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understand the difference between having a diverse portfolio and diversifying
away unique risk. The former means ˜not putting one™s eggs in one basket™
and attempting to invest in the best companies in each sector, so that if a
particular sector is suffering, it will not affect the whole portfolio. The latter
means attempting to invest to achieve the market average, for if you truly
diversify away unique risk, the market average is what you must be left with.

This book suggests that diversifying away unique risk is irrational and that the
objective must be to invest in the best companies, but have a diverse portfolio.
The logic for this assertion is that the market is made up of several companies
that follow the 20“60“20 rule. That is that 20% will be superbly managed, 60%
will be well managed, while the bottom 20% will not be so well managed.
In every year, some companies gain significant value for their shareholders,

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Accounting and Business Valuation Methods

while others turn out to be a disaster. The market for an average year can be
illustrated, using the £16 000 being invested, as below:


Whole market (average year) %

Investment (£) Closing value of Pro¬t/(loss)
investment (£) (£)

Company A 1 600 2 560 960 60.0
Company B 1 600 2 320 720 45.0
Company C 1 600 2 192 592 37.0
Company D 1 600 1 720 120 7.5
Company E 1 600 1 680 80 5.0
Company F 1 600 1 600 0 0.0
Company G 1 600 1 552 (48) (3.0)
Company H 1 600 1 440 (160) (10.0)
Company J 1 600 1 408 (192) (12.0)
Company K 1 600 728 (872) (54.5)

Total market 16 000 17 200 1 200 7.5


For illustrative purposes, it is assumed that dividends pay for transaction costs
and that the figures above show capital gains and losses only. Again, for illus-
trative purposes, it is assumed that by investing in companies C, E, F and J, it
is possible to diversify away unique risk. This is shown below:


Selection eliminating unique risk (average year)

Investment (£) Closing value of Pro¬t/(loss) %
investment (£) (£)

Company C 4 000 5 480 1 480 37.0
Company E 4 000 4 200 200 5.0
Company F 4 000 4 000 0 0.0
Company J 4 000 3 520 (480) (12.0)

Total 16 000 17 200 1 200 7.5


If we look at the ˜whole market™ above, we can be confident that if the following
year is an average year, then the market will end up as illustrated. What we do
not know, of course, is which companies will be exceptionally good, which will
be average and which will turn out to be losers. What we must try to do, though,

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Assessing risk and valuing companies

is to avoid investing in the worst 20%. How do we do this? The answer is by
analysing the last published accounts to assess the risks involved. How this is
done is explained in Chapter 2 and later in this chapter. If we are successful,
then it can be very rewarding. Suppose, for example, we had vested £2000 in
each of companies A“H, rather than £1600 in each of the 10 companies, then our
annual return would increase from 7.5% to 17.7%, a significant improvement.

We know that the risk of market failure is far greater than the risk of a portfolio
of individual companies failing, but it is also true that when the market falls,
it is the weakest companies that go to the wall. The companies that are heavily
in debt may not be able to withstand the combination of falling sales together
with an interest rate increase, while those in a better financial state will suffer,
but recover. So when the market has a bad year, it may look like:


Whole market (bad year) %

Investment (£) Closing value of Pro¬t/(loss)
investment (£) (£)

Company A 1 600 1 840 240 15.0
Company B 1 600 1 760 160 10.0
Company C 1 600 1 720 120 7.5
Company D 1 600 1 440 (160) (10.0)
Company E 1 600 1 360 (240) (15.0)
Company F 1 600 1 240 (360) (22.5)
Company G 1 600 1 200 (400) (25.0)
Company H 1 600 1 008 (592) (37.0)
Company J 1 600 512 (1 088) (68.0)
Company K 1 600 0 (1 600) (100.0)
Total market 16 000 12 080 (3 920) (24.5)

Again, the effect of diversifying away unique risk can be illustrated as follows:

Selection eliminating unique risk (bad year)

Investment (£) Closing value of Pro¬t/(loss) %
investment (£) (£)

Company C 4 000 4 300 300 7.5
Company E 4 000 3 400 (600) (15.0)
Company F 4 000 3 100 (900) (22.5)
Company J 4 000 1 280 (2 720) (68.0)
Total 16 000 12 080 (3 920) (24.5)

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Accounting and Business Valuation Methods

This time, avoiding the bottom 20% of companies reduces the loss from
24.5% to 9.6%.

There will be years when the ˜bulls™ beat off the ˜bears™ and the market as a
whole flourishes. However, even in these years, some companies will have to
cease trading because they ran out of cash and the banks declined to support
further. For example, 2006 was a very good year for the stock market as a whole,
but that did not stop Farepak Food and Gifts Limited going into administration
leaving approximately 125 000 of the poorest in the society going without the
Christmas festivities they were expecting (Farepak website, December 2006).

For the illustration of a good year for the stock market, we have not shown
any company being completely wiped out, but nevertheless the mix of fortunes
will remain:

Whole market (good year) %

Investment (£) Closing value of Pro¬t/(loss)
investment (£) (£)

Company A 1 600 2 992 1 392 87.0
Company B 1 600 2 720 1 120 70.0
Company C 1 600 2 640 1 040 65.0
Company D 1 600 2 000 400 25.0
Company E 1 600 1 960 360 22.5
Company F 1 600 1 920 320 20.0
Company G 1 600 1 632 32 2.0
Company H 1 600 1 552 (48) (3.0)
Company J 1 600 1 544 (56) (3.5)
Company K 1 600 1 200 (400) (25.0)
Total market 16 000 20 160 4 160 26.0

For the third time it is assumed that unique risk can be diversified away:

Selection eliminating unique risk (good year)

Investment (£) Closing value of Pro¬t/(loss) %
investment (£) (£)

Company C 4 000 6 600 2 600 65.0
Company E 4 000 4 900 900 22.5
Company F 4 000 4 800 800 20.0
Company J 4 000 3 860 (140) (3.5)
Total 16 000 20 160 4 160 26.0

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Assessing risk and valuing companies

This time, eliminating the bottom 20% of companies improves the return to
36.1%. So as can be seen, if it were possible to avoid investing in the worst 20%
of companies, the annual return that could be achieved would be far better
than the market as a whole. But can it be done?




The experiment
Hemscott is a website dedicated to providing financial information. In
2003/2004, Tom Stevenson was Hemcott™s head of research and in that capac-
ity he wrote about the systematic approach to selecting shares. He regularly
reviewed systems such as Jim Slater™s price/earnings to growth (PEG) ratio,
Michael O™Higgins high-yield approach and David Dreman™s contrarian low
price/earnings ratio (PER) method. Using these systems of selecting shares and
using Hemcott™s database, he drew up four shortlists from the FTSE Small Cap
index. These were the following:

• The five with the lowest PERs
• The five producing the highest yields
• The five with the lowest price/tangible asset book value ratios
• The five with the lowest price/cash ratios

Ten months later at the end of June 2004, Tom Stevenson noted that although
some shares produced amazing results in each category, there were also heavy
losers. Overall, each section achieved net gains of 16%, 29%, 23% and 46%
compared with an 8% gain for the market as a whole in the same period.

