Business valuation is ‘an art not a science’. These are the words used by many ACCA financial management tutors (including myself) when introducing this topic to students preparing for Papers F9 or P4. The words imply that when trying to value the equity capital of a business, there is range of possible correct answers, all of which can be justified as being the most appropriate. To a certain extent this is true but, as I like to put it, ‘there are different degrees of correctness’.
Reviewing the past Paper F9 and Paper P4 exams demonstrate how important business valuation is within the ACCA financial management syllabuses. Questions on this topic have been included in the majority of F9 papers since December 2007. The questions have tested the ‘basic’ equity valuation methods of:
- net assets
- dividend valuation model (or dividend growth model)
- earnings model using P/E ratio or earnings yield
Paper P4's syllabus builds on those methods tested at the lower level paper. The concept is the same – to find the value of equity. However, the techniques and methods are more sophisticated. As I stated above, ‘there are different degrees of correctness’.
The primary purpose of this article is to demonstrate how to tackle a Paper P4 business valuation question. The detailed understanding of this topic will be gained from your Paper P4 studies, whichever mode you choose to use. My aim is to show you how to successfully apply this knowledge under exam conditions.
Equity valuation – categorising the methods
As stated above, there are more methods and models that can be used to find an equity share price at Paper P4. The official textbooks explain these in detail and choose different ways of categorising them within their material. I prefer to take a simple view of equity valuation by allocating the methods into two main categories:
Under the first category, the question will be asking the students to ascertain an equity value for a company. The entity may be a private company and, hence, no stock market price exists or that even if the company is listed, the market price may not be appropriate for the relevant situation. The valuation methods appropriate here are:
- net assets
- dividend valuation model (or dividend growth model)
- earnings model using P/E ratio or earnings yield
- net assets + calculated intangible value (CIV)
- free cash flows (FCF)
Past Paper P4 questions have, in my view, clearly indicated which method should be used to arrive at the share price. However, it is fair to say that the free cash flow model has been tested more than any other method, especially since December 2010.
Post-acquisition valuation requires a different mindset and series of methods. Here, students will need to ascertain the value of the combined companies after acquisition. More importantly, past exam requirements have requested students to ascertain the percentage gain or loss to both groups of shareholders – those of both the buying and selling companies.
The post-acquisition valuation methods are:
- bootstrapping – applying the price earnings ratio of the buyer to the combined expected earnings of the two entities
- combining the pre-acquisition values of the two companies and appending these with the fair value of the synergies
- free cash flows (FCF) – present value of the combined companies FCF using the relevant discount rate.
As I have stated above, your Paper P4 preparation should include ample time to study and understand the equity valuation methods above, allowing you to apply your knowledge successfully in the exam room.
Below is a worked sample question illustrating how I would tackle a 25-mark exam style question, based broadly on previous Paper P4 content.
Borgonni and Venitra
Borgonni Co is a very successful entity. The company has consistently followed a business strategy of aggressive acquisitions, looking to buy companies that it believes were poorly managed and hence undervalued. Borgonni can be described as a modern day conglomerate and its business interests stretch far and wide.
Its board of directors has chosen the takeover targets with care. Always looking for companies with potential, but which were poorly managed and having a below par market value, Borgonni has maintained its price earnings (P/E) ratio on the stock market at 12.2.
Borgonni’s 2013 figures show a profit after tax of $886m and it has 375m shares in issue.
Venitra Pvt is a well-established owner-managed business. In financial terms it has a rather chequered history with its up and downs corresponding directly with the state of the global economy. Since 2008, its profits have fallen each year with the 2013 values standing at:
Profit before tax
Taxation @ 25%
Profit after tax
Number of shares in issue
However, with economists predicting an upturn in the Western economies, Venitra’s management team feel that revenue will increase by 6% per annum up to and including 2017. The company’s operating profit margin is not expected to change for the foreseeable future.
Operating profits are shown after deducting non-cash expenses (including tax allowable depreciation) of $125m. This is expected to increase in line with sales. However, the company has recently spent $210m on purchase of non-current assets. Venitra’s management believes this value will have to increase by 10% per annum until 2017 to enable the company to remain competitive. Venitra has estimated its overall cost of capital to be approximately 12%, but this assumes it will maintain its debt to equity ratio at 40:60.
Some of Venitra’s major shareholders are not so confident about the future and would like to sell the business as a going concern. The minimum price they would consider would be the fair value of the shares, plus a 10% premium. Venitra’s CFO believes the best way to find the fair value of the shares is to discount the forecasted free cash flows of the firm, assuming that beyond 2017 these will grow at a rate of 3% per annum indefinitely.
(a) As at 1 January 2014, prepare a schedule of Venitra’s forecast free cash flows for the firm. Ascertain the fair value of the Venitra’s equity on a per share basis.
(b) Borgonni intends to make an offer to Venitra based upon a share for share swap. Borgonni will exchange one of its shares for every two Venitra shares. Assuming that Borgonni can maintain its earnings rating at 12.2, calculate the percentage gain in equity value that will earned by both groups of shareholders?
(c) What factors should the Venitra shareholders consider before deciding whether to accept or reject the offer made by Borgonni?
At this stage, you can choose one of two ways to follow my approach to answering this question. My solution to each part along with the relevant explanation is shown below.
