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Basic Business Valuation Principles


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Title: Basic Business Valuation Principles

Basic Business Valuation Principles
Income Statement
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IAS 18
  • Significant risks and rewards transferred
  • Seller retains no control
  • Revenue can be measured
  • Economic benefits will probably flow to the
  • Costs can be measured
  • Stage of completion can be measured (applicable
    to services only).

Problem of Revenue Recognition
  • Warranties
  • Premium
  • Vouchers
  • Subscriptions
  • Loyalty reward
  • Services guarantee

Research and DevelopmentIAS 38
  • Research phase -original and planned
    investigation undertaken with prospect of gaining
    new scientific or technical knowledge
  • All of the costs associated should be written off
    as incurred
  • Development phase the application of research
    findings or other knowledge to improve or
    substantially develop company products, services
    or processes
  • Development costs must be capitalized if
  • The project is technically feasible.
  • There is an intention to complete the intangible
    asset and use or sell it.
  • The enterprise has the ability to sue or sell the
  • It must be clear how the intangible can be used
    or how it could be sold.
  • The company has adequate resources to complete
    the project.
  • The expenditure associated with the intangible
    asset can be reliably measured.

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Foreign Exchange Gains
  • Gains on trading transactions are reported as
    reductions in operating expenditures
  • Gains on financing transactions are reported as
    part of finance charges.

Government Grants
  • Revenue grants treated as income when related
    expense is incurred
  • Capital grants treated as deferred credit.

Leasing Accounting Treatment
  • Capital Leases immediate recognition of total
    sale value of assets under lease based on the
    revenue receivable
  • Operating Lease recognizing rental receipts
    over lease term as profit

Criteria for Finance Leases IAS 17
  • Criteria
  • Ownership is transferred at the end of the lease
  • There is a bargain purchase option
  • Leases term is for the major part of the assets
    economic life
  • Present value of minimum leases payments is
    substantially all of the fair value of the leased
  • Assets are of a specialized nature
  • Residual value fluctuations belong to the lessee
  • Lessee can extend the lease at a below market
  • Comment
  • This would effectively be payment by installments
  • If the asset can be bought below its fair value
    then it is a bargain
  • Typically 75 of the assets life is the
  • Fair value can be read as cash price.
    Substantially all normally equates to 90
  • If only the lessee can use them its the lessees
  • This would be an indicator of where the economic
    risks and rewards lie
  • The secondary period brings the lessee closer to
    economic ownership

All leases are a form of debt (irrespective of
accounting treatment)
  • Add back the existing rental to EBIT (and adjust
    taxes if appropriate)
  • Capitalize the rental as an obligation (debt) and
    an asset
  • Charge interest on the debt
  • Charge depreciation on the capitalized asset

Signs of Trouble relating to Revenues
  • Unexpected changes in revenues
  • Increasing disparity between profit and cash
  • Unexpected ballooning of accounts receivable
  • Change in segment mix, especially unexpected
    and/or inconsistent with strategy
  • Significant revenues or increasing proportion
    coming from a related party.

  • Nick Antill and Kenneth Lee,
  • Company Valuation under IFRS Interpreting and
    Forecasting Accounts Using International
    Financial Reporting Standards,
  • Harriman House, 2005

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Given Company A and Company B are identical in
all respects except that Company A owns its fixed
assets while Company B leases its fixed assets
Different rates of return because of risk
Valuation is different because risk is different
Basic Principles in Business Valuation
Value is Based on Prospects
Operational decisions drive the price and margin
positioning of the companys products (services)
  • Investment decisions involve the companys use of
    both current and capital assets.

Financial decisions determine the companys
financial leverage and dividend policy
Factors to be considered in business valuation
  • Nature and history of the business is it an
    asset holding company or an operating business?
    Is there any prior transactions?
  • Industry and types of company Is it a growth
    business? Is the business cyclical/ what is the
    competition? What is the economic outlook that
    may affect the subject business?
  • Level of Sales and profit margin
  • Financial strength/ tangible asset backings
  • Management strength and weakness
  • Distribution networks
  • Liability issues are there identifiable or
    contingent liabilities? Are there proposed
    changes in safety or environmental regulations
    that may affect the industry?

