There is nothing so dangerous as the pursuit of a rational policy in an irrational

world.

Introduction to Valuation

The market can remain irrational longer than you can remain solvent.

John Maynard Keynes

 Introduction

• Value can be an abstract concept in some cases.

• Value of an asset for us, would be present value of the expected cash flows.

• We assume that the asset is being brought for the cash flows it is expected to produce.
 Valuation: Reality Check

• Unlike a bond, cash flows for equity assets are uncertain.

• Estimation involves lot of bias.

• Starting point of cash flow and the growth rate assumed makes a lot of difference.

• Not predicting exact cash-flows but more of average.

• Valuation is not timeless, needs to updated based on new information

 Use

• Investment Management

• Mergers & Acquisitions

• Corporate Finance
 Methods

• Book value, liquidation value, replacement value

• Discounted cash flow

• Dividend
• Free cash flow to Firm
• Free cash flow to equity
• Adjusted Present Value

• Relative Valuation
• Price multiples
• Value multiples

• Contingent claim valuation

• Value an oil reserve if price of oil increase to a level.
 Book Value, Liquidation Value, Replacement Value

• Valued of the company from the balance sheet i.e. Net Assets (Total Assets –total
liabilities excluding equity). Also termed as Net Worth.
• Book values are based on historical cost, not actual market values.
• Market value may not be related to book value and can be higher or lower.

Liquidation Value
• Value remaining after the assets are liquidated and sold to meet all the liabilities.
• Provides a floor to the value of the company

Replacement Value
• Replacement cost of assets less all liabilities.
• Market value higher than replacement value would attract competitors to the industry.
 Discounted cash flow

• Cash-flows can be different from different assets classes (interest for bonds, dividends for
equities and after tax cash-flow for projects).

• Discount rate is a function of risk

• Intrinsic value is a value computed by all knowing analyst with knowledge of the cash-
flows and the right discount rate.

• Market price can deviate from intrinsic value but would eventually converge.
 Limitations of DCF…

• Firms with negative earnings/cash-flows: For firms that are expected to fail, the DCF does
not work since cash-flows need to be estimated until they turn positive.

• Cyclical firms: In depths of recession these firms appear like troubled firms, estimating
cash-flows in these companies becomes an exercise in predicting the upturn of the cycle.

• Firms with unutilized or underutilized assets: need to add value of underutilized or

unutilized assets to the cash-flows.

• Firms with patent or product options

 …Limitations of DCF

• Firms in process of restructuring: means firms that sell or acquire other assets or change
their capital structure or dividend policy or management. In these cases the historical
cashflows can-not be used for prediction.

• Firms involved in acquisitions: requires estimation of synergies for computation of

cashflows.

• Private firms: estimating the discount rate

 Model Structure types in DCF
• Gordon Model
• Two-stage Model (also includes H-model)
• Three-stage Model
 Discounted Cash Flow Methods
Gordon Model
Value of a share is equal to present value of future benefits.

𝐷0 ∗ 1 + 𝑔 𝐷0 ∗ (1 + 𝑔)2
𝑃0 = + 2
+⋯…
(1 + 𝑘) (1 + 𝑘)

𝐷0 ∗ 1 + 𝑔 = 𝐷1
=
(𝑘 − 𝑔)

𝐷1 = 𝐸1 ∗ 1 − 𝑏
𝑃0 =
(𝑘 − 𝑔)
• Where ‘k’ is the cost of equity
• ‘b’ is the retention ratio and g=b*ROE
Q. GIPCL ltd has current earnings of Rs.16.85 per share, and the average ROE is 8.6% the
payout ratio is 22%. Given the cost of equity is 12%, compute the value of the firm.

𝑔 = 1 − 22% ∗ 8.6% = 6.7%

16.85 ∗ 1 + 6.7% ∗ 0.22

𝑃0 = = 74.6
12% − 6.7%
 DDM Implications

• The constant-growth rate DDM implies that a stock’s value will be

greater:
1. The larger its expected dividend per share.
2. The lower the market capitalization rate, k.
3. The higher the expected growth rate of dividends.
4. The stock price is expected to grow at the same rate as dividends.
 Present Value of Growth Opportunities
If a company pays all its earnings as dividend then there will be no-growth since g=b*ROE.
Thus the no growth price of the company is:
𝐸1
𝑃0 (𝑁𝑜𝑔𝑟𝑜𝑤𝑡ℎ) =
(𝑘)
While the price including growth is:
𝐸1 ∗ 1 − 𝑏
𝑃0 (𝑤𝑖𝑡ℎ 𝑔𝑟𝑜𝑤𝑡ℎ) =
(𝑘 − 𝑔)
The difference would thus give the PVGO
𝐸1
𝑃0 𝑤𝑖𝑡ℎ 𝑔𝑟𝑜𝑤𝑡ℎ = + 𝑃𝑉𝐺𝑂
𝑘
𝐸1 ∗ 1 − 𝑏 𝐸1
𝑃𝑉𝐺𝑂 = −
(𝑘 − 𝑔) (𝑘)
• Look at Earnings given by GIPCL.
• Average ROE is 8.6% while average payout ratio is 0.22. g=(1-0.22)*8.6%=6.7%.
• Assume cost of equity of 12%, Compute the No growth and with growth price .
𝐸1 16.85
𝑃0 𝑁𝑜𝑔𝑟𝑜𝑤𝑡ℎ = = = 140
𝑘 12%

