In this section of the thesis incentives for valuation are presented as well as basic concepts and theories associated with a company’s value. The section also includes a thorough explanation of the valuation models and their various forms used in the thesis. The theoretical framework ends with a short financial presentation of the case companies are given in combination with an assumption strategy for the Empirical Findings & Analysis section.
Outline of the Theoretical Framework
This section begins with a discussion and definitions on related concepts that will be needed in order to implement the analysis. The following part will cover different financial models applicable to firm valuation. It narrows down the perspective by focusing on the DDM and FCFE methods in particular. This step will explain the basics of both the DDM and the FCFE model and highlight some of their inadequacies when it comes to firm valuation.
The intention of this first theoretical part of the literature study is to give the reader an insight into the process of valuation, highlighting important concepts and definitions from a broad perspective. It then narrows down to the valuation models and their forecasting implications.
Next part of the theoretical frameworks will discuss some relevant, and in the firm valuation aspect relatively undeveloped related academic theories around firm valuation. These theories are relevant since they are part of the discussions mentioned in the previous steps, and it could be useful to analyse them in order to examine different approaches and perhaps improvements to the process of firm valuation. This part will furthermore cover some non-financial aspect of the valuation process, which in most cases are just as important in the decision-making.
In the next step a more comprehensive explanation is given to the valuation process when applying the valuation models. The models and their various versions explained in this part are the ones that are going to be applied on the case study as the thesis progresses. The formulas for the two valuation models are general versions, why the reference has been left out.
The final part of the theoretical framework will consist of an analysis based on the theories discussed and developed in the previous steps. This analysis will be the founding source for the final conclusions.
Motives for Valuation
A basic belief is that managers who put emphasis on creating value for shareholders will generate healthier companies than managers who do not. Healthier companies leads to healthier economies, more business and career opportunities or individuals, this leading to higher living standards (Copeland, et. al, 2000).
The Swedish professor, Sven-Eric Johansson, who was a supporter of the development of a theoretical foundation for how businesses should be valued had the opinion that one should treat every acquisition as an investment (Hult, 1998). A more theoretical definition of a company’s value based on this investment theory is the present value of future distributable earnings from the company. The future cash flows provide the limits of the company’s survival and future development. These cash flows, or dividends, are the foundation for share value of the company. On the basis of this is the intention of an external stakeholder, such as a shareholder (or a prospective one), to form an opinion about the company’s ability to generate cash flow (Hult, 1998).
This cash flow can take the form of income, dividends paid by the company, or capital, which is realized by a sale of the shares (Barker, 2001).
Who Values Stocks?
As mentioned in the previous part, there are several categories of people with an interest of value stocks. Since these people are different they also have different reasons for undertaking stock valuations. Some of the motives can be the desire to form effective economic policies in order to better understand and manage companies, the potential to profit from trading with stocks, and the need to communicate correct yet simplified information to the public (Hoover, 2005). The following part will further explain why financial analysts, corporate managers, asset managers, economic policymakers or regular individuals would have an interest in the stock valuation process.
