ACCT6101 – Session #1: Introduction to Valuation
ACCT7106 – Session #1: Introduction to Valuation
PART 1 – Background
3 main types of business organizations:
(1) sole proprietorship – a business owned by one individual
– easily and inexpensively formed
– subject to relatively few government regulations
(2) partnership – when 2 or more people associate to conduct business
– can operate under different degrees of formality
– relatively easy and inexpensive to form and/or dissolve (dissolution)
(3) corporation – a legal entity created by government
– separate and distinct from both its owners and managers
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proprietorship partnership corporation
Taxes personal rate* personal rate* corporate rate & when paid as a dividend then personal rate (“double” taxation)
Owner liability unlimited unlimited limited to equity investment
Longevity limited to life of proprietor dissolution if any change unlimited
Funding debt (restricted forms) debt (restricted forms) equity and/or debt (many alternatives
These forms of enterprise differ in 4 critical ways:
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Our primary focus – corporate form of business (although the process followed for valuation applies to all forms of business & ownership)
There are 3 parties of fundamental interest:
(1) the legal owners (shareholders);
(2) the board of directors; and
(3) management
shareholders board of directors management
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re: shareholders legal owners – have right to
1) vote (to elect board of directors)
2) attend annual meetings
3) receive dividends, if declared
4) share in residual assets, if liquidated
5) receive information (e.g., annual reports)
re: board of directors act as trustees for shareholders
oversee management; set corporate policy; approve important decisions
2 broad categories of obligations
1. to exercise care and skill in carrying out functions
2. fiduciary duties i.e. to act
– honestly and in best interests of the firm
– for the furtherance of firm’s, not personal, objectives
– to avoid conflict of interest
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re: management operate firm
assumed objective of management = maximise shareholders’ wealth
maximise share price!
Why? If management maximises share price, investors can always sell their shares if they don’t like the firm’s policies and receive maximum price
Further, given well-functioning markets and rational investors, share price will reflect the market’s risk attitude, time preference, and opportunity cost
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asides:
1. Why not the more typical economic objective of maximising profit?
– profit should be viewed relative to investment concept of opportunity cost
– since multiperiod, the time value of money must be acknowledged
– profit must be judged relative to risk
2. What underlies the assumed objective of max shareholders’ wealth?
given rational and well-informed investors, and a free market economy
forces of supply and demand will drive share price to reflect
– aggregate market’s risk attitude
– aggregate market’s time preference
– aggregate market’s opportunity costs
but why only concerned about aggregate market?
argue that if individual shareholder is dissatisfied, can always sell shares (at max value)
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difficulties underlying the objective of maximizing wealth and the market system
1) the market may not be rational or well-informed
for example, markets may focus on short-term interests and ignore the long-term interests of the firm, the owners, and/or society
2) there may be market imperfections i.e., externalities, social responsibility
e.g., environmental and/or corporate social responsibility (CSR) concerns
should the firm focus only on $$$, or on society, or on ????
solution sometimes includes government regulation to enforce a uniform standard
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Question: Are substantive ethical, social responsibility, and/or legal issues considered in corporate financial theory?
by failing to consider ethical implications explicitly, corporate financial theory implicitly assumes that shareholder wealth maximization (SWM) satisfies the ethical requirements
basic question:
while it is possible for management to select any number of ethical or unethical strategies, does the securities market discriminate among different sources of net cash flows based on ethical, social responsibility, or legal concerns?
to the extent that the market rewards ethical, socially responsible, and/or legal behaviours (as reflected in price), the objective of SWM incorporates these considerations!
alternatively, to the extent that it does not AND these objectives are deemed to be “desirable”, regulators must impose rules to induce the desirable behaviours!
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3) conflicts of interest
(a) shareholders vs creditors
– some actions may effectively cause a wealth transfer from creditors to shareholders
e.g., A Ltd. has debt of $42,000 due in 1 year, its sales have dropped to approximately zero, and it can liquidate its assets for $40,000 at the present time
alt #1 – liquidate assets and invest $40,000 in T-bills @ 5% creditors get $42,000 at year-end, shareholders get $0
alt #2 – liquidate assets and invest $40,000 in a new hi-tech firm
if loose the entire $40,000 creditors and shareholders get $0
BUT if do well, repay first $42,000 to creditors and shareholders get the rest
shareholders never worse off if take the risky alternative and may be better off; conversely, creditors potentially worse off since they shoulder the entire risk
– other types of behaviours with similar consequences include:
– the payment of a large dividend
– issuing additional debt of the same seniority
note: many (most) of these actions are precluded by clauses in the bond indenture
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(b) managers vs shareholders
– standard assumption is that “all economic agents act in their own self-interest”
since managers are likely work-averse, they will make reduced effort
value of manager’s product reduced
firm value reduced (relative to “first-best”)
is realistic to assume that management’s true objective in their decision-making process is to maximise firm value?
i.e., do managers actually act in shareholders’ best interests?
