MA 3103 Valuation Methods - Financial Analysis Quick or acid test ratio = Current assets – inventories

INTRODUCTION TO BUSINESS VALUATION Current liabilities

b.) Asset management ratios – a set of ratios that

● Valuation – is the analytical process of
measure how effectively a firm is managing its assets.
determining the current or projected worth of an
asset or a company. In placing a value on a b-1. Inventory turnover ratio – it shows how many
company, an analyst takes into consideration its times the particular asset is “turned over” during the
business management, the composition of its year. This ratio is calculated by dividing sales by
capital structure, the prospect of future earnings, inventories.
and the market value of its assets, among other Inventory turnover ratio = Sales__
metrics. Inventories

VALUATION CONCEPTS c.) Debt Management Ratios – a set of ratios that

Valuation is based on economic factors, industry measure how effectively a firm manages its debt.
variables, an analysis of the financial statements and
the outlook for individual firm. The purpose of a c-1. Debt ratio – the ratio of total debt to total assets;
valuation is to determine the long-run economic measures the percentage of funds provided by
value of a specific company’s common stock. creditors.
Debt ratio = Total debt_
Analysis of Financial Statements Total assets
1. Ratio analysis – involves conversation of financial
numbers for a firm into ratios. It allows comparison of c-2. Times-interest-earned (TIE) ratio – a measure of
one firm to another, since ratios look at relationships the firm’s ability to meet its annual interest
inside the firm. Ratios are divided into five categories, payments. It is determined by dividing earnings
namely: before interest and taxes (EBIT) by the interest
charges.
a.) Liquidity ratios – ratios that show the relationship TIE ratio = EBIT____
of a firm’s cash and other current assets to its current Interest charges
liabilities.
c-3. EBITDA coverage – this ratio is more complete
a-1. Current ratio – it indicates the extent to which than the TIE ratio in that it recognizes that
current liabilities are covered by those assets depreciation and amortization expenses are not cash
expected to be converted into cash in the near future. charges and thus are available to service debt and
This ratio is calculated by dividing current assets by that lease payments and principal repayments on
current liabilities. debt are fixed charges
Current ratio = Current assets__ EBITDA coverage = EBITDA + Lease payments__
Current liabilities Interest + Principal pmts +
Lease pmts
a-2. Quick or acid test ratio – this ratio is calculated .
by deducting inventories from current assets and d. Profitability Ratios – a group of ratios that show
then dividing the remainder by current liabilities. the combined effects of liquidity, asset management,
and debt on operating results.

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 e-2. Market/Book (M/B) Ratio – the ratio of a stock’s
d-1. Operating Margin – this ratio measures market price to its book value; it gives another
operating income, or EBIT per peso of sales; it is indication of how investors regard the company.
calculated by dividing operating income by sales. Companies that are well regarded by investors have
Operating margin = Operating income (EBIT) high M/B ratios.
Sales Book value per share = Common equity_
Shares outstanding
Market/book ratio = Market price per share
d-2. Profit Margin – this ratio measures net income Book value per share
per peso of sales and is calculated by dividing net
income by sales
Profit margin = Net income 2. Trend Analysis – an analysis of a firm’s financial
Sales ratios over time; used to estimate the likelihood of
improvement or deterioration in its financial
d-3. Return on Total Assets (ROA) – the ratio of the condition. To do a trend analysis, simply plot a ratio
net income to total assets. over time. Example: A graph that shows ROE has been
Return on total assets (ROA) = Net income declining since 2016 even though the industry
Total assets average has been relatively stable.

d-4. Basic Earning Power (BEP) Ratio – this ratio 3. The DuPont Equation – a formula that shows that
indicates the ability of the firm’s assets to generate the rate of return on equity can be found as a product
operating income; it is calculated by dividing EBIT by of profit margin, total asset turnover, and the equity
total assets. multiplier. It shows the relationships among asset
Basic earning power (BEP) = EBIT___ management, debt management, and profitability
Total assets ratios.

d-5. Return on Common Equity (ROE) – the ratio of ROE = Profit margin x Total asset turnover x
net income to common equity; measures the rate of Equity multiplier
return on common stockholders’ investment.
Return on common equity (ROE) = Net income_ = Net income x Sales x Total assets _
Common equity Sales Total Assets Total common equity

e. Market Value Ratios – ratios that relate the firm’s = Net Income _
stock price to its earnings and book value per share. Total common equity

e-1. Price/Earnings (P/E) Ratio – the ratio of the price

per share to earnings per share; shows the peso Notes: The profit margin shows how much the firm
amount investors will pay for P1 of current earnings. earns on its sales. The total assets turnover shows
Price/Earnings (P/E) ratio = Price per share_ how many times the profit margin is earned each
Earnings per share year. The equity multiplier is the adjustment factor. It
shows how many times the assets are greater than its
equity.

