Valuation Methods in Financial Management

This document discusses various valuation methods in financial management, including the price/earnings ratio, dividend valuation method, and discounted cash flow method. It provides a detailed explanation of each method, along with their applications, benefits, and limitations. Additionally, the document explores different investment appraisal techniques such as the payback period, accounting rate of return, net present value, and internal rate of return.

Financial Management

TABLE OF CONTENTS
Question 2..................................................................................................................................3
a) Price/earnings ratio............................................................................................................3
b) Dividend valuation method................................................................................................3
c) Discounted cash flow method............................................................................................4
d. Critical evaluation..............................................................................................................5
Question 3..................................................................................................................................7
1. Application of different investment appraisal techniques..................................................7
2. Benefits and limitations of different investment appraisal techniques............................11
REFERENCES.........................................................................................................................15

Question 2
a) Price/earnings ratio
The price earnings (P/E) ratio is the ratio which is commonly utilized by the
businesses for the purpose of measuring the stock value of the company in relation to its per
share earnings. This approach is useful for valuing the companies which is having a record of
profitable business (Susanti and Ilhami, 2018). This technique is mainly used in valuing the
quoted companies but it can also be utilized for valuing the unquoted companies as well. For
example, the after-tax profit of the organization is £200,000 and was offered £1,000,000, then
the PER will be 5. The quoted companies mainly have greater PER where a growing and
larger company will have excellent prospect having ratio in excess of 20. For deriving the
value of the company, the P/E ratio of the similarly quoted company is used.
MPS 3.89
EPS 0.21
P/E ratio of Aztec (A) 18.52
Distributable earnings 40.4
number of shares 147
EPS of trojan (B) 0.27
Value per share of Trojan (A * B) 5.0004
Total market value 735.06
Statement showing valuation using price earning ratio
The table given above shows the valuation of the Trojan plc using the PER valuation
method. The value derived under this method is £735.06.
b) Dividend valuation method
Under this technique, mostly the Gordon Growth model is utilized by the businesses for
the valuation purpose. This is based on the assumption that the dividend will continue rise at
the fixed rate of growth indefinitely. Using this assumption, one can determine the fair price
of the stock to be paid today in respect to the future payments for dividend (Sharma, Parekh
and Dhanuka, 2018). It is very straightforward approach for determining the price of the
stock using future dividends as the base. The valuation can be done using the formula P = D
(1- g) / (K-g). This method is mainly useful for valuing the minority stacks in an organization
instead of complete company.

Current dividend (D) 0.13
Risk free rate of return (Rf) 5%
Return on the market (Rm) 11%
Beta (ß) 1.10%
As per CAPM, the required rate of
return = Rf + (Rm-Rf)*ß
= 5% + (11% -5%) * 1.10%
Required rate of return (K) 5.07%
Growth rate 2%
Market price per share = D*(1+g) / (K-g)
= 0.13 * (1+2%) / (5.07% - 2%)
MPS 4.32
Total market value 635.04
Statement showing valuation using Dividend valuation method
The calculation given above states the market price of the Trojan plc using the
dividend valuation method and it has taken in account the dividend, expected ROR along the
constant growth rate (GR) of the organization. The value of the company derived is £635.04.
c) Discounted cash flow method
The discounting cash flow (DCF) method of business valuation is utilized for the
purpose of evaluating the attractiveness associated with the speculation opportunity. DCF
approach makes use of future FCF projections and then discounting it by considering the
WACC to show up at a current worth, which is utilized to assess the potential for speculation,
frequently at the time of due diligence (He and Long, 2019). In case, if the value showed up
at through DCF approach is greater in comparison to the current COI, then the prospect can
be considered as the good one. Under this approach, the intrinsic value of the investment is
determined using the fundamental concepts of this approach. This method is effective for the
business organizations whose cash flows are presently positive and the forecasting can eb
done with some sort of reliability along with the proxy for risk that can eb utilized for
attaining the discounting rate.

