VALUATION OF UNQUOTED COMPANIES

VALUATION OF UNQUOTED COMPANIES Fifth Edition Christopher G. Glover MScFCA CCH a Wolters Kluwer business Wolters Kluwer (UK) Ltd 145 London Road Kingston upon Thames Surrey KT2 6SR Tel: +44 (0) 844 561 8166 Fax: +44 (0) 208 547 2638 E-mail: customerservices@cch.co.uk www.cch.co.uk

Preface list of figures and tables list of abbreviations vii xix xxiii Chapter 1: Valuation theory 1 1.1 Introduction 3 1.2 The comparative value judgement 3 1.3 Opportunity cost 4 1.3.1 Anticipated opportunity cost 4 1.4 Satisfaction of common demand 5 1.5 Law of equilibrium 7 1.6 Exterior values 9 1.7 Interior values and price determination 11 1.8 Price and market value 12 1.9 Valuation of shares 12 1.10 Some characteristics of value 16 1.11 Conclusion 18 Chapter 2: Concepts of property value 21 2.1 Introduction 23 2.2 Value to the owner or owner value 23 2.2.1 Deprival value 24 2.2.2 Fluctuations in owner value 24 2.2.3 Owner value and market value 25 2.3 Market value or exchange value 25 2.3.1 Elements of a market.26 2.3.2 Basis of market value 26 2.3.3 Practical considerations 27 2.4 Fair value 30 2.5 Investment value 35 2.5.1 Investment-based owner value 36 2.6 Liquidation value 37 2.6.1 Liquidation value as a limit to risk 38 2.7 Going concern value 39 2.7.1 Valuing the going concern as a break-up 40 2.7.2 Personalised goodwill 41 2.8 Intrinsic value 41 2.8.1 Definitions considered 41 2.8.2 Intrinsic value versus market value 43 2.8.3 Intrinsic value not a valid concept 43 2.9 Conclusion 44 IX

Chapter 3: The legal framework 45 3.1 Introduction 47 3.2 Limited company 48 3.2.1 Nature of a company 48 3.2.2 Separate legal personality 49 3.2.3 Perpetual succession 50 3.2.4 Ultra vires rule 50 3.3 Articles of association 51 3.3.1 Articles of association as a contract 51 3.3.2 Model articles 52 3.4 Distinction between a public and a private company 52 3.5 Division of power between the shareholders and the directors 53 3.5.1 Powers of management 54 3.5.2 Sanctions available to shareholders 54 3.6 Legal nature of a share 55 3.6.1 Importance of the articles of association 55 3.6.2 Stock market investor versus the private company shareholder 56 3.6.3 Ownership and control of the company 56 3.7 Classes of security 58 3.7.1 Ordinary shares 58 3.7.2 Preference shares 58 3.7.3 Debentures 60 3.8 Purchase by a company of its own shares... 61 3.9 Redeemable shares 62 3.10 Distributable profits 62 3.11 Degrees of control 63 3.11.1 Types of resolution 63 3.11.2 Statutory minority rights 65 3.12 Conclusion 65 Chapter 4: The rights of minorities 67 4.1 Introduction 69 4.2 Unfairly prejudicial conduct petition 69 4.2.1 Prerequisites for a petition under section 994 70 4.2.2 What constitutes unfairly prejudicial conduct? 71 4.2.3 Obligation to make use of available solutions 72 4.2.4 O'Neill v. Phillips 73 4.2.5 Powers of the court 78 4.3 Winding up petition on the 'just and equitable' ground 78 4.3.1 Circumstances in which a winding-up order may be made 80 4.4 Derivative action 81 4.5 Conclusion 82 Chapter 5: The influence of the Stock Exchange 85 5.1 Introduction 87 5.2 Quoted company comparisons 87 5.2.1 Commercial valuations 87 x

