Value the Galen Holdings PLC

Business Valuation Methods – a Case Study of Galen Holdings PLC By MAO, Zhen Zheng

Introduction:

In this case study, I will value the Galen Holdings PLC, a medium-sized biotechnology company listed in London Stock Exchange (LSE), base on the varies valuation methods, and explain the differences in valuation. For the purpose of providing a better understanding of these methods, another three biotechnology companies are used as comparison. They are Acambis PLC, Celltech PLC, and Skyepharma PLC. Consider the comparability, all these four companies are listed in FT-SE 250.

Business Valuation:

What is a business value? Before a business is valued the purpose of the valuation must be determined. Different purpose results different values. There are a lot of purposes to value a business, such as buying or selling a business, transfer shares, employee stock option plan, going public. By the EMH, the business value is determined by the market, which provide a fair value of the business. Simply, a listed company’s value is how much you can sell or buy the share in the open market. Thus, this case study will try to estimate the share value of the Galen Holdings PLC.

What the investors really want to know is why and how the share traded at the real market price, are there any clues about whether the share price will go up or down in the future. In other words, whether there is a fundamental value of a share? Unfortunately, as Crockett (2002) said ‘It’s not obviously clear’.

Theoretically, the fundamental value of a share is estimable. Generally agreed there are three main methods can be used to valuing a share (Pike & Neale 2003), that are dividend-discount model (DDM), price/earning ratio (PE ratio), and the net assets value model (NAV). In the following parts, each of these three methods will be used to test the value of Galen PLC, comparing with the competitors, and the methods employed will be estimated.

The dividend discount model approach:

First of all, the dividend-discount model will be employed to value the company. This model provides a classic formula that explains the underlying value of a share, which believes that the share is worth the sum of all its prospective dividend payments, discounted back to their net present value (Farrell 1985). There are two formulas can be used, P0=Div/r and P0=Div1/(r-g), where P0 is the present price of share, Div is the dividend per share, Div1 is the dividend per share at year 1, r is the required rate of return or the cost of capital, and the g represents annual constant percentage growth in dividend per share. The first formula assumed that the company would distribute a fixed figure of dividend per share in the foreseeable following years; the second assumed that the future dividend will growth in the fixed rate per year, which also called the dividend growth model (DGM), and the growth rate is less than the cost of capital.

Look at the Galen’s history dividend; final dividend was 1.66 pence per share at 25th-Jan-2002, final dividend at 2 pence per share at 24th-Jan-2003, and interim dividend at 1.2 pence per share at 25th-Jul-2003. If it is assumed that the final dividend at 1.2 pence per share at the first of 2004, then it can find that dividend has a growth around 20% per year (g=0.2). For the required rate of return (r) can calculated by the CAPM, r=rf + ß(rm-rf), where rf is the return of risk-free, which can seen as the rate of 3-month treasury bills, according to Financial Times the rate is around 3.8%; rm-rf is the market risk premium which usually assumed as 6% (i.e. Pike & Neale 2003), and according to Yahoo Finance the company’s beta is estimated at 1.79. Then the required rate of return is 14.54%.

Also there is an alternative formula to get the r, r=DIV1/P0 + (1-DIV/EPS) X ROE, where ROE means the return of equity, DIV/EPS is the payout ratio and 1-DIV/EPS equal the plowback ratio. Use the figure collected from the annual report, r=2.4/495 + (1-2/32) X 92042/671959, r=12.90%. Compare both two required rate of return (14.54% and 12.90%) with the rate of dividend growth (20%), one of the assumptions is conflicted, the r should be more than g, so the dividend-discount model is not suitable to value this company.

The problems with the dividend-discount model are not that it is wrong; indeed, most economists ...

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The problems with the dividend-discount model are not that it is wrong; indeed, most economists (i.e. Farrell 1985, Myers & Borucki 1994, etc.) agree that the theory is fine. The problem is the uncertainty surrounding both its components: the future stream of dividends and the appropriate discount rate. For example, does the zero dividend policy mean the company is no value? Of course, wrong. Look at the other three competitors, zero dividend policy are adopted by all of them, but they are still traded in the market. Furthermore, whether the company can insist the fixed dividend or growing rate forever? Impossible. Since no one can ensure there always have enough net NPV projects in the future. If no more valuable projects, dividends cannot be maintained. Thirdly, will the required rate of return are always exceed the growing rate of dividend? Not always. The Galen group is a good example for this problem. All in one, if shares change in the value, that must be the result of a change in either the prospective dividend flow or the right discount rate, or both.