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quick answer YES arguing that managers who fail to achieve this objective will
– be replaced by shareholders in pursuit of the objective
– find their firms the targets of takeover bids
whether managers actually act in the best interests of shareholders likely depends on:
1. how closely management goals are aligned with shareholder goals
factors affecting ‘degree of alignment’ include:
managerial compensation – tied to financial performance and share value
job prospects – promotion or alternative opportunities
monitoring – audited financial statements
2. likelihood of managers being replaced
relates to the issue of ‘control of the firm’
important because management can be replaced in a takeover and poorly managed firms are more attractive targets because a greater turnaround potential exists
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However, to the extent that shareholders can’t perfectly incentivize or monitor managers, managers may still engage in suboptimal behaviour
‘agency costs’ – arise in the ‘principle-agent’ setting
the principle (the shareholders) hires an agent (the management) to act on its behalf (i.e., management works on behalf of the shareholders)
however, the two parties likely have different interests and the agent has more or better information about its actions (information asymmetry); hence, the principal cannot directly ensure that the agent is acting in the agent’s best interest
these ‘agency costs’ will be recognized by shareholders (and the market)
share value will reflect potential agency costs!
reduced firm value relative to the “first best” solution
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PART 2 – Role of Management
1. Controller function asset efficiency
i.e., efficient use of working capital and liquidity management
running the internal accounting system
2. Treasury function long-term funds acquisition
i.e., debt or equity? – will affect the risk and tax position of the firm
3. Capital budgeting real (productive) asset acquisition
i.e., composition of the firm’s fixed assets
mix of capital and labour
determines the firm’s profitability and operating risk
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Consider the 2020 Annual reports of Coles Group Limited which contains a set of financial statements, comprising the following (see pages 96 – 148):
Balance Sheet “identifies” and “values” assets, liabilities, and equities
Income Statement summarizes revenues and expenses
Statement of Cash Flows summarizes cash inflows and outflows
Notes to the Financial Statements
provide supplemental material to aid in the understanding of the 3 primary financial statements
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preliminary cautions:
terminology and definitions are as determined through Accounting standards (e.g., assets, liabilities, revenues, expenses)
determination of ‘value’ is also based on Accounting standards
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‘Superficial’ Observations:
Re: Income Statement
the core business is the primary activity
‘sales revenue’ represents the vast majority of revenues
the two major expenses are ‘cost of sales’ and ‘administration expenses’
financing costs are relatively modest compared with the primary expenses
Re: Balance Sheet
inventories represents the largest component of current assets, followed by cash and receivables
trade payables represent the largest current liability
the major assets are ‘capital assets’ (property, plant, and equipment & right-of-use assets)
the primary source of financing is provided through non-current liabilities notably lease liabilities
shareholders’ equity represents a much more modest source of financings
a reconciliation of Owners’ equity (Statement of Changes in Equity) is presented separately
Re: Statement of Cash Flows
the statement is subdivided into three categories (operations, financing, and investing)
the operating section reveals the primary sources of inflows and outflows (net cash inflow = $2,552 million)
operating cash flow operating income
the financing section provides insights into changes in capital structure (net cash outflow = $1,842 million)
the investing section provides insights into capital expenditures (net cash outflow = $658 million)
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Note – the Balance Sheet can be reorganised to fit with the ‘financial executives’ 3 functions:
Capital Budgeting
Treasury Function
Controller Function
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Finally, what is the Coles Group Limited actually worth?
from the Balance Sheet Net Assets (Net Book Value) = Equity = $2,615 million
current share price (3 December 2020) = $17.98
market capitalisation $18 * 1,334 million shares = $24,012 million
Quite clearly: accounting value market value
Why not?
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Stated Objective of Financial Reporting:
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
Typically (always), a firm’s market value (market capitalization) will differ from its book value i.e., its price-to-book or market-to-book ratio will differ from unity (P / B 1).
Why? reasons include
orientation (historical vs. future)
GAAP (accounting ‘conventions’)
perspective (accounting vs. economic income – notion of opportunity cost)
So why do we even consider the Financial Statements?