Again using Hemscott™s database, he produced a list of the top five shares in
each category as at the end of June 2004. These were:

• The lowest PERs “ Chaucer Holdings, Cox Insurance, Goshawk Insurance,
Molins and Jarvis
• The highest yields “ Beattie (James), Molins, Hardy Underwriting and
Ultraframe;
• The cheapest price/tangible asset ratio “ Goshawk Insurance, Lavendon,
Molins, Tops Estates and UNITE Group;
• The lowest price/cash flow “ Hitachi capital, Ashtead, Lavendon, Danka
and Beazley.

203
Accounting and Business Valuation Methods

As can be seen, there were some duplications, so the original list of 20 compa-
nies came down to 16:
Ashtead Group, Beattie (James), Beazley, Chaucer Holdings, Cox Insurance,
Danka, Goshawk Insurance, Hardy Underwriting, Hitachi Capital, Jarvis,
Lavendon, Molins, Regent Inns, Tops Estates, Ultraframe and UNITE
Group.
Based on the previous experiences described by Tom Stevenson for the 2003
selected companies (range: gain of 213% to loss of 96%), it seemed likely that
the companies listed for 2004 would do either spectacularly well or excruciat-
ingly bad. The question was: Could analysis of the latest published accounts
distinguish between the two extremes?
On 1 July 2004, the latest published accounts for each of the 16 companies
were examined. Because of timing constraints (analyse the accounts and write
an article based upon the analysis), none of the accounts was reviewed in
detail, which would be the case if investing real money had been envisaged.
Instead, the exercise was simply an experiment to see if the accounts would
give obvious clues without carrying out time-consuming reviews.
Three companies out of the sixteen were eliminated because they failed one or
more of the tests described in Chapter 2. These were: Cox Insurance, Jarvis and
Molins. Another four companies were eliminated because the latest accounts
showed negative earnings. More time spent on these companies might have
revealed reasons why future earnings could be better, but that was outside
the scope of the rules laid down. Negative earnings took out Ashtead Group,
Danka, Goshawk Insurance and UNITE Group.
The remaining nine companies were analysed and were placed in the following
order:
(1) Tops Estates, (2) Chaucer Holdings, (3) Hitachi Capital, (4) Hardy Under-
writing, (5) Beattie (James), (6) Beazley, (7) Ultraframe, (8) Lavendon,
(9) Regent Inns
The top four shares were selected and backed against the whole 16 shares,
based on £4000 being invested in each of the selected four shares compared
with £1000 being invested in each of the 16 shares; the test to run over the 10
months (to be consistent with Tom Stevenson™s selected timeframe) ended on
30 April 2005. The article was written on 1 July 2004 and was published in the
October 2004 edition of ˜Financial Management™ ( Journal of Chartered Institute
of Management Accountants).

204
Assessing risk and valuing companies

The results of this test were published in the June 2005 edition of ˜Financial
Management™ (selected companies in bold, rejected on test in italics):

Opening share Closing share Percentage of
capital returneda
price, 1 July 2004 price 30 April
(pence) 2005 (pence)

Jarvis 78.00 10.25 13.1
Danka 63.00 16.50 26.2
Ultraframe 127.50 51.50 46.6
Beazley 96.50 88.00 91.5
Molins 175.00 162.50 92.9
Beattie (James) 126.50 116.50 94.9
Hardy Underwriting 237.50 212.50 100.0
Goshhawk Insurance 40.25 42.50 105.6
Chaucer Insurance 48.00 56.00 118.2
Cox Insurance 71.50 92.00 129.4
Hitachi Capital 197.50 256.50 131.4
Tops Estates 332.00 442.50 134.5
UNITE Group 197.50 285.00 145.6
Lavendon 125.00 184.50 149.4
Regent Inns 43.50 80.50 185.1
Ashtead Group 27.50 86.75 315.5
a
Percentage takes into account dividends paid in the period (excluded if ex-dividend).
The four selected shares showed a profit of £3363.67 in the period on the investment of
£16 000 (£2842 after transaction costs) compared to the profit of £2796.44 for the whole
market (£2283 after transaction costs), giving a gross percentage profit of 21.0% and 17.5%,
respectively, compared to the FTSE 100 index increasing 7.6% in the same period.

However, the methodology used for this experiment was flawed in that it used
only one valuation method, that being valuation based on earnings. To evaluate
insurance companies, the methodology should include an assessment of the
risks associated with underwritten policies that were still live. In addition,
property investment companies such as Tops Estates and UNITE Group are
primarily valued on net asset values (NAVs) and not earnings (see UNITE
Group™s accounts in Chapter 3). In the latter case, it was the potential for
increased property values in the future rather than the lack of earnings that
should have been the key feature of any valuation.

Six months later, the overall 16 shares were performing much better than the
four that had been selected. What this tells you is that reviewing a set of accounts
once, making a decision and forgetting about it is not a rational strategy. Once a
share is purchased, that company™s accounts must be reviewed every 6 months.

205
Accounting and Business Valuation Methods

This review should assess whether or not the methodology used for a particular
company was the right one and should also look for clues in the latest accounts
to see if the company is progressing or not. The old adage that ˜you should buy
into a good company and stay with it™ is valid only if the company is continuing to
perform. If a review of subsequent accounts cannot detect a problem, then by all
means stay with a share even if the price is going down, but if the accounts reveal
a reason why the share price is falling, then selling might be the best strategy.

Although the method of selecting companies had successfully eliminated the
four worst-performing companies, it had also failed to spot the four companies
that were going to show the greatest improvement. The reason why these win-
ners were missed was a combination of using only one valuation methodology (as
detailed above) and not looking at the potential for future earnings to improve. But
further analysis revealed that the investment rule that states companies failing
the tests shown in Chapter 2 (and later on in this chapter) should be avoided was
largely validated. However, although it is not impossible that there will be excep-
tions to this rule, given the probabilities such companies may best be avoided.

The fate of the bottom four and top four companies is shown below:



Share price (pence)

1 July 2004 30 April 2005 31 March 2006 5 April 2007
Bottom four
0.20a 0.18a
Jarvis 78.00 10.25
Danka 63.00 16.50 20.00 16.00
b
Ultraframe 127.50 51.50 38.75
Beazley 96.50 88.00 118.00 161.50
a
Based on restructuring where investors received one new ordinary share for every 400 old
ordinary shares.
b
Taken over by Latium Holdings Limited; price not known.


