Business Valuations - How To Value a Company

Summary

Highlights

• Asset-based valuations use assets less liabilities to value a company, especially useful for asset-heavy or loss-making companies. 🏢
• DVM calculates company value based on dividends, assuming perpetual growth, and is useful for valuing minority holdings. 💸
• PE ratios estimate business worth by comparing with similar listed companies, though they assume similar growth and profitability prospects. 🧮
• For DCFs, the business value is deduced from the present value of future cash flows, accounting for detailed year-by-year projections. 📈
• Each method's effectiveness varies based on factors like the company's growth stage, industry, and financial data availability. 📉

Key Takeaways

• Asset-based valuations rely on simple calculations using tangible assets and are a quick way to set a minimum business value. 🏢
• The Dividend Valuation Model (DVM) incorporates company dividends but assumes constant growth, making it less reliable for companies that don't pay dividends. 💰
• PE ratios require industry comparison and are often used for rapid but rough business valuations, with limitations on accuracy. 📊
• Discounted Cash Flows (DCFs) are the most detailed, considering future cash flows, but are complex and rely heavily on forecasting accuracy. 🔍
• Each method comes with its own pros and cons, suitable for different business situations and available information. 📈

Overview

Chapters

• 00:00 - 00:30: Introduction and Overview of Business Valuation Methods The chapter titled 'Introduction and Overview of Business Valuation Methods' introduces the topic of business valuations as presented in a Kaplan masterclass. The tutor, Andrew Moer, outlines the aim of the session, which is to explore four main methods of business valuation. These methods include asset-based valuations, dividend-based valuations using the dividend valuation model, PE (Price to Earnings) ratios, and discounted cash flows. Each method will be discussed in detail throughout the session.
• 00:30 - 04:30: Asset-Based Valuations The chapter discusses asset-based valuations, focusing on providing a clear overview of how these valuations are calculated by subtracting liabilities from assets. The chapter also aims to explore the advantages and disadvantages of this valuation method, indicating its popularity in examination settings.
• 04:30 - 08:00: Dividend Valuation Model (DVM) This chapter discusses the Dividend Valuation Model (DVM) by introducing a basic approach of valuing a company's equity based on its assets and liabilities. It suggests different measures for evaluating the assets, such as book values from financial statements and net realizable value, which indicates the potential revenue if a company sold off all its assets. The latter method offers a minimal estimate for asset liquidation.
• 08:00 - 13:00: Price Earnings (P/E) Ratio In this chapter, the concept of valuation methods for a company is discussed, specifically highlighting two approaches. The first method is the liquidation value, represented by selling all the company's assets on a platform like eBay, which signifies the lowest price a company might accept in negotiations. The second method is the replacement cost, where the focus is on estimating how much it would cost to rebuild the company from scratch, including acquiring new properties and assets. This replacement cost often sets the maximum price a buyer might be willing to pay, as paying more would not be economically sensible for the buyer.
• 13:00 - 19:00: Discounted Cash Flow (DCF) Technique The chapter discusses the Discounted Cash Flow (DCF) technique as a method for valuing a company. It mentions alternative methods such as buying a company for less than its replacement cost. The DCF technique is praised for being straightforward and quick, utilizing readily available information from a company's financial statement to determine its value based on assets.
• 19:00 - 19:30: Conclusion and Summary of Methods The chapter discusses the use of a particular method in negotiations, particularly for setting minimum prices, which can benefit sellers. It is useful for companies that are making losses or are near liquidation. Asset-heavy businesses, such as property investors, can also gauge their business value using this method. However, it acknowledges that there are significant disadvantages to employing this strategy.

