Valuation Approaches and Metrics - Term Paper Example

1.0 Most Reliable Primary Valuation Method The process related to the valuation of private companies is considered to be of paramount importance. It helps to provide pertinent information hence provides a platform for understanding the overall operations of a business. It important for the management team of private equity funds to examine the values of these entities in different moment in time whenever they focus on investing in acquiring another company; has the aspirations of being listed in a stock exchange program or in cases where; there is a possibility of selling or liquidating a company. Most of the financial analysts are allowed to choose from a distinctive level of valuation methods for purposes of evaluating companies. These methods are basically categorised into different macro-classes that include; single-period valuation approaches like market multiples method and multi-period valuation techniques like the discounted cash flow (DCF) as well a residual income method (RIM) (Healy & Palepu, 2012). In essence, numerous empirical researches have shown that most of financial analysts would definitely prefer a single-period earnings models like market multiples since it is very simple to apply (Bradshaw, 2002). Subsequently, these researches indicate that financial analysts will only focus on adopting complex and time-consuming multi-period techniques for purposes of valuing those companies that are characterised by a higher degree of uncertainty as a result of a significant level of volatility earnings or even unstable growth levels. Just recently, Koller, Goedhart, and Wessels (2010)notes that sell-side analysts have been perceived to have increased their preferences for using DCF models due to enormous influence by the immediate clients or rather potential investors and, also as a result of the imminent popularity garnered by this technique over the period. The underlying corporate finance theory as well as other fundamental financial analysis researches indicates that the overall estimation of a company’s value using multi-period valuation techniques is adopted for the mere reason that it is able to effectively capture its overall fair value (Fernández, 2007b). This means that the adoption of such superior valuation techniques should thus result to more accurate target stock prices. Bradshaw(2002) notes that analysts that focuses on issuing more accurate earnings forecasts and those that deploy rapid valuation approaches like Residual Income Method(RIM) enjoy better and almost perfect target prices. In comparison to price-to-earnings growth (PEG), Residual Income Method (RIM) is deemed to be a superior method in regards to generation of target prices accuracy (Brösel, Matschke, &Olbrich, 2012). In other research studies, enough set of evidence has been shown to postulate that in comparison to market ratio methods, Discounted Cash Flow (DCF) method is fairly positioned to produce more accurate and reliable target prices (Damodaran, 2007). However, the use of price-to-earnings ratio approach is deemed to be far weaker in comparison to DCF technique. It is noted that both finance theory and professional practice all propose alternative set of methodologies for purposes of evaluating a given entity. The conventional difference that arises is between valuation that is focused on the fundamentals of the company- future cash flows and earnings, and those based on market ratio techniques, which are dependent on market multiples of a firm (Dittmann & Maug, 2008). In regards to the overall quality of different valuation techniques, it can thus be safely argued that the finance theory and practice both consider fundamental-focused valuation methods to be superior ways for evaluation purposes whenever compared to market multiple techniques in place. 2.0 How to Go About Valuing Jupiter The process related to the valuation of a company and selecting the most relevant valuation technique is dependent on a given number of factors. Among this notable factors include; the size of the company under evaluation process; the overall growth of its assets-base; as well as the underlying levels of competition. Size; is an imminent control variable that is used for purposes of establishing the valuation technique for adoption in evaluation process. It is basically represented by the overall market capitalisation of a given firm. Research indicates that there is always a positive relationship between target price accuracy and the firm size and a significant negative association between forecasted erroneous measurements and the aspect of size (Silvius, 2008). This presumption is based on the perception that it is much easier for analysts to value an enormous, mature and fairly-established company that has readily available information related to its future prospects. On the contrary, relatively smaller firms are perceived to be far much less complicated in their overall structure but will normally conduct operations within a specific niche market hence future performance is deemed to be more uncertain. Growth; is yet an important aspect to assess whenever determining a relevant and reliable valuation technique to adopt. It is measured using the price-to-book-value ratio and is attributed with the firm as a whole (Silvius, 2008). The nature of a company also plays a greater role in determining the valuation technique to be used. For instance, in the case of banking institutions and other investment management companies, the focus of