Share price (pence)

1 July 2004 30 April 2005 31 March 2006 5 April 2007
Top four
Ashtead Group 27.50 86.75 223.00 153.75
Regent Inns 43.50 80.50 97.50 113.75
Lavendon 125.00 184.50 280.00 416.00
UNITE Group 197.50 285.00 450.00 535.00


206
Assessing risk and valuing companies


Risks associated with taking on unique risk
The benefits of taking on unique risk can be substantial, as detailed above, but
there must be associated risks. The greatest risk is that a selected company
will go badly wrong and be wound up, with the result that the investor will
lose the total investment. A smaller risk is that despite financial analysis being
accurate, the share price does not meet expectations in the short term. For
this reason, buying and selling stocks and shares is less risky than buying
and selling options, but because of leverage, options could provide the greatest
profit. In simple terms, the greater the risk, the greater the potential for profit,
the greater the potential for making a loss.

The example below explains. You have analysed a company and believe that
the share price should be £10, compared to the current market price of £8,
with a call (right to buy) at the current price anytime up to three months from
the contract date at an option price of 40 pence per share. If you have £10 000
to spend, then ignoring transaction costs yon can either buy 1250 shares or
25 000 options.

If your analysis proves to be spot on and within 3 months the share price
moves up to £10, then:


Owning the shares

Sales 1 250 — £10 = £12 500
Sell the shares for £10
Less: cost of shares £10 000
Profit £2500



Do not own the shares
Cost of option £10 000
Exercise option “ 25 000 shares at £8 £200 000
Cost of shares £210 000
Sale of shares: 25 000 at £10 £250 000
Profit £40 000




207
Accounting and Business Valuation Methods

However, three other results can be imagined, price moves down (say) £2, price
stays the same, or price moves up £2, but after three months it has expired.
Now, the bigger picture can be reviewed:

Share purchase Share option
Profit/(loss) (£) Profit/(loss) (£)
Price moves up £2 within 3 months 2500 40 000
Price moves up £2 after 3 months 2500 (10 000)
Price does not move “ (10 000)
Price goes down £2 (2500) (10 000)

Of course, put (right to sell) options can be even more dangerous. The situation
can be imagined where the analysis of the latest accounts suggests that the
company in is serious trouble and might not survive in the long term, so a
put option is bought. Within 3 months, the company is in serious trouble and
its shares are suspended. The analysis is spot on. However, the put option
is worthless because you cannot buy the shares, so you cannot exercise the
option.
Companies are never forced out of business for merely making a loss. The
problems arise only when they have insufficient cash to meet their liabilities
and their bankers refuse to bail them out. Failure to make a due payment to
Revenue & Customs will often be fatal. For this reason, companies with huge
debt and failing to generate a reasonable level of cash must be considered a
higher risk than those companies either without debt or with little debt.
As explained in Chapter 2, companies whose working capital ratios are very
much adverse when compared to their competitors must be considered to be
a higher risk than such competitors. In such cases, the market might have
discounted the share price to take account of this risk, but it has to be a matter
of judgement as to whether such discount is reasonable or not.
Companies heavily indebted and not generated cash at reasonable levels,
together with companies with adverse working capital ratios, are deemed to
be high-risk companies, the rest are considered medium-risk companies. What
investors choose to invest in will be dependent upon their risk profile. This
book is designed for the risk profile shown in bold (below).
Some investors choose to invest in companies they think will grow, others
might buy for a relatively high dividend yield. Many investors will aim for a
combination of these attributes.

208
Assessing risk and valuing companies


Risk pro¬le Investment type

Enjoys a high level of risk and Invest in options
expects very high returns (all or
nothing)
A risk taker expecting to be Invest in stocks and shares in high-risk
rewarded for bravery companies
May also invest in venture capital and
biotechnology companies not yet in
pro¬t
Not a risk taker by nature, but Invest in stocks and shares in
will take some risk to beat the medium-risk companies
market May try to predict takeover targets
Risk-averse Invest in tracker funds, to eliminate
unique risk
Do not take any risks Invest in Government risk-free bonds




Assessing company performance
The accounts of 20 companies with a year end of 31 December 2005 or later
were added together. All the accounts were prepared using the rules laid down
by IFRS. The companies selected covered a broad range of industries as the
objective was to find most, if not all, of the idiosyncrasies that can be found
in a set of published accounts. The sum of the numbers was divided by 20
to arrive at a mean and the results are shown as a fictitious company “ Con
Glomerate plc.

Figure 4.1 shows the Income Statement (said to be for the year ended 31
December 2006). Figure 4.2 shows the Balance Sheet (said to be at 31 December
2006). Figure 4.3 shows the Cash Flow Statement (again said to be for year
ended 31 December 2006).

The problem we have with these accounts is that the Income Statement as
prepared under IFRS may not give us an earnings figure and consequently an
˜earnings per share™ figure that we can effectively use to judge performance. Of
course, here we are in the realms of judgement because opinions are bound
to differ. Indeed, if opinions did not differ, then we would not have a market.
Some will argue that an IFRS Income Statement gives a true and fair view

209
Accounting and Business Valuation Methods

Con Glomerate plc

Income Statement for year ended 31 December 2006

£™000

Turnover 1,311,510

Cost of sales 1,116,443

Gross profit 195,067

Distribution costs 37,340
Administration costs 89,089
Net valuation (gains) on investment property (9,154)

Operating profit 77,792

Interest payable 10,659

Profit before tax 67,133

Tax 19,028

Net profit 48,105

Number of ordinary shares (™000) 145,230

Earnings per share (pence) 33.1

Figure 4.1 Con Glomerate plc “ Income Statement for year ended 31 December 2006



of earnings for investment purposes; others including the writer of this book
argue otherwise.

So the adjustments recommended below represents the writer™s view and
although reasons for such views will be given, readers are invited to form their
own opinions. To make the adjustments, it is necessary to look at the Cash
Flow Statement (Figure 4.3).