There are two kinds of financial analysts, investment bankers and equity researcher. As this section explains, whilst their techniques are somewhat similar their intentions with the valuation differs. The investment banker’s main role is to pair companies with potential investors; their goal is to help companies find ways to raise money for different projects. In this process, the investment banker does not only have to evaluate the company’s shares, but also try to convince the company that their valuation is justified. In other words, the investment banker’s goal is not to find a “true” stock value, but at what price the investment bank can sell the stock in order to raise the money needed. The equity researchers on the other hand have to follow and assess companies in order to find a true stock price of those companies. These assessments and the stock values are then used to make recommendations to both public and private investors. The recommendations can publicly take the form of buy/sell recommendations, or downgrades and upgrades of the stocks. (Hoover, 2005)
Managers both have an interest in valuing their own company and other, perhaps possible mergers or acquisitions, companies. To know the value of their own stock can be helpful for managers in order to properly raise money. If they, for instance, believe that their stock is currently overvalued in the market they can make money on selling some of their shares, if they on the other hand believe that their stock is currently undervalued in the market they normally would not want to issue more shares. The same reasons holds for knowing the value of other company’s stocks, if a manager thinks that a company’s stock presently is undervalued in the market, and plans on acquiring that company exists, now could be a good time to go through with the acquisition. (Hoover, 2005)
An asset manager is someone who is hired by companies or individuals with the objective to invest their money. They invest this money in their own constructed portfolios, whose main goal is to outperform benchmark portfolios (typically the “market”) in the long run. It is evident that an asset manager who lacks the ability to find stocks that are misaligned in the market, for his portfolio, will in the long run not be able to outperform the market, thus lose current and potential customers. (Hoover, 2005)
The objectives of policymakers in different economic institutions over the world are somewhat different to the ones previously mentioned. Their focus is usually not on specific companies and their stocks, but at the value of the whole stock market compared to its “true” value. By knowing if the stock market as a whole is currently over- or undervalued allows them to, for example, in a more accurate way evaluate the stability of the financial market, which forms a foundation in their interest rate policies. They could for example increase interest rates to slow down the market or contrary decrease interest rates to generate economic growth. (Hoover, 2005)
In recent years, is has become more and more popular amongst individuals to invest in the stock market. In order for them to do so, an understanding of how the valuation process can be conducted is therefore crucial. Since this process can be, especially for non-professionals, both challenging and time-consuming, individuals are typically better off investing in an index fund, rather than trying to choose stocks themselves. (Hoover, 2005)
The goal of this part of the theoretical framework is to give the reader an idea of some related concepts to the valuation process one have to be aware of. This part is however not only associated with valuation, it serves as a basics for how the capital structure of a firm can be designed as well as the different forms of market efficiency.
The Concept of Value
As mentioned in the previous part, value can take the form as either dividends or by acquiring capital through share transactions. The value that stakeholders obtain is determined by future returns that the company is expected to get, as well as the risk that the returns deviates from those expected. Hence, it is not unusual that different parties have different perceptions of value. This difference often originates from different assessments regarding the plausibility of the forecast development in relation to what has historically been achieved by the company (Öhrlings PricewaterhouseCoopers, 2007).
The authors, William M. Crilly and Andrew J. Sherman, of “The AMA Handbook of Due Diligence” (2010) defines due diligence as a process whereby an individual, or an organization, seeks sufficient information about a business entity to reach an informed judgement as to its value for a specific purpose.
A good example of an organization with the need of proper due diligence are consultant firms that often assists, either the buyer or the seller, in the case of an acquisition. The following part of the due diligence section consist of a brief explanation of the global consulting firm PriceWaterCoopers’s take on the due diligence process.
This process often affects the buyer’s view of the company and gives him or her a sense of what demands to give the seller in their negotiations. An analysis of this kind is often categorised in to the following areas:
(Öhrlings PricewaterhouseCoopers, 2007)
This thesis is mainly focusing on the financial part of an acquisition (whether it is an entire company or a fraction of its shares), thus is the Financial Analysis the area of focus. The Financial Analysis normally includes an in-depth review of the company’s continuous level of profitability and cash flows (both historic and forecasts), an overview of customer and supplier dependency and an overview of the balance sheet (in order to identify any possible surplus or deficit). (Öhrlings PricewaterhouseCoopers, 2007)
In light of the fact that buyers are increasing the use of due diligence, the need for the sellers to prepare both themselves and their company for a pre-acquisition analysis has increased. This is a so called “sell-side due diligence”, through which the seller gains increased knowledge of the object up for acquisition and thereby get an advantage in the coming negotiations. (Öhrlings PricewaterhouseCoopers, 2007)
Capital Market Efficiency
If prices in a specific market, for example the Swedish stock market, are adjusting rapidly and correctly in accordance with new information available the market is said to be efficient. Hence, in an efficient capital market, such as the stock market, there is no reason to believe that the current stock prices are too high or too low, provided that all information is available. (Ross et al, 2008)
The next following part of this section of the thesis will provide a simple explanation to the different forms of market efficiency, forms that differ when it comes to what information is reflected in the stock prices.
