CHAPTER 6

VALUATIONS
 Objectives
 At the end of the chapter, you should be able to:
 Outline the concepts applied in the valuation of assets
 Understand the effects of risk and return on valuations
 Value debentures
 Value preference shares
 Use the constant dividend growth model to value ordinary shares
 Apply a two stage valuation dividend model to value ordinary shares
 Use the DCF (Free Cash flow) model to value a company and the ordinary
equity of a company
 Use relative valuation methods such as the price-earnings (P/E) ratio and
EBITDA multiples to value ordinary shares
 Use the EVA approach to value the ordinary equity of a firm
 Explain how share options will affect the value of equity
 Understand how valuations affect the role of the financial manager
 Adjust valuations for lack of marketability and understand how to account
for non-controlling interests in a valuation

Financial Management 9e © Carlos Correia  2

 Outline
 What are valuations?
 Some valuation myths
 What is the effect of the risk and return relationship on value?
 Valuation of debentures
 Debentures in perpetuity and redeemable debentures
 Valuation of preference shares
 Cumulative and non-cumulative preference shares, redeemable and
convertible preference shares
 Valuation of ordinary shares
 Dividend Growth model – constant growth and two stage valuation model
 Free Cash Flow model
 Free cash flow to the Firm
 Free cash flow to Equity
 Relative valuations – P/E ratio (earnings yield) & EBITDA approaches
 The EVA approach to valuations
 Lack of marketability discounts

Financial Management 9e © Carlos Correia  3

 What are Valuations?

 Determination of the value of an asset stated in monetary terms

 Value = present value of future cash flows
 As the future is uncertain, valuations are subject to uncertainty
 An active market for assets creates a value due to the actions of
many buyers and sellers

Financial Management 9e © Carlos Correia  4

 Valuation Myths

 Valuations based on quantitative models are always accurate

 Valuations are objective
 Valuations are precise
 Valuations are valid over extended time periods
 The valuation number is the most important aspect of any
valuation

Financial Management 9e © Carlos Correia  5

 What are the Building Blocks of a
Valuation?

 The amount of each future cash flow

 The timing of such cash flows
 The riskiness of future cash flows
 The required rate of return

Financial Management 9e © Carlos Correia  6

 How does Risk and Return Affect
Value?
 Effect of Return on Value
 If asset A is returning R1m per year and asset B is
returning R1.2m per year, then asset B will have a
HIGHER value if the assets are of similar risk
 Effect of Risk on Value
 If asset C and asset D are both offering R1m per year, but
C is more risky, then asset D will have a HIGHER value
 Value and rates of return
 Assume cost = R10m and annual return (forever) = R1m.
If required return = 12%, then value < 10m. Why?
Because the actual return is only 10%. To offer 12%, the
price must fall to R8.333m.

Financial Management 9e © Carlos Correia  7

 Required Return
 To determine the present value of future cash flows,
we need a discount rate? How do we determine the
discount rate or required rate of return?
 Are there similar assets trading on financial
markets?
 Comparison of debentures to ordinary shares
 The required return on ordinary shares is called the
cost of equity
 This is dealt with in Chapter 7 on the cost of capital

Financial Management 9e © Carlos Correia  8

 Valuation of Debentures / Bonds
 TERMS
 Par Value (Face Value)
 Coupon interest rate
 Maturity date (redemption date)
 Yield to Maturity
 Yield to Call

Financial Management 9e © Carlos Correia  9

 Valuation of Debentures / Bonds
 Debentures in perpetuity (non-redeemable debentures)
 No redemption date
 Face value = R100 and coupon rate = 15% per year. If the required
return is 9%, then the value is;
 R15/0.09 = R166.67

 Redeemable debentures / bonds

 Face value is repaid on the set maturity date, plus interest until that date.
 Face value of R100, the coupon rate is 15% and the redemption date is
in 5 years time. Market yield = 9%.
 PV of interest: R15 x 3.8897 = R58.34
 PV of redemption of face value: R100 x 0.6499 = R64.99
 Total value = R58.34 + R64.99 = R123.34 (slight rounding difference)