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ECONOMIC VALUE ADDED (EVA) VS. NET INCOME Exercise 1: Indicate the effects of the transactions
listed below on total current assets, current ratio, and
Economic Value Added (EVA) – is a measure of how
effect on net income. Use (+) to indicate an increase,
much management has added to the shareholders’
(-) to indicate a decrease, and (0) to indicate either no
wealth during the year.
effect or an indeterminate effect.
EVA = EBIT (1-Corp. tax rate) – (Total investors’
a. Cash is acquired through issuance of additional
capital) x (After-tax cost of capital)
common shares.
EVA = Net income – (Equity capital x Cost of equity
b. A fixed asset is sold for less than the book value.
capital)
c. A fixed asset is sold for more than book value.
Note: A positive EVA indicates that the company’s
shareholders actually earned more than they could d. Payment is made to trade creditors for previous
have earned elsewhere by investing in other stocks purchases.
with the same risk as the company. The difference e. A fully depreciated asset is retired.
between the net income and EVA is the return on the
equity capital that the stockholders invested in the f. Merchandise is sold on credit
firm because they could have invested in other
g. Equipment is purchased with short-term notes.
companies with comparable risk. We call this the cost
of a company's equity. h. The estimated tax payable is increased.

i. Cash is obtained through short-term bank loan

Exercise: Assume all of the company’s capital was
supplied by investors. The investor-supplied capital j.10-year notes are issued to pay off accounts payable
consists of P180,000 of notes payable, P800,000 of
Answer:
long-term debt, and P13,620,000 of common equity,
Total Current Current Effect on
totaling P14,600,000. We estimate its capital cost at Assets Ratio Net Income
10%. The cost of capital includes both debt and
equity. Thus, the firm’s total cost of capital is a. + + 0
P1,460,000. Its operating income is P4,800,000 and
b. + + -
its interest expense is P900,000. Tax is 40% of taxable
income. c. + + +

Required: Calculate the net income and EVA. d. - + 0

Net income = P4,800,000 – 900,000 e. 0 0 0

= 3,900,000 x (1-40%) f. + + +

= P2,340,000 g. 0 - 0

EVA = P4,800,000(1-40%) – (14,600,000 x 10%) h. 0 - -

= P2,880,000 – P1,460,000 i. + - 0

= P1,420,000 j. 0 + 0
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Exercise 2: Debt ratio Exercise 5: TIE ratio

The entity has an equity multiplier of 2.2 and its The entity has an annual sales of P50 million, its
assets are financed with some combination of average tax rate is 30%, its profit margin is 7%, and its
long-term debt and common equity. What is the debt operating margin is 12%.
ratio?
Required: (a) How much would be the company’s
Total debt = 2.2 – 1 = 1.2 interest charges? (b) What is the TIE ratio?

Debt ratio = 1.2 / 2.2 = 54.55% EBIT = P50 million x 12% = P6 million

EBT = P50 million x 7% = P3.5 million / 70% = P5

Exercise 3: Market/Book ratio million

The entity has P11,000,000 in assets. Its balance a) Interest charges = P6 M – P5 M = P1 million
sheet shows P1,200,000 in current liabilities,
b) TIE ratio = P6 million / P1 million = 6 x
P3,300,000 in long-term debt and P6,200,000 in
common equity. It has 846,000 shares of common
stock outstanding, and its stock price is P36 per share. Exercise 6: Current ratio
What is the market/book ratio?
A firm has current assets of P3,000,000 with a current
M/B ratio = Market price / Book value per share ratio of 1.2. Its quick ratio is 0.8.
BV/share = Common equity / shares outstanding Required: (a) What are its current liabilities, and (b)
inventory?
BV per share = P6,200,000 /846,000 = 7.33/share
a) Current liabilities = P3,000,000 / 1.2 = P2,500,000
M/B ratio = P36. / 7.33 = 4.91 x
Quick assets = P2,500,000 x 0.8 = P2,000,000
Exercise 4: Market/Book ratio b) Inventory = P3,000,000 – P2,000,000 = P1,000,000
XYZ Industries has P120 million in total assets. Its
balance sheet shows P30 million in current liabilities Exercise 7: DuPont analysis
and P20 million in long-term debt. It has 4 million
shares of common stock outstanding. It has a ABC International has an ROA of 12%, a 2.2% profit
market/book (M/B) ratio of 1.5 x . What is its market margin, and an ROE of 16%.
price per share?
Required: (a) What is its total assets turnover? (b)
Market price/share = M/B ratio x BV per share What is its equity multiplier?

BV per share = (P120M – 30M – 20M) / 4M shares a) Total assets turnover = 16% / (2.2% x 1.33333)

= P17.50 per share = 5.45456 x

Market price / share = P17.50 x 1.5 = P26.25 b) Equity multiplier = 16% / 12% = 1.33333

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Exercise 8: DuPont and Net income

The company has P6 million in sales, its ROE is 12%

and its total asset turnover is 3.2 x The company is
50% equity financed. What is its net income?

Net income = 12% x P6 million / (3.2 x 2) = P112,500

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