Significant Variance on the Net Asset Value of the Equity Shares and the Market Share Price - Case Study Example

Abstract This paper looks at the causes of the differences between the net asset value and market value of shares as well as well as the various asset measurement basis employed by various companies. The paper starts with a review of the available literature on the various measurement basis applied by different companies in measuring different corporate assets. The paper then looks at the differences between the net asset value of a company’s equity shares and the market value or the share price of a company’s shares. The paper starts with the calculation of the net asset value of equity shares for three companies in the food and drugs sector at the London stock exchange including Booker Group PLC, Tesco PLC and SSP Group PLC. The paper then compares the results with the market prices for the companies’ shares. The paper then looks at the reasons that would explain the differences between the two methods of valuation of company’s shares. The paper then looks at the various measurement basis that various corporates employ before giving recommendations on whether there is one best measurement base to be applied by all the organizations globally in measuring and reporting various corporate assets. Table of Contents Abstract 2 This paper looks at the causes of the differences between the net asset value and market value of shares as well as well as the various asset measurement basis employed by various companies. The paper starts with a review of the available literature on the various measurement basis applied by different companies in measuring different corporate assets. The paper then looks at the differences between the net asset value of a company’s equity shares and the market value or the share price of a company’s shares. The paper starts with the calculation of the net asset value of equity shares for three companies in the food and drugs sector at the London stock exchange including Booker Group PLC, Tesco PLC and SSP Group PLC. The paper then compares the results with the market prices for the companies’ shares. The paper then looks at the reasons that would explain the differences between the two methods of valuation of company’s shares. The paper then looks at the various measurement basis that various corporates employ before giving recommendations on whether there is one best measurement base to be applied by all the organizations globally in measuring and reporting various corporate assets. 2 A look at the available literature 4 Background 5 Net asset value of a single equity shares for each of the chosen companies 6 Company 1: Booker Group PLC 6 Causes of the differences between the Net asset value of the companies’ shares and the share market price as at the balance sheet date 7 The basis on which the value of the different types of corporate assets is reported to shareholders and the extent to which this satisfy users need for information 12 Review of various measurement methods used by various organizations for reporting on various corporate assets 13 The extent to which the different methods of valuation satisfy the informational needs of users and the practical implications of adoption for preparers 16 Recommendations for a future improved financial reporting and disclosure regime 17 Conclusion 18 References: 18 A look at the available literature A great deal of literature exists on the various measurement basis used by corporates in measuring and reporting on corporate assets. Heaton et al. (2009) argues that measurement of corporate assets is a crucial factor in the process of financial statements preparation in an effort to fairly represent the entity’s economic activity. He lists the various measurement basis adopted by different firms in different jurisdictions which also depend on the kinds of corporate assets being measured. Procházka (2011) lists the measurement basis to include historical cost measurement, fair value, realizable value, the value in use measurement basis among other measurement base available for application by organizations for asset measurement and reporting purposes. It is worth noting that the application of each of the above method will depend on the assets in question as well as the economic implications to the organization in question as stated by IASB (2005). Ernst & Young (2005) is in agreement with this assertion but also states that the attributes of reliability and relevance to be key in choosing the measurement basis to be applied by the firm. As such, the author states that there is no one best measurement basis for all organizations but the basis was chosen should depend on the above factors as well as the specific circumstances prevailing in the firm. On the other hand, Penman (2006) states that conventional accounting systems root for using of amounts at which the assets were measured at the initial recognition date. This is the historical cost method that is hailed for its objectivity and conclusive evidence. However, Efrag.org (2016) blames historical cost basis for not being suitable and relevant for economic