Summary and Conclusions

To determine a realistic issue price, management must translate a company's financial history and current status disclosed by published accounts into a desirable investment profile, based on stock exchange listings for similar firms already quoted on the market. As a basis for valuation, this profile should encompass the dividend yield, the P/E ratio (or its reciprocal, the earnings yield) and latest asset position. These are factors upon which the company will be judged by prospective investors to ensure full subscription when it comes to the market.

In our illustration, the company has two dilemmas.

First, the lower range of valuations for Bowie reflects a history of low dividend payout ratios, which could deter prospective investors. After all, a share's price is ultimately determined by the discounted sum of expected future dividends. And adequate dividend yields are necessary to attract investors, now as well as in the future, who seek regular income.

On the other hand, it can be argued that the dividend valuations currently prepared for Bowie are obviously low because they are based on the capitalisation of a perpetual annuity, which is constant. It ignores any allowance for growth and the possibility of capital gains incorporated into future share prices when the stock is eventually sold. The provision of further data using the Gordon growth model explained in Chapter Three can remedy this situation. But it is worth noting that a low dividend payout ratio should not necessarily worry the company. The market may interpret a low yield relative to earnings as a signal by Bowie that it has a profitable re-investment strategy.

You will recall from CVT that many companies offer high prospective dividend yields because they have no growth prospects and little idea of what to do with any cash surplus. Indeed, we have already observed theoretically, why Modigliani and Miller (MM) way back in the 1960s maintained that the purpose of a dividend is to return unused funds to shareholders. This is not to say that companies should ignore distribution policy altogether. But eventually, a company is more likely to fail if dividends are excessive, leaving too little earnings for investment.

However, this leads to our second point.

If companies seeking a stock exchange listing regard earnings as their primary valuation driver (which incorporates shareholders' future dividend and growth expectations to match those of its competitors) surely an earnings valuation should also exceed an asset valuation?

Without further information on the prospect of higher forecast levels of earnings for Bowie, the asset valuation multipliers, based on the relationship between market value and book value, produce the highest prices per share. But surely if the company is to expand and finance future growth, an earnings valuation should exceed an asset valuation, with the difference represented by what accountants' term "goodwill".

Unless there is something special about the firm's asset mix (such as a high proportion of recently valued property or investments) data drawn from its accounts is the least reliable measure of corporate worth, given the deficiencies of financial reporting based on GAAP analysis.

To conclude, the question that the company's chairman (Mr David) should address is not whether Bowie should seek a stock exchange listing, but whether it is worth more "dead than alive"?

Selected References

1. Hill, R.A., Corporate Valuation and Takeover (2011).

2. Gordon, M. J., The Investment, Financing and Valuation of a Corporation, Irwin, 1962.

3. Miller, M. H. and Modigliani, F., "Dividend policy, growth and the valuation of shares", The Journal of Business of the University of Chicago, Vol. XXXIV, No. 4 October 1961.

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