Industry x Competitive Position Profitability
  • Two things determine a company's
    profitability-the industry in which it competes
    and its strategic position in the industry
    (Michael E. Porter)

Michael E. Porter is a leading authority on
competitive strategy and the competitiveness and
economic development of nations, states, and
regions. He is the Bishop William Lawrence
University Professor, based at Harvard Business
Industry Analysis Competitive Strategy
Aims to establish a profitable and sustainable
position relative to industry competitors.
5 competitive forces that determine industry
attractiveness through their collective effect on
prices, costs, and required investment
  • Entry of new competitors barriers of entry,
    economies of scale, product differentials, brand
    identity, capital requirements, access to
    distribution channels, switching cost to buyers,
    government policy, cost advantages.
  • Threat of substitutes relative price and
    performance, switching costs to buyers
  • Bargaining power of buyers buyer concentration,
    buyer volume, buyer information, available
    substitutes, switching costs, price sensitivity
  • Bargaining power of suppliers differentiation
    of inputs, presence of substitute inputs,
    supplier concentration, importance of volume to
    supplier, threat of forward integration
  • Rivalry among existing competitors industry
    growth, fixed-Variable costs, value added,
    product differences, brand identity, diversity of
    competitors, exit barriers, informational

  • Michael E. Porter, Competitive Strategy The Core
    Concepts, Free Press, New York, 1985, 1998
  • Michael E. Porter, Competitive Advantage, Free
    Press, New York, 1985

The Need for Financial Statement Analysis
Earnings quality is of paramount importance
  • While accounts are prepared in accordance with
    the generally accepted accounting principles,
    distortion can arise because many of the entries
    are subject to management decision or discretions
    that may prove to be inaccurate or they may be
  • The companys operations themselves are never
    completely smooth and often contain one-time
    events which may not recur in the future.

Three goals of financial analysis and adjustment
  • Understanding of the relationships existing in
    the profit and loss statement and the balance
    sheet, including trends over time, to assess the
    risk inherent in the business operations and the
    prospects for future performance.
  • Comparison with similar businesses to assesses
    risk and value parameters.
  • Adjustment of historical financial statements to
    estimate the economic abilities of and prospects
    for the business

Hong Kong Financial Reporting Standards (HKFRS)
  • Effective from 1 January 2005

Effect of IFRS on Reported Earnings in HK
  • IASBs shift
  • Income Statement Balance Sheet
  • Measure Assets and Liabilities with Fair
  • More one-off items on Income Statement
  • Change in Fair Value of Investment Properties on
    Income Statement
  • Impairment of Goodwill

Net Income Cannot be Taken at Face Value
  • Recurring earnings
  • Can be used in year-to-year comparison
  • Can be used in calculating P/E ratio
  • Transitory earnings
  • Restructuring charges
  • Acquisition expenses
  • Asset sale gain/loss
  • Realized Investment gain/loss
  • Litigation charges
  • Goodwill amortization
  • Tax adjustment

Financial Misreporting The Seven Shenanigans
  • Recording revenue before it is earned
  • Inventing revenue
  • Boosting profits with nonrecurring items
  • Shifting expenses to later periods
  • Failing to disclose and/or record liabilities
  • Shifting income to later periods
  • Shifting expense to earlier periods

Red flags warning of an impending decline in
earnings quality
  • Adoption of less conservative accounting
    practices, such as using a longer life for
    depreciation purposes.
  • One-time transactions to generate gains, such as
    tax deals or asset sales.
  • Operating actions designed to accelerate the
    recognition earnings, such as speeding up
    shipments to customer.
  • Inclusion of past profits in the current period.
  • Early adoption of new accounting standards that
    boost earnings
  • Reduction of managed costs, such as Research and
    Development, maintenance, or advertising.
  • Not fully allowing for bad debts, warranty
    obligations, returns, and other future costs of
    current sales.
  • An increasing receivables period, i.e. the time
    between the recording a sale and the subsequent
    collection cash from the customer.
  • An increasing reliance upon sources of earning
    outside the companys core business.
  • Capitalizing types of expenses that were
    previously recognized when they were incurred.
  • A major acquisition with inadequate disclosure,
    making comparisons difficult.
  • Write-off of investments soon after they are
  • An increasing amount of financial leverage
  • A slowdown in inventory turnover.