Strong Form Efficiency
In the case of a strong form of market efficiency, all information, both public and private, is reflected in the stock prices. In recent years, the topic of inside information has been widely discussed. In this form of efficiency there is no such thing, as inside information, everyone knows everything that there is to know about the stock or company. Common sense tells us that this cannot always be the case; there are several situations when people do in fact hold private information or knowledge to themselves. This means that it may exist private (inside) information about a stock that is not currently reflected in its price. (Ross et al, 2008)
Semi-Strong Form Efficiency
The semi-strong efficiency differs from the strong form since only publicly available information is believed to reflect current stock prices. This form of efficiency suggest that there is no idea trying to analyse the price of a stock, or looking for mispriced stocks, since all public information already reflects the stock price. (Ross et al, 2008)
Weak Form Efficiency
The last of the three forms is the weak form efficiency, in which the stock prices are only reflected by historical prices of that stock. This means that if the market is weak form efficient there is no gain in looking for mispriced stocks by studying past stock prices. (Ross et al, 2008)
Capital structure and firm value
Fundamental to the discussion on company valuation, the Miller-Modigliani theorem, which states that the value of a firm is independent of its capital structure, is essential to discuss when writing a thesis on firm valuation. That is, the level of debt, the split of debt into claims with different levels of collateral and different seniorities in the case of bankruptcy, dividend distribution policies, and many other characteristics or policies relative to the financial “pie” have no impact on the total firm value. This means that if a firm decides to do, an increase in total debt or a dividend distribution dilutes the debt-holder’s claim and benefits the shareholders, but the latter’s gain exactly offset the former’s loss. (Tirole, 2006)
Table of Contents
1.1 BACKGROUND INFORMATION
1.2 PROBLEM DISCUSSION
1.5 OUTLINE OF THE THESIS
2.1 METHOD APPROACHES
2.2 THE CASE STUDY
2.3 COLLECTION OF THE DATA
3 THEORETICAL FRAMEWORK
3.1 OUTLINE OF THE THEORETICAL FRAMEWORK
3.2 MOTIVES FOR VALUATION
3.3 RELATED CONCEPTS
3.4 FINANCIAL MODELS & VALUATION
3.5 THE COMPANIES
3.6 PREVIOUS RESEARCH
3.7 ASSUMPTIONS PRIOR TO EMPIRICAL FINDINGS & ANALYSIS
4 EMPIRICAL FINDINGS & ANALYSIS
4.1 FUTURE GROWTH ASSUMPTIONS
4.2 ABB (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
4.3 ASSA ABLOY (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
4.4 ASTRAZENECA (HEALTH SERVICE – LARGE CAP)
4.5 ATLAS COPCO (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
4.6 AXFOOD (FAST MOVING CONSUMER GOODS – LARGE CAP)
4.7 GETINGE (HEALTH SERVICE – LARGE CAP)
4.8 MEDA (HEALTH SERVICE – LARGE CAP)
4.9 NCC (INDUSTRIAL GOODS & SERVICES – LARGE CAP)
4.10 ORIFLAME (FAST MOVING CONSUMER GOODS – LARGE CAP)
4.11 SWEDISH MATCH (FAST MOVING CONSUMER GOODS – LARGE CAP)
4.12 SUMMARIZING THE ANALYSES
5.1 CONCLUSIONS IN RELATION TO THE PURPOSE
5.2 IMPLICATIONS AND SUGGESTIONS FOR FUTURE STUDIES
GET THE COMPLETE PROJECT
Firm valuation Which model gives me the most accurate share price, the Dividend Discount Model or the Free Cash Flow to Equity model?