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“To summarize, the value problem means that financial statements typically yield distorted information about company earnings and market value. This limits their applicability for many important managerial decisions. However, financial statements are frequently the best information available, and it their limitations are borne in mind, they can be a useful starting point for analysis.” (R.C. Higgins, “Analysis for Financial Management)
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Why do we analyze historical performance as presented in the financial statements?
provides insights into the firm’s
– operating policies
– production techniques and technologies
– inventory and credit-control systems etc. etc.
the ties between its operating decisions and its financial performance
the financial statements are an important window and facilitate an understanding of the factors that fundamentally determine a firm’s financial profile
In the ideal world, the analyst would like to have access to full ‘market value’ information about the firm’s assets, etc. etc. etc.
“the primary reason for looking at historical accounting information is that we don’t have, and can’t reasonably expect to get, market value information”
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To provide a frame of reference, consider the following relatively simple capital budgeting (NPV) analysis:
Example #1-1
XYZ Ltd. is considering the purchase of a sailboat in order to entertain clients. Management has decided that the best choice is the HK41 manufactured by Heavy Keel Inc.
The HK41 will cost $250,000 and is expected to lead to additional net revenues for the firm of $80,000 in the first year and $135,000 in each of the following four years.
At the end of five years, the firm will give the boat to its president.
XYZ’s cost of capital is 10% and its tax rate is 44%. The firm is unable to take a depreciation charge for tax purposes because of the unique circumstances surrounding the purchase.
Based on this information, should XYZ purchase the HK41?
PART 3 – Valuation: Preliminaries
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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Initial investment (250,000) – – – – – – – – – – – – – – –
Net after-tax cash flows – – – 44,800 75,600 75,600 75,600 75,600
Total Cash Flow (250,000) 44,800 75,600 75,600 75,600 75,600
Projected cash flows –
Net Present Value (NPV)
= -250,000 +
= -250,000 + 258,577 = $8,577
should purchase since NPV > 0 (i.e., adds wealth to the firm)
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44,800 = 80,000 * (1 – 0.44)
75,600 = 135,000 * (1 – 0.44)
a typical capital budgeting analysis consists of:
1. Estimating project cash flows
2. Determining the economic value of the project by:
a) assessing the risk profile of the project
b) assigning the appropriate discount rate to reflect the risk
c) calculating the net present value (NPV) of the project
the process requires the decision-maker to:
estimate the future flows (the numerator)
assess risk and identify the appropriate discount rate (the denominator)
Note: in this example, the maximum that XYZ should be willing to pay for the HK41 is $258,577 (the price that equals the present value of the estimated future flows – at this price, NPV = 0 i.e., the firm is earning exactly its required rate of return)
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value of a financial asset derives from the cash flows that its holder has a claim to
in general terms, the value of a financial asset is the present value (PV) of the future cash flows that accrue to it
to value a financial asset, we need to:
(1) estimate the future cash flows; and
(2) establish an appropriate discount rate
(i.e., functionally the same exercise as the NPV exercise)
definitions:
real asset – a productive asset that generates cash flows
financial asset – a claim to the cash flows generated by the firm’s real (productive) assets
e.g., debt, equity
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Example #1 -2: valuation of debt (bonds) –
Treasury Fixed Coupon Bonds, $100 face value (assume today is 7 December 2020)
coupon rate 2.75% (half yearly) interest = (½)(0.0275)(100) = $1.375
maturity date 7 December 2030;
current market yield 4.18% ( half-yearly yield = 0.0207 = {(1.0418)½ – 1})
value depends on two components
regular income stream
terminal value both discounted back to the present
V0 =
= 22.332 + 66.380 = 88.712 $88.71
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for bonds, the periodic cash flows (interest) and terminal value (principal) are fixed contractually
further, the discount rate (required return) is based on the risk of the investment (typically as assessed by a bond rating agency)
for debt, the valuation process is relatively straightforward and largely mechanical
Alternatively, for equity, both the future flows and the discount rate must be estimated
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A bond is legal evidence of a loan obligation. The typical corporate or government bond is a promise to return a regular, fixed interest payment plus a lump-sum repayment at the maturity of the bond. The annual interest payment is determined as the bond’s coupon rate times the face value of the bond, and typically ½ of the annual amount is paid half-yearly. The lump-sum repayment at maturity is equal to the face value of the bond, typically $100. The bond contract, called the bond indenture, contains the terms or provisions of the bond. The standard terms appearing in the indenture include the important aspects of the bonds i.e., face or maturity value, coupon rate, payment dates, maturity date, and often additional features designed to either make the bond more attractive to investors (known as sweeteners) or to reduce the investor’s risk exposure
Equity securities (preference and common shares) are ownership certificates, and represent sources of permanent financing to the firm. Any cash distribution to the common shares, called a dividend, is not fixed in either timing or amount, but rather can be varied (up or down) at the discretion of the firm’s board of directors. A dividend only becomes a legal obligation when declared by the board.
