Assignment

Of
Business valuation

Discounted Cash Flow Valuation and Relative Valuation

Submitted to Submitted by:

Ankurima Goswami Sandeep kumar Paul
Assistant Professor, M.Com 3rd semester
Dept. of Commerce, Roll no: MCO17006
Tezpur University. Dept. of commerce
 ACKNOWLEDGEMENT

I like to express my gratitude to everyone who supported me throughout this

assignment and thankful to their aspiring guidance, invaluable and constructive
criticism and friendly advice during this assignment.
I would like to express my warm thanks to my course instructor,
Ankurima Goswami, Assistant Professor, Dept. of Commerce, Tezpur University
for support and guidance.
I would also like to thank all the people who provided me with the
facilities being required and conductive conditions for this assignment on
Discounted Cash Flow Valuation and Relative Valuation.

Thank You
 CONTENTS
SL NO. TOPICS PAGE NO.

1 Discounted cash flow 1

1.1 Used and applicability 1

1.2 Illustration of Discounted Cash Flow Valuation 2-3

2 Relative Valuation 4

2.1 Relative Valuation Multiples 4

2.2 Estimate Relative Value of Stock 5

2.3 Illustration of Relative Valuation 5-6

3 3. Conclusion 7

Bibliography 8

ii
1. Discounted cash flow
Discounted cash flow (DCF) valuation is a method of valuing a project, company, or asset
using the concepts of the time value of money. All future cash flows are estimated and
discounted by using cost of capital to give their present values (PVs). The sum of all future
cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the
value of the cash flows in question.

Using DCF valuation to compute the NPV takes as input cash flows and a discount rate and
gives as output a present value; the opposite process—takes cash flows and a price (present
value) as inputs, and provides as output the discount rate—this is used in bond markets to
obtain the yield.

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts
them, using a required annual rate, to arrive at present value estimates. A present value
estimate is then used to evaluate the potential for investment. If the value arrived at through
DCF analysis is higher than the current cost of the investment, the opportunity may be a good
one.

1.1 Used and applicability

The discounted cash flow method is used by professional investors and analysts at investment
banks to determine how much to pay for a business, whether it’s for shares of stock or for
buying a whole company.

And it’s also used by financial analysts and project managers in major companies to
determine whether a given project will be a good investment, like for a new product launch or
a new manufacturing facility.

It’s applicable to any scenario where you are considering paying money now in expectation
of receiving more money in the future.

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1.2 Illustration of Discounted Cash Flow Valuation
Table-1: Showing Cash Flow to Firm

Year Net Non- Interest Tax Rate Net Fixed Net Cash
income cash (percentage) assets Working flow to
charges investment capital firm
investment
2017-18 9000 6000 3500 30 7000 4000 6450
2016-17 9500 6500 4500 30 8000 4500 6650
2015-16 11000 6400 3000 30 5000 2900 11600
2014-15 12500 5120 2110 30 5210 4100 9787
(Figures are in lakhs)
*Note= Projected amount are taken
The formula used for calculating Cash flow to Firm is:

Cash flow to Firm = Net Income + Non-Cash Charges + [Interest * (1- Tax Rate)] – Net
fixed Capital investment – Net Working Capital Investment + Preference Dividend.

Table-2: Showing Cash Flow to Firm

Year Cash Interest Tax Preference Net Cash

flow to Rate(percentage) Dividend borrowing flow to
firm Equity

2017-18 6500 4560 30 0 9000 18692

2016-17 4950 2980 30 0 11000 18036
2015-16 7640 3200 30 0 8900 18780
2014-15 8240 2150 30 0 8500 18245
(Figures are in lakhs)
The formula used for calculating Cash flow to Equity is:
Cash flow to Equity = Cash flow to Firm - [Interest * (1- Tax Rate)] –Preference Dividend +
Working capital.

2
Table-3: Showing Cash Flow to Firm and Cash Flow to Equity

Year Cash flow to firm Cash flow to Equity

2017-18 6450 18692
2016-17 6650 18036
2015-16 11600 18780
2015-14 9787 18245
Terminal value* 356400 468300

Table-4: Showing Cost to Equity and Weighted Average Cost of Capital

Cost of equity 15%

Weighted Average Cost of Capitalisation 13%
*Note= 4 year average is taken for Cost of Equity and WACC

𝑛=𝑡 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦

Value of Equity= ∑
(1+𝑘𝑒)𝑡

18692 18036 18780 18245+468300

Value of Equity =
(1.15)
+ 2 + 3 + (1.15)4
((1.15)) ((1.15))

=16253.9 + 15929.34 + 12348.11 + 278184.67

= Rs.322716.027 lakhs

𝑛=𝑡 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐹𝑖𝑟𝑚

Value of Firm= ∑
(1+𝑊𝐴𝐶𝐶)𝑡

6450 6650 11600 9787+356400

= + (1.13)2 + (1.13)3 + (1.13)4
1.13

= 5707.96 + 5207.93 +8055.56+ 224589.8

= Rs.243561.25 lakhs

3
2. Relative Valuation

A relative valuation model is a business valuation method that compares a company's value
to that of its competitors or industry peers to assess the firm's financial worth. Relative
valuation models are an alternative to absolute value models, which try to determine a
company's intrinsic worth based on its estimated future free cash flows discounted to their
present value, without any reference to another company or industry average. Like absolute
value models, investors may use relative valuation models when determining whether a
company's stock is a good to buy.