Financial Management 9e © Carlos Correia  10

 Valuation of Debentures / Bonds
 Formula

 Using Excel

A B C D E F G
6 Year 0 1 2 3 4 5
7 Coupon interest 15 15 15 15 15
8 Redemption 0 0 0 0 100
9 Total cash flows 15 15 15 15 115
10 Present value 123.34
11 [Excel function: =NPV(9%,C9:G9)]

Financial Management 9e © Carlos Correia  11

 Debentures – Yield to Maturity

 Assume that the debenture (bond) is trading at R118. What is

the yield to maturity (YTM)?
 Use the IRR function on a financial calculator OR use Excel.
You can also use trial and error (not recommended)
A B C D E F G
20 Year 0 1 2 3 4 5
21 Bond cash flows -118 15 15 15 15 115
22 YTM 10.2%
23 [Excel function: =IRR(B21:G21,9%); Note - 9% is a guess]

 YTM = IRR. In Excel you need to indicate an estimate of IRR.

Then Excel starts with this and will do many trial and error
calculations (iterations) super quickly until it gets to IRR

Financial Management 9e © Carlos Correia  12

 Preference Shares
 Preference shareholders receive a fixed dividend whilst
debenture (bond) holders receive interest.
 Dividends are paid only after all expenses have been
incurred, including interest. This means that dividends
are more risky and therefore preference shares need to
offer a higher return.
 What is the effect of taxation?
 Types of preference shares
 Cumulative
 Redeemable
 Participating
 Convertible

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 Cumulative Preference Shares In
Arrears
 100 preference shares with an issue price of R1 each, is two years in
arrears. The preference dividend rate is 12% and similar shares are
offering yields of 14%.

 If non-redeemable and will be paid in the future, then the value would be;
R12/0.14 = R85.71

 If the next two years’ dividends will not be paid, then the value will be
determined in two parts;
 Value of perpetuity at end of year 3 = R12/0.14 = R85.71
 Dividend at end of year 3 = R12 x 3 = R36
 Present value today: (R36.00 + R85.71) x 0.675 = R82.15 Note:
 In terms of the Companies Act of 2008, preference shares no longer
have a face value (par value). It has an issue price (as above) and a
redemption value (if applicable).

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 Valuation of Ordinary Equity
 Dividend Discount Model
 Free Cash Flow Model
 Price Multiples (relative valuation)
 EVA Discount Model

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 Valuation of Ordinary Equity – Zero
Dividend Growth
 Assume a company is expected to maintain the same
dividend in future years. What are we valuing?

 We are valuing a perpetuity.

 Value = D / k

 If dividend is R0.80 and the Cost of Equity is 11%, then the

value is 0.80/.11 = R7.27

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 Valuation of Ordinary Equity
 Dividend Growth Model
 Value = PV of future dividends
 If dividends are growing at a constant rate, then;
 PV = D(1+g)/(k-g)
 Where
• D(1+g) = next year’s dividend
• k = cost of equity
• g = future constant growth rate in dividends

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 Dividend Growth Model
 How do we estimate growth in dividends?
 Use surrogates such as;
 Growth in earnings
 Growth in cash flow
 Sustainable growth rate formula as a check
 Growth in dividends over the long term should reflect
earnings growth.
 If EPS is growing at 10% per year, and if current dividend
growth is 20%, then this is not sustainable over the long
term. Earnings growth is a long-term anchor for
dividends.

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 Dividend Growth – Two Stage
Model
 How do we value a company which is experiencing a high
growth in dividends which is followed later by a lower but
stable growth rate in dividends?

 Example: HiFly Ltd is expected to experience a growth rate

of 30% for the next 3 years and thereafter will experience a
growth rate of 6% per year. The cost of equity is 12% and the
current dividend is 60 cents.

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 Two Stage Valuation
 Dividend per share in year 1, 2 and 3 will be;
 Yr 1: 0.60 x 1.3 = 0.78
 Yr 2: 0.78 x 1.3 = 1.01
 Yr 3: 1.01 x 1.3 = 1.31
 Present Value of future dividends in years 1-3 = R2.43

 What is the value of the ordinary equity at the end of year 3?

