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Business valuations and market efficiency

Question 2

PE ratio valuation

BC Co is looking to take over ZJ Co, an unquoted company and has gathered
the following information:

Profit after taxation for the most recent accounting period was $250,000. This
was after deducting $15,000 for the write off of a bad debt and salaries of
$120,000 for managers who will no longer be employed if BC purchases the
company. Preference dividends of $25,000 and ordinary dividends of $45,000
were paid out of these profits. ZJ Co has no debt.

Quoted businesses similar to ZJ Co have an average PE ratio of 9. As ZJ Co is
unquoted, BC Co decides to reduce the calculated value by 20% when
determining ZJ Co’s value.

Calculate the value of equity in ZJ Co for BC Co’s purposes.

Maintainable profit figure: $250,000 + $15,000 + $120,000 – $25,000 =
$360,000

Apply average PE ratio: $360,000 × 9 = $3,240,000

Reduce by 20%: $3,240,000 × 0.8 = $2,592,000

Illustrations and further practice

Now try TYU question 2 from Chapter 20.

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