210
Assessing risk and valuing companies



Con Glomerate plc

Balance Sheet at 31 December 2006

£™000

Goodwill 103,215
Other intangible assets 7,495
Tangible assets 221,609
Investments and deferred tax 34,776

Fixed assets 367,095

Inventories 202,579
Trade and other receivables 108,225
Current tax 376
Other current assets 3,375
Cash and cash equivalents 33,906

Current assets 348,461

Total assets 715,556


Trade and other payables 181,376
Financial liabilities 50,140
Provisions 1,965
Current tax liabilities 10,918

Current liabilities 244,399


Financial liabilities (long term debt) 184,017
Deferred tax 12,624
Pension deficit 20,134
Provisions 5,733
Other payables 7,173

Non-current liabilities 229,681

Total liabilities 474,080

NET ASSETS 241,476


Share capital 27,430
Share premium account 63,402
Other reserves 13,899
Retained earnings 136,745

EQUITY SHAREHOLDERS™ FUNDS 241,476

Figure 4.2 Con Glomerate plc “ Balance Sheet at 31 December 2006


211
Accounting and Business Valuation Methods

Con Glomerate plc

Reconciliation between Operating profit
and Cash Inflow from operating activities

£™000
Operating profit 77,792

Depreciation 15,100
Amortisation and impairment 4,977
Share options (IFRS 2) 918

Exceptional (gains)/losses (3,164)
Movement in long term provisions (2,417)
Dividend paid to minority interests (175)
Revaluation gains on investment property (9,154)

Defined benefit charge to Income Statement 203
Cash contribution to defined benefit scheme (3,138)

(Increase)/decrease in stock (17,224)
(Increase)/decrease in debtors (14,198)
Increase/(decrease) in creditors (34)

Interest paid (8,828)
Tax paid (11,168)

Cash inflow from operating activities 29,490

Figure 4.3 Con Glomerate plc “ Part Cash Flow Statement for the year 31 December 2006


Exceptional gains
Companies may choose what depreciation rates they use and a gain on a sale of
an asset might merely reflect that it has been depreciated too quickly. Of course,
it could be depreciated equally too slowly and this is why Revenue and Customs
do not allow gains and losses to be used in corporation tax computations. The
figure in brackets in the Cash Flow Statement indicates that the gain was only
a ˜paper™ gain that did not generate cash. Accordingly, for assessment purposes
it should be ignored.


Revaluation gains on investment properties
As discussed earlier, property companies are assessed primarily on NAVs and
while it makes sense to have up to date valuations in the Balance Sheet,

212
Assessing risk and valuing companies

declaring a profit in the Income Statement when clearly no such profit has
been earned seems illogical. Accordingly, again for assessment purposes such
profits should be ignored.


Share options
The cost of share options can be considered a mythical cost that simply will
not happen in the context that cash will never be expended. Therefore, the
cost of ˜share options™ should be added back to profits.


De¬ned bene¬t charge to Income Statement
The problem here is one of consistency and to achieve this we are going to
charge the Income Statement with what we believe the charge should be, but
after arriving at ˜shareholders™ operating profit™. Therefore, the actual charge is
added back to profits to arrive at ˜Real Operating Profit™. The effect of these
adjustments is to reduce the ˜operating profit™ of £77 792 000 to a ˜Real operating
profit™ of £66 595 000 (Figure 4.4).
The next step is to add ˜depreciation™ and ˜amortisation and impairment™ to
the ˜Real operating profit™ of £66 595 000 to arrive at ˜Operating profit before
depreciation and amortisation and impairment™ of £86 672 000 (Figure 4.4).

What we want to work out next is the tricky bit, what the ˜true™ earnings
really are. In other words, we want to assess how much profit is available to
shareholders and accordingly what the ˜true™ earnings per share really are. As
discussed before, the real problem with the IFRS Income Statement is that the
profit declared from one year to the next can be subject to significant volatility,
when what we need to establish is the trend over time.

So from ˜Operating Profit before depreciation and amortisation and impair-
ment™, we must take off those costs that will allow the company to stay in
business and that must include making due allowance for known liabilities.


Depreciation
Depreciation is the charge to the Income Statement that takes into account that
assets are being consumed and consequently are reducing in value over time.
Applying the concept of ˜fair value™ might mean that assets are being depre-
ciated unevenly and this will prevent the establishment of a trend. However,

213
Accounting and Business Valuation Methods

Con Glomerate plc

Calculation of REVISED (adjusted) ˜earnings™
(profit belonging to shareholders)

£™000

Operating profit 77,792

Exceptional (gains)/losses (3,164)
Revaluation gains on investment property (9,154)
Share options (IFRS 2) 918
Defined benefit charge to Income Statement 203
Real ˜operating profit™ 66,595

Depreciation 15,100
Amortisation and impairment 4,977

Operating profit before depreciation
and amortisation 86,672

Depreciation (Actual from Cash Flow Statement) (15,100)
Amortisation (10% of intangibles) (11,071)

˜Shareholders™ operating profit 60,501

Interest (Actual from Income Statement) (10,659)
Pension deficit (10% of Balance Sheet figure) (2,034)
Tax at 28% (from April 2008) (16,486)
Dividend paid to minority interest (175)

˜Shareholders™ earnings 31,147

Number of ordinary shares (™000) 145,230

Earnings per share (pence) 21.4

Figure 4.4 Con Glomerate plc “ revised Earnings Statement (revised Figure 4.1)



such variations on assets normally depreciated are not thought to be significant,
so no adjustment will be made.


Amortisation
Under UK GAAP, goodwill was amortised at the rate of 5% per annum. Under
IFRS, goodwill is not amortised, but it is subject to an annual review and

214
Assessing risk and valuing companies

impairment as necessary. The difficulty with this decision is that readers of
published accounts are reliant upon the directors having excellent judgement,
but, more problematically, will experience extreme volatility in earnings.

It could be argued that although under UK GAAP goodwill was amortised,
5% per annum was too low a rate. The world changes rapidly in 20-year
cycles. Twenty years ago, desktop computers had been in the United Kingdom
for about 4 years and although they were novel at the time, their memory
when compared to today was infinitesimal. Twenty years before that, only the
largest of companies had computers. Such computers were located in large
air-conditioned hanger-type rooms and could only slowly process punch cards.
The currency in the United Kingdom was £sd, where 12 pennies made one
shilling and 20 shillings made one pound. Calculators did not exist and all
calculations were done by specialist comptometer operators who first converted
£sd to decimals, did the calculations and converted back again.

The point of this story is to justify the view that goodwill will not last for an
infinite time and that any goodwill today will not likely have much value in
20-years time as the world has moved on. Accordingly, in Figure 4.4, goodwill
and other intangible assets have been amortised at the rate of 10%, again based
on the values given in the Balance Sheet. Taking off depreciation and amor-
tisation leaves a ˜Shareholders™ operating profit™ of £60 501 000 (Figure 4.4).
From this is deducted ˜interest™, being the actual figure taken from the Income
Statement (Figure 4.1).


Pension de¬cit
The ˜pension deficit™ shown as a non-current liability in the Balance Sheet is
the difference between the liabilities of the company™s salary-related pension
scheme in respect of the scheme™s members and the fair value of the assets
held by the pension fund to meet these liabilities.

This figure will change each year and some volatility is impossible to avoid.
However, this liability should be recognised and it is assumed that over 10 years
the company will fund the deficit. Accordingly, 10% of this deficit is charged
to the Income Statement. First, any amount charged to the Income Statement
(which has been added back to profits) is added back to the pension deficit
in the Balance Sheet. The resultant figure from this addition is divided by
10 to arrive at the figure to be charged in the Adjusted Income Statement
(Figure 4.4).