decision making. It is for this reason that Whittington (2010) states that standard setters prefer measurement basis that is based on the current market information. In this regard, fair value is the most preferred measurement base. Efrag.org (2016) states that there ought to be one measurement base for all organizations globally to ensure consistency and comparability. However, this is countered by Whittington (2010) in that every organization should choose a measurement base that best suits its circumstances. Background Three companies listed on the food and drugs segment of the London stock exchange are analyzed on the basis of their net asset value of a single equity share and the company’s share prices. Differences are observed and hence the possible causes of the differences between the two forms of evaluation are analyzed below. The companies analyzed include Booker Group PLC. This is a UK company dealing with catering, retailing and sale of tobacco and nontobacco products. Another company analyzed is Tesco PLC, which is one of the largest retailers not only in the UK but also globally. On the other hand, SSP Group PLC is a leading operator of food and beverage outlets in travel locations across several countries. Net asset value of a single equity shares for each of the chosen companies The net asset value of a single equity share is a Company’s net assets divided by the outstanding ordinary share. Company 1: Booker Group PLC The balance sheet date for the company is 25th March 2016 Outstanding number of shares at the balance sheet date = 1,772,837,070 shares Net assets as at the balance sheet date are worth =£590,200,000 Net asset value of the company’s shares= £590,200,000/1,772,837,070 = 33.29p Share price on the balance sheet date = 163.50p Company 2: Tesco PLC The Balance Sheet Date for the Company is 27th February 2016 Outstanding number of shares at the balance sheet date = 8,152,000,000 shares Net assets as at the balance sheet date are worth = £8,616,000,000 Net asset value of the company’s shares = £8,616,000,000/8,152,000,000 = 105.69p Share price on the balance sheet date = 184.15p Company 3: SSP Group PLC The Balance Sheet Date for the Company is 30th September 2015 Outstanding number of shares at the balance sheet date = 475,113,354 shares Net assets as at the balance sheet date are worth =£291,700,000 Net asset value of the company shares = £291,700,000/475,113,354= 61.39p Share price on the balance sheet date = 296p The following table compares the net asset value and share prices for the three company’s equity shares. Table 1: Comparison of Net Asset Value and Share Price (in pence) Reference Company Name Net asset value of shares Share price 1 Booker Group PLC 33.29p 163.5p 2 Tesco PLC 105.69p 184.15p 3 SSP Group PLC 61.39p 296p Causes of the differences between the Net asset value of the companies’ shares and the share market price as at the balance sheet date The chart below gives a comparison of each of the company’s net asset value of equity share and the company’s share market value/price. Chart 1: Comparison of Net Asset Value and Share Price (in pence) Company 1 is Booker Group PLC. The company’s net asset value of its shares as at the balance sheet date of 25th March 2016 was 33.29p compared to the company’s market value of its shares which sold at 163.50p on the London stock exchange. Company 2 was Tesco PLC. The company has its net asset value of its equity shares as calculated above being 105.69p. This greatly differs from its market value per share of 184.15p which was the company’s share price at the London stock exchange as at the company’s balance sheet date of 27th February 2016. Company 3 which is SSP Group PLC also shows a similar trend between its net asset value of its equity shares and its price per share as valued by the market. The company’s net asset value of each equity share as per the above calculations was 61.39p which greatly differed with the share price at the London stock exchange of 269p as at the company’s balance sheet date of 30th September 2015. The above differences between the market value or share price of a company’s share and the company’s net asset value per equity share are caused by a number of factors that are discussed below. Accounting principles The above differences to a large extent are caused differing accounting principles and presentation bases applied by different companies in different jurisdictions. It is worth noting that base of presentation of values presented in the financial statements as well as the accounting principles applied by different companies differs world over. This means that the market may not have a common comparison base as the company uses in composing its net asset value of its equity shares (Weygandt & Kieso, 2011). Valuation In most cases, almost all of the company’s shares are measured and recorded on the basis of historical cost. In other instances, different methods of valuation are applied with such assets as receivables that are measured at fair value. This is the case with the three companies that have been studied above including Booker Group PLC, Tesco PLC and SSP Group PLC. In