Discounted cash flow
Net operating profit 40.4
Add: depreciation 0
Add: change in working capital 0
Less: change in capital expenditure 0
Free cash flow 40.4
Discounting rate = WACC = 9%
Pv of cash flow = Annual cash flow/discounting rate
Cash flow growth rate 2%
Market value per share = 40.4 / 9%
448.89
Total market value 65986.67
Statement showing valuation using Discounted cash flow method
The value of the company under the DCF technique is £65986.67 in which the free
cash flow and discounting rate is used for obtaining the present market value of the share.
d. Critical evaluation
Price/earnings ratio
Even though PER is very popular and widely used method but one cannot rely upon
it. It is important to use it with the other valuation methods in order to arrive at the correct
picture. There are various problems associated with it. The calculation of PER takes into
account only the market price of the share (MPS) and completely ignores the debt aspect of
the business. There are various businesses which are highly leveraged and are mainly
considered as the riskiest investment. Therefore, the higher PER of such organizations does
not bring much. The PER is based on the assumption that the net earnings of the organization
will remain stable and constant in the coming up years (SALSABILA, 2018). Also, the
earnings of the organization are depending upon the various other factors as well and which
can be volatile. Ideally, the investor mainly invests in the company which is continuously
generating cash flow through the lifecycle along with the increasing rate. But the PER does
not show whether the organization’s cash flow (CF) is going to rise or reduce in the coming
years. Therefore, it leaves the space for doubt in respect to the direction of the growth. It is
also been assumed that the organizations having very low PER such as 10 is very cheap in
compared to the companies having higher PER like 15. This valuation method does not
provide the information in regard to the quality of the company’s earnings. If the organization
is trading at the cheaper rate but has the poor quality of the cash flow, in that case it will not
be considered as an ideal investment plan.

Dividend valuation method
Just like other methods, this is also prone to certain problems or issues. The first and
the foremost import thing is that it is overly simplistic and in reality the dividends of the
organization does not grow at the stable rate and some organizations even raise their dividend
at the end of the time but some reduces it as well. Therefore, it is mostly meaningful for the
business organizations which consistently offers the constant dividend growth rate every
year. This approach only useful for the stocks that pays out the dividend and not suitable for
the small businesses who have performed well on long term but are not in the capacity to
offer dividend (Heaton, 2020). Thus, if the investor only put the focus over this model only
then they might miss other value added opportunities to their portfolio. There are different
types of factor that is having impact over the valuation like brand loyalty but this model
ignores all the non-dividend-based factors so there are chances that the result derived might
not be accurate. Along with that the buyback of the stock has an immense impact over the
shareholders value in terms of the return received. It forces the investors to make an
assumption that no such events will happen over the entire life of the businesses. Again,
under this, assumption is that the companies will offer stable rate of return which is their top
priority and for which the business might have to borrow additional funds for ensuring that
status. In case, where the earnings of the organization are not directly linked to their income
then this technique will become worthless.
Discounted cash flow method
The DCF technique is very sensitive to the assumptions in respect to the growth rate
along with the discounting rate. Even a small or slight mistake the DCF valuation will give
fluctuating value which will not be accurate and correct and leading to wrong decision
making. This approach performs well when there is greater degree of confidence in regard to
the cash flow. Along with that if the organization is not clear about its business and it
operation and lacks future visibility then in such circumstances it will be difficult to predict
about the future sales and operational expenditure including the capital investment with some
sort of certainty (TIKU, 2016). Another problem is that under DCF approach the terminal
value involves around 65-75% of the entire value, therefore, even a small error in the
assumption made in respect to the terminal year would be having a crucial influence over the
final valuation. The valuation changes with the variation in the expectation and based on
which the fair value will also change.

Based on the analysis of the various approaches to valuation, the PE ratio is the best
technique for the purpose of valuation. Since, it is very easy to apply and is very popular
among the businesses and the investors makes use of this approach in taking crucial
investment related decisions.
Question 3
1. Application of different investment appraisal techniques
a. The payback period
The PBP is very simplest method among all other investment appraisal methods. It
states about the time frame in which the company would be able to get back the amount it has
invested initially in the project. It is based on the assumption that shorter the PBP better it is
for the company for making an investment in the undertaking. It also helps in taking quick
business decisions.
Compute the payback period
(PBP)
Payback period (PBP)
3.79 years
The Lovewell Ltd can invest in purchasing the asset as it will take nearly 3.79 years
for getting back the money invested which can be considered feasible. Along with that, it also
signifies the greater earnings in the near future.
b. The Accounting Rate of Return
The ARR represents the return which is being expected from the money invested
while making a comparison with the amount invested initially. This investment evaluation
technique provides assistance to the businesses in making a better comparison among the
various projects in terms of the expected return from it. If the ARR is more than the cost of
capital deployed in the undertaking then it is acceptable to invest in it otherwise, reject it.
There are various approaches for determining the ARR one of the approaches is stated below.

Compute the average
investment
Average investment
£158,125
Compute the accounting rate of
return (ARR)
Accounting rate of return
Accounting rate of return
(ARR) 45.85%
Based on the above computation of ARR, it can be interpreted that the company can
make an investment in buying the asset since the ARR is higher than COC.
c. The Net Present Value
The NPV is the most popular method of analysing the investment. It considers the
NPV as the base for the purpose of determining whether the investment proposal should be
accepted or rejected. It utilizes the discounting rate for figuring the current value of the
investment being made. It is a very easy approach and can be made understandable by
anyone.

