Question 12.E.6: Mojave plc supplies frozen desserts to supermarkets and rest...
Mojave plc supplies frozen desserts to supermarkets and restaurant chains throughout the UK. The business has enjoyed strong growth since it was formed six years ago and is now considering a listing on the Stock Exchange. At a forthcoming meeting of the board of directors, the likely price of the business’s shares upon listing is one of the key items on the agenda.
The draft financial statements for Mojave plc for the most recent financial year are set out below:
Statement of financial position as at 30 November 2019
ASSETSNon-current assetsProperty plant and equipmentLand and buildingsMotor vansFixtures, fittings and equipmentCurrent assetsInventoriesTrade receivablesCash and cash equivalentsTotal assetsEQUITY AND LIABILITIESEquityOrdinary share capital (£0.25 nominal)Retained earningsNon-current liabilitiesLoan notesCurrent liabilitiesTrade payablesTaxationTotal equity and liabilities£m19.12.66.728.42.35.91.39.537.912.013.625.68.03.80.54.337.9Income statement for the year ended 30 November 2019
RevenueCost of salesGross profitDistribution expensesAdministration expensesOperating profitFinance expensesProfit before taxationTaxationProfit for the year£m40.6(21.5)19.1(6.7)(7.2)5.2(0.8)4.4(1.2)3.2The assets of Mojave plc have recently been provided with the following independent valuations concerning realisable values:
Land and buildingsMotor vehiclesFixtures and fittingsInventoriesTrade receivables£m29.82.04.13.54.7The following additional information is also available:
1 The current dividend payout ratio is 60 per cent.
2 Dividends are expected to grow at the rate of 5 per cent per year for the foreseeable future.
3 The required return to equity shares in similar companies listed on the Stock Exchange is 9 per cent.
4 The average price/earnings (P/E) ratio for similar businesses listed on the Stock Exchange is 12.6 times.
Required:
(a) Calculate the value of an ordinary share in Mojave plc using the following valuation methods:
(i) net assets (net book value) basis;
(ii) net assets (liquidation) basis;
(iii) dividend growth basis;
(iv) price earnings ratio basis.
(b) State, with reasons, which one of the valuation methods identified in (a) above is likely to provide the most realistic estimate of the market price of an ordinary share in Mojave plc.
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(a) Net assets (net book value method)
(i) P0 = Net assets at statement of financial position values/No.of ordinary shares= £(37.9m−8.0m−4.3m)/48m= £0.53
(ii) P0 =Net assets at realisable values/No. of ordinary shares=[£m(29.8+2.0+4.1+3.5+4.7+1.3)−(8.0+4.3)]/48m= £0.69
(iii) P0=D0(1+g)/(r−g)
where
D0 = current dividend
g = expected annual growth in dividends
r = required rate of return
= £0.04 (1 + 0.05)/(0.09 – 0.05)
= £1.05
(Note: Dividend = 60% × £0.067 = £0.04)
(iv) P_0=P/E ratio × Earnings per share (EPS)
= 12.6 × £0.067
= £0.84
* EPS is calculated as follows:
EPS = £3.2m/48m
= £0.067
(b) The P/E ratio method, which reflects the market valuations of similar businesses within the same industry as Mojave plc, may produce the most realistic valuation for its shares. This method assumes, however, that Mojave plc has the same risk and growth characteristics as the industry average. Hence, the valuation produced is unlikely to be useful unless this assumption holds.
While the P/E ratio method is not a perfect valuation method, the other methods considered have even greater weaknesses. The net asset (net book value) method is limited by certain accounting conventions, such as historic cost and money measurement. As a result, the asset figures produced may not reflect current values and some valuable resources, such as internally generated goodwill and brands, may be ignored. The net asset (realisation) method is an improvement on the net assets (net book value) method as it provides market-based valuations. These valuations, however, are normally lower than the valuations of assets held when they are in use. In common with the net assets (net book value) method, this method may ignore certain valuable resources in the valuation process. Thus, both asset-based methods
discussed are flawed and may well produce conservative values.
Although theoretically appealing, the dividend growth model depends on the accuracy of forecasts made concerning key variables, in practice it is extremely difficult to predict dividends and growth rates over time. Furthermore, this method cannot be applied where a business does not distribute dividends.