 Value3 = D3(1+g)/(k-g)
 Value3 = 1.31(1.06)/(0.12-.06) = 23.17
 Present value today = 23.17/(1.12)3 = 16.49

 Total Value of the shares = 16.49 + 2.43 = 18.92

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 Valuations – Distant Dividends
 What about a company that is growing at a rapid rate in terms of
market share and will only pay a dividend in the distant future?
 Example: A biotech company expects to only start making a profit
from year 8 and paying a dividend from year 11, which will
double until year 13 and then grow at 7.5% per year.

 Cost of Equity = 14%. If Cost of Equity falls to 11%, then value

will rise to R6.71
Financial Management 9e © Carlos Correia  21
 Dividend Growth – From the real
world
 Let’s apply the dividend growth model to Woolworths
 Assume a long-term sustainable growth rate of 8% (approximately 5% inflation
and 3.0% real growth). Assume the cost of equity is 14% (Risk free rate of 9% +
risk premium of 5%).
 Assume that the high growth in earnings and dividends will continue for the next
5 years, before falling to 8% per year. Expected growth rate for 2019 is 15% and
then 11% per year until 2023.

 Compare to current listed price. [Share price on 9 January 2019 = 55.89]

 Note: Value is at 30 June 2018. One year later equivalent value: 50.44 (1.14) =
R57.50

Financial Management 9e © Carlos Correia  22

 Price Multiples - Price Earnings
 Use of price multiples such as price-
earnings (P/E) ratios and market to book
ratios to determine whether shares are over
or under-valued.
 A Co. with a high growth rate will normally
have a high P/E ratio. Yet this may also be
due to very low earnings for a particular
year.
 High P/E ratios may indicate that shares are
over valued. Use P/E ratios of comparable
companies.
 Use of listed company P/E ratios to value
unlisted companies
 P/E is based on historical earnings
 P/E is based on accounting earnings
©
Financial Management 9e Carlos Correia  23
 Price Earnings
 Assume a company has an EPS of 1.50 and
comparable firms have an average P/E ratio
of 10. Value = R15.00
 Do high P/E ratios indicate that company
shares are overvalued?
 Research by Schiller of Yale indicates that
high P/E ratios generally do indicate over-
valued shares
 Refer to Internet Bubble in year 2000.
 Average P/E ratio in South Africa is about 17.

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 What Returns do High PE companies
Achieve in Subsequent Years?
Price earnings ratios and the subsequent 10 year real returns
Subseq. 10yr real return

Low PE = High return

20%
in next 10 years

15%

Upper boundary
10% High PE = Low return
in next 10 years

5%

Lower boundary
0%

-5%
5 10 15 20 25 30
P/E ratios
Financial Management 9e © Carlos Correia  25
 Enterprise Value
 P/E ratio used to value ordinary equity

 Use EBIT or EBITDA multiples to determine the value of the firm or enterprise
value

 Use of EBITDA enables us to ignore differences in depreciation policies and use

of EBIT or EBITDA multiples means we can ignore differences in financial
leverage

 EBITDA of R240m x 7.5 = R1800m. Deduct value of debt to get to value of

equity

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 Market to Book Ratio
 Book value per share = shareholders equity/no. of shares

 High growth companies will have high market to book ratios

 Market to book ratios are dependent on the industry sector
 Is the sector capital intensive?
 Specific sectors
 Pharmaceutical sector – High R&D – is this an asset or expense?
 Branded products – advertising costs – asset or expense?
 Are Tiger Brands and Woolworths capital intensive?
 Market to Book is an important ratio in the valuation of banks

Financial Management 9e © Carlos Correia  27

 Free Cash Flow Model
 Value of the Firm = present value of future operating cash flows discounted at the
firm’s cost of capital (WACC)

 FCF = Net operating profit after tax (NOPAT) + depreciation – capital

expenditure –increase in net working capital

 Value of Ordinary Equity = Value of Firm less value of debt

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Alternative: Free Cash Flow to Equity

 We can determine the value of ordinary equity by discounting the cash flows due
to shareholders after financing costs and changes in financing flows
 FCFE = NOPAT + depreciation – capital expenditure – increase in net working
capital – financing costs plus (minus) increase (decrease) in debt financing
 Discount rate = cost of equity
 Recommended for valuing firms with high levels of debt and banks. For other
firms, use FCF to operations to value the firm and then deduct debt.

