Chapter 6- Valuations:
Factors to consider when considering buying a business:
Profit
Cash flow
Required rate of return
What the price of a similar business is
Value of assets
Competition
Might be seasonal
Why did the previous business sell
Price negotiations (NB!!)
Definition:
Process whereby the value of an asset is determined and expressed in monetary value
Overview:
Underlying principle- time value of money
Value of asset?
o Present value (PV) of all FUTURE economic benefits
(profits/cash/dividends/interest) discounted at appropriate required rate of
return (that reflects the risk of the instrument)
Different techniques:
1. Asset based
a. NAV
2. Earnings based
a. Profit
b. Historical price earnings
3. Dividend based
a. Dividend per share
b. Dividend yield
4. Cash flow based (NB!!)
Valuation myths:
Valuation is quantitative and therefore correct
o A lot of factors are not quantitative of nature and vary according to circumstances
Valuation is objective
o Influenced by bias and the needs of the people performing them
Valuation has precision
o Even in the best circumstances, they are approximations
Valuation is valid over an extended time period
o Estimates of the future need to be changed as new information is received about
interest rates and currency rates
Only the answer matters
o The process enables us to understand the fundamentals of the business and what
drives the value. It also uncovers the key variables on which the valuation relies
,Risk and return:
The value of an item is inextricably bound to the return it generates and to the risk it
carries
Technique
o Time value of money
Example:
Asset C Asset D
Return R1 m R1.2m p.a.
p.a.
Risk 10% 10%
o Higher future risk will lower the value of the asset
o If assets have the same risk, choose the one with the higher return
Example:
Asset C Asset D
Retur R1 m p.a. R1m p.a.
n
Risk 12% 10%
o D is clearly worth more than C. To make a valuation, we need to look at the
relationship between expected return and risk, and this is reflected in the required
return for that particular asset. If the expected return, based on its cost to us, is less
than the return received on similar risk assets, then the asset is not worth the price we
paid for it.
Required rate of return:
Since the value of an asset is the PV of future cash flows, we need a rate at which to
discount our future cash flows.
The required rate of return is the return that an investor requires, given the
environment in which the investment is made.
Example:
Cost R10m
Expected return R1 m
Return on similar 12%
assets
Investor wants to invest in an investment with an annual return of 12%. The
Investment will have an annual return of R1m. What will the investor be willing to
pay?
Price x Rate of return =Return
Price x 12% = R1m
Price = R1m/12%
= R8.33m
OR PMT/r = 1 000 000/0.12 [Easier method]
, It is clear that the asset is not worth R10 million. This asset is returning only 10%, whereas
it should yield 12%.
Debentures, Bonds and Preference shares (Self study)
Valuation of Debentures and bonds:
Two types
o Redeemable
o Non-redeemable
Relevant terms:
o Par value refers to the face value of the bond
o The payment divided by the par value is known as the coupon interest rate
o Maturity date/ redemption date represents the date that the bond will be redeemed
o Yield to maturity refers to the implicit return that an investor will earn by holding
the bond or debenture until maturity.
Non-redeemable bonds (continue indefinitely to pay interest at the coupon rate):
Face value of bond: : R 100
Coupon rate : 15% per annum
Yield to maturity in market: 9% per annum
The value of the bond is clearly not R100. You will receive R15 per annum and you should be
getting R9. The required return may be said to be 9%.
Value of the bond = 15/ 0.09 (15% x .09)
= R166.67 (What you get / Market = Value)
Redeemable bonds (has a maturity date on which redemption will take place):
Face value of bond : R1 000
Coupon rate : 15% per year
*Coupon payments are made twice a year.
Redeemable in : 5 years
Yield to maturity in market: 9% pa (Compounded six-monthly)
Calculator:
NB!! 1% = 100 base points
Redemption value: FV = 1 000
Coupon payments: PMT = 150/ 2 = 75
Yield to maturity: I/YR = 9, P/YR = 2
o Always use the market interest rate for I/YR
Number of payments: N = 5 x 2 = 10
PV = R1237.38
Cumulative non-redeemable preference shares:
Example 1- Valuation of preference shares
A person would like to sell 100 preference shares. The shares have a nominal value of
R1 each, and carry a dividend of 10% per year. Similar shares available on the stock
exchange yield an 8% dividend per year. What is the value of the preference shares?
