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Part IV: Valuation and Takeover

8. A Stock Exchange Valuation

Introduction

Our study is based on the normative assumption of financial theory, namely shareholder wealth maximisation, using share price as a suitable metric. Wealth is measured by movements in price based upon the economic law of supply and demand in a capital market that may not be perfect but reasonably efficient. Investors respond rationally to new information (good, bad or indifferent) and buy, sell, or hold shares in a market without too many barriers to trade.

Theoretical models of share price determination based on the capitalisation of a perpetual annuity, using either current dividends or earnings, underpin practical performance measures published by stock exchanges throughout the world. Yields, cover, P/E ratios and market capitalisation combine to provide current shareholders and prospective investors (whether they are private individuals, companies, or financial institutions acting on their behalf) with a sturdy framework for analysing investment decisions. Any market participant can evaluate the relationship between a company's current share price, its latest reported dividend and earnings per share within the context of their personal risk-return profile.

Having explained a number of universally available measures by which individual investors analyse stock market performance, the remainder of this text is devoted to two practical applications available to corporate management who wish to maximise shareholder wealth. They not only provide an opportunity to reflect upon the relevance of dividend policy and earnings to investment and financial decisions outlined in Part Two but also represent the most important strategic decisions that management is ever likely to encounter.

- The first case concerns an unlisted company coming to the capital market, requiring an aggregate flotation value and "offer for sale" price per share. Particular attention is paid to the dividend yield, dividend cover and price earnings (P/E) ratio required by future shareholders.

- The second evaluates an acceptable bid price based on various methods of valuation that support the motives for acquiring a business as a going concern in the event of a takeover.

By the end of our study, you should be in no doubt that the derivation of a share's price, which utilizes a DCF analysis of either prospective earnings or dividends, rather than actual data drawn from published financial accounts, represents the ideal wealth maximisation criterion.

8.1. Coming to the Market

To appreciate why just a few selected measures published in the financial press, such as market price, dividend yield, dividend cover and the P/E ratio are believed to capture the essential features of a company's market performance, let us consider the case of Duran Ltd. It is an unlisted company wishing to finance expansion by having its shares marketed on the Stock Exchange. What management need to determine are:

a) A total market value for the company, (the market capitalisation of equity).

b) A recommendation for the aggregate flotation value.

c) Knowledge of how many shares should be issued, and in what denominations, having regard to the dividend yield and dividend cover required by investors.

d) The price at which shares should be offered for sale.

To guide these decisions, comparative financial data relating to Duran and three companies, A, B and C, engaged in the same type of business but already listed on the stock exchange has been prepared (summarized in Table 8.1 for the past three years).

Primary Data

Table 8.1: Primary Data

Duran has a sound financial history with adequate liquid assets. However, profits have made little progress in recent years. Its own forecast before corporation tax at 25 percent for next year (Year 4) is £810,000 although this may be optimistic in view of its track record. Further market research also reveals that:

A: has rising dividends, underpinned by gradual earnings growth.

B: exhibits solid dividends, although earnings have failed to advance.

C: reveals a pattern of dividends and earnings with negligible movement in recent years.

In order to produce a total market valuation and price per share for Duran initially we must determine valuation and income profiles of all four companies using accounting data (Table 8.2). Only then can Duran establish a prospective investment profile based on comparative stock market ratios which are attractive to potential investors. It is important to realize that as a listed company, the share price of Duran plc will be judged by this structure and also compared with similar firms on the market.

A

B

C

D

£000s

£000s

£000s

£000s

Notes:

Equity

4,310

5,800

2,650

4,700

Share capital plus reserves.

Market Value

16,000

8,624

5,578

-

Earnings

1,100

550

275

605

Dividend

390

266

159

-

Percentage on ordinary shares

Profits after tax

Return on equity %

25.5

9.5

10.4

12.9

Capital employed minus loan

Table 8.2: Valuation and Income Profiles

 
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