attention is directed towards the overall operating profit, which is basically the financial margin less possible commissions less underlying operating expenses that is adjusted for bad debts (Fernandez, 2007). Their overall industry portfolio is equally analysed. For this case, valuations models like price-to-earnings ratios are adopted; as well as net worth method The level of competition in the sector as whole will also be taken into consideration whenever determining the form of valuation to adopt (Mellen & Sullivan, 2007). In this regards, competition helps to determine the position of a company in relation to the entire share market in place. Currently, Jupiter is a market leading fund manager in the United Kingdom retail mutual fund sector based on its overall size of the underlying asset-base as well as net sales. It has managed to beat down competition in the sector as a result of its relative stronger investment performance track record; the overall strength of its brand and the imminent presence of its fundamental distribution platforms. As at 2010, Jupiter’s enjoyed approximately £19.5M in assets under its management (AUM) that was distributed along 47 mutual funds. In relation to competition, it was positioned 5th largest fund manager of UK retail mutual funds and 4th largest by its net and gross sales within the same period. The company has also set to implement a progressive dividend policy that will focus on account historic and anticipated profits, cash flow and balance sheet position within the any given moment in time. Following this line of facts, Jupiter should thus engage those valuation techniques that match up with its overall abilities. For a fact, it cannot adopt net asset valuation model because the firm is already trading well given that its income generating capacity stands at a significant level when compared to the net asset values. Other methods like DCF, industry benchmarks, market multiples and the price of recent investment can all be used for the purpose of evaluating this company effectively. 3.0 Estimating the Value of Jupiter (Offer Price) A. Discounted Cash Flow Method This is a valuation model that is aimed at establishing the overall intrinsic value of the company by way of estimating the present values of future cash flows. The method’s immediate benefits include; its being a scientific and detailed model and, also it is fairly-positioned to provide the company’s intrinsic value. On the contrary, however, it is indeed sensitive to a great number of factors that are at the immediate discretion of the financial analysts and, also it fails to capture the imminent level of sentiment provided by the value of the company. Despite this, the model is used for Jupiter since it is reliable and relevant in today’s valuation environment while still is able to capture the fair value. Variables; NOPAT (net operating profit after tax) is a formula that is used in the measurement of a company’s earnings whenever it is ascertained that the firm has already met its overall commitments in clearing its existing debt. The formula used for computing NOPAT is given as below; NOPAT = EBIT* (1-Tax Rate) Free Cash Flow is a valuation model that seeks to expound on the remaining cash-base that has been left in the company after it has successfully met its expenditure obligations for purposes of ensuring a future smooth level of operations. To effectively get the FCF value, the existing amounts of cash that has been consumed by the company from its underlying net operating profits after taxes. To arrive at FCF value; the valuation process adopts a series of formulas that are expounded as follows; Free Cash Flow (FCF) = NOPAT – Net Investment on Working Capital (NIOC) NIOC = Operating Capital CURRENT YEAR – Operating Capital PREVIOUS YEAR Operating Capital (OC) = Net Operating Working Capital (NOWC) + Fixed Assets Net Operating Working Capital (NOWC) = Operating Current Assets (CA) – Operating Current Liabilities (CL) NOPAT Year 2009 £M 2010 £ M 2011 £M EBIT 52.4 70.5 83.6 Tax Rate 0.2 0.2 0.2 NOPAT 41.92 56.4 66.88 Free Cash Flow (FCF) Company/ Year Apple 2009 2010 2011 NOPAT 52.4 70.5 83.6 Current Assets 355.8 390.6 269 Current Liabilities 165 188.8 149.2 NOWC 190.8 201.8 119.8 Fixed Assets 565.1 527.1 499.5 OC 755.9 728.9 619.3 NIOC -27 -109.6 FCF 43.5 193.2 Offer Price= 193.2/122.375 556= £ 1.58 B. Economic Value Added Economic value added is a market value approach that is focused on determining the level of effectiveness of a firm’s immediate management capability in creating value for shareholders. It is a valuation method that is used to establish the relative level of profits that are generated by a company over specific period. It is deemed to be a crucial method for evaluating Jupiter because fund progress and efficiency can be determined by assessing existing employee’s performance that adds value. EVA is calculated using the formula; EVA= NOPAT-(OC* WACC) Whereby, NOPAT is the net operating profits after taxes OC= operating capital WACC= is the weighted average cost of capital For this case, WACC is assumed to be 8.5%; a figure that is tandem with the market conditions at the time of executing the IPO Thus, EVA= (52.4+70.5+83.6/3)- {(755.9+728.9+619.3/3)* 0.085} = 68.83- (701.36*0.085) = 68.83- 59.62 = 9.21/122.375 556= £1.43 IV Offer Price in Prospectus and Estimated Share Price Taking a closer look at the offer price within the prospectus of $1.65 and the estimated share prices, there is a significant level of differences, which is a clear indication