5.2.2 Fiscal valuations 87 5.2.3 Objections to quoted company comparisons 88 5.2.4 Effect of lack of marketability 88 5.2.5 Main indicators of comparability 89 5.3 The London Stock Exchange 89 5.3.1 Main Market versus AIM 91 5.3.2 PLUS 91 5.4 Selection of comparable companies 92 5.5 Published share and bond price information 93 5.6 Stock Market indices 95 5.6.1 FTSE All Share Index 95 5.6.2 FTSE 100 Index 96 5.6.3 30-Share Index 97 5.6.4 FTSE Gold Mines Index 97 5.6.5 Fixed Interest Indices 97 5.7 Efficient capital markets and portfolio theory 97 5.7.1 Efficient market hypothesis 97 5.7.2 Modern portfolio theory 99 5.8 Conclusion 101 Chapter 6: The efficient market hypothesis 103 6.1 Introduction 105 6.2 Weak form 105 6.3 Semi-strong form 107 6.3.1 The theory and its implications 107 6.3.2 Generalised hypothesis incapable of conclusive proof. 108 6.3.3 Academic evidence in support of the hypothesis 109 6.3.4 FFJR study examined in detail 110 6.3.5 Critique of FFJR's findings 113 6.3.6 Other academic studies. t 116 6.4 Strong form 118 6.4.1 Academic test of the strong form 118 6.4.2 Indirect tests - the United States 119 6.4.3 Indirect tests - the United Kingdom,.. 119 6.4.4 Jensen's mutual funds study 120 6.5 Review of findings 125 6.6 Conclusion 126 Chapter 7: Risk and rate of return 131 7.1 Introduction 133 7.2 Nature of risk 133 7.3 Risk measurement 135 7.3.1 Variability of future returns 135 7.3.2 Pay-back period 142 7.3.3 Sensitivity/scenario analysis 142 7.4 Risk premium 143 7.5 Relationship between risk and the rate of return 147 7.5.1 Utility function for wealth 148 7.6 Capital Asset Pricing Model 150 7.6.1 Notion of diversifiable risk 150 XI

7.6.2 Beta co-efficient 151 7.6.3 Calculating betas 152 7.6.4 Critique of the CAPM/MPT 153 7.7 Conclusion 157 Appendix 7.1 Calculation of the standard deviation of returns for Company A and Company B 160 Appendix 7.2 Calculation of the revised 'expected' rate of return and standard deviation for Company A and Company B 161 Appendix 7.3 Calculation of the standard deviation of returns for QRS pic and ABC pic 162 Chapter 8: The dividend basis of valuation 163 8.1 Introduction 165 8.1.1 General remarks 165 8.1.2 Fundamental significance of dividends 165 8.1.3 Relationship of dividends to earnings and asset backing. 165 8.1.4 Valuations not for portfolio investment purposes 167 8.2 Basic approach 167 8.2.1 Assuming a fixed annual dividend 167 8.2.2 Assuming a dividend increasing at a constant annual rate 168 8.2.3 Derivation of die dividend discount model 169 8.2.4 Adjusting the DDM for temporary abnormal growth.. 170 8.2.5 Relationships between the DDM and the PE ratio 170 8.3 Required rate of return 171 8.3.1 Two elements of the required rate of return 171 8.3.2 Assessing the degree of risk 172 8.3.3 The Stock Exchange risk premium 172 8.3.4 Risk premium on individual stocks 173 8.4 Initial yield method 175 8.5 Non-dividend paying companies 176 8.5.1 Hypothetical dividend yield method 176 8.5.2 Valuation for portfolio investment purposes. : 177 8.5.3 Valuation for other purposes 181 8.6 Discount for lack of marketability 182 8.6.1 The need for a discount 182 8.6.2 Empirical studies in the United States 182 8.6.3 Position in the United Kingdom 185 8.7 Dividend cover 186 8.7.1 Its significance and calculation 186 8.7.2 Dividend cover for valuations prior to April 1999 186 8.8 Conclusion 188 Chapter 9: The earnings basis of valuation 191 9.1 Introduction 193 9.2 Meaning of control 193 9.2.1 Composition of the board 193 9.2.2 Reflecting the degrees of control in a valuation 194 9.2.3 Deadlock companies, ie whose equity is held 50:50.... 195 XII

