FM – Nov 2024 – L2 – Q4a – Business Valuation

Valuing a company using the discounted cash flow model and price multiples.

Question

Djokoto PLC (Djokoto) has 12 million ordinary shares outstanding and no other long-term debt. The Finance Director of Djokoto, Adepa, estimates that Djokoto’s free cash flows at the end of the next three years will be GH¢0.5 million, GH¢0.6 million, and GH¢0.7 million, respectively. After Year 3, the free cash flow will grow at 5% yearly forever. The appropriate discount rate for this free cash flow stream is determined to be 15% annually.

In a separate analysis based on ratios, Adepa estimates that Djokoto will be worth 10 times its Year 3 free cash flow at the end of the third year. Adepa gathered data on two companies comparable to Djokoto: Mesewa and Dunsin. It is believed that these companies’ price-to-earnings, price-to-sales, and price-to-book-value per share should be used to value Djokoto.

The relevant data for the three companies are given in the table below:

Variables	Mesewa	Dunsin	Djokoto
Current Price Per Share	7.20	4.50	2.40
Earnings Per Share	0.20	0.15	0.10
Revenue Per Share	3.20	2.25	1.60
Book Value Per Share	1.80	1.00	0.80

Required:
i) Estimate Djokoto’s fair value based on the discounted cash flows model. (5 marks)
ii) Compute the following ratios for the comparable companies:

P/E Ratio (2 marks)
Price-to-Sales Ratio (2 marks)
Price-to-Book-Value Ratio (2 marks)
iii) Based on the valuation results, discuss whether an investor should buy, sell, or hold Djokoto shares. Justify your recommendation. (4 marks)
iii) Identify two advantages and two disadvantages of business combinations.

Answer

i) Discounted Cash Flow Valuation
The enterprise value (EV) is calculated using the free cash flow method:

Terminal Value (TV) = $0.7m×(1.05)(0.15−0.05)\frac{0.7m \times (1.05)}{(0.15 – 0.05)}$
TV = GH¢7.35m

Using the discounted cash flow formula:

$EV0=CF1(1+r)1+CF2(1+r)2+CF3+TV(1+r)3EV_0 = \frac{CF_1}{(1+r)^1} + \frac{CF_2}{(1+r)^2} + \frac{CF_3 + TV}{(1+r)^3}$ $EV0=0.5(1.15)1+0.6(1.15)2+0.7+7.35(1.15)3EV_0 = \frac{0.5}{(1.15)^1} + \frac{0.6}{(1.15)^2} + \frac{0.7 + 7.35}{(1.15)^3}$ $millionEV_0 = 6.18 \text{ million}$

ii) Ratio Analysis for Comparable Companies

Price-Earnings Ratio (P/E Ratio)
- Mesewa: $7.200.20=36\frac{7.20}{0.20} = 36$
- Dunsin: $4.500.15=30\frac{4.50}{0.15} = 30$
- Mean: $36+302=33\frac{36 + 30}{2} = 33$
- Djokoto’s Implied Price: $33 \times 0.10 = GH¢3.3$
Price-to-Sales Ratio (P/S Ratio)
- Mesewa: $7.203.20=2.25\frac{7.20}{3.20} = 2.25$
- Dunsin: $4.502.25=2.00\frac{4.50}{2.25} = 2.00$
- Mean: $2.25+2.002=2.125\frac{2.25 + 2.00}{2} = 2.125$
- Djokoto’s Implied Price: $2.125 \times 1.60 = GH¢3.4$
Price-to-Book-Value Ratio (P/B Ratio)
- Mesewa: $7.201.80=4.00\frac{7.20}{1.80} = 4.00$
- Dunsin: $4.501.00=4.50\frac{4.50}{1.00} = 4.50$
- Mean: $4.00+4.502=4.25\frac{4.00 + 4.50}{2} = 4.25$
- Djokoto’s Implied Price: $4.25 \times 0.80 = GH¢3.4$

Final Valuation of Djokoto:

$methods=3.3+3.4+3.43=GH¢3.37\text{Average of all three pricing methods} = \frac{3.3 + 3.4 + 3.4}{3} = GH¢3.37$

iii) Advantages and Disadvantages of Business Combinations

Advantages:

Economies of Scale: Business combinations help firms reduce costs by benefiting from bulk purchases, streamlined operations, and improved efficiencies.
Market Expansion: A merger or acquisition allows a company to enter new markets, reach more customers, and enhance its brand presence.

Disadvantages:

Cultural Integration Issues: Mergers often result in differences in corporate culture, creating operational and human resource conflicts.
Regulatory Challenges: Business combinations may require approval from regulatory bodies, which can delay the process and increase costs.

Tags: Business Valuation, Discounted Cash Flow, Financial Modelling, Price-Earnings ratio, Price-to-Book Ratio, Price-to-Sales Ratio
Level: Level 2

Topic: Business valuations
Series: Nov 2024

Uploader: Salamat Hamid