Valuation using Excess Earnings

The Excess Earnings method assumes that a business is worth the market value of the tangible assets plus a premium for goodwill if earnings are high enough. It takes the market value of tangible assets and multiplies it by a rate of return appropriate to these assets to calculate the earnings attributable to tangible assets. The assets earnings figure is then deducted from the total earnings to get earnings attributable to intangible assets or goodwill. The excess earnings are capitalized at an appropriate rate of return to get the value of goodwill.

The value of the business is the market value of tangible assets plus value of goodwill.

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Valuing "WPP WPP PLC"

Valuation Assumptions

Latest quoted share price	£
Number of ordinary shares

Required annual rate of return	%

Latest reporting financial year

Profit before tax	£
Interest expenses	£
Depreciation & other non-cash expenses	£

Operating tangible fixed assets (assets needed to run the business) - at market value
Land & buildings	£
Plant & equipment	£
Furnishings & fixtures	£
Inventory	£
Other tangible fixed assets	£

Required working capital to run the business	£
Required return from investment in assets	%

Current assets transferable to buyer - at market value
Cash & cash equivalent	£
Trade debtors	£
Other current assets	£

Liabilities assumed by buyer - at market value
Total short-term liabilities	£
Total long-term liabilities	£

Valuation Results

£10.44 Highest price you can pay to get 10% annual return	12.5% Your annual return if you pay at market price £8.35
100.5% Your annual return if you pay at intrinsic value £1.04	-87.5% Value Vs Price variation

Calculations

Profit before tax	£323,666,667
+ Add interest expenses	£377,000,000
+ Add current depreciation & non-cash expenses	£422,000,000
Adjusted profit before tax	£1,122,666,667
Total market value of tangible assets	£4,563,000,000
+ Add required working capital	£532,800,000
Total amount to be financed	£5,095,800,000
Annual cost of financing	£509,580,000
Excess earnings (£1,122,666,667 - £509,580,000)	£613,086,667
Intangible business value (£613,086,667 / 10%)	£6,130,866,667
+ Add market value of tangible assets	£4,563,000,000
+ Add transferable current assets to buyer	£13,670,000,000
- Less liabilities assumed by buyer	£23,247,000,000
Business intrinsic value	£1,116,866,667
Business intrinsic value per share	£1.04

+Tips & Advice

A company with strong business franchise often has consistent earnings with a long-term upward trend. Consistent earnings are usually a sign that the company is selling products that don’t need to go through the expensive process of change. The upward trend in earnings means that the business’s economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion. Steady earnings make profit projections more reliable. A company in a fiercely competitive industry is prone to booms and busts, and profits are often erratic. Its share price swings wildly, caused by the company’s unpredictable earnings and sometimes can create the illusion of buying opportunities for traditional value investors. Exponential growth in earnings is very hard to sustain. Very few companies have actually maintained high double-digit growth for a decade. Even when growth is well established, there are ceilings in every marketplace. As that ceiling is approached, growth becomes difficult to sustain and eventually fades. Look for businesses that can generate internally funded future long-term average sustainable growth of 10% to 20%.
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.
Working capital is the funds that are readily available for immediate short-term use. The faster a company expands the greater will be its working capital needs. Many business failures are due to lack of working capital. Supermarket business usually has negative working capital as most of its short-term funds are provided by its suppliers in the form of interest-free credits.
A stable company with a reliable cash flow can support a higher level of debt much more easily than a volatile company with erratic cash flows. The amount of debts a company takes on is normally influenced by interest rates. Low interest rates encourage companies to borrow more. Most debts are usually expired after a few years. As debts expire, they are frequently replaced but with different payment terms. Besides long-term interest-bearing debts, a company’s pension liabilities should also be taken into account when evaluating a business. A company is obligated to spend cash in topping up the pension fund if there is a significant deficit.