Further Reference
  • Howard Schilit, Financial Shenanigans, 2nd
    Edition, McGraw-Hill, New York, 2002
  • Martin Fridson and Fernando Alvarez, Financial
    Statement Analysis A Practitioners Guide, 3rd
    Edition, Wiley, New York, 2002

Common Size Analysis
  • A technique that enables Valuer to determine the
    component makeup of a companys balance sheet and
    income statement in relation to a critical
    component (total assts or total sales).
  • When this technique is used in conjunction with a
    balance sheet, all balance sheet items will be
    represented as a percentage of net sales or
  • As the name of the method goes, common size
    analysis can be used to compare companies of
    different sizes.

Common-size analysis can either be vertical or
  • In vertical analysis for a given year, all
    balance sheet items are expressed as a percentage
    of total assets and all income statement items as
    a percentage of net sales.
  • Horizontal analysis develops trends in balance
    sheet or income statement percentages over time.
    A particular year is designated the base year and
    percentage changes in subsequent years are

Financial Ratio Analysis
Earning power the Return of Equity
  • ROE
  • net profit margin x asset turnover x equity
  • Net Income x Sales x Assets
  • Sales Assets Equity (Book Value)
  • (the DuPont formula)

Other financial ratios
  • Liquidity ratios demonstrate the companys
    ability to meet its current (short-term)
  • Current Raito Current assets
  • Current liabilities
  • Quick Ratio Current Assets Inventories
  • (Acid-Test) Current Liabilities

Other financial ratios
  • Asset Management or Activity Ratios measures how
    effectively a company manages its assets.
  • Accounts Receivable Turnover Sales
  • Accounts Receivable
  • or Average Collection Period (Days)
  • Accounts Receivable Turnover
  • Inventory Turnover Cost of Goods Sold
  • Inventories
  • or Average Days Inventory 365
  • Inventory Turnover
  • A slow (low) inventory turnover means a long
    average holding period. It would put a strain on
    the companys liquidity and may indicate obsolete
    or otherwise undesirable inventory. A too fast
    (high) inventory turnover may indicate that sales
    are being lost due to insufficient inventory on

Other financial ratios
  • Cash Conversion Cycle
  • Days in inventory Days in accounts receivable
    Days in accounts payable
  • The cash conversion cycle is a rough measure of
    the time it takes for a companys operations to
    produce cash, beginning with the initial
    inventory investment.
  • Working Capital Turnover Sales
  • Working Capital
  • If a companys current ratio, accounts receivable
    collection period, and inventory turnover remain
    constant as sales go up, the working capital must
    rise, because the company will have to carry more
    receivables and inventory to support the
    increased sales level. A high ratio of sales to
    net working capital results from a favourable
    turnover of accounts receivable and inventory and
    indicates efficient use of current assets. But a
    high sales-to-net-working-capital ratio also can
    indicate risk arising from possibly inadequate
    short-term liquidity.

Other financial ratios
  • Debt Management Ratios
  • Cash Flow Coverage
  • Cash Flow from Operations
  • Total Debt
  • Interest Coverage
  • Earnings before Interest and Tax (EBIT)
  • Interest Expense

Further Reference
  • Krishna G. Palepu, Paul M. Healy, and Victor L.
    Bernard, Business Analysis Valuation Using
    Financial Statements, 3rd Edition, South-Western
    College Publishing, 2003

Further Adjustments
  • Non-operating Items
  • Redundant assets
  • Depreciation
  • Management Compensation and Perquisites
  • Occupancy Costs
  • Discretionary items

Financial statement adjustments are made for the
purpose of assisting the Valuer in reaching a
valuation conclusion.
  • Adjustments made should be fully described and
  • If the Valuer is acting as a consultant to either
    the buyer or seller in a proposed transaction,
    the adjustments should be understood by the

Financial Statement Forecasting
, the careful estimates of security analysts
(based on industry studies, plant visits, etc.)
do little better than those that would be
obtained by simple extrapolation of past trends,
  • Burton G. Malkiel,
  • A Random Walk Down Wall Street, W.W. Norton
  • Revised and Updated Edition, 2003