215
Accounting and Business Valuation Methods

Corporation tax
With IFRS Income Statements taking unearned profits and then taxing such
profits, it is impossible to assess what the true current corporation tax liability
really is. Therefore, some assessment has to be made, although we know we
cannot arrive at the correct figure. This really has to be the best estimate.

In Figure 4.4, corporation tax is calculated as follows:

£™000
Operating profit before depreciation and amortisation 86 672
Less: depreciation (15 100)
: interest (10 659)
: pension deficit (2034)
Taxable profit 58 879
Taxable profit of £58 879 000 at 28% = 16.486

Depreciation is not an allowable expense for corporation tax, so this calculation
assumes that capital allowances will equal depreciation. Also expenses, such
as entertainment expenses, that are also non-allowable for corporation tax
purposes are not known and therefore cannot be taken into account. However,
in the overall scheme of things, the error is unlikely to be significant.


Dividends to minority interests
Dividends to minority interests usually mean dividends to preference share-
holders, who must be paid before ordinary shareholders can take their share.
For this reason, such dividends are taken from the Income Statement before
arriving at the figure that belongs to ordinary shareholders.

We are now left with earnings of £31 147 000 and with 145 230 000 ordinary
shares; the earnings per share calculation (EPS) is 21.4 pence per share. The
principal reason for making the adjustments described above is to take a pru-
dent view and to be able to assess different companies fairly. We are being
prudent:
• By calculating ˜earnings per share™ as ˜earnings™ divided by the ˜ “diluted”
number of ordinary shares™. These are the number of ordinary shares in
issue after adding the maximum number of outstanding share options.
This gives the worse-case scenario as it does not increase Balance Sheet

216
Assessing risk and valuing companies

value to take into account the price paid for the shares on exercising
the option.
• By taking account of all known liabilities that will come out of share-
holders™ funds.

We are also taking these liabilities into account to fairly compare one company
with another. So all other things being equal:
• A company with no intangible assets will be a better bet than one with
intangible assets.
• A company with no pension deficit on its salary-related pension scheme
will be a better bet than another with a pension deficit.

Having adjusted the Income Statement, we can put together a Cash Flow State-
ment that both reconciles to the revised earnings and is also in a format that
we need for assessment purposes (Figure 4.5). We now have the information
needed to assess the company and come up with a valuation. Though, we need
to carry out basic checks.

Con Glomerate plc

Reconciliation between Operating profit
and Cash Inflow from operating activities (Revised [adjusted] statement)

£™000

Shareholders™ operating profit 60,501

Depreciation 15,100
Amortisation 11,071

(Increase)/decrease in stock (17,224)
(Increase)/decrease in debtors (14,198)
Increase/(decrease) in creditors (34)

Cash inflow from operations 55,216

Movement in long term provisions (2,417)
Dividend paid to minority interest (175)
Cash contribution to defined benefit scheme (3,138)

Interest paid (8,828)
Tax paid (11,168)

Cash inflow from operating activities 29,490

Figure 4.5 Con Glomerate plc “ revised Part Cash Flow Statement (revised Figure 4.3)

217
Accounting and Business Valuation Methods


Basic checks
Although the calculation of profit can be judgemental, the generating of cash
is not. Either cash is generated or it is not. A company making a profit should
be generating cash, so the first check is to find out whether this is the case,
with the rule being:

˜Cash Inflow from Operations™ should be greater than ˜Operating profit™

If we look at Figure 4.5, we see that ˜cash flow from operations™ of £55 216 000
is lower than the operating profit of £60 501 000. The reason for this is that we
have had an outflow from both inventories and receivables, so the next step is
to calculate the key ˜asset management ratios™, namely:

Calculate ˜inventory (stock) days™ and compare with other companies in the
same sector.
Calculate ˜receivable (debtor) days™ and compare with other companies in the
same sector.

If the company is generating cash and both inventory days and receivable
days seem reasonable (always assuming that the company has inventory and
receivables), then the next check is:

If the company has debt, read through the accounts to ensure the company
has sufficient facilities in place to enable it to meet its liabilities.

If examination of the figures at this stage throws up any concerns, then ratio
analysis, as described in Chapter 2, can be carried out.

The final check is to see how well the company is utilising its assets. Before
companies invest in capital projects, they attempt to ensure that, taking into
account the time value of money, the income derived from them will exceed
their cost of capital.

In Chapter 2, the concept of the relationship between the cost of capital and
the risk was discussed. It was argued that the lower the cost of capital, by
having high debt levels compared to equity, the greater the risk that the com-
pany would be forced out of business. Accordingly, it seemed inappropriate to
judge capital projects on a company™s actual cost of capital and instead it was
suggested that a rate that was risk-neutral should be used.

The rate of return used for illustrative purposes is a net 15%, after taking tax
at the rate of 28% into account, but, of course, it is a matter of judgement as to
what the required rate of return should be.

218
Assessing risk and valuing companies

Formula to calculate discount factors

Gross Net
Interest rate 20.83 15.00
Discount
Year Principle Interest Tax Net Factor
£p £p £p £p
1 1,000.00 208.33 (58.33) 1,150.00 0.869565
2 1,150.00 239.58 (67.08) 1,322.50 0.756144
3 1,322.50 275.52 (77.15) 1,520.87 0.657518
4 1,520.87 316.85 (88.72) 1,749.00 0.571755
5 1,749.00 364.37 (102.02) 2,011.35 0.497179
6 2,011.35 419.03 (117.33) 2,313.05 0.432330
7 2,313.05 481.88 (134.93) 2,660.00 0.375940
8 2,660.00 554.17 (155.17) 3,059.00 0.326904
9 3,059.00 637.29 (178.44) 3,517.85 0.284265
10 3,517.85 732.88 (205.21) 4,045.52 0.247187


Discounted Cash Flow

Year Investment Return Tax on return Net Dis. Factor DCF
£p £p £p £p £p
0 (1,000.00) (1,000.00) 1.000000 (1,000.00)
1 0.00 0.869565 0.00
2 0.00 0.756144 0.00
3 0.00 0.657518 0.00
4 0.00 0.571755 0.00
5 0.00 0.497179 0.00
6 0.00 0.432330 0.00
7 0.00 0.375940 0.00
8 0.00 0.326904 0.00
9 0.00 0.284265 0.00
10 4,045.52 4,045.52 0.247187 1,000.00
0.00


Figure 4.6 Formula to calculate discount factors

Figure 4.6 shows how to calculate discount factors for 15%, although the prin-
ciple shown can be used for any rate. First, the compound return over 10 years
for an investment of £1000 (this can be any amount) is calculated. So £1000.00
— 1.15 = £1150.00, then £1150.00 — 1.15 = £1322.50 and so on. As shown,
£1000 invested at a fixed 15% would return £4045.52 at the end of the period.
The discount factors are calculated by dividing £1000 (or the figure used at the
start) by the net amount on each line. So £1000.00 · £1150.00 = 0.869565,
£1000.00 · £1322.50 = 0.756144, etc.
The bottom half of Figure 4.6 shows that a return of £4045.52 in year 10
multiplied by that year™s discount factor of 0.247187 would net down in
£1000.00, being the exact investment. What this shows is that a net figure
of zero (adding the positive return to the negative investment) means that
the required return of 15% has been exactly achieved. If the figure had been
positive, it would mean that the return was greater than 15%, while if the
figure had been negative, it would mean that a return lower than the required
rate of return had been achieved.

