Calculations and Assumptions
At this stage in our analysis you will note from Table 8.2 that we have no figures for the market value or dividend for Duran, since they still require definition based on a comparative analysis of its competitors performance (A,B and C). Note also that the earnings for all four companies no longer reflect historical accounting convention, but rather a feeling for anticipated events, using calculations based on reasonable assumptions.
(a) Market Value is derived by the following two stage procedure:
(ii) Number of Shares x Current share price = Total market value
(b) Earnings have been approximated using the following assumptions:
Activity 1
Before proceeding with our case study, you should note that we are already manipulating data to establish interÂrelationships between accounting data and comparative stock ratios, which will encourage investors to buy the company's shares when they are launched on the market. If you are unsure about this framework of ratios, refer to the Appendix at the end of the text as a guide for future reference.
So far, so good: Table 8.2 itemizes the salient features of the four companies' accounts as a basis for analysis. The "unknown" variables are the required forecast of market value and dividend relating to Duran. However, these may be established by reference to the investment profiles of A, B and C that are given in Table 8.3 below. These profiles are simply a reformulation of the financial data contained in Table 8.2 into all the investment ratios (yield, cover and the P/E) with which you are familiar. Perhaps you can confirm this?
Activity 2
Using Table 8.3 and the market ratios in the Appendix, you should now be able to determine the "unknowns" for Duran as basis for its total market valuation, flotation value, share denomination and offer price per share, relative to the dividend policies of its competitors.
Table 8.3: Investment Ratio Profiles
A Total Market Valuation
The simplest and typically most conservative valuation to be placed upon all Duran's shares would be based upon its net assets calculated directly from the accounts. On the information available, this would take the form of assets minus liabilities, without any adjustment for current values as either a going concern (net replacement cost), surplus assets (realizable value) or intangible items, producing a figure of £4.7 million.
However, the disparities between nominal (par) and market values for A, B and C suggest that this figure is no more than a lower benchmark. Even if book values were appropriate, a more sophisticated valuation based upon the return on capital employed (ROCE) of similar firms, provides a significantly higher figure. For example, ignoring the anomalously high return of A and taking an average return on capital plus reserves of 11 percent for B, C and Duran from Table 8.2 provides a capitalisation of Duran's post-tax earnings as follows:
£605,000 / 0.11 @ £5.5 million
Ignoring book values altogether, a more satisfactory current market valuation may be determined using the P/E ratios from Table 8.3. Clearly, Duran's growth does not match that of A. It is nearer that of Company B. If Duran's earnings are therefore capitalized using the latter's P/E ratio, the following market value would result:
£605,000 x 15.7 @ £9.5 million
An Aggregate Flotation Value
To ensure full subscription, financial prudence dictates that Duran's shares should be offered at a figure below their market value. To ascertain the aggregate flotation value for an offer for sale, a lower P/E ratio would therefore be more appropriate. Taking the figure for C, the following valuation may be determined:
£605,000 x 13.0 @ £7.9 million
It therefore seems reasonable to conclude that Duran should be floated on the market at an aggregate value, somewhere in the region of £8 million.
The Number and Denomination of Shares
With regard to the total number and denomination of shares issued by Duran, the dividend policies of similar companies now come into play. Given the information relating to A, B and C, it appears that the dividend paid by Duran should be covered twice. Thus, the total dividend payout based upon our earlier estimate of its after-tax earnings would be:
£605,000 / 2 = £302,500
Given an aggregate flotation value of £8 million, then the dividend yield on Duran's shares (its "real" rate of return) will be:
£302,000 / £8million @ 3.8%
This should prove satisfactory to potential investors since it falls between the forecast yields of 3.1% and 4.4% for B and C respectively.
A Valuation per Share
Proceeding to the final stage of Duran's analysis, the nominal and market values per share will also be constrained by the data for similar stock currently traded on the market.
The values for B and C in Table 8.3 suggest that an issue made at 25 pence, with a premium of 75 pence attached, representing a market value of £1.00 per share, might succeed. Given a total dividend payout of £302,500 on 8 million shares nominally valued at 25 pence each, this would then result in the following dividend percentage:
But would this satisfy potential investors in the new Duran plc?
When compared with the percentages for A, B and C, 15.2 percent might be considered rather on the low side. A nominal value of 22 pence per share with a 78 pence premium would improve this figure and could be justified, particularly if we consider the low par value for A. The revised calculation would produce a figure more in line with Duran's other competitors.
Summary and Conclusions
It must be stressed that dividend yields, rather than percentages, are the "real" measure of a share's return and it is the yield of 3.8 per cent on market price which should motivate rational subscribers to take up an offer for sale. However, we cannot ignore the dividend percentage, if only because it is published in company accounts, and might sway the investment decisions of less informed individuals.
To ensure success, it is suggested that Duran should therefore place its shares on the market for £1.00, comprising a 22 pence par value and a 78 pence premium. Table 8.4 sets out the proposed capital structure and investment profile in accordance with this recommendation having regard to the dividend expectations of investors (yield and percentage).
Duran plc |
£000s |
Ordinary share capital (8 million) |
1,760 |
Reserves (share premium) |
6,240 |
Flotation Value |
8,000 |
Earnings (profits after tax) |
605 |
Dividends |
302.5 |
Dividend cover |
Twice |
Nominal value per share |
£0.22 |
Premium per share |
£0.78 |
Market value per share |
£1.00 |
Dividend % |
17% |
Dividend yield |
3.8% |
Earnings yield |
7.6% |
Price/Earnings ratio |
13 |
Table 8.4: Capital Structure and Investment Ratio Profile