Calculating NPV
Cost £2,75,000
Life 6 years
Cost of capital 12%
Net annual inflow Annual cash flow-Annual cash outflow
(£85000-£12500)
£72500
Net present value (NPV) Present value of cash inflows- Present value of cash
outflows
Year Cash flow Amoun
t in £
Present value
factor @12%
Present
value
(PV) in
£
0 Outflow (cost)
-
2,75,00
0
1 -
2,75,000
1 Net annual cash inflows 72500 0.893 64732.1
4
2 Net annual cash inflows 72500 0.797 57796.5
6
3 Net annual cash inflows 72500 0.712 51604.0
7
4 Net annual cash inflows 72500 0.636 46075.0
6
5 Net annual cash inflows 72500 0.567 41138.4
5
6 Net annual cash inflows 72500 0.507 36730.7
6
6 Scrap value 41,250 0.507 20898.5
3
Net present
value £43,976
The present value (PV) in respect to the given case is £43,976 which means it is
positive and company can go for making an investment in the same and also it seems to be
profitable and economically feasible to invest.
d. The Internal Rate of Return
IRR determines the profits attached to the undertaking or the venture. At the IRR
rate, the NPV of the undertaking is made equivalent to the 0. Therefore, it becomes very

imperative for the organizations to consider the IRR before making any final decision on
account of business growth.
Computing the IRR using trial and error method
Year Cash flow Amount
in £
Present
value factor
@15%
Present
value
(PV) in £
0 Outflow (cost) -2,75,000 1 -2,75,000
1 Net annual cash inflows 72500 0.87 63043.48
2 Net annual cash inflows 72500 0.756 54820.42
3 Net annual cash inflows 72500 0.658 47669.93
4 Net annual cash inflows 72500 0.572 41452.11
5 Net annual cash inflows 72500 0.497 36045.31
6 Net annual cash inflows 72500 0.432 31343.75
6 Scrap value 41,250 0.432 17833.51
NPV £17,209
Year Cash flow Amount
in £
PV factor
@18%
Present
value
(PV) in £
0 Outflow (cost) -2,75,000 1 -2,75,000
1 Net annual cash inflows 72500 0.847 61440.68
2 Net annual cash inflows 72500 0.718 52068.37
3 Net annual cash inflows 72500 0.609 44125.74
4 Net annual cash inflows 72500 0.516 37394.69
5 Net annual cash inflows 72500 0.437 31690.42
6 Net annual cash inflows 72500 0.37 26856.29
6 Scrap value 41,250 0.37 15280.3
NPV £-6,144
IRR
17.18%ൌͳͷ ൅ ൅ ൅ ௧൅ ൅ ൅ ൅ ൅ ൅௦௧ ൅ ൅൅ ൅௩௨̷  ଵହΨ൅ ൅ ௧൅ ൅ ൅ ൅ ൅ ൅௦௧ ൅ ൅൅ ൅௩௨̷  ଵହΨି ൅ ൅ ௧൅ ൅ ൅ ൅ ൅ ൅௦௧ ൅ ൅൅ ൅௩௨̷ ଵ଼ Ψ
*(18-15)ൌͳͷ ൅ ൅ ൅ ൅ ൅ଵଶଽ൅ ൅ ൅ ൅ଵଶଽି  ሺି ൅ ଵସସሻ
*3ൌͳͷ ൅ ൅ ൅ ൅ ൅ଵଶଽ
ଶଷଷହଷ*3

As depicted, it can be very well inferred that it is useful for the organization to buy the
asset based up on the total assessment did above. The IRR is 17.18% which is around 17%
more than the cost of investment of 12% which isn't a lot higher and might not be unable to
enhance the venture. However, at that point as well, it is possible to make a venture by
buying the new machinery.
2. Benefits and limitations of different investment appraisal techniques
The Payback Period
Advantages
 This technique does not require many information and is found as simple for figuring
others kinds of investment analysis techniques.
 It encourages quick assessment of the task which empowers the supervisors in settling
on fast decisions, which is exceptionally crucial for the organizations having
constrained assets (Paseda, 2016).
 It uncovers basic data as undertaking with the short PBP has low risk and such data is
exceptionally important for organizations for rapidly recuperating their cost for
reinvesting in different sorts of opportunities that comes up.
 This method is helpful for the businesses that manages unsure conditions because of
fast technological upgradation. Such vulnerability makes troublesome in anticipating
future yearly money inflows. This, undertaking and utilizing the proposals with short
payback period help in minimising changes of causing misfortune by method of
devolution.
Disadvantages
 It overlooks time factor that is viewed as vital idea for business as it states cash got
most earlier is worth more prominent than the one which comes later because of its
potential for procuring extra return if reinvested.
 This procedure considers just those incomes till time an underlying speculation is
been regained. It comes up short for considering incomes which arises in the coming
up years, such restricted perspective on incomes may compel the organization in
disregarding the venture that can produce worthwhile incomes in coming years.
 This strategy is easy to such an extent that it doesn’t think about the ordinary
situations of business (Popli and Popli, 2019). As a rule, the capital ventures are not