219
Accounting and Business Valuation Methods

Discounted Cash Flow calculation for Con Glomerate plc
Year Investment Return Tax on return Net Dis. Factor DCF
£™000 £™000 £™000 £™000 £™000
0 (471,157.00) (471,157.00) 1.000000 (471,157.00)
1 86,672.00 86,672.00 0.869565 75,366.94
2 86,672.00 (24,268.16) 62,403.84 0.756144 47,186.29
3 86,672.00 (24,268.16) 62,403.84 0.657518 41,031.65
4 86,672.00 (24,268.16) 62,403.84 0.571755 35,679.71
5 86,672.00 (24,268.16) 62,403.84 0.497179 31,025.88
6 86,672.00 (24,268.16) 62,403.84 0.432330 26,979.05
7 86,672.00 (24,268.16) 62,403.84 0.375940 23,460.10
8 86,672.00 (24,268.16) 62,403.84 0.326904 20,400.06
9 86,672.00 (24,268.16) 62,403.84 0.284265 17,739.23
10 86,672.00 (24,268.16) 62,403.84 0.247187 15,425.42
11 (24,268.16) (24,268.16) 0.214942 (5,216.25)
(142,078.92)


Figure 4.7 Discounted cash ¬‚ow for Con Glomerate plc

In Figure 4.7, the principles described in Figure 4.6 are used. What we are
assessing is whether or not Con Glomerate plc is achieving a discounted return
of 15% or not.

The investment is taken to be total capital employed, as follows:

£™000
Total assets 715 556
Less: current liabilities 244 399
Total capital employed 471 157

Neither depreciation nor amortisation is taken into account in investment
appraisal, apart from the ˜accounting rate of return™ method, so the ˜return™ is
taken to be ˜operating profit before depreciation and amortisation™. The figure
(£™000) of £86 672 is taken from Figure 4.4. Tax is assumed to be at the rate of
28%, paid one year in arrears.

From Figure 4.7, it can be seen that if profits are maintained throughout the
period, then the final discounted figure is negative (£™000) £142 078.92. This
means that the required rate of return of 15% has not been achieved.

Figure 4.8 simply adjusts Figure 4.7 by putting a formula into the ˜return™ line
that adds in a growth factor. Different growth factors are then keyed in until
the bottom figure on the DCF line gets to (positively) as near zero as possible.
From this it can be seen that if Con Glomerate plc achieves an annual growth
in earnings of 10.0307%, then it will achieve its required rate of return of 15%.

220
Con Glomerate plc “ Growth Factor required to achieve 15% return
Year Investment Return Tax on return Net Dis. Factor DCF
£™000 £™000 £™000 £™000 £™000
(471,157.00) (471,157.00) 1.000000 (471,157.00)
0
Growth Factor 86,672.00 0.869565
1 86,672.00 75,366.94
95,365.81 (24,268.16) 0.756144
2 71,097.65 53,760.06
1.100307 104,931.67 (26,702.43) 0.657518
3 78,229.24 51,437.13
115,457.05 (29,380.87) 0.571755
4 86,076.18 49,214.49
127,038.20 (32,327.97) 0.497179
5 94,710.23 47,087.94
104,210.32
6 139,781.02 (35,570.70) 0.432330 45,053.25
114,663.34 43,106.54
7 153,802.03 (39,138.69) 0.375940
126,164.88 41,243.80
8 169,229.45 (43,064.57) 0.326904
138,820.10 39,461.70
9 186,204.35 (47,384.25) 0.284265
152,744.73 37,756.51
10 (52,137.22) 0.247187
204,881.95




Assessing risk and valuing companies
11 (57,366.95) (57,366.95) 0.214942 (12,330.57)
0.79

Figure 4.8 Con Glomerate plc “ growth factor required to achieve a 15% return
221
Accounting and Business Valuation Methods

Assuming that there are no outstanding matters causing concern, we can move
on to making an assessment as to a reasonable valuation of the company.


Valuation techniques
Many sectors make up the economic climate of a country and each sector is dif-
ferent in some way from the next. This gives rise to the necessity that compa-
nies in a particular sector should be valued differently from those in a different
sector. For example, companies could be put in ˜valuation™ sectors as below:
• Investment companies
• Property developers
• Banks and utility companies
• Insurance companies
• Biotechnology and similar scientific companies
• Companies owning professional football clubs
• General industrial, leisure and retail companies


Investment companies
Investment companies can be defined as those companies that invest in private
companies, although they do invest in publicly quoted companies also. Most of
these companies are either members of the British Venture Capital Association
(BVCA) or the European Venture Capital Association (EVCA) and value their
investments in accordance with the ˜International Private Equity and Venture
Capital Valuation Guidelines™ (VCVG) that have been endorsed by both these
organisations.
Members of the BVCA and EVCA comply with their respective organisa-
tion™s ˜code of conduct™. Given that the objectives of private equity companies
are sometimes misinterpreted, it is worthwhile reviewing how members are
expected to conduct themselves. As an example, the BVCA Code of Conduct
is shown below.


The BVCA Code of Conduct
Membership of the BVCA implies support for the development of the UK
private equity industry by encouraging entrepreneurs and investing in viable
economic activity. In addition, members should contribute to the creation of a
favourable climate for companies seeking private equity.

222
Assessing risk and valuing companies

(1) Members shall promote and maintain ethical standards of conduct
and at all times deal fairly and honestly with each other and with
companies seeking private equity.
(2) Members shall conduct their business in a professional way and will
not engage in practices which would be damaging to the image of the
private equity industry.
(3) Members recognise that their primary business is building the strength
of their investee companies which will result in the funds under man-
agement making long-term capital gains.
(4) Membership of the BVCA implies an active involvement by members
in the companies in which they invest and this involvement shall be
applied constructively to the benefit of the company concerned.
(5) Members who sponsor investment syndications with other parties,
whether members of the BVCA or not, must operate on the basis of
full disclosure to such other parties.
(6) Members will not accept in their funds subscribed capital from unspec-
ified sources.
(7) Members shall be accountable to their investors and keep their
investors fully and regularly informed including the provision of reg-
ular financial reports.
(8) No member shall take improper advantage of his position in the BVCA
nor any information addressed to the BVCA.
(9) Members shall respect confidential information supplied to them by
companies looking for private equity or by companies in which they
have invested.
(10) All members must supply investment information to the BVCA or its
nominated agent. This information will be treated confidentially and
used in the compilation of private equity industry reports where only
aggregate information will be published.