16.85 ∗ 1 + 6.7% ∗ 0.22

𝑃0 𝑤𝑖𝑡ℎ 𝑔𝑟𝑜𝑤𝑡ℎ = = 74.6
12% − 6.7%

𝐸1 ∗ 1 − 𝑏 𝐸1
𝑃𝑉𝐺𝑂 = − = 74.6 − 140 = −65.40
(𝑘 − 𝑔) 𝑘

What does it mean? Why is this happening?

 …..Discounting Cash Flow Models..

Two stage Model

• Under Gordon model the assumption was that the firm would grow at a
constant growth ‘g’ for extended period of time.

• In two stage we assume that for first few years the firm grows at a high
rate and after that grows at a constant rate forever.
• Value= PV of extraordinary dividends+ PV of ordinary dividends
 5
𝐷0 ∗ 1 + 𝑔𝑎 𝐷0 ∗ 1 + 𝑔𝑎 𝐷5 ∗ 1 + 𝑔𝑛 = 𝐷6
𝑃0 = +. . + +
(1 + 𝑘) 1+𝑘 5 𝑘 − 𝑔𝑛 ∗ 1 + 𝑘 5

In case payout ratio changes in two stages, better to use the following:

5
𝐸0 ∗ 1 − 𝑏𝑎 ∗ 1 + 𝑔𝑎 𝐸0 ∗ 1 − 𝑏𝑎 ∗ 1 + 𝑔𝑎 𝐸5 ∗ 1 − 𝑏𝑛 ∗ 1 + 𝑔𝑛 = 𝐷6
𝑃0 = +. . + +
(1 + 𝑘) 1+𝑘 5 𝑘 − 𝑔𝑛 ∗ 1 + 𝑘 5

Where:
ga: is abnormal growth rate and ba: is abnormal payout ratio
gn: is normal growth rate and bn: is normal payout ratio
Eo and Do: are EPS and DPS in year ‘0’
In the current year Berger Ltd earned Rs.7 per share and paid a dividend of Rs.2.50 per
share. The earnings were expected to grow at the rate of 10% for the next three years and
stabilize at 3%. The pay-out ratio is expected to remain at the same level during the three
years and then increase to 60%. If the required rate of return is 16%, compute

(a) The expected price of Berger at the end of third year

(b) The current price of the stock

Answer
(a) Rs. 44.30
(b) Rs.35.13
 …..Discounting Cash Flow Models..

H-model
• Considers different growth in different periods.
• However the growth is not constant in the initial period as was assumed by the
previous model
• The growth rate in the initial period declines linearly with time and reaches a
stable growth rate.
• Payout ratio is constant
Growth rate

ga

gn

Extraordinary growth Infinite growth phase

phase: 2H years years
 DPS0 * H *( g a  g n ) DPS0 *(1  g n )
P0  
(k  g n ) (k  g n )

PV of the extraordinary growth phase

PV of the stable growth phase
The market price of Info Highway is Rs.150. For the current year, the
dividend declared was Rs.8. You, as an analyst, find that the growth
rate of dividends will decline to the long run stable rate of 3% over
four years transition period from the current growth rate of 9%.
Using H-model, compute the present value of the stock. The nominal
return is 15%.

8+68.67=76.67
 FCFE

Value the firm by discounting free cash flow at cost of equity.

Free cash flow to the equity, FCFE, equals:

Net Income (i.e. PAT)
Plus depreciation (cash less expenditure)
Minus capital expenditures
Minus increase in net working capital
Add increase in net debt
Q3 Page 613

a. 0.286 per share

b. 40.74 per share
 Free Cash Flow Approach
FCFF
• Value the firm by discounting free cash flow at WACC.
• Free cash flow to the firm, FCFF, equals:
After tax EBIT i.e. EBIT *(1-T)
Plus depreciation (Add: all cash less expenditure)
Minus capital expenditures
Minus increase in net working capital
Now the question could be that if tax has to be paid on PBT then won’t applying tax on EBIT lead to inflating of tax liability.
Therefore the right way to compute FCFF should be as follows:
𝐹𝐶𝐹𝐹 = 𝑃𝐴𝑇 + 𝐼 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.--------(2)
Let’s explore why the second expression is incorrect.
𝑃𝐴𝑇 = 𝐸𝐵𝐼𝑇 − 𝐼 ∗ (1 − 𝑇)
Let’s substitute this in the 2nd expression. So
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 − 𝐼 ∗ (1 − 𝑇) + 𝐼 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.
Solving the above leads to
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 − 𝐼 + 𝐼𝑇 + 𝐼 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 + 𝐼𝑇 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.
Now in the above expression we show a term ‘IT’ which is nothing but the benefit in form of interest tax shield i.e. since
interest is deducted before the computation of tax, so it lowers your tax liability and hence it is a benefit. This is discounted by
WACC. Look at the expression of WACC below:
𝑊𝐴𝐶𝐶 = 𝑘𝑒 ∗ 𝑤𝑒 + 𝑘𝑑 ∗ 1 − 𝑇 ∗ 𝑤𝑑
Here we are again considering the tax benefit by reducing the cost of debt by multiplying it with the expression of (1-T). Thus if
we take the second expression then same tax benefit is being considered twice. It is for this reason that for computing FCFF
the following expression is used:
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.
 Socrative