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In general terms, the value of equity can be expressed as:
where xt and kt are the relevant flows and discount rate, respectively, for period t
note, the formula adopts an infinite investment horizon (t = 1 ) because equity financing is permanent financing.
in principle, must estimate both the amount and the timing of the future flows, and establish an appropriate (period-specific) discount rate
= + + + + +
Both the task and the formula can be made somewhat easier if certain simplifying assumptions are adopted
If the equity instrument is assumed to yield a constant (uniform) stream of flows in perpetuity and the discount rate is assumed to remain constant (a flat term structure), the valuation equation becomes:
Alternatively, if the stream is assumed to grow at a constant rate, g, in perpetuity and the discount rate is assumed to remain constant, the valuation equation reduces to:
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Aside, to confirm the value of a perpetuity (g = 0 x1 = x2 = x3 = x4 = ……. = x):
V0 = + + + + +
multiplying both sides by (1 + k):
V0 = + +
V0 V0 V0 – V0 = V0 =
*****************************************************************************************************************************
Aside, to confirm the value with constant growth in perpetuity (g) i.e., perpetual growth:
V0 = + +
multiplying both sides by (1 + k) and divide both sides by (1 + g):
= + + +
= V0 V0
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Finally, drawing upon the above: under the assumptions
constant discount rate (flat term structure) the ‘time subscript’ can be dropped from k
year-by-year estimates are made for a finite period (n years) after which flows are assumed to, on average, grow at a constant rate g
the valuation model then simplifies to the following:
Example #1-3:
Suppose that an analyst has reliably projected the future cash flows for CC Ltd. over the next 5 years to be as follows:
year 1 2 3 4 5
FCF 3.429 3.753 4.059 4.310 4.488
The analyst also believes that these flows will grow at an average annual rate of 5% post year 5. Finally, the analyst believes that CC’s risk profile is expected to remain unchanged into the foreseeable future and that the appropriate discount rate, ke, is 10.7%.
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PART 4 – Valuation Preliminaries (cont)
Based on these forecasts, the residual equity value (value to the common shareholder) of CC Ltd. is:
year-by-year estimates for 5 years
Terminal value = PV of flows from year 6 onward
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understanding the ‘terminal value’ (TV) calculation –
recall, under the assumptions of a constant discount rate (k) and that the flows (x) grow at a constant rate, g, the valuation model simplified to the following formula:
on this basis, shifting the point in time to year 5 from year 0 (which is today), we have
and the present value of this amount at time 0 (the starting point) is
= 49.731
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Thus, in general terms, we need to address the following basic issues:
determination of an appropriate discount rate, k
choice of flow measure, xt
selection of an appropriate forecasting horizon, n
estimation the post-forecast horizon TV (g)
Sources of input information include:
analysts and analyst forecasts
management guidance (management earnings forecasts)
financial statements
non-financial disclosures (e.g., CSR reports)
Why should historical financial accounting information play a role in the valuation process)?
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What is accounting –
PERCEPTION
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What is accounting –
REALITY
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Example #1-4:
LAJ Inc. manufactures precision parts for the space industry. Earnings per share in the fiscal year just ended were $1.40. Earnings per share are forecasted to grow at 10% per year for the next three years, and at 8% per year thereafter. It is assumed that LAJ will maintain its current 30% dividend payout ratio. Estimate the value of LAJ shares using a discount rate of 12% and basing the valuation on the dividends that investors will receive:
D0 = 0.3(1.40) = 0.42
D1 = 0.3(1.10)(1.40) = 0.46
D2 = 0.3(1.10)2(1.40) = 0.51
D3 = 0.3(1.10)3(1.40) = 0.56
D4 = 0.3(1.10)3(1.08)(1.40) = 0.60
V0 = = $11.90
and thus again, in general terms, the required inputs for the valuation process are:
appropriate risk-adjusted discount rate, k
choice of flow measure, xt (e.g., free cash flows, earnings, dividends)
appropriate forecasting horizon, n
estimation of year-by-year flows until the forecast horizon
estimation the post-forecast horizon TV ( estimation of the ‘on average’ growth rate, g)
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