9.2.4 Value of voting rights with no equity entitlement 196 9.3 Earnings 196 9.3.1 Nature of profit 196 9.3.2 Estimating future profits 199 9.4 Discounted earnings method 202 9.4.1 Present value of future earnings 202 9.4.2 Importance of retained profit 203 9.4.3 Allowing for retained profit 203 9.4.4 A formula for the present value of future earnings... 204 9.4.5 Selecting the rate of return 206 9.5 PE ratio 208 9.5.1 PE ratio and the earnings yield 208 9.5.2 Problems with the PE ratio 209 9.5.3 Use of the PE ratio in valuing unquoted shares 211 9.6 Pretax profits yield 212 9.7 Conclusion 212 Appendix 9.1 Derivation of the discounted earnings formula 215 Chapter 10: Discounted Cash Flow technique and other valuation methods 219 10.1 Introduction 221 10.2 Discounted Cash Flow method 221 10.2.1 Investment projects versus company valuations 222 10.2.2 Net present value and price 222 10.2.3 Information required 223 10.2.4 Treatment of financing needs 224 10.2.5 Allowing for a minority interest 226 10.2.6 Terminal value 227 10.2.7 Discount rate 227 10.2.8 Cost of capital : 228 10.2.9 Some cautionary remarks 232 10.3 Assets basis 234 10.3.1 General rule.234 10.3.2 Winding-up.235 10.3.3 Suitability of fixed assets for their purpose 235 10.3.4 Formal net asset valuations 236 10.4 Minority shareholdings in property companies 237 10.4.1 Stock market's focus on asset backing 237 10.4.2 Dividends nevertheless are important 237 10.5 Asset backing and risk 239 10.6 Weighted-average techniques 239 10.7 Rules of thumb 240 10.8 Conclusion 241 Chapter 11: Choosing the appropriate valuation basis 245 11.1 Introduction 247 11.2 Controlling shareholdings 247 11.2.1 Manufacturing, trading or commercial companies... 247 11.2.2 Investment / property companies 247 11.2.3 When break-up value is relevant 247 Xlll

11.3 Minority shareholdings 248 11.3.1 The basic rule 248 11.3.2 Many exceptions to the basic rule 248 11.3.3 Some further points 250 11.4 Dividend irrelevance proposition 251 11.4.1 Effect of dividend policy with perfect markets, rational behaviour and perfect certainty 252 11.4.2 What does the market 'really' capitalise? 255 11.4.3 Earnings, dividends and growth rates 257 11.4.4 Effects of dividend policy under uncertainty 257 11.4.5 Dividend policy and market imperfections 260 11.5 Conclusion 263 Chapter 12: Goodwill and other intangibles 265 12.1 Introduction 267 12.2 Tangible and intangible assets 267 12.3 Goodwill 268 12.3.1 Its nature 268 12.3.2 As defined by the courts 268 12.3.3 Super-profits definition 268 12.3.4 As defined in accounting standards 270 12.3.5 'Positive' and 'negative' goodwill 270 12.3.6 Goodwill - a non-separable asset 271 12.4 Intellectual property rights 271 12.4.1 Patents 272 12.4.2 Trademarks 274 12.4.3 Registered designs 275 12.4.4 Copyright 276 12.4.5 Brands 276 12.5 Valuation techniques 277 12.5.1 Royalty method 277 12.5.2 Premium pricing technique 278 12.5.3 Earnings basis : 278 12.5.4 An illustrative brand valuation, 279 12.6 Deferred revenue expenditure 282 12.7 Conclusion 282 Chapter 13: Options, warrants and convertibles 285 13.1 Introduction 287 13.2 Share options 287 13.2.1 Traditional options 287 13.2.2 Traded options 287 13.2.3 Market terminology 290 13.3 Pricing of options 290 13.4 Uses of share options 291 13.4.1 Options used to hedge risks 291 13.4.2 Options used as highly-geared investment 292 13.4.3 Options as speculative devices 293 13.5 Stock Exchange warrants 293 13.5.1 Introduction 293 13.5.2 Gearing ratio 294 XIV

13.5.3 Conversion premium 294 13.5.4 Capital fulcrum point 294 13.5.5 Volatility factor 295 13.5.6 Intrinsic or formula value 295 13.5.7 An illustrated example 295 13.5.8 Covered warrants 296 13.6 Quoted convertibles 296 13.6.1 Basic characteristics 296 13.6.2 Value on the income differential basis 296 13.6.3 Implied value of conversion rights 297 13.7 Unquoted share options 298 13.7.1 A suggested valuation approach 298 13.7.2 Cross-checking the results of the valuation 299 13.8 Unquoted convertibles 300 13.8.1 Income differential method of valuation 300 13.8.2 Valuing the straight debt and conversion rights separately 301 13.9 Conclusion 302 Chapter 14: Fixed interest securities and miscellaneous valuation topics.. 305 14.1 Introduction 307 14.2 Fixed interest securities 307 14.2.1 General characteristics 307 14.2.2 Required rate of return 307 14.2.3 Inverse relationship between yield and value 307 14.2.4 Flat yield 308 14.2.5 Yield to redemption 308 14.2.6 Published yields 309 14.2.7 Valuation technique illustrated 309 14.2.8 Participating preference shares 310 14.3 Deferred shares 310 14.3.1 General characteristics...'. 310 14.3.2 Valuation considerations 310 14.3.3 An illustrative valuation,311 14.4 Non-voting ordinary shares 312 14.5 Valuations cum div and ex div 313 14.6 Prior sales 314 14.7 Purchase by a company of its own shares 315 14.7.1 General considerations 315 14.7.2 Controlling interests 315 14.7.3 Effect of the buy-back on the other shareholders... 315 14.8 Conclusion 317 Chapter 15: Legal or binding valuations 319 15.1 Introduction 321 15.2 Binding force of the valuation 321 15.2.1 Fraud or collusion 322 15.2.2 An erroneous principle 322 15.2.3 Speaking certificate 324 15.3 Valuer's liability for negligence 324 15.4 Representations to the expert valuer 327 XV

