBDIT)

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Earning or Cash Flow?

• Investors are generally less interested in net
  profit on an accounting basis, and more
  interested in the amount of cash generated by a
  particular business which will be available to
  them for discretionary spending and investment.
• Free cash flow to equity may also be viewed as
  being less prone to manipulation by management
  than earnings.

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Earning or Cash Flow? (Contd)

• Value is created when it is earned, even on
  accounting basis, rather than when cash is
  collected.
• Anyway, earnings and cash flow are highly
  correlated, particularly over the long run.

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MillerModigliani Theorem

• In a world of no tax and default, the value of a
  firm is independent of its capital structure,
  i.e. the capital structure or financial mix
  should have no effect on the firm value.

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The Use of EBIT or EBDIT

• Because of the MillerModigliani Theorem, broader
  measures of income, like EBIT or EBDIT can be
  more appropriate as measure of firms value
  though the firm may have varying capital
  structures

Modigliani won the Nobel prize in economics in
1985 and Miller in 1990.
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VL VU TD (PV of expected costs of financial
distress) (PV of agency cost)

• The addition of financial distress and agency
  costs results in a trade-off.
• The optimal capital structure can be visualized
  as a trade-off between the benefit of debt (the
  interest tax shelter) and the costs of debt
  (financial distress and agency costs).

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Value of a Firm is partially a function of
Leverage
Value of Firm V
Pure MM value of Firm VL VU TD
Present Value of Tax Shield TD
PV of Financial Distress and Agency Costs
VU
Value of Levered Firm VL
Debt
0
A
B
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The Trade-off Model

• The trade-off models enable us to make three
  statements about leverage
• Firms with more business risk ought to use less
  debt than lower-risk firms, other things being
  equal, because the greater the business risk, the
  greater the probability of financial distress at
  any level of debt, hence the greater the expected
  costs of distress. Thus, firms with lower
  business risk can borrow more before the expected
  costs of distress offset the tax advantages of
  borrowing (Point B).
• Firms that have tangible, readily marketable
  assets such as real estate can use more debt than
  firms whose value is derived primarily from
  intangible assets such as patents and goodwill.
  The costs of financial distress depend not only
  on the probability of incurring distress but also
  on what happens if distress occurs. Specialized
  assets and intangible assets are more likely to
  lose value if financial distress occurs than are
  standardized, tangible assets.
• Firms that are currently paying taxes at the
  highest rate, and that are likely to do so in the
  future, should use more debt than firms with
  lower tax rates. High corporate taxes lead to
  greater benefits from debt, other factors held
  constant, so more debt can be used before the tax
  shield is offset by financial distress and agency
  costs.

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The Trade-off Model (Contd)

• According to this trade-off models, each firm
  should set its target capital structure such that
  the costs and benefits of leverage are balanced
  at the margin, because such a structure will
  maximize its value.
• If this is correct, firms within a given
  industry should have similar capital structure
  because such firms should have roughly the same
  types of assets, business risk, and profitability.

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Consistency is more important

• No matter which income base is adopted, the
  capitalization rate used must be appropriate for
  the definition of income used.

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Discounted cash flow analysis

• Cash receipts are estimated for each of several
  future periods.
• These receipts are converted to value by the
  application of a discount rate using present
  value techniques.
• The timing of cash inflows and cash outlays are
  important as well as the amount of the receipts.
• The discount rate must be appropriate for the
  definition of cash flow used.
• where P0 present value or market price
• r investors required rate of return
• C1, C2, C3 expected income flows in
  periods 1, 2, 3

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Example Using the Discounted Future Income
Method to Estimate the Value of a Business
Terminal Value Estimate
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Example Using the Discounted Future Income
Method to Estimate the Value of a Business
(contd)
Terminal Value Estimate Assuming discounted rate
at 25
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Principal difficulties with the discounted cash
flow technique

• Long-term cash flow projections are subject to
  substantial error.
• The choice of the discounting horizon, the point
  of competitive equilibrium, is also uncertain.
• The terminal value, which often accounts for 70
  of the final valuation, is subject to the highest
  error

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Discretionary earnings

• Net Operating Profit
• Gross sales Cost of goods sold Operating
  expense
• or
• Net Income (after-tax)
• Income tax
• Interest Expenses
• Depreciation
• One-time, nonrecurring expenses
• All owners compensation and perquisites

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Sustainable Capital Reinvestments

• The capital outlays required on an annual basis
  to maintain or sustain the existing business
  volume, competitive abilities etc.
• They are the non-discretionary cash flow that
  must be deducted from the net income because the
  investors return comes only from the balance of
  the cash flow (or the discretionary portion of
  the cash flow).
• They may be estimated by
• reviewing the fixed asset additions for a number
  of years to determine the amount that has been
  spent historically on maintaining existing
  capacity
• examination of the budget of the business and
• discussion with senior management

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Capitalization Rates or Discount Rates?