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 Free Cash Flow - Continuing Values
 Using the Free Cash Flow Model, we estimate the future cash flows for an explicit
period, normally 7-10 years, and determine a continuing value after the initial
period, assuming a constant sustainable growth rate and margin.
 Continuing values (terminal values) are determined at the end of the initial period as
follows;

 Note that FCF1 or FCFE1 in this context is the following year’s cash flow (at the
end of the initial period).

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 Free Cash Flows - Example
 Assume a company, Stop-to-Shop Ltd, has current earnings before interest and
tax (EBIT) of R72m on sales of R600m. The following parameters apply;

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 Stop-to-Shop Ltd
0 1 2 3 4 5
Stop-to-Shop Ltd Actual Forecast Forecast Forecast Forecast Forecast
Cash flows Rm 20x3 20x4 20x5 20x6 20x7 20x8
Sales revenue 600.000 684.000 779.760 888.926 1,013.376 1,074.179

EBIT 12% 72.000 82.080 93.571 106.671 121.605 96.676

Tax on EBIT 28% -20.160 -22.982 -26.200 -29.868 -34.049 -27.069
Add: Depreciation 9.600 10.944 12.476 14.223 16.214
Gross cash flows 68.698 78.315 89.279 101.779 85.821

Investment in NWC and PPE

Net increase in working capital 13.440 15.322 17.467 19.912 9.728
Capital expenditure 26.400 30.096 34.309 39.113 28.375
Investment cash flows 39.840 45.418 51.776 59.025 38.103

Free Cash Flows (FCF) 28.858 32.898 37.503 42.754 47.718

PV factor 11% 0.9009 0.8116 0.7312 0.6587 0.5935
PV of FCF (WACC) 25.998 26.700 27.422 28.163 28.318
Sum of Years 1-4 (20x4-20x7) 108.283
Continuing Value (terminal value)
PV of FCF in 20x8 (FCFn+1) 28.318
PV of CV -20x9 onwards 600.347 CV 20x8 = FCF20x8(1+g)/(WACC-g)
Value of the Firm 736.948 FCF 20x9 50.581
= 1,011.620
Less: Value of debt - 320.000 WACC-g 5%
Value of Ordinary Equity 416.948 PV of CV 1,011.620 0.59345 600.347
Note the effects of rounding, for example,
No. of shares in issue 280.000 FCF 20x9 47.717854 106% 50.580925
Value per ordinary share 1.49

Financial Management 9e © Carlos Correia  32

 Free Cash Flow - Workings
 Stop-to-Shop Ltd

A B C D E F G H
41 Workings 20x3 20x4 20x5 20x6 20x7 20x8
42 Net Inv. in working capital1 16% 96.000 109.440 124.762 142.228 162.140 171.869
43 Change in working capital 13.440 15.322 17.467 19.912 9.728
1.
44 [0.18+0.12+.02-.16]
45
46 Capital Expenditure1 26.400 30.096 34.309 39.113 28.375
47 Closing net book value 20% 120.000 136.800 155.952 177.785 202.675 214.836
48 Depreciation 8% 9.600 10.944 12.476 14.223 16.214
1
49 Capital expenditure = Closing net book value +depreciation -prior year's closing net book value

Financial Management 9e © Carlos Correia  33

 Adjustments

 Depreciation
 Add back depreciation, all non-cash charges and amortisation of intangible
assets
 Change in Working Capital
 Include change in net working capital for the year as an application of
funds and sometimes as a source of funds. This can have an immediate
effect on value and is after tax as the investment in working capital is not
deductible. Use operating working capital.
 Provisions/Accruals/Tax/Dividends
 Ignore dividends payable
 Provisions – specific or ongoing? If specific – liability. If ongoing –
treat as working capital
 Capital Expenditures
 This includes expenditure on new and replacement property, plant and
equipment. Calculate capital expenditure from the balance sheet and
income statement as the increase in net PPE plus depreciation expense for
the period. From 2019, include change in right-of-use assets [IFRS 16]
Financial Management 9e © Carlos Correia
 EVA Approach
 EVA = NOPAT – (WACC x Asset Book
Value)
 Assume Asset Book Value = Invested
Capital
 Value of firm = Book value + PV of future
EVAs