Solution:
PV of yearly dividend that is received in perpetuity
Value of yearly dividend = 100 x R1 x 10% = R10
Capitalize this against the required rate of return (Given as 8%)
R10/0.08 = R125
Factors to consider when considering buying a business:
Profit
Cash flow
Required rate of return
What the price of a similar business is
Value of assets
Competition
Might be seasonal
Why did the previous business sell
Price negotiations (NB!!)
Definition:
Process whereby the value of an asset is determined and expressed in monetary value
Overview:
Underlying principle- time value of money
Value of asset?
o Present value (PV) of all FUTURE economic benefits
(profits/cash/dividends/interest) discounted at appropriate required rate of
return (that reflects the risk of the instrument)
Different techniques:
1. Asset based
a. NAV
2. Earnings based
a. Profit
b. Historical price earnings
3. Dividend based
a. Dividend per share
b. Dividend yield
4. Cash flow based (NB!!)
Valuation myths:
Valuation is quantitative and therefore correct
o A lot of factors are not quantitative of nature and vary according to circumstances
Valuation is objective
o Influenced by bias and the needs of the people performing them
Valuation has precision
o Even in the best circumstances, they are approximations
Valuation is valid over an extended time period
o Estimates of the future need to be changed as new information is received about
interest rates and currency rates
Only the answer matters
o The process enables us to understand the fundamentals of the business and what
drives the value. It also uncovers the key variables on which the valuation relies
,Risk and return:
The value of an item is inextricably bound to the return it generates and to the risk it
carries
Technique
o Time value of money
Example:
Asset C Asset D
Return R1 m R1.2m p.a.
p.a.
Risk 10% 10%
o Higher future risk will lower the value of the asset
o If assets have the same risk, choose the one with the higher return
Example:
Asset C Asset D
Retur R1 m p.a. R1m p.a.
n
Risk 12% 10%
o D is clearly worth more than C. To make a valuation, we need to look at the
relationship between expected return and risk, and this is reflected in the required
return for that particular asset. If the expected return, based on its cost to us, is less
than the return received on similar risk assets, then the asset is not worth the price we
paid for it.
Required rate of return:
Since the value of an asset is the PV of future cash flows, we need a rate at which to
discount our future cash flows.
The required rate of return is the return that an investor requires, given the
environment in which the investment is made.
Example:
Cost R10m
Expected return R1 m
Return on similar 12%
assets
Investor wants to invest in an investment with an annual return of 12%. The
Investment will have an annual return of R1m. What will the investor be willing to
pay?
Price x Rate of return =Return
Price x 12% = R1m
Price = R1m/12%
= R8.33m
OR PMT/r = 1 000 000/0.12 [Easier method]
, It is clear that the asset is not worth R10 million. This asset is returning only 10%, whereas
it should yield 12%.
Debentures, Bonds and Preference shares (Self study)
Valuation of Debentures and bonds:
Two types
o Redeemable
o Non-redeemable
Relevant terms:
o Par value refers to the face value of the bond
o The payment divided by the par value is known as the coupon interest rate
o Maturity date/ redemption date represents the date that the bond will be redeemed
o Yield to maturity refers to the implicit return that an investor will earn by holding
the bond or debenture until maturity.
Non-redeemable bonds (continue indefinitely to pay interest at the coupon rate):
Face value of bond: : R 100
Coupon rate : 15% per annum
Yield to maturity in market: 9% per annum
The value of the bond is clearly not R100. You will receive R15 per annum and you should be
getting R9. The required return may be said to be 9%.
Value of the bond = 15/ 0.09 (15% x .09)
= R166.67 (What you get / Market = Value)
Redeemable bonds (has a maturity date on which redemption will take place):
Face value of bond : R1 000
Coupon rate : 15% per year
*Coupon payments are made twice a year.
Redeemable in : 5 years
Yield to maturity in market: 9% pa (Compounded six-monthly)
Calculator:
NB!! 1% = 100 base points
Redemption value: FV = 1 000
Coupon payments: PMT = 150/ 2 = 75
Yield to maturity: I/YR = 9, P/YR = 2
o Always use the market interest rate for I/YR
Number of payments: N = 5 x 2 = 10
PV = R1237.38
Cumulative non-redeemable preference shares:
Example 1- Valuation of preference shares
A person would like to sell 100 preference shares. The shares have a nominal value of
R1 each, and carry a dividend of 10% per year. Similar shares available on the stock
exchange yield an 8% dividend per year. What is the value of the preference shares?
Solution:
PV of yearly dividend that is received in perpetuity
Value of yearly dividend = 100 x R1 x 10% = R10
Capitalize this against the required rate of return (Given as 8%)
R10/0.08 = R125
