Strategic Financial ManagementValuation (I) – input session

©Bob Ryan

January 2001

Valuation Theory

• Valuation theory (axiology) and related theory of cost underpins Strategic Financial Management.

• Value is traditionally described as:– Intrinsic, inherent, instrumental or contributory

• For most purposes we simple distinguish– Intrinsic, extrinsic

Economic Valuation Theory

• assumes values are intrinsic

• value generated by assets intrinsic ability to earn cash flows

• many assets have value because of their situation (i.e., extrinsic factors)

• entanglement is the phenomenon where assets are embedded in value nets.

Core valuation concept

deprival value: the value of an asset is the cost the firm would incur if it were deprived of the use of that asset

1. (if value in use > replacement cost)– then deprival value is it replacement cost

2. (if replacement cost > value in use > realizable value)– then deprival value is value in use

3. (if realizable value > value in use– then deprival value is realizable value

Valuation Theory (value in use)

• The value of an asset in use consists of its intrinsic element (VI), i.e., its value in an open market plus its extrinsic element, i.e., the value added (ΔVE) brought about because the asset is embedded in an organisation (a network of incomplete contractual relationships). Note that the delta sign reads the difference between the asset’s value in use and its intrinsic value.

EIA VVV

The model extended

• In a perfect market, the intrinsic value of an asset is its market price (Pm) and by definition the Net Present Value of the asset in use will be zero.

• In an imperfectly competitive market there will be a value variation in use to the firm equal to the net present value of the asset concerned.

• The NPV of an asset is therefore the extrinsic component of value

AMAA NPVPV ,

Even further

• In principle, some market imperfections impact upon all traders in a given asset market and some are not. Thus:

• We, therefore come up with a full asset valuation model as follows:

FAMAA VVV ,,

EAFAMAMAA VVVPV ,,,,

What the NPV of an asset means

• in a perfectly competitive market NPV=0

• in the presence of systematic market imperfections only projects will have –ve NPV (eg: uncertainty)

• in the presence of firm specific imperfections (eg: degree of monopoly power) then + ve NPV

• in the presence of entanglement the +++NPV

The Valuation Matrix

The Entanglement Premium (Ve)

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Cash Productivity

Lo Hi

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Valuing Cash Generating Assets(securities and other assets)

Valuing a firm or part of a firm

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Input parameters to the growth model

• D0 = last full year’s dividend paid net of tax

• i = cost of equity capital (use CAPM)

• g = long run expected dividend growth rate ( calculate nominal not real growth)

Example valuing FTSE ASI

• assume growth in FTSE = GDP growth (2.2% real)• assume rate of inflation = 2.5%• nominal rate = 1.022*1.025 = 1.04755 ≡ 4.755%• assume beta on FTSE ASI = 1.00• assume rate of return on FTSE ASI = 8.0% per annum• assume risk free rate = 5.4%• Rate of return on ASI = 5.4% + 1 x (8.0% - 5.4%) = 8.0%• current index level = 2329• current index yield = 2.9• current dividend = 2.9x2329/100 = 67.54

FTSE valuation data set

Asset yield 2.9Current asset price 2329.0Asset dividend 67.5GDP Growth (real) 2.2Inflation 2.4GDP Growth (nominal) 4.7Risk Free RoI 4.5ER(m) 7.5beta 1.0Asset return 7.5

Value of FTSE ASI

Constant Growth Value

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-3 -2 -1 0 1 2 3 4Grow th relative to GDP

BT Data SetAverage return 7.50%Beta 0.61E(Rf) 4.50%E(Ri) 6.33%Excess return 1.17%Price per share 398.00Dividend per share 3.30

Market value using GDP growth 212.47

Earnings based valuation

• Calculate firm’s earnings per share

• Generally P/E should be the same for similar investments of common business risk

• Find P/E of similar firm or for industry

• Apply P/E multiple to target firm

PE and Growth Model Compared

• EPS = dividend per share (D0)/payout ratio (p)

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Issues in PE comparatives

• PE ratio is a function of payout ratio, dividend growth and required rate of return

• Would need to find comparator with exactly same make up!

Projected real GDP growth

Inflation (RPIX) forecast