Business Valuations - How To Value a Company Transcription

• 00:00 - 00:30 hi there welcome to this kaplan masterclass on business valuations my name is andrew moer and i'm a tutor at kaplan financial now the aim of the session today is that we're going to look at four main business valuation methods the first of which are these asset-based valuations we're then going to move on to dividend-based valuations looking at the dividend valuation model we're then going to move on to pe ratios and then we're going to finish off with our discounted cash flows now with each of
• 00:30 - 01:00 these methods i just want to give you a really nice simple overview of each method so for each one we'll think about how you calculate the valuation using the method and also then look at some advantages and disadvantages of each method which seem to be really popular in exams at the moment so let's start with these asset-based valuations then um so as you can see the value of a company if we're just valuing it based on its assets is just its assets less its liabilities so really nice straightforward way to
• 01:00 - 01:30 value a company you just take their assets deduct the liabilities and that effectively gives you the value of the company's equity now when we're doing this there are a few options as to what we can use for our assets we could use and our book values from the statement of financial position so just looking at what they are on the financial statements we could use this thing the net realizable value so that's if the company were to sell off all their assets how much would they get for them now that tends to be the absolute lowest that that company would want to sell
• 01:30 - 02:00 their business for it's pretty much if we put it all on ebay how much would we get and so that's probably the lowest they'd want to go in any negotiations a company could use their replacement cost which is where we look to instead think how much would it cost to build this business up from scratch so if we were to start it completely again everything brand new so new property new assets everything how much would it cost and we often assume that's the most that a buyer would want to pay because otherwise yeah why would they bother
• 02:00 - 02:30 buying a company for less if they could get it brand new and using that replacement cost so there are a few alternatives and again you just be led by the question as to which of these um would work um but yeah a really nice as i say straightforward way to value a company now the great thing about this is it's so quick and easy to do um readily available information if you've got a company's statement or financial position you can work out the value of that business based on their assets it's nice and easy and as i mentioned we can
• 02:30 - 03:00 use it to set a minimum price in negotiations often for the uh for the the seller which is great it also works for loss making companies um so if companies are making a loss or they're looking to potentially go into liquidation soon um yeah then this is a method that works quite nicely it's also quite good if you're a particularly asset heavy business so if you're a property investor for example then this gives you a good indication as to the value of your business as well now there are several major disadvantages though of using this
• 03:00 - 03:30 technique the first one is the fact that the information may be outdated uh depending on how they value their things on on the statement of financial position if they held them at a cost less accumulated depreciation these figures may be really really out of date so that may not give you a relevant figure when you're valuing a business it also ignores intangibles so it's not going to include things like the company's skill sets and their brands and reviews and their customer base and the data
• 03:30 - 04:00 that they've acquired over the years so all these things that haven't been capitalized haven't been included in their statement of financial position wouldn't be included and so that's a big weakness the other thing is it's not looking at their growth potential we're not looking at what's going to happen in the future we're valuing a business based on their current assets and people don't invest in companies because of their assets if you think about service industries if you think you know you may be a a world-renowned uh chef or a
• 04:00 - 04:30 world-renowned personal trainer your reputation all the celebrities might want to eat at your restaurant or use you to um for their personal training sessions but that's just getting ignored and we're just looking at what assets they've got so it's it's a really it's a really sort of tricky one and we don't look at what potential they've got going forward um and and what they could earn so it's just looking at their assets so it's a nice starting point it's really quick really easy to do but overall yeah it's not going to give you the most accurate valuation of the business
• 04:30 - 05:00 our second method i want to consider is this idea of the dividend valuation model now this one uses a company's dividends to predict what the business is worth and so have a little think about what the company's going to be worth here there is a formula and so the value of the company you take the dividend and you times it by one plus their growth rate and then you divide that by the cost of equity minus growth and that will give you the value of a company now if you use the total dividend of the
• 05:00 - 05:30 business so you know the the overall figure of dividends for the year um so potentially millions of pounds or dollars that will give you the value of the whole company when you use this formula if you just use one dividend so dividend per share effectively that will give you the value of one share so this formula you can use it either way just in case you see it um done in a slightly different way if you use total dividends that will give you the value of the whole company if you use one dividend that will just give you the value of one share you've then got your dividend growth
• 05:30 - 06:00 percentage um which is g and so that will go in there that is an estimate of how much we expect our dividends to grow by each year and then ke is the company's cost of equity now this dvm is assuming that the value of a company is worth all the dividends it will ever pay out into the future so this formula is actually this growing perpetuity formula we're assuming if this company pays dividends in perpetuity so forever and
• 06:00 - 06:30 ever growing at this constant rate g if we took the present value of all those dividends it will ever pay that's how much it's worth right now um so that's what this this formula is looking at that's the theory behind it um so it is we're looking at potential um future growth and we're looking at the dividend policy um so it's quite a nice way of doing it and again it's not too tricky to um to find out we'll think about some advantages and disadvantages so it does include growth and it does also link to shelder wealth