Members shall require their directors, employees, representatives and nomi-
nees to comply with these standards. Members will avoid financing enterprises
or participating in activities which are inconsistent with these goals. The Coun-
cil of the BVCA reserves the right to cancel membership or refuse to renew
membership if, in its sole opinion, a member is in breach of the above condi-
tions or is deemed to have acted in a way that could harm the reputation of
the private equity industry or the BVCA.

(Source: Reproduced from page x of the BVCA Directory 2006/2007, by kind
permission from the British Venture Capital Association.)

223
Accounting and Business Valuation Methods

To value ˜investment companies™, it will be appropriate to see how these com-
panies value their own investments. The VCVG states that investments should
be valued at ˜fair value™ using one or a combination of the following methods:
• Price of recent investment
• Earnings multiple
• Net assets
• DCFs (from the investment)
• Industry valuation benchmarks

There are three steps in valuing investments:

(1) Assess the fair value of the business.
(2) Calculate the ˜Gross Attributable Enterprise Value™.
(3) Calculate the ˜Net Attributable Enterprise Value™.

The ˜Gross Attributable Enterprise Value™ is defined as:

The Enterprise Value attributable to the financial instruments held by the Fund
and other financial instruments in the entity that rank alongside or beneath the
highest ranking instrument of the Fund.

What this means, for example, is that if the Fund held ordinary shares in a
company, but not preference shares, then the value of the ordinary shares,
ranking below preference shares, would be the total value of the company, less
the value attributable to holders of the preference shares.

The ˜Net Attributable Enterprise Value™ is defined as:

The ˜Gross Attributable Enterprise Value™ less a ˜Marketability Discount.™

The ˜marketability discount™, being the difference between the gross and the
net attributable enterprise value, takes account of the difficulty in marketing
the investment. Private equity companies invest in unquoted companies and
may invest in management buyouts. There will be times when the management
team and the venture capital company do not see eye to eye; the private equity
company might want to sell, but the management team do not. In such cases,
the VCVG advises that any valuation should take into account:
• Are there other like-minded shareholders with regard to Realisation and what
is the combined degree of influence?
• Is there an agreed exit strategy or exit plan?
• Do legal rights exist which allow the Fund together with like-minded share-
holders to require the other shareholders to agree to and enable a proposed
Realisation to proceed.

224
Assessing risk and valuing companies

• Does the management team of the Underlying Business have the ability in
practice to reduce the prospects of a successful Realisation? This may be
the case where the team is perceived by possible buyers to be critical to the
ongoing success of the business. If this is the case, what is the attitude of the
management team to Realisation?

Assuming all parties agreed to the sale, consideration would be given as to
how likely a sale would be. The more likely a deal, the lower the ˜marketabil-
ity discount™; the less likely a deal, the higher the marketability discount.
Marketability discounts are usually in the range between 10% and 30% and
move in 5% steps.
The VCVG notes that ˜the Fair Value concept requires the Marketability Dis-
count is to be determined not from the perspective of the current holder of the
Investment, but from the perspective of Market Participants.™

Thus it can be seen that investment companies, like all other companies, are
constrained by the IFRS rules as laid down by the IASB. Of course, private
investors can please themselves how they arrive at all valuations; indeed one of
the objectives of this book is to try to show where the ˜market™ might have got
it wrong.
Apart from the ˜price of recent investment™ method of valuation, which is
peculiar to private equity, all the other methods listed in the VCVG can be
used to value quoted companies.


Earnings multiple
The ˜earnings multiple™ is simply the average P/E ratio for the sector a particular
company is in. If the earnings multiple for a particular company is higher than
the average, then the market believes that that company is better than average;
conversely a lower than average P/E ratio indicates the opposite.
Whereas an investment company is assessing what a P/E ratio should be for
an unquoted company, the private investor is trying to assess whether the P/E
ratio for a quoted company is reasonable. To assess this, the private investor
should follow the same procedures as an investment manager following VCVG
guidelines:

The P/E ratio should be considered and assessed by reference to the two key
variables of risk and earnings growth prospects which underpin the earnings
multiple. In assessing the risk profile of the company being valued, the Valuer

225
Accounting and Business Valuation Methods

should recognise that risk arises from a range of aspects, including the nature of
the company™s operations, the markets in which it operates and its competitive
position in those markets, the quality of its management and employees and
its capital structure. For example, the value of the company may be reduced
if it:

• is smaller and less diverse than the comparator(s) and, therefore, less able
generally to withstand adverse economic conditions;
• is reliant on a small number of key employees;
• is dependent on one product or one customer;
• has high gearing; or
• for any other reason has poor quality earnings.

This recommendation from the VCVG is consistent with the view taken
throughout this book that the most important aspect of any business is the
quality of its management and employees and the importance of having the
right gearing. As the VCVG notes, a high geared and less diverse company is
less able to withstand adverse economic conditions than a low-geared diverse
company.

˜Quality of the earnings™ has been discussed earlier in this chapter, with reasons
given as to why the earnings shown in the Income Statement might have to be
adjusted. Many of the valuation methods shown use ˜earnings™ or ˜earnings per
share™ as part of the equation, so it will be obvious that this figure often plays
a key part in the final valuation.


Net assets
The ˜net assets™ valuation of a business is simply the figure shown in the
Balance Sheet and is the same figure as the bottom block in the Balance Sheet
shown as ˜equity shareholders™ funds™. If this figure is divided by the number
of ordinary shares in issue, the resultant calculation gives a figure that is the
˜book value per share™. The difference between this book value per share and
the market value per share is the ˜goodwill™ built into the share price over and
above the goodwill shown in the Balance Sheet.

Given an IFRS Balance Sheet has been computed at ˜fair values™, we should get
a ˜true and fair™ valuation of the net assets of the company. However, it must
be borne in mind that we are more than ever reliant upon the directors of the
company having sound judgement.



226
Assessing risk and valuing companies

Discounted cash ¬‚ow or earnings
The VCVG defines this valuation method as:

This methodology involves deriving the value of a business by calculating the
present value of expected future cash flows (or the present value of expected
future earnings, as a surrogate for expected future cash flows). The cash flows
and “terminal value” are those of the Underlying Business not those from the
Investment itself.

The VCVG points out that this method is flexible in that it can be applied to
any stream of cash flow (or earnings), but cautions:

The disadvantages of the DCF methodology centre around its requirements for
detailed cash flow forecasts and the need to estimate the “terminal value” and
the appropriate risk-adjusted discount rate. All of these inputs require substantial
subjective judgements to be made, and the derived present value amount is often
sensitive to small changes in these inputs.

