Analysis of Valuation Methods
Present Value
Any future cash flows are discounted to reflect their present values. This is crucial in appraising not only the future performance of the firm but also the relative value of such performance at present. To derive a useful and appropriate present value, the discount rate must be computed initially. The level of the discount rate is the single most important figure to transform future values to present values. The discount rate is a proxy for the cost of capital or investor’s required rate of return. Due to this, it represents the benchmark of valuing cash flows and shows the expectation of investors of the firm’s future performance. There is no initial bias in present cash flows unlike other valuation techniques (e.g. book value) that situates an asset as a revenue generating machine.
Present value tells the investors what is the equivalent present value of those expected future cash flows. This will provide them a more realistic view of the value of the firm based on future expectations. To compute for present value, three components are important; namely, discount rate, the number of years in the future included in the analysis and the present value interest factor table. This is the case if there are no problems in the cash flow figures. As the data to be analyzed are cash flows, it should exclude non-cash transactions in the final amount such as depreciation, taxation and interest. In this way, the computed present value will only reflect the cash-based considerations which can simplify decision-making of investors (e.g. exclusion of depreciation methods).
The nature of present value makes it one of the best valuation methods in project management that a company will undertake. Projects cycle and duration is more predictable than a company because a firm is basically always in a going concern mode. As a result, it will be impractical and perhaps unrealistic to measure the present value of a firm if there as this will only lead to valuing for indefinite period. On the other hand, if the firm is valued based only on a limited number of years, this would mean that it will only operate on that duration which is detrimental to expectation of investors. A project can reflect the value of the firm on an activity basis. Performance is the basis for valuation unlike other techniques such as book value that assumes that corporate assets will generate cash flows even without specific plans of use. Although projects assume timeframe where cash flows will be received, it is based on experience and similar projects in the industry.
Market Value
A publicly-listed company can derive its market value by simply measuring its share price as reflected in financial markets. In analogy, when the CEO of the company promises to double the value of shareholders, this implies that the market value of the firm will also be doubled. When securities of the firm are being traded, the transactions to buy and sell them will be the determinant of the firm’s market value. There are two important components to derive the market value; the market value of equities and the market value of debts. The quality and accuracy of market value figure is based on the trading regularity of the firm’s debt and equity in the financial markets. Although this is a sign of weakness to private firms, public companies can enjoy this valuation method particularly those who have securities actively traded in liquid markets.
The advantage of using this technique is largely due to absence of insider influence to valuation. This means that an investor has relative trust to financial markets merely acting as bridge between borrowers (e.g. firms) and lenders (e.g. investors) of capital than the firms themselves. Firms can manipulate data and develop creative accounting to increase the value of prospective projects, assets and dividends which can make other techniques questionable. Market values are harder to manipulate particularly because of indefinite financial market actors that are acting according to their own investment decisions. Thus, the invisible hand in economics and the law of supply and demand is likely to occur. With this valuation, investors have the potential to speculate, follow the market reaction or use their own investing hunches. The value of a company is viewed from the outside in which an investor is assured that the market accepts the computed corporate value.
However, there are several bottlenecks. First, market value gives investors a more unpredictable guide to investing because information is scattered all over the financial markets. Unlike in other techniques wherein only the accounting books and internal assumption of companies are used as reference points, investors are faced with numerous market factors in consideration. This problem can only be minimized if there is an assumption that financial markets are efficient. This means that investors, companies and other financial market actors cannot apply superior investing strategies to outperform the entire market performance. In this way, an investor will have a reliable benchmark where his expectation of performance can be based. The presence of average returns, however, is not common and investors are continually searching for ways to outperform their past gains and the market itself.
Book Value
Praised for highly available information, corporate value is computed as assets less liabilities which is found in balance sheets of a firm. The asset of the firm is held as storage of value which has the capacity to provide future revenues. However, this view of asset is criticized due to its generality and failure to recognize different conditions of a firm. For example, fixed asset such as machineries has greater value to supply income streams. But measuring these streams would take different approaches for different firms. Heterogeneous accounting approach is a bottleneck to appropriately compare the corporate value of companies in question. There are book value formula that primarily concerned with acquisition costs and their corresponding depreciated amount. With this, an investor decision will be highly influenced by different and somehow conflicting formulas.
