Arriving At Value By Averaging Different Models – Not Acceptable · The Concept Of Re–Investment Risk · Crude Reality Checks On Valuations

Charles Hattingh valuation buzzValuation Buzz series is written and published by Charles Hattingh CA (SA)...

Try this one for size

I received this valuation through the post (R'000):


Using the super profits model:

Fixed Assets R8,000
Stock R650
Net Asset Value (A) R8,650
Interest per annum 8% R692
Manager's salary R600
Interest plus salary (B) R1,292
Net Profit (C) R2,583
Super Profit (C–B) R1,291
Goodwill factor 2
Goodwill R2,592
Value of business using super profits model R11,232

Using the payback period model:

Annual net profit (before managers' salary!) R2,583
Payback period required – years 3
Value of business using payback period model R7,749

Using the return on investment model:

Net profit R2,583
Manager's salary R600
Actual net profit R1,983
Actual return on investment expected 40%
Value of business using ROI model R4,958

Conclusion:

The value is the average of above three models R7,980

Have you ever seen anything so gross? When is Practice Review going to start looking into this type of gross negligence and ignorance on the part of auditors? This is a disgrace to our profession.


Reinvestment Risk

During our valuations workshops we discuss reinvestment risk. Seldom is this risk taken into account when doing capital budgeting exercises. Try this capital project:

Project's Cash Flows:

YR 0
-100
YR 1
50
YR 2
40
YR 3
25
YR 4
25
YR 5
10
NPV
0

Management's target rate of return is 20% p.a. The net present value of this cash flow is 0. Therefore, the project will yield 20% p.a. The cash is to be used to repay borrowings. The after tax cost of borrowings is 7% p.a.

The future value of the cash flow is, therefore:

YR 0
-100
YR 1
66
YR 2
49
YR 3
29
YR 4
27
YR 5
10
TOT
180

An investment of 100 to yield 180 gives a return of 12,5% p.a. This is way below management's requirement of 20% p.a.!!!

It is essential to understand reinvestment risk if you do not want to undermine your wealth.

Window period residual value

At a recent the valuation workshop I was hammered on my concept of the terminal value in my valuation models. I tried to explain that at the terminal date, i.e. the end of the window period, the goodwill at the valuation date would have been 'used up' and that the company would be earning a fair rate of return. To assume that an entity would continue to earn super profits in perpetuity is, in my opinion, unrealistic. However, I had some really independent thinkers in this group and they were not happy with my explanation. Another problem is that at the end of the window period capital gains tax is payable on the profit between the cost price and the selling price and this should be taken into account. As a result of these debates I have decided to modify the models by giving the valuer more information and control over his or her view of what the residual value should be.

Reality Check Definitions

More than a few participants asked me to summarise the reality check definitions and the rules for applying them.

Definitions

  • Dividend yield: (r – g)/(1 + g)
  • Price earnings ratio: DP%/((r – g)/(1 + g))
  • Price book ratio: (ROE – g)/(r – g)
  • DP%: Dividend payout percentage of earnings
  • Growth (g): Return on opening equity x ploughback
  • Fair rate of return (r): After tax risk free rate plus a premium for risk

Some Rules

  • The higher the risk the higher the dividend yield and the lower the price earnings ratio and vice versa
  • The higher the growth the lower the dividend yield and the higher the price earnings ration and vice versa
  • The higher the return on equity the higher the growth rate and vice versa
  • If the actual return on opening equity is higher than the fair rate of return, the price equity ratio will be greater than one and vice versa.

Test (assume growth to last in perpetuity)

The opening equity is 100, the actual return on equity is 20% p.a., the fair rate of return is 16% p.a. and the dividend cover is 2,5. Calculate:

  • The dividend yield
  • The price earnings ratio
  • The price book ratio

Have fun.

Answers: DY 3,6%, PE 11,1, PB 2,2 Did you win?