• 06:30 - 07:00 now because we're thinking about those dividends we're thinking about how much we're expecting to earn as investors which is which is good and it you can use it to value minority holdings so if you're only buying a few shares it's quite a nice method um to use because if you're only buying a few shows you're not going to affect the company's dividend policy so using their their forecast dividends is absolutely fine big big weaknesses though first of all it assumes constant growth of dividends so that g figure we're assuming stays
• 07:00 - 07:30 the same forever so if we say growth is five percent we're assuming uh we're always saying is that these dividends are going to grow at five percent forever and ever into the future which isn't going to happen yeah there will be years where they may not even pay a dividend there'll be years the dividend might go down and so having that constant growth is is really um a massive assumption it also relies on this cost of equity figure in the formula ke and as you may know from um from other studies that's not necessarily the easiest figure to find and also we're
• 07:30 - 08:00 assuming that that's constant forever and all it takes is a change in the company's gearing levels or the change in their risk and that cost of equity figure would change um so again assuming that that's constant forever is is not necessarily going to be valid and also not all companies pay dividends you know some companies especially newer companies like to reinvest that money in the business rather than paying out dividends so then you can't use this it's not going to work or loss making companies aren't going to be paying dividends as well as unlikely they will
• 08:00 - 08:30 so again this um this this method wouldn't work in those situations um but again it's it's a start we're building in a bit of growth now and a little bit of the future potential which is which is better than the asset one we looked at earlier the third method is this idea of using a p e ratio which is the price earnings ratio so to value your company you need to take a suitable pe ratio and times it by your earnings now when i say a suitable p e ratio what you're often going to have to do here is
• 08:30 - 09:00 borrow a p e ratio from a similar company now it might be that there's a company that's in the same industry as you which you could use or there might be industry average figures for p e ratios that you could use and the idea is that the p e ratio is um the value of a company divided by its earnings a couple of ways of doing it as you can just see on that on that second line there so for example if a company's pu ratio is 12 what that's saying is this company is worth 12 times more than its annual
• 09:00 - 09:30 earnings or you can do it on a single share basis as well you could say that this company's share is worth 12 times more than its earnings per share so again you can do it on a big scale or a little scale doesn't matter so the concept is we want to value a company um so it's likely to be unlisted if it's a listed company it would know its value already probably um so if it's an unlisted company we want to know how much is this company worth what we'll do is we'll find a similar listed company
• 09:30 - 10:00 who have a p e ratio we can go and look at their share price and and their earnings and we can work it out and we can say right their p ratio is 12. so this company that's similar to us is worth 12 times more than they're on your learnings we therefore can say that we are going to be worth 12 times more than our annual earnings so we're going to say if they're worth 12 times more than their annual earnings so will we um we can just apply it to our own earnings and so that's what we're doing you're just taking a suitable p e ratio which is borrowed from someone else and times
• 10:00 - 10:30 it by our earnings figure to give you a value of the company we're borrowing someone else's and assuming that that multiple applies to us as well now when we're doing earnings as you can see at the bottom that's profit after tax less any preference dividends so if there are any preference dividends in there you would need to take those off so their earnings and when we're doing that we want to make sure that those earnings are what we call sustainable earnings so we need to make sure that they're going to continue into the future um so they're not we're not including any sort of one-off items so if this year for
• 10:30 - 11:00 example they um sold a load of land um so they they sold loads of land this year that's probably not going to happen again in the future um so when you're doing this we just need to make sure that these are sustainable earnings is what we expect to happen and going forwards um so take out any one-off items and that'd be great so the good things about this um they are based on similar listed companies so hopefully it'll give us a good idea as to what our business is worth
• 11:00 - 11:30 includes the impact of their brand and reputation because we're looking at earnings which is good and it is widely used i know a lot of people who work in in companies who need to value other businesses and this is a method that they use a lot it's again it's really quick it gives you a rough indication as to the value of the business which is nice this idea of um borrowing someone's pe ratio there is a disadvantage is yeah it's unlikely to give us you know an accurate figure isn't it
• 11:30 - 12:00 you're just borrowing a similar company they'll do things slightly different they'll have a different attitude to risk they'll have different levels of gearing they'll have all sorts of different things going on there so borrowing a p e ratio is is potentially a um yeah a major disadvantage so that word proxy um is just that idea of you're just borrowing someone else's um so when we talk about proxy um it just means that you've you've borrowed it from somewhere else now you are using historic earnings so we're using last year's earnings um so going forwards it may not be um again
• 12:00 - 12:30 that may not be the case so we're not including any future earnings we're just looking at what we've what we've achieved this year and this idea of an adjustment for non-marketability as i mentioned we're going to be valuing a company that's not listed um so it's shares are going to be much harder to sell compared to a listed company so when we're borrowing this pe ratio we'll be borrowing it from a listed company um we then have to take off a little bit just deduct a bit just to reflect the fact that right our
• 12:30 - 13:00 company isn't as attractive as this other one because our shares are harder to sell we're also less regulated um so yeah less less information available about us and so on so what we tend to say is that there's usually around about a 25 um deduction to reflect the non-marketability of our company shares um now that's fairly arbitrary it's it's fairly random but if this comes up in the exam you're just looking to to show the markers well i