Due to various formulas available in deriving the book value, regulation is highly applied on what formula should be used. This is an assurance for investors of having a priority formula. In contrast, this incentive is undermined by the development of derivatives where the underlying asset can have fixed or flexible values depending on the contract. This is the reason why some analysts argued that book value is a meaningless technique to corporate valuation since assets are able to acquire pre-determined values. However, book value is vital in internal decision-making of the firm as in the case of entering derivatives transaction where value can be locked based on the firm’s preference. The company can also retain the original value of assets including other formula effects to this value before the actual sale. In effect, the firm can evaluate the profitability of the sale by realizing the adjusted book value where difference between book and market values are settled.
This valuation does not provide information about the current value of the firm. It also does not tell whether the firm will be profitable in the future or not. Specifically, cash flow data is not indicated in balance sheets. Therefore, book values are only useful when valuating the company’s assets with assumption of not using them for economic gains. They are idle properties of a company and therefore the firm may be similar to properties in a typical household only the former is bigger and more complex. Asset inventory and valuing intangible assets such as goodwill perhaps are the most important contribution of book value. But this information is limited to the use of the company. Investors are concerned about future cash flows that may arise from these assets. The concern is not only the price of those assets but how they can perform in actual operations where their purpose is employed.
Book valuation is useful when investors are using financial ratios to value a firm albeit limited to fixed and non-current assets. This is because current assets such as bank deposits and other short-term investments do not have acquisition costs or depreciation. Fixed asset turnover, which analyze the efficiency of property, plant and equipments in relation to sales, can give investors hint on how well the company use its assets to generate revenues. This practice, however, emphasize the shortcoming of book value method. Although book value provides what is the value of the assets of the company, such figure is less helpful to investors since the bottom-line is that the assets’ ability to provide revenues. Book value, unlike the two earlier methods, is not a standalone basis to investors. There is more work necessary (e.g. computing for financial ratios) for the book value figure to have significance in decision-making.
Price-to-Earnings Ratio
This is a technique that utilizes corporate earnings or net income as a measure of the firm’s value. If the present value method allows comparison with alternative projects, PE ratio allows comparison with other companies. It is computed as share price divided by earnings per share (EPS). The latter is further computed as earnings divided by the number of outstanding shares in the market. Flexibility of PE ratio is observed to the choosing of an investor whether to use trailing PE or forward PE. The former describes the past performance of the firm while the latter its future performance. Due to this, investors have greater independence what variables to include in their analysis. This valuation challenges the inability of market value investors to set the value by themselves rather rely on market participants. With this flexibility, they can insert their own risk stances to value the firm.
The level of PE ratio is vital to corporate valuation. Specifically, when PE is too high compared on historical performance, it could mean that investors in the financial market have high expectation on the income growth of the firm. There is caution; however, that PE ratio must be compared with companies in the same industry to provide an in-depth view of the company’s value. This practice will provide a comparative analysis between companies in similar industry with regards to PE ratio. In effect, PE ratio is a signal on whether the market is expecting specific earning outcomes in the future. Therefore, compared to market value, PE ratio accounts future cash flows in the valuation. Such characteristic enables this valuation method to integrate the features of present value technique as well as market value technique. With two techniques observable in PE ratio, investors can have a more useful investing tool.
Although found as a hybrid of two valuation techniques, PE ratio is still vulnerable to accounting manipulation just like other methods. Its denominator in the formula is based on earnings which can be inflicted with creative accounting. Due to this, an investor must apply an effort to check managerial controls and corporate governance to measure how he/ she are at risk on having a manipulated data. When this is accounted, PE ratio can be used for valuation decisions. A peculiar feature of this valuation is that the earlier recognition that high PE ratios are favorable is not always true. With good indicators in cash flow, revenue accumulation and governance, low PE ratio firms show very promising earnings growth in the future. In effect, they are more favorable. But in this valuation, the size of comparable firms in the same industry must also be the same as small firms tend to have bias for smaller PE ratio.
Dividend Valuation
Valuing a company based on its ability to provide regular and increasing dividends is a worthy practice. This is because dividends represent the only real gains of investors in a company where they have stake. Either in cash or asset payout, dividends are the boldest way that a company can announce their performance and earnings potential. Unlike market value which indicates the idle wealth of shareholders, dividend valuation injects the past, present and future earning performance of the firm as it cannot distribute dividends without any excess money to finance operations and expand. On this ground, however, growing companies are likely not regularly distributing dividends. This is caused by their interests to re-invest excess earnings and concentrate them to growth prospects rather than disbursed to individual investors.
