Valuation of Ordinary Shares pt 2

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By Joanne Lloyd-Jones, TPS Afin Subject Controller

3 June 2016

In the first part of our Back to basics on ordinary shares, we looked at the four methods of calculation for buying and selling. Now we investigate a worked example using these methods and key points to remember.

Worked Example:

Jeres plc (‘Jeres’) is interested in buying shares in Samon Ltd (‘Samon’). It has asked you to calculate a range of prices for the shares using all four valuation methods. It has provided you with the following information:

  • Samon has 100,000 ordinary shares in issue
  • Samon operates within the retail sector and is a small enterprise
  • Listed companies in the same sector have dividend yields of 5% and PE ratios of 12
  • Samon generated £70,000 in post-tax profits last year.  However, this includes an after-tax loss of £10,000 due to inventory write-offs
  • An ordinary dividend of £32,000 was paid last year
  • Samon’s statement of financial position reveals total assets of £1,200,000 and total liabilities of £550,000
  • Samon has a history of reliable budgeting, and forecasts operating cash flows (after tax and finance costs) to be £75,000 for the next three years, and £85,000 for the two years after that. Jeres has suggested that a terminal multiplier of seven can be applied to the year five cash flows
  • The gilt rate is currently 4% and the average return on the market is 7%
  • Jeres has a Beta of 1.2
  • There are no transferability restrictions in the Articles of Association

1. Dividend yield method:

Price of share = Ordinary dividend per share / Adjusted dividend yield

Ordinary dividend per share = 32,000 / 100,000 = 32p

Adjusted dividend yield = 5% x 1.3 (increased for marketability issues (20%) and size (10%)) = 6.5%

Price of share = 32p / 6.5% = £4.92

2. Earnings method:

Price of share = Earnings per share (based on FME) x Adjusted price earnings ratio

Earnings per share = (£70,000 + £10,000) (loss was an unusual, one-off item) / 100,000 shares

= 80p

Adjusted price earnings ratio = 12 x 0.7 (decreased for marketability issues (20%) and size (10%))   = 8.4

Price of share = 80p x 8.4 = £6.72

3. Net asset method:

Net assets = Total assets – Total liabilities

= £1,200,000 - £550,000 = £650,000

Price of share = Net assets / Number of ordinary shares in issue

= £650,000 / 100,000 = £6.50

4. Discounted cash flow method:

CAPM = Risk-free rate + Beta (Return on the market - Risk-free rate)

= 4% + (1.2 (7% - 4%)) = 7.6%

Description

£

Discount rate (CAPM)

Present Value

Y1 cash flow

75,000

0.9294

69,705

Y2 cash flow

75,000

0.8637

64,778

Y3 cash flow

75,000

0.8027

60,203

Y4 cash flow

85,000

0.7460

63,410

Y5 cash flow (terminal multiplier applied)

85,000 x 7 = 595,000

0.6933

412,514

Total

670,610

Price of a share = Total discounted cash flows / Number of ordinary shares in issue

= £670,610 / 100,000 = £6.71

Finally, here are a few key points:

  • Show all workings
  • Explain your adjustments
  • If the exam does not specify the method to be used, calculate as many methods as you can and then make a recommendation
  • Technique is more important than the actual number answer
  • Refer to the course material and workshop exercises for the best layouts and to check where marks are usually awarded
  • Work quickly and precisely – valuations should not take you long and should enable you to score good marks
  • This guide covers the basics. If you do not understand the reason behind any of the calculations, please refer to Module 1 of the Advanced Finance course
  • This guide has also not considered significant minorities – make sure you are comfortable with the concept and the calculation before your exam.

Topics

  • CA Student blog

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