Returns and Capital

Returns and Capital

In practice, investment horizons used in equity markets by market participants can be very different and therefore, there are numerous approaches used to value companies. Some are grounded in fundamental corporate finance theory, some are the result of a fad or fashion that is the “flavour of the month”. However, whichever valuation approach is being used, the underlying question that the approach is trying to answer is the same: what return is being generated and how much capital is being used to generate the return? If a cash flow based valuation is used, the return (the company’s cash flows) and the company’s cost of capital (the discount rate calculated using a value of the company’s capital) will be used to calculate an absolute valuation. If a multiple-based valuation is used, return and capital multiples (P/E, EV/EBITDA) will be compared with those of similar companies to arrive at a relative valuation. 

Returns take many forms, commonly used market-based returns include metrics such as earnings, cash flow and returns based on other profitability measures. Capital can also take various forms, from the accounting-based capital employed (used in ratio analysis) to market-based equity and enterprise value capital. The key thing to remember is that the return that is used must be consistent with the capital that is being used. 

The most common forms of returns and capital used in valuation and analysis are as follows:

When looking at returns and capital, there are two basic valuation approaches: to value the whole of a company (the enterprise value or total firm value approach) or to value just the equity of the company (the shareholders’ share of value). The enterprise value approach will use returns (cash flow, profits, etc.) available to all the providers of capital, and the equity approach will just use the returns available to the equity shareholders. The enterprise value approach values all the capital provided to the company, whereas the equity value approach focuses on the value of the company’s shares.

In practice, the end objective is usually to calculate the equity value of a company to determine how much a company’s shares are worth. This could, for example, either be for a valuation being performed by an equity analyst on the buy or sell side or, if the valuation is being produced for a potential M&A transaction, to determine how much would be paid to acquire a 100% stake in the company.

An equity value produces the value of the shares directly and there is no more work required, but an enterprise value needs a bit more effort. The difference between the enterprise value and the equity value is called non-equity finance (or the “BG bridge”). This represents the proportion of the enterprise value owned by providers of capital other than the shareholders of the company. Determining the value of the non-equity finance allows the translation of an enterprise value into an equity value, so calculating the BG bridge correctly is a key element of determining the value of a company’s shares. The interaction between equity and enterprise valuations can be represented as follows:

BG Bridge

The valuation approach taken determines how the BG Bridge is used. For example, if an absolute valuation approach [e.g. a Discounted Cash Flow (DCF)] is used to calculate an enterprise valuation, the valuation starts at the left-hand side of the bridge with an enterprise valuation of operations, adds in non-core assets (which are not generally included in an absolute valuation) and deducts the elements of the bridge (net debt, provisions – including pensions – and minority interest) to arrive at an equity value. If a relative valuation approach is used to produce a valuation (i.e. the approach uses the company’s share price to calculate equity value and the market value of debt, etc.), then noncore assets do not have to be considered (they are assumed to be correctly valued by the market and included in the share price of the company). Exactly how this affects the approach to calculating returns and capital will be dealt with at a later stage as well as how non-core assets are incorporated into a valuation.

Key learning points:

1. There are various valuation approaches used in markets depending on the time horizon being used.
2. A pragmatic approach to valuation would use both fundamentally based and short-term valuation approaches.
3. Returns and capital are the core elements of valuation.
4. The BG bridge describes how an enterprise valuation is translated into an equity value depending on the valuation approach (absolute or relative) used.

Copy Right: BG COnsulting LTD 2014

BG Consulting

Ordinary Shares

An ordinary share forms the basic capital of a limited company. As a unit of ownership, shares convey a number of rights to the holder:

1.       Rights of Transfer – of ownership by sale (or gifting).

2.       Dividends – payments made by a company to its shareholders. When a company earns a profit, the cash can be put to two uses: either re-invested in the company (retained earnings), or paid to shareholders of the company as a dividend. Publicly traded companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.

3.       Right To Vote – the right to vote at members’ meetings on the major strategic issues of the company. These must be usually held at least annually (in the form of an AGM – Annual General Meeting) and on any major corporate action (e.g. mergers and acquisitions). In most cases, one share carries one voting right.

4.       Rights of Inspection – under normal circumstances, the shareholder has the right to inspect the shareholder list, minutes of shareholders’ general meetings, copies of the directors’ service contracts and various registers maintained by the company.

5.       Liquidation Rights – ordinary shareholders have the right to share in proceeds in the event of the liquidation of the company. However, ordinary shares have the last claim upon liquidation after trade creditors, debt holders and preferred shareholders have been paid.

6.       Pre-emptive Rights (anti-dilution clause) – under UK company law, on the issue of any new shares, the present shareholders must be offered the new shares to allow them to maintain their proportionate ownership in the company. Note that there are many countries, such as the USA, which do not require existing shareholders to receive pre-emptive rights on any new shares.

Understanding the Different Products in the Capital Structure

What is Equity?

Equity capital, or financing, is money raised by a business in return for a share of ownership in the company. It is permanent capital (it does not need to be repaid). Ownership of equity gives the right (but not an automatic entitlement) to share in the profits of the business, after all other stakeholders (employees, debt holders, the taxman) have been paid. Companies are under no obligation to pay dividends, and dividends cannot be offset against tax.

Owning equity is the riskiest form of investment in a company. Ordinary shareholders are the last to be paid in the event of the business failing. As compensation for this risk, equity holders generally earn the highest return. Investors in public listed companies are free to sell their shares without requiring the approval of the company. The returns for investors are a combination of dividends and capital appreciation.