  • The Park Company runs a retail chain.
  • It started its operation 3 years ago by opening
    on average 3 new stores per year.
  • After this 3-year growth, Park Company plans to
    just open 2 more new stores in the coming four
    years only.
  • The opening costs for a new store, excluding
    fixed assets, are approximately 35,000.
  • It appears that a new store takes one year to
  • Park Company has shown the following results from

Unscrupulous Projection
Suggested answer
Analysis Year 1 3 immature stores produced
30 Year 2 3 mature stores and 3 immature
stores produced 90 i.e. 3 mature stores
produced 60 Year 3 6 mature stores and 3
immature stores produced 150 i.e. 6 mature
stores produced 120 Year 4 9 mature stores and
2 immature stores will produce 180 20
If Park Company opens no new store in Year 5
Year 5 11 mature stores will produce 220 Year
6 If no new store come forth, the net income
before tax will still be 220 assuming
everything remains the same
Actual Performance
Product Life Cycle
Product Life Cycle
Percent-of-sales method
  • Once the sales have been forecasted, the Valuer
    should try to develop a pro forma income
    statement and balance sheet.
  • The most commonly used technique is the
    percent-of-sales method, which is to express
    income statement and balance sheet items as a
    percentage of future sales.
  • This method is viable when variable costs as well
    as most current assets and liabilities vary
    directly with sales.

The percent-of-sales method follows a simple
three-step process
  • Forecast the future periods sales.
  • Determine which financial statement items have
    varied directly with sales in the past. This will
    be a good indication of whether those same
    accounts will vary with sales in the future.
  • Forecast all income statement and balance sheet
    items that vary directly with sales. Obtain
    independent forecasts of those items that do not
    vary with sales.

Typical Forecasting Techniques for Financial
Forecasting growth
  • The above shows the forecasted sales of a
    business for eight years.
  • The eight-year period is called the explicit
    forecast period, with the eighth year being the
    forecast horizon.
  • The initial forecasted growth rate is 10, but
    high growth attracts competition and eventually
    the market becomes saturated.
  • Therefore, population growth and inflation
    determine the long-term sustainable growth rate
    for most companies that have no international
    market sales.

Then, the forecasted financial statement of the
coming year is presented as follows
Business Valuation Approaches
The concepts, processes, and methods applied in
the valuation of businesses are the same as those
for other types of valuations
Asset-based business valuation approach
  • The asset-based approach should be considered in
    valuations of controlling interests in business
    entities that involve one or more of the
  • An investment or holding business, such as a
    property business or a farming business
  • A business valued on a basis other than as a
    going concern

Asset-based business valuation approach (contd)
  • Like the cost approach in the valuation of real
    property, the asset-based approach should not be
    the sole valuation approach used in assignments
    relating to operating businesses appraised as
    going concerns because it cannot be easily
    applied to intangible assets.
  • This approach is generally considered to be a
    floor value for a company being valued as a
    going concern.

Asset-based business valuation approach (contd)
  • For this reason, the asset-based approach is
    generally not used for the following types of
    business valuation assignments
  • Service businesses
  • Asset-light businesses
  • Operating companies with intangible value
  • Minority interest, which have no control over he
    sale of the assets (because the minority
    shareholder does not have the ability to
    liquidate the assets.)

Income approach to business valuation
(Direct) capitalization of income
  • A representative income level is divided by a
    capitalization rate or multiplied by an income
    multiple to convert the income into value.
  • This method is most appropriate to valuation of a
    business that is not too asset intensive.

(Direct) capitalization of income (contd)
  • Income can be a variety of definitions of income
    and cash flow. Some of the more common
    definitions include
  • Net income after tax
  • Net income before taxes (pretax income)
  • Cash flow (gross or net)
  • Debt-free income
  • Debt-free cash flow (gross or net)
  • Earnings before interest and taxes (EBIT)
  • Earnings before depreciation, interest and taxes

Earning or Cash Flow?
  • Investors are generally less interested in net
    profit on an accounting basis, and more
    interested in the amount of cash generated by a
    particular business which will be available to
    them for discretionary spending and investment.
  • Free cash flow to equity may also be viewed as
    being less prone to manipulation by management
    than earnings.

Earning or Cash Flow? (Contd)
  • Value is created when it is earned, even on
    accounting basis, rather than when cash is
  • Anyway, earnings and cash flow are highly
    correlated, particularly over the long run.