• 13:00 - 13:30 acknowledge the fact we borrowed someone else's pe ratio that's for a listed company we're not listed so i'm just need to take a little bit off just to just to make it a bit of a fairer comparison so 25 as i say is is pretty much the going rate for for a deduction for non-marketability again it is fairly arbitrary but it just shows that you know what you're doing the final one is the discounted cash flow technique and all this is really it's just a big old mpv so the discounted cash flow the value of a
• 13:30 - 14:00 company is the present value of future cash flows um so it's what we expect our cash flows to be in the future um discounted back to the present value um now when you do this what you tend to do is you'll have you'll set up a column like um you'll set up a table almost like this so you have your t1 t2 your t3 and t4 etcetera so you'll set up an mpv like you usually would we don't often have a t0 column when
• 14:00 - 14:30 we're doing these that usually starts we're usually looking at the cash flows in the future so we'll start from t1 t2 t3 t4 and so on now what sometimes happens is that you end up with this final year perpetuity so what they often say is that in the final year we'll have some sort of year five to infinity type thing um so they often call that the planning horizon for the first few years they're the years that we know in detail what we expect to happen so you'll have your sales your costs um your capital allowances your tax all those sorts of
• 14:30 - 15:00 bits just like a normal mpv and for those four years you might have fairly detailed forecasts as to what your figures will be once you get to maybe year five or again depends on the question and the business but once you get to year five we sort of go right we're not too sure about the figures from here on because it's quite hard to forecast that far in advance so we'll just assume that they carry on at the same level into the future um so we'll just assume that they carry on like that forever so that's the idea of a perpetuity so in that final year we've got what we
• 15:00 - 15:30 call a delayed perpetuity and they might even include a little bit of growth so within this there's this final year perpetuity factor so rather than using a discount factor in that final year what you do is you can do one over the rate minus growth so that's the r minus g and then you times it by the discount factor for the year before the perpetuity is starting so in that little example i just did up there um the perpetuity starting in year five so what you do is you times it by the discount factor for
• 15:30 - 16:00 year four so that's that idea of a delayed perpetuity you always times by the discount factor for the year before um so if there is some sort of growth if it says it's growing at one percent you do one over the rate which will be your cost of capital and take off your growth and then times it by the discount factor for the year before that's that that final year perpetuity factor um now in some qualifications they split your the way you can do this into a couple of couple of things you've got your free cash flows your fcfs um which
• 16:00 - 16:30 are the ones that are before interest but post tax if you are given those and need to use those you use the whack as your discount rate and then at the end you need to take off the market value of debt to give the value of equity for the business which is what we're after and if you've got fcfes which are free cash flows to equity now they're the after tax and after interest um cash flows so the fcfes um you've you've already taken off your interest and your tax on these you can just discount those
• 16:30 - 17:00 using the cost of equity and that'll give you straight to uh the value of equity of the business so free cash flows to equity you discount using the cost of equity and that gives you the value of equity so sort of equity equity equity uh which makes it a little bit easier to remember now in some qualifications they don't distinguish between those and you don't need to worry too much about that but just thought i'd flag that in case um in case that's useful so in terms of how you structure it you need to do a big old mpv from year one onwards looking at sales costs etc
• 17:00 - 17:30 and then you just discount it all using the suitable discount rate that we've just talked about there in terms of the um advantages really detailed is it's the best method we look at in terms of the accuracy and everything that's going on because you're looking at each year's cash flow separately which is incredibly detailed when you compare that to something like the p e ratio where you've taken one year's profits and times it by a number yeah this is far far better isn't it includes forecasted growth so you're
• 17:30 - 18:00 anticipating what's going to happen over the next few years which is which is also good and also the fact it uses cash flows we much prefer because they're more factual you can spend cash profits are theoretical you can manipulate profits by changing a few things whereas these cash flows are much much more factual so we prefer those in terms of disadvantages we are relying on these forecasts again really hard to know um what's going to happen that far in advance especially with that perpetuity if there is one in that final
• 18:00 - 18:30 year um yeah we don't know that it's going to carry on going at that rate so we just have to we have to take a little bit of a guess they are quite complex they're quite time consuming um and so yeah they're quite again but due to the fact they are so detailed and thorough um they do take a little bit of time to get there also they're really relying on that cost of capital so if you use a cost of capital or or cost of equity depending on the question of say 10 if you then did that again using the rate of 12 the value of that business is going to
• 18:30 - 19:00 be far lower um so it's really dependent on that and again there are so many assumptions guesses um and things that go into that when you calculate it um that just just a small change would really affect the value of the business so again very um sensitive to changes in some of these assumptions when you're doing these these methods um but again it is by far the best method that we that we consider the most detailed the most okay so they're the four methods um just as a quick overview thinking about the
• 19:00 - 19:30 pros and cons speech um you'll have loads of examples that you can practice and yeah really good to get some numbers in there and but hopefully that gives you a nice oversight of the key methods and the advantages and disadvantages of each which seem to be very popular in various exams at the moment asking you to to evaluate these methods and so i hope you found that useful and good luck with your studies