Suggested answers to selected problem questionsThere are many problems with these valuations, for example:
l The first two methods rely on finding a suitable business, or businesses, whose shares
are traded in an ‘efficient’ market, to use as a basis for comparison. The principle of these
two approaches is that the P/E ratio and cost of equity of listed businesses can be
applied directly to the unlisted one. This makes all sorts of assumptions about the com-
parability of such factors as
lactivities;
ldividend policy;
loperating risk; and
lfinancial risk (gearing).
l The use of the Gordon growth model also assumes constant dividend growth of HP Ltd
into the future.
l The net assets basis assumes that the balance sheet represents a fair value of assets and
claims, on a going concern basis. It also assumes that all assets and claims are included
on the balance sheet. These assumptions are unlikely to be valid. The balance sheet is
(and is intended to be) a historical record of the assets, still in existence, acquired by the
business as a result of transactions and the sources of funds used to finance them. Thus
the balance sheet has little to do with current values of assets and claims, and still less
to do with assets such as goodwill which were not acquired as a result of a particular
transaction but through a gradual process.
The P/E and net assets bases of valuation tend to be applied where the buyer is inter-
ested in acquiring the whole of, or at least a controlling interest in, the business, that is, a
majority stake.
Dividend valuation methods tend to be used where a minority stakeis involved. The
logic of this is that, for the minority shareholders, their only economic interest in the busi-
ness is related to dividends.
Other approaches that could have been used include:
l Dividend yield. Here, the valuation is obtained by taking the view that two similar busi-
nesses, one listed and the other not listed, will have a similar dividend yield. Normally
a 25 to 30 per cent discount will be applied to the valuation obtained to allow for the lack
of marketability of the unlisted one’s shares.
l Economic value. This is, without doubt, the most theoretically correct approach. It is
based on estimations of the amount and timing of the net cash flows that are likely to be
generated by the shares and an appropriate discount rate. Estimating cash flows and
discount rates is difficult, which may well explain the popularity of ‘market’ and balance
sheet based methods. Nevertheless, an approach that has a sound base in logic has a
head start on other approaches.BUSF_Z03.qxd 11/19/08 10:33 Page 499