MillerModigliani Theorem
  • In a world of no tax and default, the value of a
    firm is independent of its capital structure,
    i.e. the capital structure or financial mix
    should have no effect on the firm value.

The Use of EBIT or EBDIT
  • Because of the MillerModigliani Theorem, broader
    measures of income, like EBIT or EBDIT can be
    more appropriate as measure of firms value
    though the firm may have varying capital

Modigliani won the Nobel prize in economics in
1985 and Miller in 1990.
VL VU TD (PV of expected costs of financial
distress) (PV of agency cost)
  • The addition of financial distress and agency
    costs results in a trade-off.
  • The optimal capital structure can be visualized
    as a trade-off between the benefit of debt (the
    interest tax shelter) and the costs of debt
    (financial distress and agency costs).

Value of a Firm is partially a function of
Value of Firm V
Pure MM value of Firm VL VU TD
Present Value of Tax Shield TD
PV of Financial Distress and Agency Costs
Value of Levered Firm VL
The Trade-off Model
  • The trade-off models enable us to make three
    statements about leverage
  • Firms with more business risk ought to use less
    debt than lower-risk firms, other things being
    equal, because the greater the business risk, the
    greater the probability of financial distress at
    any level of debt, hence the greater the expected
    costs of distress. Thus, firms with lower
    business risk can borrow more before the expected
    costs of distress offset the tax advantages of
    borrowing (Point B).
  • Firms that have tangible, readily marketable
    assets such as real estate can use more debt than
    firms whose value is derived primarily from
    intangible assets such as patents and goodwill.
    The costs of financial distress depend not only
    on the probability of incurring distress but also
    on what happens if distress occurs. Specialized
    assets and intangible assets are more likely to
    lose value if financial distress occurs than are
    standardized, tangible assets.
  • Firms that are currently paying taxes at the
    highest rate, and that are likely to do so in the
    future, should use more debt than firms with
    lower tax rates. High corporate taxes lead to
    greater benefits from debt, other factors held
    constant, so more debt can be used before the tax
    shield is offset by financial distress and agency

The Trade-off Model (Contd)
  • According to this trade-off models, each firm
    should set its target capital structure such that
    the costs and benefits of leverage are balanced
    at the margin, because such a structure will
    maximize its value.
  • If this is correct, firms within a given
    industry should have similar capital structure
    because such firms should have roughly the same
    types of assets, business risk, and profitability.

Consistency is more important
  • No matter which income base is adopted, the
    capitalization rate used must be appropriate for
    the definition of income used.

Discounted cash flow analysis
  • Cash receipts are estimated for each of several
    future periods.
  • These receipts are converted to value by the
    application of a discount rate using present
    value techniques.
  • The timing of cash inflows and cash outlays are
    important as well as the amount of the receipts.
  • The discount rate must be appropriate for the
    definition of cash flow used.
  • where P0 present value or market price
  • r investors required rate of return
  • C1, C2, C3 expected income flows in
    periods 1, 2, 3

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Example Using the Discounted Future Income
Method to Estimate the Value of a Business
Terminal Value Estimate
Example Using the Discounted Future Income
Method to Estimate the Value of a Business
Terminal Value Estimate Assuming discounted rate
at 25
Principal difficulties with the discounted cash
flow technique
  • Long-term cash flow projections are subject to
    substantial error.
  • The choice of the discounting horizon, the point
    of competitive equilibrium, is also uncertain.
  • The terminal value, which often accounts for 70
    of the final valuation, is subject to the highest

Discretionary earnings
  • Net Operating Profit
  • Gross sales Cost of goods sold Operating
  • or
  • Net Income (after-tax)
  • Income tax
  • Interest Expenses
  • Depreciation
  • One-time, nonrecurring expenses
  • All owners compensation and perquisites

Sustainable Capital Reinvestments
  • The capital outlays required on an annual basis
    to maintain or sustain the existing business
    volume, competitive abilities etc.
  • They are the non-discretionary cash flow that
    must be deducted from the net income because the
    investors return comes only from the balance of
    the cash flow (or the discretionary portion of
    the cash flow).
  • They may be estimated by
  • reviewing the fixed asset additions for a number
    of years to determine the amount that has been
    spent historically on maintaining existing
  • examination of the budget of the business and
  • discussion with senior management

