The following is a brief guide on how to get to grips with the valuation challenges in relation to valuing shares on the takeover or purchase of a business being a limited company.
Whenever a company is bought, what the new owners have a right to depends on the stake they hold.
For majority shareholders they have access to their share of earnings, and because they can opt for a winding up, their share of net assets of the company. Minority shareholdings by contrast do have access to dividends the majority decide to pay and a share of the net assets if the majority decides to wind the company up.
Because minority shareholders have relatively little power and no control, a 20% share of a company should be worth less than 20% of its total value.
Conversely an 80% share should be worth more than 80% of the full value of the company as a majority shareholder should be prepared to pay a premium for control.
There are three broad approaches to share valuation, these are:
- An assets based approach.
- An income based approach.
- A cash-flow based approach.
Assets based approach
Looking firstly at an assets based approach, here the equity of the business is estimated as being worth the value of its net assets. There are three common ways of valuing net assets which are book value, net realisable value and replacement value. The book value approach is not hugely helpful, as the book value of non-current assets is based on historical costs and relatively arbitrary depreciation. These amounts are unlikely to be relevant to buyer or seller and the book values and net current assets other than cash might also not be relevant as inventory as receivables might require adjustment.
In terms of the net realisable value of the assets less liabilities, this amount would represent in essence what is left for shareholders if the assets were sold off and the liabilities settled. However, if the business being sold is successful then the shareholders would expect to see more than just this because successful businesses are worth more than the sum of their net assets. They also have intangible assets such as goodwill, know-how, brands and customer lists, none of which is likely to be reflected in the net realisable value of the assets less liabilities.
The net realisable value basis therefore represents a worst case scenario and the selling shareholders could therefore accept less than the net realisable amount but always hope for more.
Finally, with replacement values, this is not of great practical benefit. The approach tries to determine what it would cost to set up the business if it was being started now. The value of successful business use and replacement values is likely to be lower than its true value unless an estimate is made for the value of those intangible assets such as goodwill etc. Furthermore, estimating the replacement cost of a variety of assets can be difficult. So, if looking at an assets based approach to share valuation the net realisable value is likely to be the most useful, but it will only present the sellers with the lowest value that they can accept.
Income based approach
Turning now to the income based approach, this method relies on finding companies in similar businesses to the company being valued and then looking at the relationship they share between share price and earnings. Using that relationship as a model the share price of the target company can be estimated.
The profit earning ratio (known as the P/E ratio) is the price of a share divided by the earnings per share and shows how many years’ worth of earnings are paid for in the share price. This is used more in the listed company sector but what would happen would be similar listed companies would be identified, the P/E ratios would be looked at together with their range of activity and an approximate value taken from that.
Cash-flow based approach
Finally, turning to the third of the three broad based approaches to valuation, the cash-flow based approach suggests that the market value of a share should be supported by the present value of future dividends. The first dividend growth model formula looks at the future annual growth, the dividend rate and the rate of return required by the equity shareholders. It looks at business risk which derives from the type of business which the company engages in and the level of borrowing, as the more borrowing there is, the more risk that shareholders are exposed to and the higher will be their required return. This will come up with a value of a share but is very much a theoretical value.
In conclusion, the other metrics used under cash based valuation would be where a company’s market value is compared to its book value or whether its value relative to its earnings before interest, taxes, depreciation and amortisation (known as the EBITDA) are taken into account. There are adjustments as said before in terms of private companies and comparable companies and the other considerations in relation to these valuation methods take into account industry specific factors, the company’s risk profile, growth prospects and market conditions and any legal or tax implication.