that the IPO was somehow over-valued. A successful pricing of IPO is entirely focused on examining a company’s underlying earnings and the future performance capacities. Research indicates that the share price would have been placed over and above the estimated fair value of the shares due to imminent level of demand of the stock options (Tack, 2009). Certainly, there is a likelihood that the company’s financial analysts might have used a different valuation approach, which then resulted to a different value altogether. Financial related researches allow a company’s financial analysts to adopt any one of the valuation techniques in coming up with their share price estimates (Tack, 2009). However, it is not fairly-advised to use more than one valuation model to conduct this exercise because the end outcomes would definitely be different hence bring about unnecessary conflicts that relate to the selection of the most viable estimated value for adoption. While the adoption of different valuation models to conduct this exercise is allowed; financial analysts emphasise on the need of depending on such modern methods as DCF to come up with a present value of the share and, in doing so, not jeopardize the expected prices at any given moment in time (Nangia, Agrawal & Reddy, 2011). The differences can also be brought about by the use of different factors as assumptions in coming up with figures related to weighted average cost of capital and return in invested capital employed. Considering the fact that private companies are exposed to different environmental challenges at any given moment in time, these situations might change and can be very difficult to interpret and formulate almost correction approximates that are used in developing such important items as free cash flows (Nangia, Agrawal & Reddy, 2011). There is also a distinctive factor that relates to the long-term price performance of initial stock options to the market. Possible market uncertainties as well as the benchmark adopted in pricing techniques of shares offered within given stock exchange platform can result to a very huge margin between the estimated offer price and the initial stock price placed in the course of the IPO (Paglia & Harjoto, 2010). The intentional offering of share prices in discounts plays an important role on the concept of under-pricing. This indicate that the part of the under-pricing will likely be a result of underwriters engaging in a deliberate discounting process in order to augment the potential investor’s immediate interest with the company (Paglia & Harjoto, 2010). Despite the fact that the intentional price discount is recouped by a rather higher price update, it still remains to be one of the most crucial drivers of under-pricing as a whole. In this regard, a portion of under-pricing thus seems to be a form of compensation for investors to portray their overall demand for IPO shares. Consequently, another section of under-pricing is a result of intentional price discount that happens prior to any given information that relates to investor demand is ascertained and collected for that matter. In most cases, underwriters will adopt intentional price discount for purpose of cementing investor demand. As a result, the stock options then engage in higher level of price updates as a way of regaining the discounted pricing model (Paglia & Harjoto, 2010). Despite of this, a consistency with the partial level of adjustments rationale does not translate to a full adjustment. In fact, it is argued that a part of the intentional pricing discount remains as being an augmentation for higher rate of returns of the investors as a whole. Under-pricing possibly occurs whenever there is a significant level of differences between the overall market capitalisation immediately after the equilibrium price has been established and the final offer value ascertained. V. Differences between Offer Price and First-day Trading Share Prices There is also a significant difference between the stock IPO offer price and the first-day of trading price. Different concepts are adopted in the course of coming up with IPO price. The first-day offer price is able to almost interpret the future performance of the shares in the exchange platform. Hot shares are ones that are offered and attain an efficiency tendency of between 10 and 60% (Oakshott, 2012). This is most likely since hot shares have a high degree of demand from potential customers that might have been interested in the affairs of the company long before the shares were made public. It always happens in the case where a private entity is perceived to be operating under a successful environment hence able to attract a large set of potential shareholders who might purchase the entire shares offered. To prevent a scenario whereby these shares are not diluted to a wider number of potential shareholders, then the IPO of offered at a premium price and traded at an increasing price level (Oakshott, 2012). Hot shares occur in the event where the initial return is more than 60% while its immediate future performance is noted to be slightly much higher for that reason. Further research into the probable cause of the difference is attributed to the fact that the reality of the market conditions cannot allow a constant price level over a certain period due to the numerous levels of risks involved. For this case, the difference in the IPO offer share prices and the first-day trading can be an issue of under-pricing. Under-pricing always works for the potential and existing