IFFM Blog 7. Corporate Valuation Gan Kian Siong ID No: 14045693
Dated: July 24, 2016
The essential process of a business valuation is to determine the financial value of a business or an acquiring a company, the main task is to determine the fair value. Businesses need to be valued for a number of reasons such as their purchase and sale value, obtaining a listing, inheritance tax and capital gains tax computations for M&A or partnership separation proceedings through a third party professional agency or a commercial law firm engagement (Rappaport & Sirower, 1999). Generally, valuation difficulties are restricted to unlisted companies because listed companies have a quoted share price. However, even listed companies could encounter valuation challenges. For example, when the company is assuming an effect of a takeover on the share price and how it would affect the overall capital structure would be an ongoing concern (Sherman & Young, 2016).
For example, a company usually does not follow the universal standard when comes to acquisition buyout. 1) the implications of failing to reconcile GAPP and IFRS results can be a different and adequate reason to change an acquisition process. 2) the shortcoming of the company revenue recognition practices, and rigid reconciliation of using WACC employed have caused companies to increasingly use an unofficial earnings measure to report financial performance, such as P/E, EPS, perpetual free cash flow and dividend yield are not the same bottom-line results in the shareholder payout. 3. All types of businesses have been deploying non-GAAP and non-IFRS measures for earnings for a long time, most commonly seen in the quarterly or annually financial reported using EBITDA. 4. Two companies’ stakeholders have different view and measures at their disposal to determining the value of the firm’s assets and liabilities, companies use fair value to yield capital structure variances and reconcile cross-examine the balance sheets. 5. Lastly, in the games theory for M&A, corporation stakeholders do take a strategic decision rather than decide based on book value to pay a higher premium for making acquisition deals. (Rappaport & Sirower, 1999)
A brief review of global M&As deals and the Trend
Based on Thomson Reuters M&A quarterly reviewed, in the full year assessment 2015. Table 1. The global M&A value has totaled US$4.7 trillion during 2015. There is a 42% surge in the same period of 2014 levels. The overall 42,300 global deals, 71 deals with a value greater than $10 billion were announced during 2015. While looking ahead the corporate M&A strategy for the next 12 months, according to Deloitte Table 2. M&A trends 2016 surveyed over 2,300 executives at US companies and private equity firms to scale their expectations, experiences, and plans for M&A. The sentiment and outlook for M&A activity remain favorable with significant optimism and continued M&A activities (Deloitte & Touche LLP, 2016). However, the global growth concerns have started to dampen the recent pace of activity while IMF cuts 2016 global economic growth outlooks after the Brexit vote (The Wall Street Journal, 2016).
Table 1. Source: Thomson Reuters, M&A Review full year 2015.
Table 2. Source: Deloitte, M&A Trend report 2016 Survey
In the case of M&A greatest concerns, table 3. The survey extracted from Deloitte 2013 reports found that between 37% ~ 43% of the key stakeholder failed to effectively integrate has major going concerns. For example, the company has high R&D intensity, unique brand value, high variable expenditure with hidden cost on unknown terrain and local taxations, essential cross-border training for culture differences, and excessive cost expenditure for bridging communication gaps for technical specification translations, local language translation, legal translation, employee morale and satisfaction, staff retention customer service satisfaction (Edmans, 2011).
In the operation perspective, the newly product launch acceptance by the domestic markets, high-quality defects or contaminated product disposal, finished goods debugs recalls and repairs, production inefficiency causes downtime, inventory overdue, pass due provision or aging scrap, excessive production yield loss and material loss, costly legal suits on patent rights issues, account receivable payment default etc. And as well as the corporate unique core (irreplaceable) competencies which have no easy comparator. Such intangible assets could not be fully integrated effectively when company valuation is in the bids. The stock market price does not fully value or discounted these intangibles assets, the effect could cause a major impact on an operational efficiency, capital investment, and the bottom-line results of the financial performance. In worst case scenario, if any improper leadership execution could have faltered off the corporate financial evaluation distress and chaos lead to a pitfall on shareholders retain earnings and scrutinize its corporate core values and affect the share price directly.
Nevertheless, in the wider economic and financial perspective, if the market is reasonably efficient to the market price can be trusted as a fair assessment of the value of an asset (Harrison, 2016). Most problems arise from valuing unique assets, or such as the shares of most unquoted companies.
The basic valuation approaches
Net asset values based valuation
Classify a business is estimated as being the worth of share price value of its company net assets. Fundamentally, there are various common ways of valuing a company net assets approaches, Book value, Net realizable values, Replacement value and Fairness opinions.
Some investors look at the book value is somehow controversial as the non-current assets is based on historical cost and the net current assets may not be relevant as inventory, receivable and financial related claims provision might require adjustment, and in some case report as in the impairment buckets then the book values in the earnings could be affected by accounting decisions on depreciation, write off or scrap being carried out and other variables. When accounting standards varied widely across the firms, the price book value ratios may not be comparable across to the firms. Book values may not carry much meaning for service firms which do not have significant fixed assets (Damodaran, 2011).
Stock Market Valuations
Stock market valuation of an asset would draw in the marketplace that is traded in the secondary stock exchange. Market values are also commonly used to refer to the market capitalization of a publicly-traded company and is obtained by multiplying the number of its outstanding shares by the current share price. Market values are the easiest to determine for exchange-traded instruments such as stocks and futures index since their market prices are widely spread and easily available for buy and sell in the key global stock exchange marketplaces (MSCI Index Research, 2013).
