Frequently Asked Questions

Question 1: What multiples should be used for valuing a brokerage firm (financial intermediation only – broking with no on-line business): enterprise value on the number of clients, DCF or NAV?

Question 2: What impact does financial communication have on the valuation of a company, and more specifically on its risk premium?

Question 3: Is there a formula that can be used to determine the change in normalised free cash flows or do these normalised free cash flows fade in an arbitrary manner until the company’s ROCE is equal to its WACC?

Question 4: When valuing a company, how much importance should be given to the company’s book value?

Question 5: How do you calculate the market value of a debt?

Question 6: What are the different methods used for calculating the holding company discount? What are the methods used to reduce this discount?

Question 7: What is the difference between valuation methods based on discounted cash flows and those based on discounted dividends?

Question 8: I want to value a telecoms start-up company that has never made a profit or paid a dividend. I was wondering what methods I should use, since many of the methods described in the Vernimmen are based on the payment of a dividend.

Question 9: How do you go about valuing a company for a merger-acquisition? What are the most frequently used ratios? Are there any standard formulas? How do you calculate goodwill?

Question 10: Could you explain how to calculate the logarithmic returns of a share portfolio and provide an example?

Question 11: What are the different ways and formulas for calculating EVA and MVA, and what are they useful for?

Question 12: What assumptions are relied on for stating that a security is under or over valued? What is the basis for assumptions that the market is anticipating a rise in share prices in a given sector, or even a rise in the stock exchange index?

Question 13: How should one value a Very Small Enterprise (VSE) with sales of around €1m that operates on the very specific construction services sector?

Question 14: Is the government bond rate really the floor rate? In your view, what is the most appropriate method for calculating the risk premium on equity markets? Can you find the calculation of the discount rate on the internet?

Question 15: What valuation methods are used for valuing a brand/business in the consumer goods segment?

Question 16: How do companies fix the price range for IPOs? Do they use special, pre-established links or not?

Question 17: When valuing a company’s shares, should minority shareholders be factored in? What sort of discount should be applied? Do you have any examples of actual valuations?

Back to Questions and answers

Question 1:

What multiples should be used for valuing a brokerage firm (financial intermediation only – broking with no on-line business): enterprise value on the number of clients, DCF or NAV?

Answer:

Customer value multiples are to be used with great caution, since if they are to be of relevance, earnings per customer must be equal, which is rarely the case, as can be seen from the wide disparity of these types of ratio within the same sector. At the very best, it provides a bracket, which will almost certainly have to be narrowed using other criteria.


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Question 2:

What impact does financial communication have on the valuation of a company, and more specifically on its risk premium?

Answer:

The impact of a good communications policy is difficult to measure. The aim should be to provide investors with as much visibility as possible over future results and the strategy followed, in order to avoid any bad surprises which are always heavily sanctioned by the stock markets.

A good communications policy will thus reduce the risk premium slightly, but this is very difficult to measure, except in extreme cases like Michelin, which despite its simplicity (single product) is seriously lacking in transparency, which is one of the factors underlying a higher than average beta (1.25) and a higher cost of equity.

For more information, see chapter 22 of the Vernimmen.

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Question 3:

Is there a formula that can be used to determine the change in normalised free cash flows or do these normalised free cash flows fade in an arbitrary manner until the company’s ROCE is equal to its WACC?

Answer:

There is no ready-made formula for determining cash flow fade. There are two levers that can be used for reducing ROCE – EBIT margin and asset turnover, over a period that you select. Depending on the sector and your perception of risk, you can modulate these levers so that ROCE equals WACC at the end of the year.

For more information, see chapter 40 of the Vernimmen.

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Question 4:

When valuing a company, how much importance should be given to the company’s book value?

Answer:

A company is worth its book value if its expected ROCE is equal to its weighted average cost of capital (WACC), or put differently, if it is not creating value. If its expected ROCE is lower than the weighted average cost of capital, the company is worth less than its book value. In this case, it is interesting to study book value, especially with a view to a sum-of-the-the parts valuation.

For more details, see chapter 32 of the Vernimmen and also the site glossary.

