1. Strategic Financial Management Valuation (I) – input session ©Bob Ryan January 2001

2. 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

3. 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.

4. 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

5. Valuation Theory (value in use) The value of an asset in use consists of its intrinsic element (V I ), i.e., its value in an open market plus its extrinsic element, i.e., the value added (ΔV E ) 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.

6. The model extended In a perfect market, the intrinsic value of an asset is its market price (P m ) 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

7. 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:

8. 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

9. The Valuation Matrix

10. Valuing Cash Generating Assets (securities and other assets)

11. Valuing a firm or part of a firm

12. Input parameters to the growth model D 0 = 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)

13. 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

14. FTSE valuation data set

15. Value of FTSE ASI

16. BT Data Set

17. 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

18. PE and Growth Model Compared EPS = dividend per share (D 0 )/payout ratio (p)

19. 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!

20. Projected real GDP growth

21. Inflation (RPIX) forecast