• Capitalization rate is indeed a divisor used to
  convert a constant stream of earnings or cash
  flow to a capital amount or value.
• It can be sometimes referred to as a multiplier
  which mathematically, is simply the reciprocal of
  a discount rate (without the projected long-term
  growth rate of future income).
• However, capitalization implicitly assumes that
  the constant earnings stream to be infinite while
  the discounting process may take into account the
  definite period of cash flow.
• Capitalization rates typically do not include an
  inflation component as the indicated
  earnings/cash flow are stated in constant
  dollars.

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Example Relationship Between Discount Rates and
Capitalization Rates
Terminal Value Estimate
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Example Relationship Between Discount Rates and
Capitalization Rates (contd)
Terminal Value Estimate Assuming discounted rate
at 25
Capitalization of income method assuming a 5
growth rate and 25 discount rate 100,000/(.25-
.05) 500,000
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A Function of Risk

• Both the capitalization rate and the discount
  rate are reflections of perceived investment
  risk.
• Risk here means the degree of uncertainty as to
  the realization of expected future returns.

Expected
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• High capitalization rates or low earnings
  multiples are associated with highly risky or
  uncertain earnings expectations.
• Conversely, low capitalization rates or high
  earnings multiples are associated with good
  prospects for growth in earnings.

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The Efficient Frontier
Expected return
Volatility of Returns
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Estimating the Discount Rate

• Establishing the proper discount rate is one of
  the most difficult and, at the same time,
  critical parts of a valuation.
• A cursory check of the rates of return and
  dividend yields in terms of the selling prices of
  corporate shares listed on the major exchanges
  will give no ready or simple solution.
• Wide variations will be found even for companies
  in the same industry.
• The ratio will fluctuate from year to year
  depending upon the economic conditions.

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The Required Rate of Return

• In essence, the capitalization rate or discount
  rate is a combination of the opportunity cost
  plus a premium for risk associated with obtaining
  the expected returns.
• If you pay the market value, (provided that
  markets are efficient), you must earn the cost of
  capital on the investment. The expected economic
  return equals the cost of capital.

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Cost of Capital an Opportunity Cost

• Cost of capital for a given investment is the
  minimum risk-adjusted return required by
  shareholders of the firm for undertaking that
  investment
• Unless the investment generates sufficient funds
  to repay suppliers of capital, the firms value
  will suffer
• This return requirement is met only if the net
  present value of future project cash flows, using
  the projects cost of capital as the discount
  rate, is positive.

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Weighted Average Cost of Capital (WACC)
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WACC

• Cost of Equity x percentage of Capital in
  Equity
• Cost of Debt x percentage of Capital in Debt

E
D i.e. re ---------- rd (1-t) ---------------
E D E
D where E the total market value of the
companys equity D the total market value of
the companys debt re the cost of equity rd
the cost of debt t the companys effective
tax rate and re gt rd
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Cost of Equity

• The cost of equity is the rate used to capitalize
  total corporate cash flows
• It is the weighted average of the required rates
  of return on the firms individual activities
• It is a function of the riskiness of the
  activities in which the firm engages
• Thus, the cost of equity capital for the firm as
  a whole may not be used as a measure of the
  required return on equity investment in future
  projects unless these projects are of a similar
  nature to the average of those already being
  undertaken by the firm.

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Capital Asset Pricing Model

• CAPM is a basic theory that relates risk and
  return for any asset.
• It is based on the concept that the required rate
  of return for an asset is directly related to the
  riskiness of the asset.
• Risk here means the degree of uncertainty as to
  the realization of expected future returns. CAPM
  therefore measures risk in terms of the relative
  volatility of the asset price.
• Greater risk requires a higher rate of return.
• R Rf ß(ER) CS
• where
• R discount rate, Rf risk-free rate, ß
  beta, ER equity risk premium, CS
  company-specific risk factor

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Two Components of Risk
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Systematic Risk v. Unsystematic Risk

• Systematic risk, which is also known as the
  market risk, is the uncertainty of future returns
  due to the sensitivity of the return on the
  subject investment to movements in the return for
  the investment market as a whole.

