Business valuation is ‘an art not a science’. These are the words used by many ACCA financial management tutors (including myself) when introducing this topic to students preparing for Advanced Financial Management. The words imply that when trying to value the equity capital of a business, there is range of possible correct answers, all of which can be justified as being the most appropriate. To a certain extent this is true but, as I like to put it, ‘there are different degrees of correctness’.
Questions on Business Valuations are included in every Financial Management exam. The questions have typically tested the ‘basic’ equity valuation methods of:
- net assets
- dividend valuation model (or dividend growth model)
- earnings model using P/E ratio or earnings yield
The Advanced Financial Management syllabus builds on those methods tested at the lower level paper. The concept is the same – to find the value of equity. However, the techniques and methods are more sophisticated. As I stated above, ‘there are different degrees of correctness’.
The primary purpose of this article is to demonstrate how to tackle an Advanced Financial Management business valuation question. The detailed understanding of this topic will be gained from your studies, whichever mode you choose to use. My aim is to show you how to successfully apply this knowledge under exam conditions.
Equity valuation – categorising the methods
As stated above, there are more methods and models that can be used to find an equity share price in Advanced Financial Management. The official textbooks explain these in detail and choose different ways of categorising them within their material. I prefer to take a simple view of equity valuation by allocating the methods into two main categories:
- Pre-acquisition
- Post-acquisition
Under the first category, the question will be asking the students to ascertain an equity value for a company. The entity may be a private company and, hence, no stock market price exists or that even if the company is listed, the market price may not be appropriate for the relevant situation. The valuation methods appropriate here are:
- net assets
- dividend valuation model (or dividend growth model)
- earnings model using P/E ratio or earnings yield
- net assets + calculated intangible value (CIV)
- free cash flows (FCF)
Past questions have, in my view, clearly indicated which method should be used to arrive at the share price. However, it is fair to say that the free cash flow model has been tested more than any other method.
Post-acquisition valuation requires a different mindset and series of methods. Here, students will need to ascertain the value of the combined companies after acquisition. More importantly, past exam requirements have requested students to ascertain the percentage gain or loss to both groups of shareholders – those of both the buying and selling companies.
The post-acquisition valuation methods are:
- bootstrapping – applying the price earnings ratio of the buyer to the combined expected earnings of the two entities
- combining the pre-acquisition values of the two companies and appending these with the fair value of the synergies
- free cash flows (FCF) – present value of the combined companies FCF using the relevant discount rate.
As I have stated above, your preparation should include ample time to study and understand the equity valuation methods above, allowing you to apply your knowledge successfully in the exam room.
Below is a worked sample question illustrating how I would tackle a 25-mark exam style question, based broadly on previous exam content.
Borgonni and Venitra
Borgonni Co is a very successful entity. The company has consistently followed a business strategy of aggressive acquisitions, looking to buy companies that it believes were poorly managed and hence undervalued. Borgonni can be described as a modern day conglomerate and its business interests stretch far and wide.
Its board of directors has chosen the takeover targets with care. Always looking for companies with potential, but which were poorly managed and having a below par market value, Borgonni has maintained its price earnings (P/E) ratio on the stock market at 12.2.
Borgonni’s 20X3 figures show a profit after tax of $886m and it has 375m shares in issue.
Venitra Pvt is a well-established owner-managed business. In financial terms it has a rather chequered history with its up and downs corresponding directly with the state of the global economy. Over the past five years, its profits have fallen each year with the 20X3 values standing at: