3.9 Accounting Rate of Return (ARR)
Under this method, the future earning of the target company is divided by the predator's return on capital employed (ROCE). It is important to note that the future income will be adjusted to take care of expected increase in administration and other costs notably the following:
(i) New level of Director's remuneration (ii) New level of interest
(iii) Charge for notional interest
(iv) The effect of product rationalization, improved management etc.
This method considers the accounting rate of return, which will be required from the shares to be valued. It is therefore distinct from the WE ratio method, which is concerned with the 'market rate of return' required.
The following formula is normally used Valuation =
Illustration 7
Heaven Ltd is considering acquiring Earth Ltd. At present Earth Ltd is earning an average of N480,000 after tax. The directors of Heaven Ltd feels that after reorganization, this figure could be increased to N600,00.
All the companies in the Heaven group are expected to yield a post - 0 tax return of 15% on capital employed.
Required
What is the value of Earth Ltd
Solution
Valuation of Earth Ltd = N600,000 N4,000,000 15%
company's physical asset.
(ii) Development expenditure if shown in the accounts would also have a value, which is related to future profit rather than to the worth of the company's physical assets.
The difficulty in an asset valuation method is not the arithmetic involved, but in the process of establishing the asset value to use. It must be remembered that the figure attached to an individual assets may vary considerably depending on whether it is valued on a going concern or break-up basis.
The following list should give some idea of the factors that must be considered.
1. Do the asset need professional revaluation, if so, how much will this cost?
2. Haven the liabilities been accurately quantified, e.g, deferred taxation?
Are there any contingent liabilities? Will any capital gain tax arise on disposal?
3. If the assets have been previously revalued, was 'tax provided on the excess over cost?
4. How have the current asset such as those given below been evaluated?
(i) Debtors — are they all collectable?
(ii) Stocks — are they all realizable?
5. Can all assets be physically located and brought into a sellable condition? This may be difficult in certain circumstances where the assets are situated in different parts of the world.
6. Can the hidden liabilities be accurately assessed eg redundancy payments and closure costs.
7. Is there an available market in which the asset can be realized?
8. Are there any period charges on the asset?
3.10 When to use Net Asset Basis
The net assets basis of valuation should be used
(i) When the company is about to go into liquidation. A break - up valuation method should thereby be used
(ii) When unquoted shares are offered as collateral for a loan. A break up valuation method should be used.
(iii) As a measure of the 'Security' in a share value, a share may be valued using the earnings basis or dividend yield basis, and this valuation may be:
(a) Higher than net asset value per share, if the company went into liquidation, the investor could not expect to receive the full value of his shares when the underlying asset are realized.
(b) Lower than the net assets value per share, in which case the share would have a higher asset backing. If the company went into liquidation, the investor might expect to receive the full value of his shares (perhaps much more) when the underlying assets are realized.
The asset backing for shares thus provides a measure of the possible loss if the company fails to make the expected earnings or dividend payment.
(iv) As a measure of comparison in a scheme of merger 9. Berliner Method
This is a simple average of (i) The Net Asset Basis and (ii) Any other Basis
It is a combination of Net asset basis plus any other method of valuation dividend by two.
Illustration 9
Assuming the price derived using Net Asset basis and earnings basis are given as:
N Net Asset per share 1.15
Price using Earning 0.9
The share price using Berliner method will be:
= = N1.025
Other qualitative Factors to consider
The final price of the shares of a company depends on the following qualitative factors:
1. The company fixture prospects
2. Composition of the Board of Directors of the company 3. The extent of foreign investment in the ownership and
management of the company
4. The company's expansion programme and capital commitment 5. The individual shareholders intention
6. The ability of the company to buy back its shares 7. The age of the company's fixed asset
8. The tax position of the company and the shareholders 9. The company's Dividend yield or cost of capital 10. Involvement of regulatory authorities in the activities
3.11 Data required for equity security analysis and valuation
In order to value any security, the following documents and information are imminently important.
(i) Audited Annual Accounts for the five years immediately preceding the valuation or actual number of years since commencement of operation if less than five years.
(ii) Detailed manufacturing, trading profit and loss Accounts for the period listed in (I) above.
(iii) Profit forecast and management accounts if the company has operation for up to six months at time of valuation.
(iv) Full description of the nature of business and the operation of the company
(v) Statement about the staff and management of the company and staff requirement in case of new companies that have not commenced operation.
(vi) Particulars of any litigation in which the enterprise is presently engaged or likely to be involved.
(vii) A copy of the Memorandum and Articles of Association — changes in the authorized capital if any should be supported with relevant documents of authorized capital if any should be supported with relevant documents of registration with the Corporate Affairs Commission. Increase in paid up capital to be supported with Board Resolutions.
(viii) A certified copy of the Certificate of incorporation.
(ix) Any other information which the issuing House may consider necessary
Issuing Houses usually work on a five — year track record when valuing shares. In case of enterprises having less than five years track record, individual enterprises is then treated on its own merit.
In the case of new companies, since they may not have any supportive audited accounts, the following documentation is required of them:
(i) A copy of the feasibility Report, if any
(ii) Operational and Cash flow projections for three to five years (iii) Statement of find utilization.
Issuing houses work only on audited and signed accounts audited accounts are not acceptable.
4.0 CONCLUSION
We have seen in this unit that by unquoted equities, we mean ordinary share of companies that are not listed on the stock exchange. Unquoted equities are "prohibited dealings" ie they cannot be traded on the stock Exchange unless they get quoted. We have also seen the various methods of valuation of unquoted stocks.
5.0 SUMMARY
In this unit you have learnt the various methods of valuation of unquoted stocks as well as the data required for equity security analysis and valuation
6.0 TUTOR-MARKED ASSIGNMENT
1. Egg Plc is proposing to take over Poop Ltd, an unquoted company. Presently, Poop Ltd is valued at PE ratio of 18. It has in issue 2,000,000 ordinary shares and earned Profit after tax of N450,000 per annum.
Required
Advise Egg Plc on how much to offer Poop Ltd.
5. The management of Horn Plc, a medium size company playing in the Telecom Sector, has just approached you. The company wishes to approach the Nigeria Capital market to raise funds to finance the roll out of its GSM lines, having been recently licensed by Nigeria Communication Commission.
The company wants to do a preliminary valuation of its share and wishes to get your advice.
Required
(i) What documents or information will you require from Horn Plc before carrying out the valuation of its shares?
(ii) What other financing options will you recommend to the Management of Horn Plc?
7.0 REFERENCES/FURTHER READINGS
Akinsulire, O. (2008). Financial management (5th Edition), Lagos : El- Toda Ventures Ltd
Dunmade, A.A (undated). Investment analysis and portfolio management, Lagos: Elite trust Ltd
Igbinosa, S.O. (2012). Investment analysis and management , Lagos:
Elite Trust Ltd
Osaze, E.B. (2007). Capital markets, Lagos : The Bookhouse Company Osuoha, J. (2010). Portfolio management, Lagos: Emmaeth Printing and
publishing
Osuoha, J. (2010). Equity valuation and analysis, Lagos: Emmaeth Printing and publishing
MODULE 5