buyers since they opt to gain from a share price that is likely to have been undervalued (Oakshott, 2012). Possible information asymmetry can result to the changes of the shares price in the first-day of trading given that the underwriters would have mispriced the shares. The possibility of information asymmetry between potential buyers and suppliers further expounds on this issue. The overall promiscuity and financial related knowledge are assumptions that could cause the difference in the share pricing. Consequently, there are the fluctuations in the share prices might be a result of information cascades. Investors will most likely focus their investment decisions on both personal information as well as on base their purchasing decision on other investor’s willingness to engage in the entire trading exercise. It is a normal occurrence for a given investment bank to offer stock options at a relatively lower price for purposes of creating imminent interest for potential bidders and thus, develop a cascade so that consequent investors will purchase it regardless of their information (Masunaga, 2007). It might also be a result of signalling where the IPO is offered at a well-informed position in comparison to the existing investors. It is safe to note that under-pricing is a distinctive way for which high-level quality entities opt to distinguish themselves from the not-so-well companies. In signalling, the exact and true value of the firm engages in issuing the share prices at a discount and the entrepreneurs are allowed to retain a significant portion of the shares at any given moment in time. Companies also engage in under-pricing for legal liability focuses where the firms are compelled to engage in the under-pricing of the shares for the purpose of reducing their legal liability that might possibly emanate from false and inadequate level of information. V. Long-term Performance of Share Price after 1-Year of Trading There has been a significant level of movements of the share prices within the first-year of trading. However, basically these shares have been increasing on their overall intrinsic values. The shifts in the price can be fairly related to the different market conditions that dictate on the supply and demand of the stock options at different periods of the year. It is important to note that the demand shares can either increase or decrease depending on the market conditions at the time (Masunaga, 2007). Such external influencing factors as political instabilities; economic downturns as well as a reduction in the amounts related to disposable income can result to a low demand. On the contrary, when the political and economic environment of a country are said to be working properly then it means that the degree of demand will improve tremendously. Research further indicates that the whenever the profitability growth of a company is perceived to be improving over time then the demand for the shares also improves significantly as potential investors will likely need to benefit from the possibility of being paid dividends in addition to the growth of stock options (Masunaga, 2007). The differences and a possibility of a share price assuming an almost stable position can also be a result of its capability to stabilise within the stock exchange platform. The activities related to potential investors purchasing and thus, holding onto purchased stock options can cause artificial shortage of shares of particular company, which is likely to push the prices even more higher as more of them would now want to at least have ownership of the company altogether. Winner’s curse is a theory that is focused on expounding on under-pricing that is a result of asymmetric information. It is noted that companies will always be subjected to a great deal of uncertain demand from both the informed and uninformed investors. Research has it that the informed investors will likely submit endless level of bids in the case when the offering price is deemed to be less than the true value (Hilborn & Walters, 2013). On the contrary, the uninformed potential investor who lacks imminent investment and analytical skills will likely engage in the trading exercise without having to discern the real share price offering. The theory ascertains that an investor will always win lots of shares whenever they are considered to having been overpriced. References List Bradshaw M. T. 2002): “The use of target price to justify sell-side analysts’ stock recommendations”, Accounting Horizons, 16 (1), p. 27-41 Brösel, G., Matschke, M.J. &Olbrich, M., 2012. Valuation of entrepreneurial businesses. International Journal of Entrepreneurial Venturing, 4(3), pp.239-256 Damodaran, A., 2007. Valuation approaches and metrics: a survey of the theory and evidence. Foundations and Trends® in Finance, 1(8), pp.693-784 Dittmann, I. & Maug, E.G., 2008. Biases and error measures: How to compare valuation methods. Fernandez, P. 2007. ‘Company valuation methods: The most common errors in valuations’. Working Paper no.449, p.4-30 Fernández, P., 2007b. Valuing companies by cash flow discounting: ten methods and nine theories. Managerial Finance, 33(11), pp.853-876 Healy, P.M. & Palepu, K.G., 2012. 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Journal of Business Valuation and Economic Loss Analysis. Silvius, A.J., 2008. The Business Value of IT: A Conceptual Model for Selecting Valuation Methods. Communications of the IIMA, 8(3), p.57. Tack, B., 2009. Valuation Methods for Midsize Companies. Taking Out the Guesswork. Read More