The dividend policy of a firm tells so much of its lice cycle. When companies reached their maximum growth potential, dividend payouts tend to be a practice. This is because the firm wants to retain investors and encourage them to maintain their investment even growth had stopped. Investors can use dividend policy as reference whether a firm is facing financial difficulties and failed to produce planned profits. This scenario is observed in cases of dividend payment cuts. On the other hand, consistent and even rising dividend payment may also represent a negative feature like financing such payments with debt. In effect, the benefits of dividends are waived by costs and risks of debt and interest financing. With dividends coming directly from earnings or buyback programs, continuity and regularity of its distribution minimizes the probability that managers will manipulate accounting data particularly earnings.
Computing for corporate value, specifically common shares, using dividends is done in at least three ways as there as numerous models that have been developed. Zero and constant dividend growth is a formula appropriate for mature companies which can minimally expand their operations. Discount rate and expected dividend payout are required variables. Although with less uncertainty and greater potential to accurately value the firm, growth potential is not present. The second formula offers the ability to estimate future dividend growth of a firm. As this relies on historical data of actual dividends, the quality of valuation is a function of the quantity of the periods that have been collected. If the firm do not have an ample historical data, results may not likely be as statistically significant as with a sufficient data under study. Lastly, irregular dividend to be followed by constant growth is apparently a version that follows the corporate life cycle (e.g. from growth to mature years). This formula requires the beta or the degree of share sensitivity to market changes as well as the forecasted dividend growth. This computation requires extensive market research and analysis which is vital to investing but troublesome to some investors.
Free Cash Flow
Cash flow is equal to the sum of operating profit and depreciation plus or minus other non-cash transactions. This means that cash flow is actually a measurement of a firm’s capability to generate cash asset and is the true test of the firm’s performance and long-term survival and growth. On the other hand, cash flows are not really free which give rise to measurement of free cash flows (FCF). FCF is the real cash flow a company has after making necessary investments in fixed assets, distribution of dividends and tax payments. As observed, either free or tied cash flows are concern, it is necessary for a firm to continuously increase its cash flows because they are not only used for day-to-day expenses but can also be utilized for other significant costs if cash flows are fairly substantial.
Computations
Market Value
= Market Value of Debt + Market Value of Shares
= 4,500,000,000 + 9,444,000,000
= 13,944,000,000
Book Value
=Total assets – total liabilities (Net worth)
= (15,045,000,000 + 3,599,000,000) – (5,601,000,000 + 3,599,000,000)
= 9,444,000,000
PE Ratio
Market price of shares for Tesco/ Earnings of shares of company (Tesco)
= 28.74/ 1.49 = 19.28
Dividend Valuation
Dividend per share of common stock divided/ Market price per share
= 0.19/ 28.74 = 0.006610995
Free Cash Flow
Free Cash Flow= Earnings After tax + Depreciation+ interest after tax – Replacement expenditure – change in net working capital.
= 1,576,000,000 + 838,000,000 + 364,000,000 – 0 – (4,509,000,000)
= (1,731,000,000)
Conclusion
According to the computations above, the market value of Tesco is high and positive. The investor must purchase the securities of the company. However, the investor must be cautious to buy the company’s shares in liquid markets. This will avoid inefficient valuation of illiquid markets. Examples of liquid markets are US, UK and Australia. The value of shares in the market value and total book value are the same. This indicates that the value of the firm is derived from its shares which are traded in the market. It can also mean that the firm should have greater chance of raising money through financial markets. As the book value only reflects the value of the shares, the firm must firmly hold its access to capital markets and continuously create wealth for its shareholders. In effect, this is a favorable chance for investors.
Its closest competitor, Sainsbury, have a relatively higher P/E ratio 29.27 versus 19.28 for Tesco. On the other hand, it has higher PE ratio than Wal-Mart with this company having 15.60. This shows that the industry where Tesco compete is very competitive. Its size and financial depth is not assurance of success. In this regard, as Sainsbury and Tesco are eminent in Europe, European investors must invest in favour of Sainsbury rather than Tesco. However, for US investors, Tesco must be selected. This is a short-term action. However, on the long-term, the reverse of strategies for the two continents must be applied. This is because high expectations in the short-run can mean short-run returns but long-run demands will pull the P/E ratio down. Shift of investor gear should be realized. This strategy is confirmed as Tesco has a lower dividend valuation and also negative free cash flows. Long-term prospects are most promising to Tesco’s investors.
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