• Unsystematic risk is a function of
  characteristics of the industry, the individual
  company, and the type of investment interest.

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Importance of CAPM

• To the extent that the capital market theory
  assumes investors can hold or have the ability to
  hold common stocks in large, well-diversified
  portfolios, the unsystematic risk or the
  company-specific risk would be eliminated or
  negligible.

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Only Systematic Risk matters

• As a result, the only risk pertinent to a study
  of capital asset pricing theory is systematic or
  market risk, i.e.
• E(Ri) Rf ßE(Rm) Rf
• which is sometimes called the Security Market
  Line equation where
• E(Ri) Estimated Cost of Equity
• Rf Risk-free Rate
• Rm Estimated market return
• ß Beta of the equity of the company
• Alternatively,s2i ß2i . s2m s2e

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Security Market Line
Rate of Return
Risk Premium
Rf
Risk (ß)
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Measure of Rf

• The risk-free rate (Rf) is the return on
  risk-free investment.
• The rates of US treasury bonds are often used as
  standard risk free rates to be used in comparison
  with other investments.
• In Hong Kong, a popular choice is the Exchange
  Fund Notes that are issued by the Hong Kong
  Monetary Authority (HKMA).

10-year HKMA Exchange Fund Notes were only
introduced in October 1996
103
Yield Curve or the Term Structure of Interest
Rates
104
Measure of ß

• The beta (ß) measures the amount of systematic
  risk of the equity relative to the market.
• It can be estimated by regressing the historic
  returns of a stock against the corresponding
  returns of a stock market index because
• E(Ri) Rf ßE(Rm) Rf
• gt E(Ri) (1 - ß)Rf ßE(Rm)

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Alternative Computation of WACC

• WACC Expected return on the assets of the
  company
• because if a company wants to invest into new
  assets, it must finance the purchase either by
  debt or by equity, i.e.
• WACC Rf ßaE(Rm) Rf
• where Rf Risk-free Rate
• Rm Estimated market return
• ßa Beta of the assets of the company

106
Equity beta v. Asset beta

• Equity beta Asset beta (Asset beta x
  Debt/equity ratio)
• or if the issue of tax is considered
• D
• ße ßa ßa (1- t) ----
• E
• (1- t) D
• ßa 1 -----------
• E
• ße
• gt ßa ----------------- 1 (1- t)D/E
• where ße Beta of equity of the company

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Measurement of Market Risk Premium
Arithmetic Average R1 R2 .RT T
Geometric Average (1R1) (1 R2) .. (1
RT)1/T - 1
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Arithmetic Average v. Geometric Average

• Geometric average is usually less than Arithmetic
  average
• The larger the stock market return fluctuations,
  the greater the difference between arithmetic and
  geometric average
• While geometric average is often used in
  measuring the historical return realized in the
  past, arithmetic average is more widely used in
  estimating the expected return in the future.

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Past ? Future

• Market Risk Premium realised in the past may not
  be what investors expect for the future

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Dividend Growth Model (DGM)

• P0 __ D1__ __ D2_ _D3_ D4
  .
• (1k) (1k)2 (1k)3 (1k)4
• where P current stock price
• D dividends expected at the end of year 1
• k discount rate
• and D2 D1 (1g), D3 D1 (1g)2
• which may be expressed as
• P __ D1__
• k - g
• where g constant growth rate in the long-run.

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A Rate Interpreted from Market
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A 1 rise in industry-forecasted earnings growth
cause a 5 to 8 boost in industrys
price-earnings ratio

• Steven A. Sharpe, How Does the Market Interpret
  Analysts Long-Term Growth Forecasts? Finance
  and Economics Discussion Paper Series 2002-7,
  Federal Reserve Board, 2002

117
Assumptions Underlying CAPM

• Investors are risk averse, only choosing between
  different portfolios on the basis of expected
  rates of return and the risk involved, risk being
  defined as the variability of the expected rate
  of return.
• Rational investors seek to hold efficient
  portfolios that is, portfolios that are fully
  diversified.
• All investors have identical investment time
  horizons (i.e. expected holding periods).
• All investors have identical expectations about
  such variables as expected rates of return and
  how capitalization rates are generated.