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Question 5:

How do you calculate the market value of a debt?

Answer:

The market value of a debt is calculated on the basis of the interest rate schedule and the outstanding capital and on the discount rate the investor is entitled to expect given the level of risk on this debt.

To do this, take the yield curve to find the yield that is equal to the debt to be valued. You need to add in a margin to account for the risk differential between the yield curve (often the same as government bonds) and the risk of the debt to be valued. This margin is often calculated by the rating agencies (Moody’s, Standard & Poor’s).

For more information, see chapter 21 of the Vernimmen.

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Question 6:

What are the different methods used for calculating the holding company discount? What are the methods used to reduce this discount?

Answer:

The holding company discount is different from the conglomerate discount and the liquidity discount. It can be defined as follows: a holding company trades at a discount when its market capitalisation is less than the sum of the investments it holds, which it usually is. Thus, a holding company will have a book value of equity of 100, although its market capitalisation will be 80. This means that the investor which buys one share in this holding company thinks that he’s got a good deal since he paid 80 for something that’s worth 100, although this value will never be achieved since the holding company will always be discounted unless it is liquidated. You should thus value each of the parts of the holding company and compare the results with the market capitalisation of the holding company.

The discount can disappear, following a merger between the holding company and the operating subsidiary, for example. I don’t see how listing the subsidiaries could reduce the discount, on the contrary. A spin-off is the distribution of the shares of a subsidiary. It may reduce the discount but not eliminate it, since what remains in the holding company after the spin-off (discounted cash?). If shares are bought back, the holding company’s cash can be paid out but this doesn’t make the discount go away, as, it may make the holding company shares even less liquid.

For more information, see chapter 40 of the Vernimmen.

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Question 7:

What is the difference between valuation methods based on discounted cash flows and those based on discounted dividends?

Answer:

The dividends valuation method indirectly results in the valuation of the leverage effect (see chapter 40 of the Vernimmen) and the company’s dividend payment policy, while the free cash flows method measures the value of ROCE independently of the financial structure and the dividend payment policy. This last method should thus be the preferred method.

For more information, see chapter 32 of the Vernimmen.

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Question 8:

I want to value a telecoms start-up company that has never made a profit or paid a dividend. I was wondering what methods I should use, since many of the methods described in the Vernimmen are based on the payment of a dividend.

Answer:

Your company must have a business plan which, through provision for investments and the gradual growth of the business, will lead to profits.

The most appropriate method for this type of situation is the discounted cash flows method, which differs substantially from the dividends approach. In practice, we project specific cash flows over a certain number of years. This period is called the explicit forecast period. This length of this period varies depending on the sector. For the years beyond the explicit forecast period, we establish a terminal value.

Free cash flow measures the cash flow generated by operating assets. It is calculated as follows:

EBITDA
- Change in working capital
- Capital expenditure
- (Theoretical) tax on operating profit

In this case, the terminal value is based on cash flow in the last year of the explicit forecast period. This may be a terminal value calculated on the basis of key profit indicators – this measure can be, among other things, sales, EBITDA or EBIT. The most frequently used terminal value, which is based on growth to infinity of the last flow (Gordon-Shapiro formula) can also be used. The discount rate to be used is the weighted average cost of capital, which is the minimum rate of return required by the company’s sources of funding, i.e. shareholders and lenders, for financing a company’s projects. It is the overall cost of financing a company’s activities.

Chapter 40 of the Vernimmen covers business valuation.

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Question 9:

How do you go about valuing a company for a merger-acquisition? What are the most frequently used ratios? Are there any standard formulas? How do you calculate goodwill?

Answer:

In practice, a non-cash merger (or acquisition) requires first that the target company be valued. Then the acquiring company must be valued, since it must issue new shares to the target’s shareholders.

Shares are then exchanged (x shares in the target company for y shares in the acquiring company), on the basis of the exchange ratio set out in a valuation report on the shares of the two companies.

In order to determine this relative value, a full valuation of the two companies must be made using standard methods (discounted cash flows and comparable multiples or transaction methods, sum-of-the-parts method, described in chapter 40 of the Vernimmen). There is no ready-made formula. It is customary in the mergers and acquisitions business however, to examine the impact of the exchange ratio on the performance metrics generally monitored by the market. The most frequently used reference metrics are net income, cash flow, dividends, market capitalisation and shareholders’ equity.

