The good and the bad to shareholder valuation methods.
Placing a value on companies shares.
Placing a value on a companies shares can be a tricky task due to a vast variety of variables that can impact. Firstly, we must understand value, and it can be defined as, business value shown through the cash or assets offered to purchase a target company (Lintner, 1965).
In an ordinary case, it is a companies assets that shows value, however intangible assets are hard to value, such as; brands, employees contribution or market efficiency etc. Intangible assets are not always obvious to see. For example, consider McDonalds or Coca Cola, their brands are probably their most important asset to these companies, and thus must be reflected in their share price.
In an ordinary case, it is a companies assets that shows value, however intangible assets are hard to value, such as; brands, employees contribution or market efficiency etc. Intangible assets are not always obvious to see. For example, consider McDonalds or Coca Cola, their brands are probably their most important asset to these companies, and thus must be reflected in their share price.
Lets look at an example, when Saatchi & Saatchi paid a premium of $100m to purchase another company and take their clients, they fired the existing management structure of that company. These managers formed their own company and over the years reclaimed their previous clients from Saatchi & Saatchi, which ultimately resulted in their $100m company being worthless.
In order to give a company share value, there are three techniques to use; Stock market evaluation, Net asset valuation (NAV) or income based.
Stock Market Evaluation
For listed companies in the stock market, the stated share should be fair, and accepted as true value in an efficient market (Roll, 1984). (I have written another blog on this type of market for those that would like further information, please check it out). It gives a potential shareholder the price that is needed to pay in order to purchase shares. To value shares using this method;
Number of ordinary shares in issue x share price = share value.
However, this assumes that all information is in the market place, thus assuming that there is no insider trading. It seems that this method is a useful starting point, but does not go far enough for shareholders to accept as it can only be used for some shares. Those that are not traded frequently or quoted on the stock exchange are not easily valued. See the current FTSE 350 share price here (Hargreaves Lansdown, 2014).
Net Asset Valuation
NAV can be evaluated in two ways;
(1) through its book value
(2) and net reasonability value.
Net asset value considers a companies balance sheet as a company is worth the sum of their net assets. Here we can see fixed assets, stock, cash or liquid assets owned by a company, as well as their duty to pay creditors (Arnold, 2013). Assets are given a 'fire sale value', which is it's price sold on the current market. The issue with this method is that it considers historical data, not necessarily current at its current value. Therefore, even if brand names or goodwill are valued, which they usually are not, it is still at historic cost, rather than current worth. This could then value a going concern at a reasonably high share price, potentially tricking shareholders into investing. For example, a company in the pharmaceutical industry can't be valued by machinery, as their value is generated by the products that machine creates. On the other hand, a company that builds and lets housing is perfect for this valuation method, as their value is very much generated by the assets they hold. This means that it is only useful during takeovers or if a company is in financial trouble, unfortunately it does not effectively value a companies share price due to a lack of future consideration.
Income Based
This looks to the future to predict changes using a number of techniques, meaning that it goes beyond the net asset valuation method. The issue here is that it assumes all companies will remain constant, potentially causing a fake share price for companies that are going-concerns. Furthermore, it does not consider potential factors that can affect inaccuracy's when making predictions or even companies that do not pay dividends.
This valuation method considers a number of models.
'Gordon's Growth Model' uses the current value of dividends to determine a share price (Arnold, 2013). However, this assumes the firms growth rate will remain constant, meaning it can only effectively be used to value established companies with moderate growth rates (Cho, 1988). Therefore, this is not practical for non-dividend paying companies, or those with volatile growth rates.
Discounted cash flow (DCF) valuations are used by both shareholders and acquiring companies. DCF analyses the value an entity should be prepared to pay, rather than an efficient selling price. This method evaluates potential investments by discounting future cash flow projections using WACC, which creates a present valuation (Garrett, 2012). This is however, used only as a tool and small changes to calculations can majorly distort results.
Alternatively, the most popular being the price/earnings ratios model, which gives a sense of future growth opportunities through the eyes of an investor. This compares a share price with the companies most recent earnings per share. A high ratio generally means that a company is speculative, while a low ratio suggests a low growth company. The positive use of this method is that for those companies who are not listed in the FTSE index, surrogate companies can be used as a guideline. Despite being widely used by investors, it is becoming increasingly less acceptable since the 1990's.
Which to choose?
