Valuation using Ability to Pay

This method is based on an idea that the company’s own cash flow should be able to pay for its acquisition over a reasonable length of time with a healthy margin left for safety. It assumes a buyer purchases the business using mainly money borrowed from lenders. It involves calculating the cash flow available for debt payments after deducting 20% to 50% as safety margin. The value of the business is the maximum loan amount that this cash flow can support.

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Valuing "WPP WPP PLC"

Valuation Assumptions

Latest quoted share price	£
Number of ordinary shares

Number of years to project
Required annual rate of return	%

Latest reporting financial year
Total cash & cash equivalents	£
Total interest-bearing debts	£

Market value	£
Sales	£
Sales annual growth	%
Operating profit margin	%
Corporate tax rate	%

Depreciation	£
Depreciation annual growth	%
Amortization	£
Amortization annual growth	%

Capital expenditure	£
Capital expenditure annual growth	%

Loans
Loan to value	%
Interest rate on loans	%
Loan term in years

Valuation Results

£11.95 Highest price you can pay to get 10% annual return	0% Your annual return if you pay at market price £9.80
10% Your annual return if you pay at intrinsic value £9.23	-5.8% Value Vs Price variation

Projection

Year	Growth	Sales	Depreciation	Amortization	Capex
2019	8.4%	£16,912,568,000	£230,710,067	£0	£335,276,000
2020	8.4%	£18,333,223,712	£242,014,860	£0	£355,727,836
2021	8.4%	£19,873,214,504	£253,873,588	£0	£377,427,234
2022	8.4%	£21,542,564,522	£266,313,394	£0	£400,450,295
2023	8.4%	£23,352,139,942	£279,362,750	£0	£424,877,763

Calculations

Market price or asking price	£14,490,614,560
Loans from lenders at LTV 70% with interest rate at 5% for 10 years	£10,143,430,192
30% Cash provided from buyer	£4,347,184,368
Average revenue over the period	£20,002,742,136
Estimated operating profit margin (%)	11.7
Average operating profit over the period	£2,340,320,830
- Less average acquisition interest expenses over the period	£299,277,597
Average profit before tax	£2,041,043,233
- Less corporate income tax at 20.3%	£414,331,776
Average profit after tax	£1,626,711,457
+ Add average depreciation over the period	£254,454,932
+ Add average amortization over the period	£0
+ Add average acquisition interest expenses over the period	£299,277,597
Average net cash flow after tax	£2,180,443,985
- Less average capex over the period	£378,751,826
Average net cash flow before debt service	£1,801,692,160
- Less cash flow safety cushion required	£434,718,437
Net cash flow available for debt service	£1,366,973,723
Maximum loan that can be supported by cash flow	£10,555,408,742
Value of company operations (£10,555,408,742 / 70%)	£15,079,155,346
+ Add cash & cash equivalents	£2,643,000,000
- Less total interest-bearing debts	£6,077,000,000
Business intrinsic value	£11,645,155,346
Business intrinsic value per share	£9.23

+Tips & Advice

Sales are generally more predictable than earnings and can give a useful indication of the company’s positions in its markets. Sales growth from organic operations such as price increases, new products and new markets are much cheaper and more sustainable than growth from acquisitions. Big and too many acquisitions can lead to culture clash and goodwill write-offs when the economy take a turn for the worst. Look for businesses that can generate internally funded future long-term average sustainable growth of 10% to 20%. Very high growth rates rarely last.
Operating profit margin or return on sales shows management’s ability to manage costs, overheads and operate efficiently. It also indicates a company’s ability to withstand adverse conditions such as falling prices, rising costs or declining sales. A well-managed company tends to have stable or increasing margins. Beware if they are declining rapidly, especially on profit margins of only 5%, there is little room for error. With the exception of the supermarket business that is often heavily dependent on volume and usually has a low return on sales. Operating margins of 7.5% should be the minimum and 10% to 20% would be the ideal range. Cross-check with return on total assets for a more reliable business performance check.
Risk-free rate is a theoretical rate of return that an investor would expect from a totally risk-free investment over a specific period of time. In the real world, every investment has a risk. For business valuation purposes, most investors estimate the long-term risk-free rate using the US government 10-year treasury bill, UK government 10-year gilt or the German government 10-year bund. This is because these three countries are seen to have a stable economy and are highly unlikely to default on their bonds.
Depreciation is an allocation of the cost of an asset over a period of time for accounting and tax purposes. It is charged against earnings on the basis that the use of capital assets is a legitimate cost of doing business. Highly competitive capital-intensive business such as car manufacturer often has depreciation expense runs anywhere from 22% to 57% of its gross profits. Companies with strong business franchise such as Coca-Cola and Procter & Gamble depreciation expense runs between 6% to 8%. Depreciation is also a non-cash expense that is added back to net income to determine the company’s cash flow.
Many businesses, legally, take advantage of financial engineering to minimise the tax payable on their underlying activities. In a sense, reported profit can be thought of as the sum of “real” earnings and “artificial” tax manoeuvres. Where a tax rate appears low, the underlying profit may be lower than the reported figures suggest. Companies sometimes can enjoy tax-driven benefits because of loss carry forwards but this will eventually become exhausted. A consistent trend of apparently low tax rates than the expected rate is a strong danger signal.