Capitalization Rates or Discount Rates?
  • Capitalization rate is indeed a divisor used to
    convert a constant stream of earnings or cash
    flow to a capital amount or value.
  • It can be sometimes referred to as a multiplier
    which mathematically, is simply the reciprocal of
    a discount rate (without the projected long-term
    growth rate of future income).
  • However, capitalization implicitly assumes that
    the constant earnings stream to be infinite while
    the discounting process may take into account the
    definite period of cash flow.
  • Capitalization rates typically do not include an
    inflation component as the indicated
    earnings/cash flow are stated in constant

Example Relationship Between Discount Rates and
Capitalization Rates
Terminal Value Estimate
Example Relationship Between Discount Rates and
Capitalization Rates (contd)
Terminal Value Estimate Assuming discounted rate
at 25
Capitalization of income method assuming a 5
growth rate and 25 discount rate 100,000/(.25-
.05) 500,000
A Function of Risk
  • Both the capitalization rate and the discount
    rate are reflections of perceived investment
  • Risk here means the degree of uncertainty as to
    the realization of expected future returns.

  • High capitalization rates or low earnings
    multiples are associated with highly risky or
    uncertain earnings expectations.
  • Conversely, low capitalization rates or high
    earnings multiples are associated with good
    prospects for growth in earnings.

The Efficient Frontier
Expected return
Volatility of Returns
Estimating the Discount Rate
  • Establishing the proper discount rate is one of
    the most difficult and, at the same time,
    critical parts of a valuation.
  • A cursory check of the rates of return and
    dividend yields in terms of the selling prices of
    corporate shares listed on the major exchanges
    will give no ready or simple solution.
  • Wide variations will be found even for companies
    in the same industry.
  • The ratio will fluctuate from year to year
    depending upon the economic conditions.

The Required Rate of Return
  • In essence, the capitalization rate or discount
    rate is a combination of the opportunity cost
    plus a premium for risk associated with obtaining
    the expected returns.
  • If you pay the market value, (provided that
    markets are efficient), you must earn the cost of
    capital on the investment. The expected economic
    return equals the cost of capital.

Cost of Capital an Opportunity Cost
  • Cost of capital for a given investment is the
    minimum risk-adjusted return required by
    shareholders of the firm for undertaking that
  • Unless the investment generates sufficient funds
    to repay suppliers of capital, the firms value
    will suffer
  • This return requirement is met only if the net
    present value of future project cash flows, using
    the projects cost of capital as the discount
    rate, is positive.

Weighted Average Cost of Capital (WACC)
  • Cost of Equity x percentage of Capital in
  • Cost of Debt x percentage of Capital in Debt

D i.e. re ---------- rd (1-t) ---------------
D where E the total market value of the
companys equity D the total market value of
the companys debt re the cost of equity rd
the cost of debt t the companys effective
tax rate and re gt rd
Cost of Equity
  • The cost of equity is the rate used to capitalize
    total corporate cash flows
  • It is the weighted average of the required rates
    of return on the firms individual activities
  • It is a function of the riskiness of the
    activities in which the firm engages
  • Thus, the cost of equity capital for the firm as
    a whole may not be used as a measure of the
    required return on equity investment in future
    projects unless these projects are of a similar
    nature to the average of those already being
    undertaken by the firm.

Capital Asset Pricing Model
  • CAPM is a basic theory that relates risk and
    return for any asset.
  • It is based on the concept that the required rate
    of return for an asset is directly related to the
    riskiness of the asset.
  • Risk here means the degree of uncertainty as to
    the realization of expected future returns. CAPM
    therefore measures risk in terms of the relative
    volatility of the asset price.
  • Greater risk requires a higher rate of return.
  • R Rf ß(ER) CS
  • where
  • R discount rate, Rf risk-free rate, ß
    beta, ER equity risk premium, CS
    company-specific risk factor

Two Components of Risk
Systematic Risk v. Unsystematic Risk
  • Systematic risk, which is also known as the
    market risk, is the uncertainty of future returns
    due to the sensitivity of the return on the
    subject investment to movements in the return for
    the investment market as a whole.
  • Unsystematic risk is a function of
    characteristics of the industry, the individual
    company, and the type of investment interest.