(a) Venitra – Forecast Free Cash Flows and Value of Equity
Notes and explanations:
- As we are preparing a valuation as at 1 January 2014, I have set up columns for each future period. I need to prepare a detailed forecast for the first four years only. After 2017, the FCF of the firm will increase at the rate of 3% per annum. I have started with a 2013 column just as a reference point.
- Revenue has been increased by 6% per annum using the 2013 sales as a base point.
- The operating margin in 2013 was 32% (480/1,500). This will be maintained for the foreseeable future.
- One key factor is to ignore the interest payment. FCF for the firm must EXCLUDE interest. This is because the cost of capital used to discount these flows is the company WACC. The WACC takes into account the interest element and its tax benefit.
- Income tax on company profits is charged at 25%. In this case, it is to be paid in the same year as the profits are earned.
- The operating profit is after deducting non-cash expenses, which are allowable for taxation. These include tax allowable depreciation. In this question, these expenses will increase in line with sales and they have to be added back after the tax charge has been computed.
- Venitra needs to set aside cash each year to maintain its non-current asset (NCA) base. The amount of capital expenditure will increase by 10% per annum for the next four years.
Please note that in some past Paper P4 questions, it has been assumed that the non-cash expenses equal the required investment in NCAs. Hence, the add back and deduction will cancel out.
- The forecast FCF for the firm is a simple totalling up process for the first four years. After 2017, the FCF are expected to grow at a rate of 3% per annum indefinitely. Therefore, the 2018 value is calculated as $305m x 1.03.
- As stated in point 4, the relevant discount rate to apply to the FCF of the firm is Venitra’s WACC. This has been estimated as 12%. The first four discount factors have been copied from the discount tables provided at the end of the exam paper. The discount factor for 2018 and beyond must take into account both a 3% per annum growth rate as well as a cost of capital of 12%. The financial mathematics for a delayed perpetuity with an annual growth rate is (1/(0.12 – 0.03) x 0.636).
- The value of the entity is the total of the present value of the forecast FCF. However, this amount represents a combination of the debt and equity together. Venitra’s equity is equal to 60% of the value of the firm.
- The question requirement is to ascertain the equity value per share. Therefore, $1,866m /150m = $12.44. This is the fair value of one share of Venitra.
- Finally, I have computed the P/E ratio for Venitra. Although this was not specifically asked for, this value will be needed for part (b).
(b) Percentage gain in equity value – both groups of shareholders
The first stage is to compute the current market price per share for Borgonni:
|2013 – Earnings||886|
Value of equity
No of issued shares
|Value per share (Po)|
Borgonni expects to maintain its P/E ratio after acquiring Venitra. Therefore, the post-acquisition value of the two entities combined together can be ascertained by applying Borgonni’s P/E ratio to the sum of the latest earnings of each company. As the P/E ratio of Borgonni (12.2) exceeds that of Venitra (7.23) this is known as ‘bootstrapping’.
Borgonni – 2013 PAT
Venitra – 2013 PAT
P/E ratio – Borgonni
The purchase is to be funded via a share for share exchange. Borgonni will issue one new share in its company in return for every two shares in Venitra.
Borgonni issued share capital
Additional shares issued (150m/2)
New total issued share capital
The new equity value for a Borgonni share is now $13,945m/450m = $30.99.
However, although many candidates may stop at this point (believing they have reached Utopia!) the requirement has not been addressed. The question asks candidates to ascertain the gain that will be made on the equity value to each group of shareholders. Looking at each in turn:
Borgonni shareholders’ gain (($30.99 – $28.82)/$28.82) x 100 = 7.53%
To compute the gain for the Venitra shareholders, the candidate must first compute the post-acquisition value of a Venitra share. Venitra shareholders gave up two shares in their company to receive one new Borgonni share. Therefore, the equivalent post-acquisition value of a Venitra share will be $30.99/2 = $15.50.
The fair value of a Venitra share, per part (a), was $12.44. Therefore, the Venitra shareholders gain 24.60%.
(c) Factors to consider – for the Venitra shareholders
There is no one correct answer to this part. As long as the candidate produces a reasonable number of valid points, they will earn decent marks.
My answer would read as follows:
- Venitra shareholders wanted a gain of at least 10% on the fair value of the shares. Based upon the figures, they are gaining nearly 25%, which is likely to encourage them to accept the offer.
- The share for share exchange may be beneficial for tax planning. Any capital gain earned on the sale of the shares will be rolled over until the gain is realised in cash.
- Venitra may decide to reject this bid believing that Borgonni will make a more lucrative offer in the future.
- The fair value of the Venitra shares has been based upon forecasts and estimates. Some sensitivity analysis needs to be carried out to ensure the value is robust.
- There is no guarantee that Borgonni can maintain its P/E ratio at 12.2. There may well be an element of dilution given the much lower P/E of Venitra. Hence, the post-acquisition value is then uncertain.
- Not all Venitra shareholders want to sell the company. The constitution of the company may allow the takeover to be blocked unless a certain percentage majority of the shareholders agree.
- Venitra shareholders may also feel that as the economic conditions are improving, their business prospects and value will get better. They may reject Borgonni’s approach and stay as an independent company.
As you can see, business valuation questions require you to have a disciplined approach and to demonstrate that you have studied and understand this key area of the syllabus. Although equity valuations are an ‘art not a science’, you have to produce an answer that is pleasing to the eyes of the Paper P4 examining and marking team.
Sunil Bhandari, freelance Paper P4 tutor