all these cases, the valuation base may not reflect their current market prices and hence the value of the company as measured using the historical cost method or any other relevant method used may greatly differ with the company’s value as measured on the basis of the current value of assets. For instance, a building measured on the basis of historical cost and even differentiated using a relevant depreciation rate may even cost more than its historical cost at the moment. Yet, the historical cost of the building is the one used in computing the net asset value of the firm’s equity share. The implication of this is that the current value of the company’s assets will most likely differ from the historical cost reflected in the company’s financial statements and which is eventually used in computing the net asset value of the company’s equity shares (Hermanson & Edwards, 2008). In other words, the net asset value of a company’s equity shares may be termed as greatly being based on historical information as opposed to the market value of the shares on the stock exchange which is based on the current and even future information. Investor’s expectations about the company Another reason why the three company’s analyzed above and in fact company’s world over may have their net asset value per equity share differing from their market value or share price is because of investors or market expectations about the future prospects of the company. It is worth noting that the company’s market share value is a combination of the net asset value of the shares and the investors expectation’s on the company’s future. This is given by the Edwards-Bell-Oblson valuation model as shown below (Lee, 1996) Where P= Market value B = Net asset value (Lee, 1996) EVA= Represents wealth creation above the book value and hence investors’ expectations on the firm’s future performance. It is worth noting that a company’s net asset value of its equity shares describes its asset and liability position as at the balance sheet date. In other words, the more the net assets of a company relative to the number of equity shares that the company has, the greater will be the value of its net asset value of its equity shares. However, this is not the case with the market value or share price of the company’s equity shares. This is because should the investors have stronger belief that the company’s future growth prospects are brighter, then they will be prepared to pay more for the company’s shares than indicated by the company’s net asset value of its equity shares. This may, for instance, explain why both Booker Group PLC and SSP Group PLC has both values differ more greatly when compared to the difference observed for Tesco PLC. Thus, a company may be young or even old but with a few net assets but with great future prospects. This means that its net asset value per equity share will be very small but its market value or share price at the market will be greater since the market or investors expect to gain a lot by investing in the company’s shares owing to the great positive future prospects. Thus, they will be willing to pay more for the company’s shares than its net asset value of shares. The vice versa will also be true if the market or potential investors have negative future prospects about the company’s future. In this case, the market value or share price of the company’s shares will be much less compared to its net asset value of its equity shares (Pierre, 2007). Investor expectations will drive the demand for the company’s shares up or down. If the demand is high, the company’s market price of shares will be high and even higher than the net asset value of the equity shares with the vice versa being true where the demand for the shares is low. Assets not included in the balance sheet As stated above, balance sheet may not contain many types of information that may be necessary for the valuation of the company’s net asset value of equity shares. This includes certain types of information to do with future prospects of the company such pending legal outcomes. These type of information was it to be available and valued in the company’s assets and liabilities would probably help in bridging the differences observed above. In addition, it is worth noting that certain types of assets that are a broad indication of the company’s ability to make profits in the future that may include goodwill will normally not necessarily be included on the balance sheet though this is not necessarily the case in the present case. When this happens, such assets will not be utilized when the net asset value of the company’s equity share is being calculated. Such a scenario would therefore also be considered a contributing factor of the difference between the net asset value of the company’s equity shares and the company’s shares market value or share price. This section has compared the net asset value of equity shares for three UK companies in the food and drugs sector including Bookers Group PLC, Tesco PLC and SSP Group PLC and their market share prices. A large difference has been noted between the two types of valuation with the share