considered as investment for one-time rather such sort of tasks requires further
measure of investment of money in future periods also.
 It doesn't ensure that the proposition with shorter period would create benefits. On the
off chance that incomes from venture stops at recompense period, the proposed
undertaking would be come about as unviable after a closure of payback period.
The Accounting Rate of Return
Advantages
 This approach helps with making examination of the new undertaking with the tasks
that are considered as cost-effective or with different sorts of activities which are
competitive by the nature.
 This method makes simpler for comprehension and processing PBP. It considers the
benefits that occurs over a time of projects whole life span (Arif, Noor-E-Jannat and
Anwar, 2016).
 It presents an unmistakable picture identifying with the undertakings profits by
separating normal yearly benefits to that of starting expense.
 ARR shows considerably more interest for return of its speculations, in this way, it
helps in fulfilling interest of proprietors according to their venture returns.
 Under this the ventures that has huge life span, the method helps in processing basic
rate of return (ROR)with that of actual ROR.
Disadvantages
 This strategy is known for overlooking the time factor at the hour of choosing
alternative utilization of the resources.
 It disregards the outside factors which ruins benefit procuring ability of undertaking
into account. This causes a confinement in gaining higher amount of the benefits for
an undertaking.
 This tool makes issues in decision making as under this individual project would
show up at the various outcomes on the off chance that ROI and ARR are evaluated
individually (Gheno, 2019).
 ARR doesn't consider money inflows into the account and is intrigued only with the
accounting profits.
 In this, the undertakings can't be evaluated where portions of a venture had been made
more prominent than two times in independent parts which makes it less useful
sometimes.

 This procedure disregards a period that project take for creating benefits or gaining
return as it overlooks the time span.
The Net Present Value
Advantages
 This strategy considers an impact of inflation on future undertaking's benefit, in this
way assesses time estimation of the cash.
 In NPV, the discounting rate could be balanced according to the risk present in the
industry, along a few different components for acquiring satisfactory yield.
 It helps in deciding estimation of speculation as under NPV, income for the duration
of the life of task could be procured, that encourages the firm in knowing future
estimation of specific venture (Siziba and Hall, 2019).
 NPV gives comparative examination of the qualities produced later on by in excess of
two same tasks in discovering generally attractive or achievable alternative.
 It discovers present estimation of the proposition through looking at an impact of a
few factors, for example, money inflows and risk.
 This strategy is expressed as generally efficient in deciding actual profitability of
venture in all its years length.
Disadvantages
 This evaluation technique incorporates gauging blunders as at the time of breaking
down reasonability of tasks, an estimation of the income probably won't be exact for
later years (Benallou and Aboulaich, 2017).
 As NPV depends primarily on the discounting rates, so even a minor deviation may
result to altogether a different NPV.
 It ignores the sunk cost, for example, preliminary, R&D and so forth, carried out
before venture start is essentially high. This expense is totally disregarded under
assessment of NPV.
The Internal Rate of Return
Advantages
 This procedure gives an equivalent significance to all incomes and is required to
decide the point in which NPV of the money inflow equals to estimation of the money
outpouring.

 It is considered progressively direct and famous strategy when contrasted with NPV
as it presents the accurate rate of return (Abor, 2017).
 IRR could be utilized for positioning distinctive forthcoming proposals and the
venture with higher IRR will be considered best.
 This technique considers time factor and hence observed as sensible when contrasted
with the ARR technique.
Disadvantages
 It is somewhat difficult and complex in terms of calculation as it computed using the
trial and error approach (Kulakov and Kastro, 2017).
 It doesn't consider capital expense and along these lines it must not be used for
contrasting the activities of the diverse term or timespan.
 This technique flops in perceiving fluctuating size of different venture proposition.

REFERENCES
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RATIO, RETURN ON EQUITY, AND RETURN ON ASSETS ON STOCK PRICE ON
REAL ESTATE AND PROPERTY SECTORS 2014-2016 (Doctoral dissertation,
STIESIA SURABAYA).
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EARNING RATIO AS A BASIS FOR ASSESSMENT OF SHARES. JAZ: Unihaz
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3514044.
Abor, J. Y., 2017. Evaluating Capital Investment Decisions: Capital Budgeting.
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