Importance of CAPM
  • To the extent that the capital market theory
    assumes investors can hold or have the ability to
    hold common stocks in large, well-diversified
    portfolios, the unsystematic risk or the
    company-specific risk would be eliminated or

Only Systematic Risk matters
  • As a result, the only risk pertinent to a study
    of capital asset pricing theory is systematic or
    market risk, i.e.
  • E(Ri) Rf ßE(Rm) Rf
  • which is sometimes called the Security Market
    Line equation where
  • E(Ri) Estimated Cost of Equity
  • Rf Risk-free Rate
  • Rm Estimated market return
  • ß Beta of the equity of the company
  • Alternatively,s2i ß2i . s2m s2e

Security Market Line
Rate of Return
Risk Premium
Risk (ß)
Measure of Rf
  • The risk-free rate (Rf) is the return on
    risk-free investment.
  • The rates of US treasury bonds are often used as
    standard risk free rates to be used in comparison
    with other investments.
  • In Hong Kong, a popular choice is the Exchange
    Fund Notes that are issued by the Hong Kong
    Monetary Authority (HKMA).

10-year HKMA Exchange Fund Notes were only
introduced in October 1996
Yield Curve or the Term Structure of Interest
Measure of ß
  • The beta (ß) measures the amount of systematic
    risk of the equity relative to the market.
  • It can be estimated by regressing the historic
    returns of a stock against the corresponding
    returns of a stock market index because
  • E(Ri) Rf ßE(Rm) Rf
  • gt E(Ri) (1 - ß)Rf ßE(Rm)

Alternative Computation of WACC
  • WACC Expected return on the assets of the
  • because if a company wants to invest into new
    assets, it must finance the purchase either by
    debt or by equity, i.e.
  • WACC Rf ßaE(Rm) Rf
  • where Rf Risk-free Rate
  • Rm Estimated market return
  • ßa Beta of the assets of the company

Equity beta v. Asset beta
  • Equity beta Asset beta (Asset beta x
    Debt/equity ratio)
  • or if the issue of tax is considered
  • D
  • ße ßa ßa (1- t) ----
  • E
  • (1- t) D
  • ßa 1 -----------
  • E
  • ße
  • gt ßa ----------------- 1 (1- t)D/E
  • where ße Beta of equity of the company

Measurement of Market Risk Premium
Arithmetic Average R1 R2 .RT T
Geometric Average (1R1) (1 R2) .. (1
RT)1/T - 1
Arithmetic Average v. Geometric Average
  • Geometric average is usually less than Arithmetic
  • The larger the stock market return fluctuations,
    the greater the difference between arithmetic and
    geometric average
  • While geometric average is often used in
    measuring the historical return realized in the
    past, arithmetic average is more widely used in
    estimating the expected return in the future.

Past ? Future
  • Market Risk Premium realised in the past may not
    be what investors expect for the future

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Dividend Growth Model (DGM)
  • P0 __ D1__ __ D2_ _D3_ D4
  • (1k) (1k)2 (1k)3 (1k)4
  • where P current stock price
  • D dividends expected at the end of year 1
  • k discount rate
  • and D2 D1 (1g), D3 D1 (1g)2
  • which may be expressed as
  • P __ D1__
  • k - g
  • where g constant growth rate in the long-run.

A Rate Interpreted from Market
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A 1 rise in industry-forecasted earnings growth
cause a 5 to 8 boost in industrys
price-earnings ratio
  • Steven A. Sharpe, How Does the Market Interpret
    Analysts Long-Term Growth Forecasts? Finance
    and Economics Discussion Paper Series 2002-7,
    Federal Reserve Board, 2002

Assumptions Underlying CAPM
  • Investors are risk averse, only choosing between
    different portfolios on the basis of expected
    rates of return and the risk involved, risk being
    defined as the variability of the expected rate
    of return.
  • Rational investors seek to hold efficient
    portfolios that is, portfolios that are fully
  • All investors have identical investment time
    horizons (i.e. expected holding periods).
  • All investors have identical expectations about
    such variables as expected rates of return and
    how capitalization rates are generated.