market price being much greater than the net asset value of the equity shares. Consequently, an analysis of the likely causes of the differences has been carried out in detail. The factors identified to have a great contribution to the differences include the differing application of accounting principles among jurisdictions, the differing valuation methods between the two methods, factors affecting share demands as well as future prospects for the company’s performance. The assets not included in the balance sheet have also been cited as contributing to the differences. The basis on which the value of the different types of corporate assets is reported to shareholders and the extent to which this satisfy users need for information Different companies use different methods in reporting various assets to the shareholders as can be revealed from the three companies’ notes to the financial statements. The different assets are consequently used in valuing the company’s equity shares as in the calculations above. As such, the method used by the company in reporting the value of assets to the company’s shareholders should be such that it satisfies the users’ information needs. The table below summarizes the various measurement basis adopted by different companies in measuring various corporate assets. Table 2: Various measurement basis adopted by different companies in measuring various corporate assets (Pablo, 2004). Balance sheet Income statement based Mixed (Goodwill) Cash flow discounting Value creation Options Book value Adjusted book value Liquidation value Substantial value Multiples PER Sales P/EBITDA Other multiples Classic Union of European Accounting Experts Abbreviated income Others Equity cash flow dividends. Free cash flow. Capital cash flow APV EVA Economic profit cash value added CFROI Black and Scholes investment option. Expand the project delay the investment Alternative uses As the table reveals, various measurement basis are used by various companies in measuring various corporate assets and hence company valuation. However, this paper mainly analyzes the balance sheet based valuation models as they have been applied by the companies in question. Review of various measurement methods used by various organizations for reporting on various corporate assets The International Financial Reporting Standards (IFRS) gives a set of recommendations regarding how corporates should measure and report on different corporate assets. According to IFRS, property, plant and equipment, intangible assets and exploration assets are either measured on the historical basis or fair value basis. Assets on finance leases should be measured at the lower of fair value at the date of acquisition and the discounted value of the minimum lease payment at the date less subsequent depreciation (PriceWaterHouseCoopers, 2006). Other measurement guidelines issued by IFRS are analyzed below and form the basis on which different corporates apply different measurement basis for reporting different corporate assets. This partly explains the difference between the net asset value of a firm’s equity share and its market price of shares. It is on this basis that this section concludes that though there is no one best way of measuring and reporting corporate assets, the method adopted by the company should be the one that brings the internal valuation of the company as close as possible to the market valuation. The method chosen also ought to satisfy the user’s informational needs in that it should be both relevant and reliable. This way, it will be useful in helping the users make informed decisions about the entity in question. Some of the measurement basis used by various corporates in measuring and reporting various corporate assets include the historical cost, the deprival value or current cost, the fair value, the realizable value and the value in use basis. In deciding what measurement basis to apply, various criteria ought to be considered. However, the criteria of reliability and relevance is an important one as stated above. Other important criteria that ought to be considered include the cost effectiveness of the measurement basis adopted as well as its fitness for purposes. The various measurement basis is explained below. The historical basis This is a conventional accounting measurement basis that needs that assets be recorded or valued in the books of the business at their original purchase price as opposed to an inflation-adjusted market price. Modern historical cost basis is also known as a recoverable historical cost since it requires the amount at which an asset is stated in the accounts not exceed the amount the firm expects to recover from its use or sale (Jared, 2009). Regarding the selection criteria, the measurement method is hailed for its objectivity, simplicity, its conservative nature and consistency. The method is also hailed for its being reliable as a cost is reliably measured when taken from prices in actual transactions. However, the method is said to be subjective owing to the problem of prediction and allocation to assets and periods. The method is also hailed for its relevance for