While writing this blog, I first thought that I would simply reach a conclusion as to which method to recommend. However, it seems that the benefits or each method are burdened by it's range of limitations, due to the number of assumptions within each method that can confuse potential investors (Fernandez, 2005).
The lack of an efficient market means stock market valuation does not reflect true value. Secondly, net asset valuation doesn't reflect the true value of an asset, and actually ignores intangible assets. The value of intangibles, is 'perception' dependant, which means it can be difficult to use in medical industries (Daum, 2003). Furthermore, income based valuations do not consider all variations of business stability, so it could be detrimental to an investment portfolio as firms that are not performing can receive an inflated share price.
Therefore, given the short comings on each model it seems that using only one method will be unreliable. In order to carry out an effective valuation of company shares, I would recommend using a multitude of techniques.
'Gordon's Growth Model' uses the current value of dividends to determine a share price (Arnold, 2013). However, this assumes the firms growth rate will remain constant, meaning it can only effectively be used to value established companies with moderate growth rates (Cho, 1988). Therefore, this is not practical for non-dividend paying companies, or those with volatile growth rates.
Discounted cash flow (DCF) valuations are used by both shareholders and acquiring companies. DCF analyses the value an entity should be prepared to pay, rather than an efficient selling price. This method evaluates potential investments by discounting future cash flow projections using WACC, which creates a present valuation (Garrett, 2012). This is however, used only as a tool and small changes to calculations can majorly distort results.
Alternatively, the most popular being the price/earnings ratios model, which gives a sense of future growth opportunities through the eyes of an investor. This compares a share price with the companies most recent earnings per share. A high ratio generally means that a company is speculative, while a low ratio suggests a low growth company. The positive use of this method is that for those companies who are not listed in the FTSE index, surrogate companies can be used as a guideline. Despite being widely used by investors, it is becoming increasingly less acceptable since the 1990's.
Which to choose?
While writing this blog, I first thought that I would simply reach a conclusion as to which method to recommend. However, it seems that the benefits or each method are burdened by it's range of limitations, due to the number of assumptions within each method that can confuse potential investors (Fernandez, 2005).
The lack of an efficient market means stock market valuation does not reflect true value. Secondly, net asset valuation doesn't reflect the true value of an asset, and actually ignores intangible assets. The value of intangibles, is 'perception' dependant, which means it can be difficult to use in medical industries (Daum, 2003). Furthermore, income based valuations do not consider all variations of business stability, so it could be detrimental to an investment portfolio as firms that are not performing can receive an inflated share price.
Therefore, given the short comings on each model it seems that using only one method will be unreliable. In order to carry out an effective valuation of company shares, I would recommend using a multitude of techniques.
References
Arnold, G (2013). Valuing shares and companies, Essentials of Corporate Financial Management. 2(1) pp365-400
Fernandez, P, (2005). Most Common Errors in Company Valuation. Investment Management and Financial Innovations. 2. pp.(133-136).
Cho, D. (1988). The impact of risk management decisions on firm value: Gordon's growth model approach. The Journal of Risk and Insurance, 55(1), 118-131. Retrieved form http://search.ebscohost.com/login.aspx?direct=true&AuthType=cookie,ip,shib,uid&db=buh&AN=5131767&site=ehost-live&scope=site
Daum, J (2003). Intangible assets and value creation. (1st ed.). West Sussex: John Wiley
& Sons.
Hargreaves Lansdown (2014), FTSE 350; Market Overview, Hargreaves Lansdown, retrieved from http://www.hl.co.uk/shares/stock-market-summary/ftse-350
Lintner, J.
(1965). The valuation of risk assets and the selection of risky investments in
stock portfolios and capital budgets. The
review of economics and statistics. 47(1), 13-37. Retrieved from http://www.jstor.org/discover/10.2307/1924119?uid=3738032&uid=2&uid=4&sid=21105533108923
Garrett, I., & Priestley, R. (2012). Dividend growth, cash flow, and discount rate news. Journal of Financial and Quantitative Analysis, 47(5), 1003-1028. doi:10.1017/S0022109012000427
Roll, R. (1984).
A simple implicit measure of the effective bid-ask spread in an efficient
market. The journal of finance,
39(4), 1127-1139. Retrieved from http://onlinelibrary.wiley.com/store/10.1111/j.1540-6261.1984.tb03897.x/asset/j.1540-6261.1984.tb03897.x.pdf?v=1&t=i4cqg1ym&s=f5523f12c47c00d8b0595be9e1bff4522997babd
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