Evaluation Of Why Poundland Seeks A Stock Market Listing

Table of Contents

Appendix

List of Abbreviations

IPO Initial Public Offer

DVM Dividend Valuation Method

EBM Earnings Based Method

DCF Discounted Cashflow Method

NPV Net Present Value

FCF Free Cashflow

WACC Weighted Average Cost of Capital

APV Adjusted Present Value

CEO Chief Executive Officer

IntroductionPoundland is a chain of stores which commenced business in April 1990. Founded with a start-up capital of £50,000 by Dave Dodd and Stephen Smith, the business offers and prices a variety of commodities based on the principles of single-price retailing, selling all products at prices not more than £1.

Trading for about 24 years, on 18^th February 2014, the company made an Announcement of intention to float on the London Stock Exchange , and on 12^th March 2014, announced an Initial Public Offer (IPO) of 125,000,000 shares priced at 300 pence per unit. The floatation is estimated to raise £375,000,000 in revenue and a market valuation of £750,000,000 according to Poundland s Prospectus.

Manuela, (2011) defined an IPO as the first offering of a company stock to the local stock market to raise capital and motivate public involvement in its shares and affairs.

This piece of work is carried out to evaluate the reasons why Poundland seeks a stock market listing and to examine the main valuation techniques available to assist the advisors to Poundland s.

Finally, the study will be concluded with recommendations made on which business valuation technique meets the purpose of an IPO and will be preferred by the advisors in reaching their estimates.

Evaluation of Why Poundland Seeks a Stock Market ListingGetting listed comes with costs and consequences which should be considered in the face of accruable benefits. With appropriate plan to deal with costs and consequences, it s beneficial for private companies to go public.

The question why go public? enjoys lots of attention from the academia and business world. Hahn et al, (2013) observed there are lots of benefits that accrue to a company and its primary investors if listed. Bodnaruk, et al., (2007) and Mantecon and Poon, (2009), opine that going public creates the opportunity for the primary investors to sell part of their stakes and diversify their portfolio. To do this, they often accept underpricing of their shares during the IPO. Subsequent to the IPO, it s expected that primary investors retained shares can be traded at favourable prices. Aggarwal, et al., (2002), Cao, et al., (2004), and Boot, et al, (2006) identified insider holdings liquidation, lower cost of capital and higher liquidity is to be enjoyed by being listed. In their study, Brau and Fawcett, (2006) find that business executives go public to finance further acquisitions and as observed by Mantecon and Poon (2009), stock exchange in an acquisition is perceived more favourable. Hsieh, et al. (2011) opines that valuation uncertainties are eliminated upon being listed as the market reflects how investors value the company.

According to Poundland s Chief Executive, the company is very cash generative with hardly any debt and future investment decisions will be financed from its cash-flow suggests Poundland s motive for seeking a stock market listing is not primarily to raise capital as is usually the case with most IPOs.

Poundland listing will reduce ownership concentration. Uno and Kamiyama, (2010) suggested that de-concentration of ownership increases firm s value as corporate governance is strengthened in businesses with large shareholders.

Being listed enhances shares liquidity making it possible for Warburg and other early investors to trade their shares in the open market as the uncertainty of valuation has been eliminated.

Usual IPO underpricing and information asymmetry in stock markets is likely to influence Poundland s share prices positively. With primary investors keeping a large portion of their holdings, positive signalling effect occurs which is expected to drive up demand and market capitalization. Thus, earlier investors can profit from increased shares price profit which wouldn t accrue without being listed.

When need be for extra finance, Poundland will get favourable terms.

Valuation TechniquesQuindlen, (2000) opines that the determination of business value is a challenge. Reviewing Waldron and Hubbard, (1991) May and Simmons, (2001) suggest business valuation is more of an educated guess especially considering private companies like Poundland. Copeland et al, (2000) regards it as imprecise due to its high sensitivity to changes in factors used.

Guo et al. (2005) suggests business valuation is vital for IPO pricing. Finance literatures usually class business valuation technique into Asset Based Approach, Market Based Approach and Income Based Approach. For the purpose of Poundland s IPO, valuation techniques will be listed as five.

1. Asset Based Approach

2. Market Based Approach

3. Earnings Based Method

4. Dividend Valuation Method

5. Discounted Cash-Flow Method

The later three valuation methods are a variation of the Income Based Approach which is based on discounting future payoff into present value. For a going concern, discounting is to infinity. Sjoqvist and Stepanovych, (2008) observed that DVM and DCF are reflective of direct income to the shareholders from the company and the EBM is reflective on income as reported in company s books.

Soffer and Soffer, (2003) opines that, under similar assumptions there isn t much difference in value when using any of the three income streams. West and Jones (1999) suggest the choice of income stream to be used will be determined by ease of projections, company type and valuation purpose.

Asset Based Approach

This method relies on figures from the Statement of Financial Position and values a business as the fair value of underlying assets assuming a sale/replacement. Valuation of intangible assets or assets with no efficient market makes this method hard to use. It ignores earning potential and future cashflow, thus, it s more appropriate for liquidation purposes

It could be used for going concern purposes if the substance value is positive. Nilsson et al (2002) defines substance value as net assets after liabilities. Lunden, (2007) opines once substance value is negative, the asset based method is useless.

Lunden, (2007) observed that if market values of assets are readily available, the method is of use for businesses dependent on tangible asset usage like real estate or transportation companies. Nevertheless, such valuation may tend to ignore items not on the statement of financial position and Sjoqvist and Stepanovych, (2008) advises the method be used for comparing values with estimates of other valuation methods.