Due to the high level of subjectivity in selecting inputs for this technique, DCF
based valuations are useful as a cross-check of values estimated under market-
based methodologies and should only be used in isolation of other methodologies
under extreme caution.

Figures 4.9“4.12 explain the points made by the VCVG. Figure 4.9 use the DCF
technique to assess the valuation of Con Glomerate plc (see Figures 4.1“4.5).
The current spread of this company at the date of valuation was 321 pence
to 324 pence. What this means is that this company™s shares could be bought
for 324 pence each and sold for 321 pence. The current earnings per share
are 21.4 pence (taken from Figure 4.4) and using the same methodology to
calculate earnings, 5 years ago the earnings per share were 13.97 pence, giving
a compound growth of 11.25% over this time.

So straight away, there are two key figures that are based on judgement, namely:


(1) That the current earnings per share of 21.4 pence is the correct figure
to take.
(2) That future growth will be equal to recent compound growth.


The next judgement to make is what interest rate should be used to compensate
for the risks involved. Remember, the rate required has to be higher than the
risk-free rate of around 4%“5% and that the greater the perceived risk, the
higher the rate should be.

227
Accounting and Business Valuation Methods
228


Con Glomerate plc
Formula to calculate growth built into share price
(shaded areas contain formulae)
Price for
forecast growth
Ask Bid Spread factor EPS (pence) EPS (pence)
Year 0 Year 4
261.5 Price of share (pence) 324.0 321.0 0.990741 13.97 21.40

EPS (pence)
Year 0 13.97
1,000.00 Base expenditure (£) 1,000.00
Year 1 15.54
Year 2 17.29
985.22 Available for shares (£p) 985.22
Year 3 19.24
Forecast
Growth DCF
376.76 Number of shares 304.08 Year 4 21.40
0.76
21.40 Current EPS (pence) 21.40

80.63 Dividend amount (£p) 65.07 Built in Share
DCF
1.112500 Growth rate (%) 1.1650 Forecast growth % 1.112500
2.55

GROWTH BUILT IN 1.165 Discount
Rate
CORRECT PRICE FOR FORECAST GROWTH (pence) 261.50
11.00

Discounted Cash Flow “ Growth built into share

Sale proceeds Year Investment Return Tax on return Net Dis. Factor DCF
£p £™p £™p £™p £™p £™p
966.34 (1,000.00) (1,000.00) 1.000000 (1,000.00)
0
65.07 (6.51) 0.900901 52.76
58.56
1
75.81 (7.58) 0.811629 55.37
68.23
(Based on ˜ask™ price 2
after allowing 1% 88.31 (8.83) 0.731197 58.12
79.48
3
transaction costs) 102.89 (10.29) 0.658740 61.00
92.60
4
119.86 (11.99) 0.593458 64.02
107.87
5
6 139.64 (13.96) 0.534648 67.19
125.68
7 146.41
162.68 (16.27) 0.481665 70.52
8 170.57
189.52 (18.95) 0.433934 74.02
9 198.71
220.79 (22.08) 0.390932 77.68
10 231.51
257.23 (25.72) 0.352191 81.53
(337.79)
10 966.34
966.34 0.352191 340.34
2.55


Figure 4.9 Formula to calculate growth built into share price
Formula to calculate price needed to achieve required RR with forcecast growth
Con Glomerate plc

Discounted Cash Flow “ Forecast growth

Year Investment Return Tax on return Net Dis. Factor DCF
Sale proceeds
£™p £™p £™p £™p £™p
£p
966.34 0 (1,000.00) (1,000.00) 1.000000 (1,000.00)
1 80.63 (8.06) 72.57 0.900901 65.38
2 89.70 (8.97) 80.73 0.811629 65.52
3 99.79 (9.98) 89.81 0.731197 65.67
4 111.02 (11.10) 99.92 0.658740 65.82
5 123.51 (12.35) 111.16 0.593458 65.97
6 137.40 (13.74) 123.66 0.534648 66.12
7 152.86 (15.29) 137.57 0.481665 66.26
8 170.06 (17.01) 153.05 0.433934 66.41
9 189.19 (18.92) 170.27 0.390932 66.56




Assessing risk and valuing companies
10 210.47 (21.05) 189.42 0.352191 66.71
(339.58)
10 966.34 966.34 0.352191 340.34
0.76

Figure 4.10 Formula to calculate price needed to achieve IRR with forecast growth
229
Accounting and Business Valuation Methods
230


Formula to calculate growth built into share price
Con Glomerate plc

Price for (shaded areas contain formulae)
forecast growth
Ask Bid Spread factor EPS (pence) EPS (pence)
Year 0 Year 4
406.0 Price of share (pence) 324.0 321.0 0.990741 13.97 21.40

EPS (pence)
1,000.00 Base expenditure (£) 1,000.00 Year 0 13.97
Year 1 15.54
985.22 Available for shares (£p) 985.22 Year 2 17.29
Forecast Year 3 19.24
242.67 Number of shares 304.08 Growth DCF Year 4 21.40
0.24
21.40 Current EPS (pence) 21.40

51.93 Dividend amount (£p) 65.07 Built in Share
DCF
1.112500 Growth rate (%) 1.0600 1.76 Forecast growth % 1.112500

GROWTH BUILT IN 1.06 Discount
Rate
CORRECT PRICE FOR FORECAST GROWTH (pence) 406.00
7.20

Discounted Cash Flow “ Growth built into share

Sale proceeds Year Investment Return Tax on return Net Dis. Factor DCF
£p £™p £™p £™p £™p £™p
966.34 (1,000.00) (1,000.00) 1.000000 (1,000.00)
0
65.07 (6.51) 58.56 0.932836 54.63
1
68.97 (6.90) 62.07 0.870186 54.02
2
(Based on ˜ask™ price
after allowing 1% 73.11 (7.31) 65.80 0.811741 53.41
3
transaction costs) 77.50 (7.75) 69.75 0.757226 52.82
4
82.15 (8.21) 73.94 0.706369 52.23
5
6 87.08 (8.71) 78.37 0.658926 51.64
7 92.30 (9.23) 83.07 0.614670 51.06
8 97.84 (9.78) 88.06 0.573388 50.49
9 103.71 (10.37) 93.34 0.534877 49.93
10 109.93 (10.99) 98.94 0.498952 49.37
(480.40)
10 966.34 966.34 0.498952 482.16
1.76


Figure 4.11 Formula to calculate growth built into share price “ Con Glomerate plc
Con Glomerate plc Formula to calculate price needed to achieve required RR with forcecast growth

Discounted Cash Flow “ Forecast growth

Sale proceeds Year Investment Return Tax on return Net Dis. Factor DCF
£p £™p £™p £™p £™p £™p
0 1.000000
966.34 (1,000.00) (1,000.00)
(1,000.00)

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