GoFlow Ltd
Example: GoFlow Ltd is earning a return of
ROC 25% WACC 10%

25% for next 3 years and its WACC is

Discounting future EVAs
Closing asset book value (ABV) 180.0
0
180.0
1
180.0
2
180.0
3

10%. The book value of its assets is

NOPAT
expected to remain at R180m. The return
[25% x Opening ABV] 45.0 45.0 45.0

EVA
PV factors
after year 3 will be 10%.
Less: Capital charge [WACC x Opening ABV]

1.0000
- 18.0
27.0
0.9091
- 18.0
27.0
0.8264
- 18.0
27.0
0.7513
PV 24.55 22.31 20.29
PV of future EVAs [Discount rate=WACC] 67.15
Continuing value1 [future EVAs from Yr4] - Note: As ROC=WACC, CV=0
Beginning book value 180.00
Value of the Firm 247.15
Less: Value of Debt - 60.00
Value of Equity 187.15
1
CV0 = [(ROCxABV-WACCxABV)/WACC]/(1+WACC)^3

Financial Management 9e © Carlos Correia  35

 The Process of Valuation
Valuation process
 Value what is and what could be.

 Valuation Questions
 What is the current share price?
 Value of the company on the basis of existing operations?
 How does the value change if the company achieves industry
best practice?
 How does the value change if the company undertakes
divestments or acquisitions?
 How does the value change if the company changes its capital
structure?
 How does the value change if the company undertakes financial
restructurings?

Financial Management 9e © Carlos Correia  36

 Value the
Company as
is
Current
market value

Strategic &
Optimal
operating
Value
improvements

Potential
Financial Value with
restructuring internal
improvements

Potential
Divestures &
Value of
Acquisitions
Operations

Financial Management 9e © Carlos Correia

 Valuations and the Financial
Manager

 Focus on shareholder value means that the

financial manager will focus on value
maximisation.
 Why is valuation important?
 Valuation of company and divisions for
listing purposes
 Valuations for purpose of divestures or
acquisitions
 Valuation for purpose of determining an
optimal capital structure
 Valuation for determining cost of equity
and WACC
 Share buybacks
 Managerial remuneration
Financial Management 9e © Carlos Correia  38
 Share options
 Share options should be included in any valuation of
ordinary shares
 A share option offers the holder the right to buy a share in the
future at a fixed price (exercise or strike price)
 If options are very likely to be exercised (say current share
price is R10 and exercise price is R2.50), then increase the
value of total equity by the exercise price revenue (say 10m
options x R2.50) and increase the number of shares by 10m
to determine the value per share.

Financial Management 9e © Carlos Correia  39

 Other adjustments
 Lack of marketability discount

 Reduce value by 20-30% if using listed multiples and applying this to

unlisted companies

 Minority discounts

 A minority interest will require a discount as compared to a controlling

interest. P/Es of listed companies represent (mostly) minority valuations

 Control premium

 Premium for control if mainly using a P/E approach

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 Non-controlling interests (NCI)
 A non-controlling interest (minority interest) occurs when valuing a group with
subsidiaries.
 Deduct value of NCI to determine the value of attributable to the holding
company’s shareholders.

Financial Management 9e © Carlos Correia  41

 Valuations - Pitfalls
 Confusing the valuation of equity with the
valuation of the firm
 Using the wrong discount rate - use the cost
of equity for cash flows to ordinary equity
and the WACC for cash flows to the firm
 Adjusting for risk in the cash flows and the
discount rate
 Not recognising the risk of a changing
capital structure in the discount rate
 No comparable firms
 Double counting for synergy by increasing
cash flows and reducing the discount rate
 Increasing the discount rate for country risk
when this is already included in the risk free
rate
 Misestimating the value of control.
©
Financial Management 9e Carlos Correia  42