Assumptions Underlying CAPM (contd)
  • There are no transaction costs.
  • There are no investment-related taxes (save for
    the corporate income taxes).
  • All investors can borrow or lend an unlimited
    amount at a given risk-free rate of interest..
  • The market has perfect divisibility and liquidity
    (i.e. investors can readily buy or sell any
    desired fractional interest).

Failure of CAPM
  • The statistical distribution of returns is
    unknowable a priori Market is not necessarily
  • Investors averse to downside risk, as opposed to
  • Unsystematic variables like market cap, book
    value of equity and P/E ratio prevail.

Closely-Held Business v. Publicly Traded Company
  • Small and mediumsize businesses which have
    little, if any, prospects of going public are
    difficult to compare with publicly traded
    companies in the stock market because of the
  • Size of the company
  • Depth of management
  • Financial structure
  • Product diversification
  • Reliance on major customers
  • Reliance on major suppliers
  • Geographical diversity of customers
  • Length of time in business
  • Pattern of earnings
  • Economic factors of special concern to the

Decomposition of Risk
  • E(Ri) Rf RPm RPs RPu
  • where
  • E(Ri) the required rate of return for cashflow
  • Rf the risk-free rate
  • RPm Equity risk premium for the market
  • RPs Risk premium for small size
  • RPu Risk premium for specific company

  • Richard A. Brealey, Stewart C. Myers, Franklin
    Allen, Principles of Corporate Finance, 8th ed.,
    New York McGraw-Hill/Irwin, 2006
  • Aswath Damodaran, Investment Valuation Tools and
    Techniques for Determining the Value of Any
    Asset, 2nd ed., New York John Wiley Sons,
    Inc., 2002

Example Using Comparable Public Companies to
Calculate a Discount Rate
Long-term treasury bond yield at valuation date
(RFR) 0.07 Equity risk premium per 1993 SBBI
(ER) Historical return on common stocks
0.124 Historical return on longterm govt.
bonds - 0.052 0.072 Company-specific
risk factor (CS) 0.07 Discount rate Rf
ß(ER) CS .07 1.5(.072) .07 0.248
Rounded to 0.25
Matching the Discount Rate to the Income Stream
  • For a growing business, net cash flow is
    typically projected as follows
  • Net income (after tax)
  • Non-cash charges (e.g. Depreciation and
  • Cash needed for asset replacement
  • - Increase in working capital needed as the
    business grows
  • Increase in debt to finance business growth

Matching the Discount Rate to the Income Stream
  • Cash needed for asset replacement will generally
    exceed depreciation and amortization.
  • Therefore, when net income is used as the income
    stream, an upward adjustment should be made to
    the discount or capitalization rate.
  • This adjustment should be proportionate to the
    ratio of net income to net cash flow.
  • For example, assume net income is 60,000 and net
    cash flow is 50,000. Also assume the net cash
    flow discount rate is 20. The net income
    discount rate would be 24 as follows
  • 60,000/50,000 1.2
  • 20 x 1.2 24
  • Other valuers feel the difference between net
    cash flow and net income, in the long run, is
    usually small and can generally be ignored or
    included in the company-specific risk factor.

Examples of inadequate valuations
  • Valuation is out of date.
  • Limited or no management interviews/analysis.
  • Faulty or baseless assumptions
  • Inadequate selection/analysis/explanation of data
  • Inadequate support for valuation risks, multiples
    or adjustments
  • Arbitrary application of discounts
  • No mention of hypothetical buyer or seller
  • Absence of discussion of asset composition or
    earnings/revenues history
  • Absence of discussion of dividend history
  • Data selected has little comparative elements or
    are limited
  • Failed to use all applicable approaches/methods
    or explain their absence of use

Valuation Selecting Methods and Adjustments
Type of Technology
  • Diachronic Techniques
  • DCF at variant rate
  • Diachronic multiples
  • analysis

Established or mature
Life stage
Firm Size
  • Unsystematic risk adjustments
  • Size
  • Control
  • Illiquidity

Country risk adjustment
Developed or mature
Operating Condition
Asset-based approach
In liquidation
Going concern
Classical approaches
  • Luis E. Pereiro, Valuation of Companies in
    Emerging Markets A Practical Approach, New York
    John Wiley Sons, Inc., 2002