Market Based Approach

This approach values businesses using similar companies with a known market value as the basis of estimation. The basis of comparison may be against a similar listed company or a sold/acquired company.

A better option will be the listed company as its shares prices are readily available. However, business value of an acquired/sold business may be estimated by a look at the books of the Prey Company before and after the acquisition. Pratt et al, (2000) suggest this information should not be used without adjustments. Lunden suggests adjustments should be made for peculiarities of the business transfer like synergies, goodwill, and mode of payment amongst others.

This approach is easy to use once there is an eligible guideline company and it eliminates the need for projections like the Income Approach. The challenge is finding an appropriate guideline company and it ignores trends that are peculiar to the subject company as it s more focused on current value of Guideline Company than its history or forecasts. Also, there is a risk of transferring wrong business estimation from Guideline Company to Subject Company.

Earnings Based Method

Business value is estimated as book value plus projected future earnings discounted to present value. This method makes dividend policy irrelevant. Penman, (2007) argues that profitability and investment growth influences value and investors interest. Thus, emphasis is laid on wealth creation as opposed to wealth distribution of the DVM.

According to Jiang and Lee, (2003) share repurchases is often used by management as a form of wealth distribution. The position is that the earnings method naturally reflects changes in cash payouts in whatever form.

Since earnings are subject to accounting principles and exposed to creative accounting, they are looked upon with scepticism in business value estimation. However, according to studies by Cheng, (2005) in companies with strong ethics and corporate social responsibility, the Earning Based Method provides reasonable value estimation.

Dividend Valuation Method

This method is based on the premise of infinite dividend payment. Business value is estimated as the present value of future dividend payment. Though, dividends are tangible cashflow that accrue to investors, Penman, (2007) argues that DVM does not relate to value as it ignores capital gain element of payoffs in its forecast.

The assumption of infinite dividend payment and steady dividend growth rate makes it problematic for adoption as a business valuation method especially for corporations with erratic or no dividend policy. Steady growth rate is not defined and has to be estimated from historical data and could be manipulated. Another problem of the constant growth assumption is a situation where dividend growth rate exceeds expected rate of return as is the case with high-growth companies, a value cannot be calculated using the DVM.

According to studies carried out by Francis et al, (2000) the DVM is classified low in performance compared to other valuation model in terms of accuracy, explainability and bias

Discounted Cash Flow Method

It values a business as NPV of its estimated future free cashflows using an appropriate discount rate that s reflective of the risk associated with the company.

Cashflow is looked upon favourably as a valuation basis because it represents the business earnings potential and ability to continue to make such earnings. It s the investors primary benefit stream as dividends are paid from cashflows and not earnings/profit figures.

It is the most used valuation method due to its applicability. Forecasting FCF demands a thorough understanding of the business operations. It focuses on both current and future positioning of the company. However, Damodaran, (2002) observed that DCF method is easily manipulated as slight changes to factors of calculation can have immense influence on terminal value. Sjoqvist and Stepanovych, (2008) suggests that projected future cashflows and discount rate used are speculative especially private companies like Poundland with no beta which creates difficulty in reaching an objective discount rate.

However, DCF appeals more than other valuation methods if prudence is applied to underlying assumptions and estimation of inputs. Steiger, (2008) finds that DCF is a strong tool for a variety of asset and business valuation and the analysis of effects of changes in differing economic scenarios on company s value.

ConclusionIt is safe not to estimate business value using a single valuation method as they all have inadequacies and subject to manipulation. The use of multiple valuation method is encouraged. Although they give differing estimates, it s an intelligent basis for IPO pricing.

Business Valuation for Poundland s IPO involves projected data based on assumptions which must be realistic and reliable for estimated value to be accepted as reasonable.

DCF is more favoured. Anderson et al, (2007) suggests the Income Approach is most accepted for business valuation and DCF is the most common method under this approach. Despite its shortcomings, it s a strong valuation tool and Demirakos et al. (2004) argues it s extensively taught compared to other methods. Steiger, (2008) advises that in the face of its shortcomings, it should be used in combination with other methods to eliminate shortfalls.

DCF is highly sensitive to slight changes in input especially the discount rate. This is the WACC and it s a function of cost of equity and cost of debt. Morningstar, (2007) suggests businesses with stable cashflows like Poundland tend to have a low capital cost hence an increased value. A change in this assumption will have huge impact on its final estimate.

RecommendationThe Income Approach to business valuation is preferred in Poundland Valuation and DCF should be used in its estimation. Although, this valuation method is not necessarily superior, cashflow as an investors benefit stream has advantages over earnings and it s an indication of the ability to maintain earnings and dividend payment.

Anderson et al (2007) argues that in the absence of a market price, a reasonable choice of business valuation is economic income or capitalized income . Investors are more interested in income that accrues from their investment.

Poundland has a proven record of cashflow generation, future cashflow forecast and business value estimation can be said to be reliable.

A variation of the DCF the Adjusted Present Value may be considered as it allows the base case NPV to be known before arriving at NPV using the WACC. However, the APV and NPV yield the same results after adjusting for financing effects.

All-equity capital is more expensive compared with equity plus debt. This reduces WACC, increases value and tax savings. According to Poundland CEO, the company has hardly any debt. After listing, the company can raise debt instrument at favourable terms, reducing the discount factor on subsequent DCF estimation.

Nevertheless, it s recommended that no valuation method should be used in isolation.

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