Firstly looking at stock
market valuation which simply takes the number of issued shares and multiplies
them by the market price. This is a simple technique and gives an idea to the
buying company as to what the purchase price could be. Technically if the
efficient market hypothesis applies then using this technique should give an
accurate value of a company. However as discussed in my second blog, the stock
market is not perfectly efficient and so it is unlikely this method will give a
true valuation. It must be considered that managers within the organisation are
likely to have internal information which could significantly impact the value
of the firm. This could result in a target company rejecting a bid as they
believe it does not provide a true reflection of the value of the company.
Whilst this method is not widely used, it could be argued that Sabadell
However there are
limitations of using stock market valuation. Firstly the quoted share price
does not reflect the value of all of the shares as these shares are only a
fraction of the total amount and therefore does not fully represent a true
value of a company. Another problem with this approach is that whilst it gives
the buyer a possible share purchase price it does not reflect a company’s true
worth giving no appreciation of future cash flows. Given that BHS was part of a
wider group which was not listed on the stock exchange, this method could not
have been used during valuation. With Sabadell
Another approach which can
be used to value a company is net asset valuation (NAV). This technique uses
the value of net assets from the balance sheet in order to determine the value
of a company and includes two techniques; book value and net realisable value
(ACCA, 2012). Book value is based on historical costs which are easily
available as they are simply taken from the balance sheet. However a problem
with this approach is, for example, an asset bought 10 years ago it is unlikely
to be worth the same value today and therefore provides an inaccurate figure.
In addition, given that it solely relies on balance sheet figures it gives no
consideration to intangible assets such as a company's brand name or research and
development. Net realisable value is likely to be a slightly more accurate
approach in comparison because it uses the amount which would be generated if a
company was to sell its assets on the open market today.
However there are
significant limitations with utilising either of the NAV methods. Firstly, the
value determined from this approach does not take into consideration future
profits of the company, dividends or growth prospects as it is entirely based
on the company’s assets. In addition, it does not include intangibles, for
example a company’s brand, reputation and employees. These intangible assets
for many organisations are likely to be of significant value to a company,
particularly for organisations which are serviced based. Therefore this method
is inappropriate to value TSB given that it is primarily a service based
organisation and therefore relies heavily on having experienced employees as
well as maintaining a strong brand name which is not captured using this
method. It could be argued that this approach could have been used to value
BHS. Whilst it is a well-known company and recognised brand, it is a loss
making company and given this situation, the future prospects of the company
are very poor.
The third approach which can
be used to value a company is categorised as an income based valuation method;
discounted cash flow (DCF) valuation. This requires the combined cash flows
post-acquisition to be determined and estimate a discount value to make
adjustments to this (Penman & Sougiannis, 1998). Using this method, the
maximum a company should be prepared to pay is the difference between the
present values of cash flows before and after the acquisition. If the combined
entity’s is less than the separate entities then this will destroy shareholder
value - and thinking about it logically why would companies want to merge if
the combined entity is of less value? A benefit of using this approach is that
it incorporates the time value of money, therefore appreciates that money
available at a later date is worth less than money available now because of
future earnings potential.
Like the other approaches to
valuation, discounted cash flow valuation also has its limitations. Firstly it
is difficult to decide an appropriate discount rate as well as the number of
years of which future cash flows are discounted over and determining when this
will end. It is important to note that it may take a few years before a newly
formed entity could begin to recognise its true earnings potential. Secondly,
in reality when valuing a company for an acquisition it is very hard to predict
what benefits will arise from the combined entity and therefore it is difficult
to incorporate this into the future cash flow predictions. In reality, it is
likely that there will be a big difference between what is predicted compared
to what actually happens. Furthermore deciding the growth rate of the cash
flows can be difficult and various business risks and challenges need to be
taken into consideration when doing this. Therefore DCF is subject to a number
of assumptions, which altered, could provide different values. It is unlikely
this method was used for BHS as I believe Sir Philip Green simply wanted to get
rid of the company due to the difficulties it was facing. Even if this was not
the case it will be very difficult to forecast cash flows given that it is
currently a loss making company. On the other hand, for valuing TSB, this may
not be the preferred method as the company has not long been separated from
Lloyds TSB therefore the recent cash flows are unlikely to be a true
representation as to what future ones may be and therefore provides very little
guidance to predict future cash flows, particularly as a combined entity. This
reinforces the point that predicted cash are likely to be very different to
actual cash flows which could have lead Sabadell to coming to a very inaccurate
value.
Another income based
valuation method is the PE ratio. This is one of the most popular methods and
it considers risk and gives an indication of future company performance (Arnold
To conclude, there are many
methods which can be used to value a company and as demonstrated throughout
this blog they are all subject to their limitations. It is very difficult to
judge which method, if any at all, was used to come to a value for BHS because
I think Sir Philip Green just wanted to sell the company regardless of how much
it was worth due to the losses it is making. I think it would have been
inappropriate for Sabadell to value TSB using NAV given that it does not give
any consideration to intangibles, which as discussed are a significant part of
the company. The company may have used a combination of methods - whist I have
discussed methods within this blog, it is important to recognise that there are
other methods which could have been used and in most cases it is unlikely that
we are able to judge which method a company has used. I believe there is no
ideal method to value a company and I believe companies should use a variety of
methods which will provide a range of figures allowing a company to gain a
greater appreciation and perhaps come to a more accurate value. Therefore I
think it is fair to conclude that valuing companies is more of an art than a
science.
References
ACCA (2012). Business Valuations. Retrieved 23rd
March 2015, from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf
Arnold, G. (2012). Corporate financial
management. (5th ed.). New York: Pearson.
BBC (2015). TSB confirms
£1.7bn takeover move by Spain's Sabadell. Retrieved 23rd March 2015,
from http://www.bbc.co.uk/news/business-31848517
Financial Times (2015). Sir Philip Green sells BHS for £1.
Retrieved 23rd March 2015, from http://www.ft.com/cms/s/0/70dfb9c8-c8a6-11e4-8617-00144feab7de.html#axzz3VD2iJ52f
Penman, S. H., &
Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings
approaches to equity valuation. Contemporary Accounting Research, 15(3),
343-383. doi:10.1111/j.1911-3846.1998.tb00564.x
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