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Assumptions Underlying CAPM (contd)

• There are no transaction costs.
• There are no investment-related taxes (save for
  the corporate income taxes).
• All investors can borrow or lend an unlimited
  amount at a given risk-free rate of interest..
• The market has perfect divisibility and liquidity
  (i.e. investors can readily buy or sell any
  desired fractional interest).

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Failure of CAPM

• The statistical distribution of returns is
  unknowable a priori Market is not necessarily
  efficient
• Investors averse to downside risk, as opposed to
  variance
• Unsystematic variables like market cap, book
  value of equity and P/E ratio prevail.

120
Closely-Held Business v. Publicly Traded Company

• Small and mediumsize businesses which have
  little, if any, prospects of going public are
  difficult to compare with publicly traded
  companies in the stock market because of the
  following
• Size of the company
• Depth of management
• Financial structure
• Product diversification
• Reliance on major customers
• Reliance on major suppliers
• Geographical diversity of customers
• Length of time in business
• Pattern of earnings
• Economic factors of special concern to the
  company

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Decomposition of Risk

• E(Ri) Rf RPm RPs RPu
• where
• E(Ri) the required rate of return for cashflow
  i
• Rf the risk-free rate
• RPm Equity risk premium for the market
• RPs Risk premium for small size
• RPu Risk premium for specific company

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Reference

• Richard A. Brealey, Stewart C. Myers, Franklin
  Allen, Principles of Corporate Finance, 8th ed.,
  New York McGraw-Hill/Irwin, 2006
• Aswath Damodaran, Investment Valuation Tools and
  Techniques for Determining the Value of Any
  Asset, 2nd ed., New York John Wiley Sons,
  Inc., 2002

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Example Using Comparable Public Companies to
Calculate a Discount Rate
Long-term treasury bond yield at valuation date
(RFR) 0.07 Equity risk premium per 1993 SBBI
(ER) Historical return on common stocks
0.124 Historical return on longterm govt.
bonds - 0.052 0.072 Company-specific
risk factor (CS) 0.07 Discount rate Rf
ß(ER) CS .07 1.5(.072) .07 0.248
Rounded to 0.25
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Matching the Discount Rate to the Income Stream

• For a growing business, net cash flow is
  typically projected as follows
• Net income (after tax)
• Non-cash charges (e.g. Depreciation and
  amortization)
• Cash needed for asset replacement
• - Increase in working capital needed as the
  business grows
• Increase in debt to finance business growth

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Matching the Discount Rate to the Income Stream
(contd)

• Cash needed for asset replacement will generally
  exceed depreciation and amortization.
• Therefore, when net income is used as the income
  stream, an upward adjustment should be made to
  the discount or capitalization rate.
• This adjustment should be proportionate to the
  ratio of net income to net cash flow.
• For example, assume net income is 60,000 and net
  cash flow is 50,000. Also assume the net cash
  flow discount rate is 20. The net income
  discount rate would be 24 as follows
• 60,000/50,000 1.2
• 20 x 1.2 24
• Other valuers feel the difference between net
  cash flow and net income, in the long run, is
  usually small and can generally be ignored or
  included in the company-specific risk factor.

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Examples of inadequate valuations

• Valuation is out of date.
• Limited or no management interviews/analysis.
• Faulty or baseless assumptions
• Inadequate selection/analysis/explanation of data
• Inadequate support for valuation risks, multiples
  or adjustments
• Arbitrary application of discounts
• No mention of hypothetical buyer or seller
• Absence of discussion of asset composition or
  earnings/revenues history
• Absence of discussion of dividend history
• Data selected has little comparative elements or
  are limited
• Failed to use all applicable approaches/methods
  or explain their absence of use

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Valuation Selecting Methods and Adjustments
Type of Technology

• Diachronic Techniques
• DCF at variant rate
• Diachronic multiples
• analysis

Emerging
Established or mature
Life stage
Startup
Established
Firm Size

• Unsystematic risk adjustments
• Size
• Control
• Illiquidity

Small
Large
Control
Shareholding
Minority
Liquidity
Nonquoting
Quoting
Economy
Country risk adjustment
Emerging
Developed or mature
Operating Condition
Asset-based approach
In liquidation
Going concern
Classical approaches
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Reference

• Luis E. Pereiro, Valuation of Companies in
  Emerging Markets A Practical Approach, New York
  John Wiley Sons, Inc., 2002