It is very unusual for one company to acquire another for exactly its book value. Generally speaking, there is a difference between the acquisition price and the portion of the target subsidiary’s shareholders’ equity attributable to the parent company even after taking into account latent capital gains.

This difference is called goodwill. See chapter 6 of the Vernimmen for a discussion of goodwill.

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Question 10:

Could you explain how to calculate the logarithmic returns of a share portfolio and provide an example?

Answer:

Assume you have the following share prices: 100 ; 105 ; 110 ; 105 ; 120 ; 125.

You transform them by taking their log: 4.605; 4.654 ; 4.700; 4.654; 4.787; 4.828.

And you calculate the returns by the differences based on these figures: 4.654 – 4.605 = 0.05; then 4.700 – 4.654 = 0.046; - 0.046; 0.133; 0.041.

Then if you wish, you can calculate the average, the standard difference for this series of returns.

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Question 11:

What are the different ways and formulas for calculating EVA and MVA, and what are they useful for?

Answer:

Economic Value Added (EVA) is an idea that has been around for a long time but was popularised by the firm Stern Stewart. It is an annual measure of the company’s creation of value, established by comparing the cost of capital invested and the return on capital invested – EVA = Capital employed x (Return on capital employed – Cost of capital).
See chapter 19 of the Vernimmen for definitions of these terms.

EVA will always be high if:
1. Return on capital employed is high
2. The cost of financing the company’s capital (equity and debt) is low
3. Growth of capital employed is high
Market Value Added (MVA) measures the creation of stock market value. It is calculated as the difference between market capitalisation + value of debt – capital employed (fixed assets plus working capital).

In efficient markets, MVA is equal to the sum of expected EVA over the coming years, discounted by the weighted average cost of capital.

To summarise, these measures have several advantages:
- MVA measures the creation of the company’s stock market value.
- EVA is used by several large groups to calculated management bonuses, as it provides a snap-shot of results which factor in the specific features of the different activities. The interests of management are thus closely aligned with the interests of shareholders, which helps to reduce agency costs (see chapter 32 of the Vernimmen).
- Using EVA as a management control tool is relatively simple and easy to explain to employees.

There has however been some criticism of EVA –
- Relying only on EVA can encourage some managers to reduce capital expenditure in the short term, which will have consequences on the company’s value in the medium to long term.

For more information, see chapter 28 of the Vernimmen.

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Question 12:

What assumptions are relied on for stating that a security is under or over valued? What is the basis for assumptions that the market is anticipating a rise in share prices in a given sector, or even a rise in the stock exchange index?

Answer:

Firstly, we should remember that on markets in equilibrium on which a sufficient number of changes take place, a share will be traded at a price that reflects all of the expectations of investors – it’s like a democracy! At this price, there will be as many investors who believe that the share is undervalued as investors that believe that it is overvalued, because if everyone thought that it was undervalued, there would be a rush on the share and the price would rise until the share was trading in equilibrium, i.e. where half the investors believe that the share is undervalued and the other half think that it is overvalued.

Having said that, it’s also important to look at share prices and markets objectively. We can calculate the implicit rate of return of a share or a market on a regular basis. This rate is determined on the basis of the share price and the flow of future dividends, as estimated by financial analysts. We then compare the theoretical rate of return that the shareholder is entitled to expect, given the risk of the share. Such calculations are regularly done by financial analysts and specialised firms. If the rate of return on the share price is higher than the theoretical rate of return, this is a sign that the share is undervalued. If the rate of return on the share price is lower than the theoretical rate of return, this is a sign that the share is overvalued.

Another technique involves trying to find a peer company (same country, same sector, similar future growth and risk) and comparing the multiples (P/E, rate of return) of this company’s stock with those of the company to be valued. This method shows whether a share is undervalued compared with another share at a specific time.

For more information, see chapter 40 of the Vernimmen.

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Question 13:

How should one value a Very Small Enterprise (VSE) with sales of around €1m that operates on the very specific construction services sector?

