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Hi all. I would like to seek help if someone could check if my understanding for this question is correct. It involves the topic on valuation methods. I am still trying my best to learn. This is a past exam paper I got from someone. I am still trying my best to learn as much as possible so do correct me if I am wrong. Thank you!
I am not sure how to format it so I will try my best to make it as presentable as possible. Thank you all.
Question:
Company A has a distributable earnings of $94m, a weighted average cost of capital of 9% and a P/E ratio of 19.2. It is in the process of taking over Company B whose financial details are as follows.
Company B Key financial data
Profit before interest and tax: $74m
Interest Paid: $9.4m
Corporate tax: $12.92m
Distributable earnings: $51.68
Current dividend: 13.9p
Last 4 years dividends: 9.0p, 9.4p, 10.8p, 12.4p
Earnings Per Share (EPS): 18.7p
Price/Earnings ratio: 11.27 times
Market Price of ordinary share: $2.11
Equity Beta: 1.56
Replacement cost of non-current assets: $463m
Disposal value of non-current assets: $382mCompany B financial position statement
$m $m
Non-current assets 397
Current Assets 54
Total assets 451Equity Finance:
Ordinary shares (nominal value 50p) 138
Reserves 29 167
Long-term liabilities:
6% bond (redemption after 10 years) 265
Current liabilities 19
Total liabilities 451Company A expects to maintain an annual increase in distributable earnings of 6% due to anticipated synergy as a result of a takeover. The company will also be able to sell surplus non-current assets for $81m in 3 years time. The current estimate of cash flows of Company B is $38m, but these are expected to grow at an annual rate of 3% in future years. The risk-free rate of return is 1.40% and the equity risk premium is at 9%.
Calculate the value of Company B using the following valuation methods
a) Stock market valuation
b) All 3 Asset based valuation methods
c) Earnings yield Excluding and including growth
d) Price earnings ratio valuation (Using weighted average)
e) DCF valuation (Using company A WACC)My answer:
a)
Market Value = EPS x P/E Ratio
= 18.7 x 11.27
= 210.749b)
How do I use the 3 asset based methods? I am not sure how.c)
Earning yields = 74/210.749
= 0.35%
What is including and excluding growth?d) I have used the P/E ratio method to find the stock value. Am I wrong on part a)? How do I use weighted average to for P/E ratio?
e) I would like someone to teach me on DCF valuation because I don’t quite understand the concept yet.
Thank you all for the time.
This is not a past Paper F9 exam question! (Not all of it is examinable at F9 anyway)
For part (a) you should use the dividend growth model – the formula is on the formula sheet. You can calculate shareholders required rate of return using the capital asset pricing model because you are given the beta.
For part (b), the three approaches are to use book values of assets (from the Statement of financial position); the realisable value (i.e. disposal value); and, the replacement value.
For part (c), you are not asked to value the business using the earnings yield. The earnings available to shareholders are 51.68 , the earnings yield is 1/PE ratio which is 8.87%. Without growth you will just use 51.68/8.87%; with growth you use the dividend growth model again, but using earnings instead of dividends.
Part (d) is not in the syllabus for F9 – you cannot be asked to calculate a weighted average PE.
For part (c) you need to calculate the WACC and then discount the net cash flows at this rate.
All of the techniques involved are covered in the free lectures on here for F9 (primarily chapters 14, 15 and 16, but also obviously other chapters cover CAPM and present values) 🙂
Thank you John!
I will spend some time on the lectures. I just had a really hard time understanding from the material text I have at the moment.
Thank you again
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