some purposes when compared to information prepared from other measurement bases as it matches costs with realized income and is aligned to management information. However, it is blamed for relying on outdated information while ignoring some unrealized gains. Value to the business measurement model The model measures how much worse off the business would be if it were deprived of a certain asset. This is given by the asset’s replacement cost. The challenge is the availability of comparable price for such replacement assets as there only exists markets for only a few of such assets in the age and condition in which they are on the balance sheet. Thus the practice is to calculate replacement the cost by taking a price of a new replacement asset and making appropriate adjustments for depreciation and service potential between original asset and its replacement. The measurement method is considered reliable especially where an asset is actually being replaced with a similar asset as to service potential where the prices will be objectively reflected without the need for further adjustment. However, it could be subjective where the asset is being replaced by a different asset. The method is also hailed for its relevance as it shows a cost of entry to new entrants while showing whether operating capability is being maintained. However, it is to be known that maintenance of operational capability may not be a priority for investors while new entrants’ perspective may not be the most relevant for existing investors (Heaton, etal, 2009) Fair value measurement This is defined as the amount at which the asset could be bought or sold in a current transaction between willing parties other than in a forced sale or liquidation (Katz, 2008). The method is taken to be reliable only when fair values are taken from active markets as this would be verifiable and objective. If this is not the case, the values are taken to be estimates and hence subjective. As far as relevance is concerned, the method shows sale values and hence opportunity costs. It shows expected value of risk-adjusted future cash flows for some assets. It is the only information relevant for financial decision making. The net realizable value method The method uses the amount that the firm expects to realize from the sale of inventory or an asset in the ordinary course of business. The method is considered reliable when based on active markets and hence objective. However, subjectivity arises where there are no reliable market values. The method is considered relevant since it shows sale values and hence opportunity costs. The method shows expected value of risk-adjusted future cash flows for some assets. (Edwards, etal, 2007) Value in use method This is the discounted value of the future cash flows attributable to the asset. However, this is only applicable to businesses or business units as cash flows are generated by businesses or business units as opposed to separable assets. The method is only objective to the extent that cash flows have already occurred and hence the method is considered highly subjective and hence its reliability is doubted for being based too much on predictions. The method is however considered relevant as it shows present value of expected future cash flows and economists measure of income. (Hermanson and Edwards, 2008) Residual income valuation model The residual income is related to equity value and the companies earning more than the cost of capital ought to sell for more than book value and the vice versa is true. The residual income model has two components including the current book value of equity and the present value of expected future residual income. The intrinsic value of common stock is thus calculated as follows: (Edwards, etal, 2007) V0 = B0 +∞t=1RIt (1 + r) t= B0 +∞t=1Et − rBt−1 (1 + r) t Where V0 = value of a share of stock today (t = 0) B0 = current per-share book value of equity Bt = expected per-share book value of equity at any time t r = required rate of return on equity (cost of equity) Et = expected EPS for period t RIt = expected per-share residual income, equal to Et − rBt−1 The extent to which the different methods of valuation satisfy the informational needs of users and the practical implications of adoption for preparers As stated above, the valuation method adopted out to satisfy informational needs of users and hence preparers of financial information ought to consider this before deciding on the valuation method to adopt. The qualities to be considered in this respect include relevance and reliability. In the section above, each of the alternative valuation approaches has been considered with respect to these two aspects. For information to be considered relevant, it ought to have predictive value and be presented on a timely basis (Edwards et al., 2007). On the other hand, information that is relevant has a bearing on a decision and will be capable of making a difference in the decision. Thus, such information should help users make predictions about the outcomes of past, present and future events or confirm or correct prior expectations. Such information can be depended upon to