15.5 Interpreting the terms of reference 328 15.5.1 Identifying the value concept 328 15.5.2 'Net assets including goodwill' formula 329 15.5.3 Discounted or full pro rata basis 330 15.6 Fair value 332 15.6.1 Distinction between fair value and market value 332 15.6.2 Fair value as interpreted in Dean v Prince 332 15.7 Procedure 343 15.7.1 Accepting the engagement 344 15.7.2 Obtaining information 344 15.7.3 Valuation summary 346 15.7.4 Form of certificate 346 15.7.5 Conduct during and after the valuation 346 15.8 Conclusion 348 Chapter 16: Fiscal valuations: Statutory open market value 351 16.1 Introduction 353 16.2 Requirement for fiscal valuations 353 16.2.1 Inheritance tax 353 16.2.2 Capital gains tax 354 16.2.3 Stamp duty. 355 16.2.4 Income tax 355 16.2.5 Statutory open market value 356 16.3 Interpreting the valuation hypothesis 357 16.4 Information available 357 16.5 Share transfer restrictions 358 16.6 Purchaser orientation of the valuation hypothesis 358 16.7 Open market 361 16.8 Special purchaser 362 16.8.1 Effect on price 362 16.8.2 As illustrated in IRC v Clay 362 16.8.3 As illustrated in Glass v IRC 363 16.8.4 And other cases 364 16.8.5 Dicta in the Grossman and Lynall cases 364 16.8.6 Conclusions to be drawn from the case law 365 16.8.7 General conclusions 366 16.9 Hindsight inadmissible 367 16.10 Combined holdings 368 16.11 Expenses of sale not deductible 368 16.12 Time of hypothetical sale ; 369, 16.13 Consideration in cash 369 16.14 Conclusion 369 Chapter 17: Fiscal valuations: some practical points 371 17.1 Introduction 373 17.2 Relevance of case law 373 17.3 The influence of The Stock Exchange 373 17.3.1 Minority shareholdings 373 17.3.2 Controlling interests 374 17.4 Non-dividend paying minority shareholdings 375 17.4.1 Valuation in commercial, ie non-fiscal, situations... 375 XVI

17.4.2 Institutional investors 376 17.4.3 Private individual as investor 376 17.4.4 Relating commercial practice to fiscal open-market value 377 17.4.5 A suggested approach 377 17.4.6 An illustrative example 379 17.4.7 Hypothetical dividend yield basis 381 17.5 Shareholder with other roles in the company 381 17.5.1 Relevance to going-concern value 381 17.5.2 Effect of the statutory valuation hypothesis 382 17.5.3 More significant for the controlling shareholding.... 383 17.5.4 Thin capitalisation 383 17.6 Valuations as at 31 March 1982 384 17.6.1 High marginal saving in tax 384 17.6.2 Premium for control - a perceived unfairness 385 17.6.3 Advisability of a fully reasoned report 385 17.6.4 Relevance of prior sales and previously agreed values. 386 17.6.5 Fully taxed PE ratios 387 17.7 Goodwill 388 17.8 Conclusion 389 PRACTICAL INFORMATION 393 Section A: Valuation questionnaire/checklist 395 Section B: Engagement letters 407 Section C: Form of report 417 Section D: Financial analysis 419 Section E: Case studies 433 Section F: Selected statistics and data for 31 March 1982 valuations 481 Bibliography 539 Books 539 Articles 540 Other.542 Table of Cases 543 Index 547 xvn