Relative valuation uses multiples, averages, ratios and benchmarks to determine a firm's
value. A benchmark may be selected by finding an industry wide average, and that average is
then used to determine relative value.

2.1 Relative Valuation Multiples

There are many different types of relative valuation ratios, such as price to free cash flow,
enterprise value (EV), operating margin, price to cash flow for real estate and price-to-sales
(P/S) for retail.

One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is
calculated by dividing stock price by earnings per share (EPS), and is expressed as a
company's share price as a multiple of its earnings. A company with a high P/E ratio is
trading at a higher price per dollar of earnings than its peers and is considered overvalued.
Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is
considered undervalued. This framework can be carried out with any multiple of price to
gauge relative market value. Therefore, if the average P/E for an industry is 10x and a
particular company in that industry is trading at 5x earnings, it is relatively undervalued to its
peers.

An absolute measure, on the other hand, makes no external reference to a benchmark or

average. A company's market capitalization, which is the aggregate market value of all of its
outstanding shares, is expressed as a plain dollar amount and tells you little about its relative
value. Of course, with enough absolute valuation measures in hand across several firms,
relative inferences can be drawn.

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2.2 Estimate Relative Value of Stock

In addition to providing a volume for relative value, the P/E ratio allows analysts to back into
the price that a stock should be trading at based on its peers. For example, if the average P/E
for the specialty retail industry is 20x, it means the average price of stock from a company in
the industry trades at 20 times its EPS.

Assume Company A trades for $50 in the market and has an EPS of $2. The P/E ratio is
calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of
20x, which means Company A is overvalued. If Company A were trading at 20 times its EPS,
the industry average, it would be trading at a price of $40, which is the relative value. In other
words, based on the industry average, Company A is trading at a price that is $10 higher than
it should be, representing an opportunity to sell.

Because of the importance of developing an accurate benchmark or industry average, it is

important to only compare companies in the same industry and market capitalization when
calculating relative values.

2.3 Illustration of Relative Valuation

P/E RATIO:
A P/E Multiple, also known as the Price-to-Earnings ratio, indicates the multiple
of earningsinvestors are willing to pay for one share of a company. To determine if a
company is "expensive" it is far more useful to compare P/E ratios of similar firm than the
absolute stock price.

Market Total Shares In Issue Earnings P/E Ratio

Price Per Profit Or Per Share
Share (In Earning (In Rs)
Company Rs) (In
Crores)

A Ltd. 163 12540 76000 14 11.64

B ltd. 180 3200 630 8 22.5
C Ltd. 220 9650 65,000.00 17 12.94
D Ltd. 98 340 4,560.00 11 8.90

5
 11.64+22.5+12.94+8.90
Average P/E Ratio =
4

= 13.99
Therefore, from the above calculation we can derived that value of B ltd. is overvalued as P/E
Ratio of B ltd. > Average P/E Ratio, i.e., 22.5 > 13.99 and we can also derived that value of
A ltd, C ltd and D ltd is overvalued as P/E Ratio of A ltd, C ltd and D ltd > Average P/E
Ratio.

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3. Conclusion
With this I would like to conclude that the DCF method and relative method is very
vulnerable to changes in the underlying assumptions. Only marginally changes in the
perpetual growth rate will lead to huge variances in the terminal value. Since the terminal
value accounts for a large portion of the company’s value, this is of big significance for the
validity of the DCF method.

It is very easy to manipulate the DCF valuation and relative method to result in the value that
you want it to result in by adjusting the inputs. This is even possible without making changes
that would be significant from an economist’s point of perspective, e.g. a change in the
perpetual growth rate or in the WACC by just a few base points. Analysts or business
professionals have no tools to estimate the input factors with that kind of exactness.

However, the DCF valuation and relative method is a great tool to analyze what assumptions
and conditions have to be fulfilled in order to reach a certain company value. This is
especially helpful in the case of capital budgeting and in the creation of feasibility plans.

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BIBLOGRAPHY

 https://www.investopedia.com/terms/r/relative-valuation-model.asp
 https://www.edupristine.com/blog/importance-relative-valuation
 https://einvestingforbeginners.com/dcf-valuation/
 https://www.investopedia.com/terms/d/dcf.asp