The PE ratio approach:

Another best-known valuation method is the price/earnings ratio or multiple, which divides share prices by profits. Look at the group’s EPS for 2002, where the EPS was 32 pence and the price for the close day of 2002 was £4.95. So the PE ratio equal to 495/32 = 15.47 times. This figure means that how much pence investors willing to pay for each penny of earnings per share of the group. Compare with the three competitors, this company’s PE ratio was quiet lower. Where Acambis’s PE ratio was 28.6 times, Celltech’s was 22.3 time, 21 times for Skyepharma, and the average of these three companies was 24 times. If we apply the average ratio into Galen’s current EPS, then we can find the price per share should be 32p X 24 = 768p. The real market price, however, was £4.95 only at the beginning of year 2003. Is it undervalued? Look into the trends in the following months, the price kept an upward tendency until to 10th-Nov-03, which closed at 773.6p, and the current PE ratio is 33.28 times which similar with the competitor Celltech (31.87 times), other two competitors are facing a loss. Base on these historical figure, it is clear that the company was undervalued at the beginning of year 2003. The market experienced a movement up to the real value during the following eight-months.

Is the PE ratio always a clear and simple way to value a business? As many literatures suggested that PE ratio is a reasonable indicator for share price ( Leibowitz & Kogelman 1990), really which is widely used to value a business, especially for the new issues. However, sometimes it is confusing. According to Louth (2003), Biotech companies’ shares are traded at around average 17-20 times expected earnings currently. It is little higher than the average on the FTSE All Share that is around17 times currently. Compare to the industry and FTSE all share average level, the Galen’s share seemed overvalued, theoretically it will go in down, investor should sell out the shares. But as discussed above, the current value of Galen is more close to the real value, and it still has a rising trends in the market. Look back to the group’s annual report, the groups keep a high increasing in the R&D expense and capital expenditure that around 30% growing rate per year, and the whole group shows a strong growing tendency. All these show the group has high present value of growth opportunities (PVGO), thus the share price will go up theoretically. The two results concluded from the PE ratio are conflicting, would the investors to buy or sell the shares currently? Confusing!

The trouble with the PE ratio, naturally, centers on the elusive “E”. Reported earnings is base on the past performance of the company, it is a historical figure, and which cannot show the future cash flow. Actually, investors only concern about how much they can earn in the future, not the history, when they make an investment decision. PE ratio is misleading also because that earning is only an accounting figure, which means different things for different firms. Companies can manipulate earnings in a variety of creative ways, such as adding sales of assets into income, changing depreciation policies, cutting back on provisions for bad debts, even repurchasing own shares to reduce the number of share outstanding.

The NAV method approach:

The third method will be used is the net asset value (NAV). Net asset value equal to the total assets minus the total liabilities, which is wholly belong to the shareholders, so it also called as ‘shareholders’ fund’ or ‘owners’ equity’. In other words NAV shows the minimum value of a business. Market analysts always compare it with the total market value of the business, and the module is called market-book ratio, which divides total market value by total book value of shareholders’ fund. For the Galen Group, the number of share outstanding is around 187,805,000, and the share price was £4.95 at the end of year 2002, so the total market value equal to £4.95 X 187,805 = 929,634,750. At the same time the total net book value of shareholders’ fund was 671,959,000, so the market-book ratio equal 929,634.75/671,959 = 1.38 times. Compare to other the competitors, Acambis’s was 5.93 times, celltech’s was 3.45 time and 2.07 times for Skyepharma, the average figure of these three companies is 3.82, the Galen’s market-book ratio is quiet lower. If investors believe the average market-book ratio was suitable for Galen, then the share price should be around £13.70 (= £4.95 X 3.82/1.38) per share. There is a quite difference with the real market price, even now, almost one year passed, the price still quite lower than that figure.

