CHAPTER II LITERATURE REVIEW

Transcription

1 6 CHAPTER II LITERATURE REVIEW 2.1. Valuation Methods The valuation is needed to know the value of a company for many users in making decisions. Management and investors can not value a company just by analyzing the growth because the study of Ramezani et al. (2002, pp 56) states although the corporate profitability measures generally rise with earnings and sales growth, an optimal point exists beyond which further growth destroys shareholder value and adversely affects profitability. The method used in valuing is very important because it determines whether the valuation is proper or not. Madden (2003, pp 203) lists six criterias in selecting the valuation method, i.e. : 1. Insights from analyzing firms track records 2. Identification of key valuation issues 3. Accuracy 4. Plausibility judgements 5. Ease of implementation 6

2 7 6. Process for model improvement There are many methods in valuation (Damodaran, 2002). Two methods that will be used, i.e. : 1. Discounted Cash Flow Valuation (DCF) This method is the foundation for other method, which is the present value of cash flows by using discount rate. According to Adsera and Vinolas (2003), DCF is properly applied for valuation. It is supported by Danielson (1998) that stock value has to consider some factors of which stocks depended on i.e. expected earnings (cash flows), reinvestment rate, return on new investments, riskadjusted discount rate, and length of the period of competitive advantage (elements of DCF). 2. Relative Valuation It is the most common methods in the real world. The valuation is conducted by comparing the company to other companies which have similar characteristics Discounted Cash Flow Method Calculation of Discounted Cash Flow Method 7

3 8 Discounted Cash Flow (DCF) method uses present value (PV) of free cash flow based on discount factor. The focus in this study is Free Cash Flows to Equity (FCFE) discounted at cost of equity. According to Damodaran (2002, pp 353) : FCFE = Net Income (Capital Expenditure Depreciation) (Change in noncash Working Capital) - (Preferred Dividends + New Preferred Stock issued) + (New Debt issued Debt repayments) One of DCF models is Two Stage Model which used by a company with faster growth rate and finally be stable growth rate Value = PV of FCFE + PV of terminal price = FCFE,, where Value = Value of stock today FCFE t = Free Cash Flow to Equity in year t P n = Price at the end of the extraordinary growth period = FCFE, k e g n = Cost of equity in high growth (hg) and stable growth (st) periods = Growth rate after the terminal year forever For the valuation, earning projection for generating free cash flow is very important because wrong earning projection will lead to unproper valuation. In valuation, the projection is made based on earning because Liu et al. (2007, pp 56) 8

4 9 stated In all cases studies, earnings dominated operating cash flows and dividends. In addition, Givoly and Hayn (2002) stated that earning quality has been improved by incorporating conservatism. Futhermore, Cornell and Landsman (2003) focused on earning quality because earning definition will vary over time and among companies Calculation of Cost of Equity In valuation, one of the most important thing is measuring risk by cost of capital which consists of cost of debt and cost of equity. Easley and O Hara (2004, pp 1553) stated Fundamental to a variety of corporate decisions is a firm s cost of capital. In addition, the firm can influence cost of capital through non product related decisions, i.e. accounting standards, active analyst and listed market. According to Damodaran (2002, p 182), The cost of equity is the rate of return investors require on an equity investment in a firm. One method usually used is Capital Asset Pricing Model (CAPM). It is the longest and standard method which is used in the real world. Galiniene et al. (2010) supported that CAPM and FAMA-French model are the best cost of capital methods for valuing shares in the emerging market. In addition, CAPM validity has been proved by Guan et al. (2007) either theoretical and empirical studies. 9

5 10 Furthermore, cost of capital calculation for multinational corporation can ignore the global consideration. It is based on Koedijk and Dijk (2004, pp 37) that global risk factors, despite global integration, are not vitally important for practical cost-of-capital calculation for a remarkably high number of companies. It was proved by Koedijk and Dijk that straightforward domestic CAPM is not significant different from international CAPM. The formula of CAPM : E(R i ) = R f + β i [E(R m ) R f ) where E(R i ) = Expected retun on asset i R f = Risk free rate (certain expected return in the analysis period) β i = Beta of asset i (the risk added to the market portfolio) E(R m ) = Expected return on market portfolio The formula of β i : βi 2 where β i > 1 the asset is riskier than average β i < 1 the asset is safer than average β = 1 the asset risk is same as average β = 0 the asset is riskless 10

6 Relative Valuation Relative Valuation is a valuation by using comparable companies. Damodaran (2002, pp 482) states A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It implies that the comparable companies are not always the companies in the same industry, but companies in the same industry usually shares the same characteristics which mentioned before. In Relative Valuation, there are multiples which are used. For this study, there are two multiples which will be used, i.e. : 1. Earning multiples According to Damodaran (2002), it is the most common used multiple but can be misused because there are differences in fundamentals. In order to be properly used, the comparable companies have to be a narrowly defined group and control the differences in growth, risk and cash flow subjectively. Alternatively, the comparable companies are in the entire sector or market and control the fundamental differences using statistical techniques. Price-Earning multiple (PER) = Market price pershare / Earnings pershare 2. Book Value or Replacement value multiples It is useful for valution because it provides relatively stable value, reasonably consistent with accounting standards and can be used for negative earning companies. 11

7 12 Price-to-Book Ratio (PBV) = Market value of equity / Book value of equity The suitable multiples for financial service companies are price-eanings ratios and price-to-book ratios. Futhermore, equity book value of financial service companies is much more likely to track the market value of equity in existing assets. According to Damodaran (2002, pp 575), financial service companies are companies that provide financial products and services to others. In addition, it is quite difficult to find the same companies that can be compared. Therefore, there are two of four adjustments (Damodaran, 2002, pp 483) i.e. ; 1. Subjective adjustments In the valuation, the multiple will be compared to average multiple. Furthermore, it needs subjective adjustments whether the comparison can be explained or the multiple is under/overvalued. 2. Modified multiplies In the valuation, multiplies can be modified to reflect the most important variables. 12

8 Valuing A Conglomerate Company Nowadays, there are many companies which have subsidiaries with different sectors. It makes the valuation more complex. According to Koller et al. (2005), process of valuing a conglomerate company i.e. : 1. Creating business unit financial statements The valuation has to consider the items related to consolidated and unique issues, i.e. : a) Corporate costs Corporate costs are costs related to corporate (not each subsidiaries), e.g. CEO s compensation. b) Intercompany sales Intercompany sales are sales between subsidiaries and the parent, or a subsidiary and a subsidiary. c) Intercompany receivables and payables Intercompany receivables and payables are receivables and payables between subsidiaries and the parent, or a subsidiary and a subsidiary. d) Financial subsidiaries If the multibusiness company has financial subsidiaries, the subsidiaries have to be treated differently in valuation because they have different natures e.g. mostly financial asset and highly leveraged. 13

9 14 e) Valuation with public data In valuating listed public company, the data will be collected from published Financial Statements which are not complete. Therefore, valuing the company has to understand the characteristic and rearrange the data. 2. Estimating cost of capital for each business unit The cost related to corporate use weighted average of each subsidiary cost of capital. 3. Valuing each business separately, summing the parts, and interpreting the results Based on each subsidiary cost of capital, the valuation is conducted for each subsidiary. Furthermore, the valuations are summed to get the overall valuation. 14