represent the conditions and events that it purports to represent. Such information ought to have representational faithfulness, neutrality as well as verifiability. Thus, the adoption of any of the valuation methods by a company will majorly depend on its relevance and reliability. If such a valuation method is chosen, then it will most likely satisfy users’ informational needs. Thus, no one best method can be recommended for all the companies but each method adopted for a certain asset or class of assets should be able to satisfy the relevance and reliability criteria and hence be able to satisfy user’s informational needs. Recommendations for a future improved financial reporting and disclosure regime In future, standard setters should come up with an improved financial reporting and disclosure regime. In this regard, I would suggest that such a regime serves to improve decision usefulness of financial information thus serving to fulfil users’ informational needs of financial information. Such a regime should also improve the comparability and consistency of financial information (Edwards and Bell, 2004). I would suggest that the regime is based on a single measurement basis to be universally used in measurement in all situations. In this regard, only one point will be provided for measurement purposes that best satisfies the criteria of the financial accounting and reporting measurement. In this case, I would suggest that the basis is purely based on historical cost, fair value or realizable value. However, other measurement bases will be allowed as proxies where direct measurement is impossible. The advantage of such a measurement regime will be a consistency of measurement and comparability as well. Conclusion This section has looked at the various measurement basis available to organizations for measuring and reporting corporate assets. In this regard, various measurement bases have been discussed. The section has also conducted a review of the existing literature regarding the measurement bases as well the factors to be considered in deciding what measurement basis to apply for what assets. In future, the section recommends the development of a single measurement base as this will ensure consistency and comparability of financial statements provided the aspects of relevance and reliability are not compromised. References: Booker Group PLC 2016, Annual Report & Accounts, 2016. Retrieved on 25th June 2016, from; http://www.bookergroup.com/~/media/Files/B/Booker-Group/pdf/report-and- accounts-2016.pdf? Procházka, D. 2011, The role of fair value measurement in the recent economic crunch, Prague Economic Papers, vol. 1, pp. 71-82. Edwards, E. &, Bell, P. 2004, The theory and measurement of business income, Berkeley: University of California Press. Edwards, J., Kay, J. & Mayer, C. 2007, The economic analysis of accounting profitability, Oxford: Clarendon Press. Efrag.org, 2016, Measurement basis for financial accounting; Retrieved on 16th July 2016, from; http://www.efrag.org/Assets/Download?assetUrl=%2Fsites%2Fwebpublishing%2 FProject%20Documents%2F53%2FDP%20Measurement%20on%20Initial%20R ecognition.pdf&AspxAutoDetectCookieSupport=1 Ernst & Young 2005, How fair is fair value, London, Ernst & Young. Lee, C1996, Measuring wealth, CA Magazine, pp. 32-38. Heaton, J., Lucas, D. &, McDonald, R. 2009, Is mark-to-market accounting destabilizing? Analysis and Implications for Policy, Carnegie Rochester Conference on Public Policy. Hermanson, R. & Edwards J. 2008, Accounting principles: A business perspective, financial accounting, Richard D Irwin. Pablo, F2002, Valuation methods and shareholder value creation, Academic Press, San Diego, CA. IASB 2005, Discussion paper Measurement Bases for Financial Accounting- Measurement on Initial Recognition, London: IASCF Publications Department. Jared, B. 2009, Measurement basis for financial accounting, London, Routledge. Weygandt, J. & Kieso, D. 2011, Accounting principles, New York, John Wiley & Sons. Katz, D. 2008, Fair value revolution, Retrieved on 1st July 2016, from; http://ww2.cfo.com/accounting-tax/2008/09/fair-value-revolution/ S, B. 2011, Measurement of the elements of the financial statement, London, Routledge. Penman, S. 2006, Handling valuation models, Journal of Applied Corporate Finance Handling valuation models, Journal of Applied Corporate Finance, vol.18, no. 2, pp.48-55. Pierre, L. 2007, Accounting measurement basis, Market mispricing and firm investment efficiency, Journal of Accounting Research, vol. 45, Issue 1, pp. 155-167. PriceWaterHouseCoopers. 2006, Financial reporting in hyperinflationary environments: Understanding IAS29, PriceWaterHouseCoopers. SSP Group PLC, 2015, Annual Report and Accounts, 2015. Retrieved on 25th June 2016, from; http://investors.foodtravelexperts.com/~/media/Files/S/SSP-IR/reports-and- presentations/financial-reports/ssp-annual-report-2015.pdf Tesco PLC, 2016, Annual Report and Financial Statements, 2016. Retrieved on 25th June 2016, from; https://www.tescoplc.com/media/264194/annual-report-2016.pdf Whittington, G. 2010, Measurement in financial reporting, Abacus, vol. 46, no. 1, pp. 104- 112. Read More