Why there is a big difference the theoretical and market value? It is because there are some problems behind this NAV method. First of all, the book value of fix assets are always out-of-date. Since such value are based on the historical cost, which cannot show the real market value. Although adjusting such value by current cost accounting method annually may more close to the market value, considering time and cost involved it would be unacceptable. Except the value of tangible assets, the intangible assets are not easy to value. Since biotech company always have significant intangible assets, some are recoded in the balance sheet but some not, such as the internal acquired goodwill and the new technologies. Thirdly, stock value are often unreliable since stock maybe recorded by different methods.

Conclusion:

Overview all of these indicators, none is wholly satisfactory. Since there are too many factors need to forecast, such as the future cash flow. Also those methods are too relying on the historical accounting figure, which may mislead. Earnings, for instance, may be massaged by clever finance directors easily. And the last, there are a lot of uncertainty, such as inflation and the rate of return required by the investors. Remember the concepts of EMH? The changing of share price is a random walk that just like tossing a coin, no indicators can show the price will go in up or down. Considering these facts, are share valuation methods rubbish?

Before answering this question, let us look into the share market. In the open markets, shares just like a common goods, which value is the price at which the shares would change hands between a willing buyer and a willing seller, neither both having reasonable knowledge of the facts or not. Except such valuation methods, there are also other significant factors that influence the share value. Economy environment can drastically change from time to time especially for particular kinds of industry. As interest rates go down, the value of the share goes up. Share price also follow the rule of supply and demand. When there are a lot of bills for sale in a particular share and few buyers, the value goes down. When there are a lot of buyers and few sellers, the value goes up. Biotech companies, for instance, just three years ago the average PE ratio was much higher in the industry, at around 25-30 times (Louth 2003), which reflect that investors had high confidence in the potential future profit. But now, which is only traded at 17 times of the earning, same lever as FT-SE all companies. As Laura (2003) said ‘ biotech companies angers investors’, once investor lost their confidence in the industry and do not willing to hold the shares any more, the price go down.

If market is efficient, the share prices fully reflect available information. The share price trends is just a random walk, and no one can control or predicate the share price will go up or down, unless they have extra or internal information. Thus all the works done to valuing share in the future is wasting time. Look at the method discussed above, all of them are unsatisfactory and sometimes are misleading. Since share price are influenced by a number of factors as discussed above.

None of such methods are wholly satisfactory, however this does not mean such valuation methods are rubbish. At least they provide different concepts of the business value. Base on such concepts, different group of people predicate different price that they will buy or sell the shares. By the endless new financial and non-financial information, the acceptable price level also be changed at any time. Thus none methods can predicate the share price correctly, since that is a human being and human are changeful.

In the case of Galen Group, the market price under the PE Ratio approach was £7.68, NAV approach value is £13.70, and the DDM approach value is nil. The real market price, however, was £4.95 at the balance sheet day. There is a big difference between the result of each methods and the real market price. It is difficult to say that which method is better or not, since these methods have their own advantages and disadvantages. They just provide a basic concept about the share value in the market.

Reference:

Farrell, J, L. (1985), ‘The Dividend Discount Model: A Primer’, Financial Analysis Journal, Nov-Dec, p16-25.

Laura, S. (2003), ‘Biotech Comp Angers Investors’, online, Investment Dealers’ Digest, 3/3/2003, Vol. 69, Issue 9. Available from: http://www.emeraldinsight.com/ft

Leibowitz, M. L. and Kogelman, S. (1990), ‘Inside the P/E Ratio: The Franchise Factor,’ Financial Analysis Journal, Nov-Dec, p17-35.

Louth, N. (2003), ‘Jargon buster: Understanding P/E ratios’, MSN Money, 4th Nov 2003.

Myers, S. C. and Borucki, L. S. (1994), ‘Discounted Cash Flow Estimates of the Cost of Equity Capital – A Case Study’. Financial Markets, Institutions and Instruments, Vol 3, p9-45, August.

Pike, P. and Neale, B. (2003), Corporate finance and Investment, 4th edition, Prentice-Hall, Inc, London.