Answer:

I’d suggest that you use the sum-of-the-parts method for valuing a VSE. This sort of company will clearly not have a strategic value because it is so small. Accordingly, it would be best to look at its net revalued assets. Very high earnings would almost certainly be due to a single manager or a personal relationship with a customer or supplier, and are thus by definition very fragile.

For more information, see chapter 40 of the Vernimmen.

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Question 14:

Is the government bond rate really the floor rate? In your view, what is the most appropriate method for calculating the risk premium on equity markets? Can you find the calculation of the discount rate on the internet?

Answer:

Yes, when calculating the rate of return required by investors, you should use the 10-year government bond rate as the risk-free rate. A government-backed guarantee, in developed countries at least, is the best you can hope to get on the market. You should take a long-term rate to discount flows on shares over a long period.

There are two methods for calculating the risk premium of the market, which yield a historic premium or an anticipated premium.

The historic risk premium is calculated as the difference between returns on the equity market and the risk-free rate observed over a very long period (at least 25 years, and sometimes 100).

The anticipated risk premium is determined by observing existing share prices and anticipated dividends. We then get the rate of return that is required implicitly by shareholders today. By subtracting the government bond rate and then dividing by the share’s beta, we obtain the risk premium that is currently required.

This second method is more satisfactory as it yields a current value for this premium and not an average of previous values.

Obviously you won’t be able to go off on your own and do these two calculations as they are complex and rely on a large number of data.

Specialised firms and banks do these sorts of calculations on a regular basis.

For more information, see chapter 19 of the Vernimmen.

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Question 15:

What valuation methods are used for valuing a brand/business in the consumer goods segment?

Answer:

A brand is only of interest from a financial point of view if it enables the owner to sell its branded products at a higher price and to improve customer loyalty.

Accordingly, you have to estimate this price difference and then deduct all brand-related costs (advertising, higher manufacturing costs due to better quality product, specialised sales force, etc.). Next you deduct tax and then discount the balance over the expected life of the brand at the cost of capital. For more information, see chapter 40 of the Vernimmen.

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Question 16:

How do companies fix the price range for IPOs? Do they use special, pre-established links or not?

Answer:

The price range for IPOs is fixed by the financial analysts of the banks handling the IPO.

Analysts rely on information they have obtained on the company and use the valuation methods that are described in chapter 32 of the Vernimmen, i.e. mainly an analysis of listed peers and of the discounted cash flows of the company to be listed.

The bank then offers the price range to investors and depending on their appetite, the IPO price will be at the top or the bottom of the range, and even occasionally outside the range (e.g. Google), in line with a procedure similar to that described in chapter 26 of the Vernimmen.

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Question 17:

When valuing a company’s shares, should minority shareholders be factored in? What sort of discount should be applied? Do you have any examples of actual valuations?

Answer:

It all depends on the context. There may be a shareholders’ agreement which makes provision for the application of a minority discount or not, depending on the initial intentions of the parties or the balance of power between them.

If the shareholders’ agreement is silent on this issue, a transaction involving a minority (even a very small minority) will be valued on the basis of share price since such a transaction will be based on comparable listed companies, which could mean a few shares or a few thousand shares. Accordingly, it already includes a minority discount.

Similarly, a valuation of the controlling majority based on comparable transactions will include a majority premium. If you wish to use this method, it may be useful to neutralise this control premium, which is generally around 25%.

Finally, if you use the discounted cash flows method, there are those who claim that this is a method to value majority stake. I don’t hold this view as the minority shareholder, in countries where corporate governance is a reality, has a share in free cash flows and the majority shareholder cannot appropriate more than his share. Accordingly, I believe that applying a minority discount to this share serves no purpose.

A minority discount is the discount that the minority shareholder must bear for transforming its shareholding into cash. This can happen when a stock is listed. During IPOs, the discount between the listing price and the price reached once the share is trading in equilibrium is around 10/15%. This is a good point of departure for putting a figure on the minority discount. The tax authorities regularly accept discounts in the region of 20/25%.

For more information, see chapter 32 of the Vernimmen.

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