A company’s market value is a good indication of investors’ perceptions of its business prospects. The range of market values in the marketplace can be ranging from million dollars’ worth of an SME to large market capitalization of multi-billions MNE and companies (PWC, 2013). The stock market value is determined by the various common valuations by investors, companies, and institution such as P/E Ratio, EPS, Price / book ratio, Price to Cash Flow, Dividend per share etc. The higher the valuations, the greater the market value (Gallo, 2016). The volatility of the market value can vary from periods of time, and is greatly influenced by internal/external factors such as the market demand and supply conditions, economic and business cycles, technological and consumer behaviors, as well as political climates affecting policy changes and adjustments.
Table 4, below illustrate the S&P 500’s compare over 10 years’ valuation, the high variability in earnings estimates, the forward price-to-earnings (P/E) ratio indicated that the market was fairly expensive in late 2008. It also suggested that the S&P 500 was less expensive at the end of 2011 than it was during the end of the recession. In the illustrations, the forward price-to-sales (P/S) ratio seems to provide a smoother, more accurate estimation of the market’s valuation to yield returns.
This approach is widely used in generic market practice, investors relying on finding listed companies in some cluster of industries and similar businesses to the company being valued (given the target company), and then looking at the relationship they show between share price and potential returns or earnings. Using that relationship as a model, the share price of the target company can be estimated.
Simply in this approach, there is no single valuation strategy that works for all stocks in every situations. But a company’s characteristics provide indications to a seasoned investor about the best method to use, such as valuation models are usually “absolute” or “relative”.
- Absolute methods look for the true value of an investment based on a company’s fundamentals, like the dividends it pays or it cash flow.
- Relative Valuation models include the dividend discount model, the discounted cash flow model, and others.
Two Main common absolute method in the stock evaluations
The dividend discount model calculates the present value of a firm’s stock based on the dividends it pays. This only work for a stock that pays stable and predictable dividends, which are typically mature blue-chip companies. If the model shows a stock’s present value is more than its market value (Bohan, Josefsen, & Steen, 2012). There two types of calculation which are commonly adopted by the fund managers or the institutions known as Gordon Growth model and CAPM, these tools evaluate share value of the present value of expected future dividend earnings returns (Arnold, 2013).
The discounted cash flow method may work for a stock that does not pay a dividend. It looks at the Present Value of a firm’s future cash flow to determine a fair value of it stocks. It works best for firms that are past their growth stages. Table 5. DCF model is the discount rate and growth rate assumptions. Analysts might use the WACC of the firm as the discount rate to determine the DCF model. The rigor assessment of WACC must be correctly applied, any inaccurate WACC may overestimate or underestimate the value of the entire company. Nonetheless, both approaches rather theoretical and may not be applicable to the real world investing applications. Other investors may choose to use standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing (Jacobs & Shivdasani, 2012).
Relative valuation models operate by comparing the company to similar companies. Table 6. Illustrated FCA vs. S&P 500 with similar tier 1 Automotive OEM industry involves calculating multiples ratios, such as the price-to-earnings, price-to-book ratio, price-to-sales and price-to-cash flow and comparing them to benchmarks and the ratios of other firms (Damodaran, 2011). Bottom-line, each stock is different from each market and industry. Investors require to well conduct several valuations to create a range of possible values, or an average, to determine a stock’s true up value which requires for a good return on investments.
Table 7, based on Thomson Reuters report published on July 02, 2016, has illustrated a classic example of the bank price/book ratios is depressed. Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley all change hands below tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions and other intangible assets. The low price/book ratios stress the needs of stock buybacks or repurchase from the bank.
Table 7. Source: Thomson Reuters. July 02, 2016
References
1. Arnold, G. (2013). Corporate Financial Management . Person.
2. Bohan, O., Josefsen, M., & Steen, P. (2012, July 01). Shareholder Conflicts and dividend policy. Journal of Banking and Finance.
3. Damodaran, A. (2011). The little book of valuation. WILEY.
4. Deloitte & Touche LLP. (2016, June). M&A Trend Report 2016.
5. Edmans, A. (2011). Does the stock market fully value intangibles? Employee satisfaction and equity prices. ELSEVIER.
6. Finanical Times. (2016, July 20). Morgan Stanley boosted by cost cuts and M&A.
7. Frederikslust, R., Ang, J., & Sudarsanam, P. (2008). Corporate Governance and Corporate Finance. Routledge.
8. Gallo, A. (2016, March 17). A Refresher on Internal Rate of Return.
9. Harrison, M. (2016, May 20). Jack L. Treynor and the Birth of the Quants. CFA Institute.
10. Jacobs, M., & Shivdasani, A. (2012). Do you know your cost of Capital? Harvard Business Review.
11. Mauboussin, M., & Rappaport, A. (2016, July 01). Reclaiming the idea of shareholder value.
12. MSCI Index Research. (2013). Foundations of Factor Investing .
13. PWC. (2013). Correcting the course of capital projects.
14. Rappaport , A., & Sirower, M. (1999, From the November-December issue). Stock or Cash?: The Trade-Offs for buyer and seller in Mergers and Acquisitions. Harvard Business Review.
15. Sherman , H., & Young, D. (2016, From the July-August Issue). Where Financial Reporting Still Falls Short. Havard Business Review.
16. The Wall Street Journal. (2016, July 22). IMF Cuts 2016 Global Economic Growth Outlook After Brexit Vote.
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