Room name: SAIMTA

Quiz: Basic Models_T

Occidental Petroleum produces and markets crude oil. (fig in millions).
2018 2019
Revenues $8,494.0 $9,000.0
(Less) Operating Expenses ($6,424.0) ($6,970.0)
(Less) Depreciation ($872.0) ($860.0)
= EBIT $1,198.0 $1,170.0
(Less) Interest Expenses ($510.0) ($515.0)
(Less) Taxes ($362.0) ($420.0)
= Net Income $326.0 $235.0
Working Capital ($45.0) ($50.0)
Total Debt $5.4 billion $5.0 billion

The firm had capital expenditures of $950 million in 2018 and $1 billion in 2019. The
working capital in 2017 was $190 million, and the total debt outstanding in 2017 was $5.75
billion.

A. Estimate the cash flows to equity in 2018 and 2019.

B. Estimate the cash flows to the firm in 2018 and 2019.

FCFE

Net Income 326 $235.00

Add: Dep $872.00 $860.00

Change in WC $235.00 $5.00

CE -950 -1000
Debt -350 -400
FCFE 133 -300

FCFF

EBIT*(1-T) 567.657 419.771

Add: Dep $872.00 $860.00

Change in WC $235.00 $5.00

CE -950 -1000
FCFF 724.657 284.771
 Computing Enterprise Value of Value of the firm and equity

𝐹𝐶𝐹𝐹 ∗ (1 + 𝑔)
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒(𝐸𝑉) =
(𝑊𝐴𝐶𝐶 − 𝑔)

Assuming a one-stage model.

𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝐸𝑉 − 𝐷𝑒𝑏𝑡 + 𝐶𝑎𝑠ℎ

𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = 𝐸𝑉 − 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡

Union Pacific Railroad reported net income of $770 million in 1993, interest expenses of $320 million. (The corporate tax rate
was 36%.) It reported depreciation of $960 million in that year, and capital spending was $1.2 billion. The firm also had $4
billion in debt outstanding on the books, rated AA (carrying a yield to maturity of 8%), trading at par (up from $3.8 billion at
the end of 1992). The cost of capital is given as 10.86% and perpetual growth rate is 6.5%.

A. Estimate the free cash flow to the firm in 1993.

B. Estimate the value of the firm at the end of 1993.
C. Estimate the value of equity at the end of 1993, and the value per share, using the FCFF approach.

A. FCFF in 1993 = Net Income + Depreciation - Capital Expenditures – change in Working Capital + Interest Expenses (1 - tax
rate)
= $770 + $960 - $1200 - 0 + $320 (1 - 0.36) = $734.80 million

B. Value of the Firm = 734.80*1.065/(.1086 - .065) = $17,948 millions

C. Value of Equity = Value of Firm - Market Value of Debt

= $17948 - $4,000 = $13,948 millions
 Estimating Inputs: Discount Rates

Critical ingredient in discounted cashflow valuation. Errors in estimating the

discount rate or mismatching cashflows and discount rates can lead to serious
errors in valuation.

At an intuitive level, the discount rate used should be consistent with both the
riskiness and the type of cashflow being discounted.

• Equity versus Firm: If the cash flows being discounted are cash flows to
equity, the appropriate discount rate is a cost of equity. If the cash flows are
cash flows to the firm, the appropriate discount rate is the cost of capital.
 The CAPM: Cost of Equity

Consider the standard approach to estimating cost of equity:

Cost of Equity = Risk-free Rate + Equity Beta * (Equity Risk Premium)

In practice,
• Government security rates are used as risk free rates
• Historical risk premiums are used for the risk premium
• Betas are estimated by regressing stock returns against market returns
 A Risk-free Rate

On a risk-free asset, the actual return is equal to the expected return.

Therefore, there is no variance around the expected return.

For an investment to be risk-free, then, it has to have

• No default risk
• No reinvestment risk

1. Time horizon matters: Thus, the risk-free rates in valuation will

depend upon when the cash flow is expected to occur and will vary
across time.

2. Not all government securities are risk-free: Some governments

face default risk and the rates on bonds issued by them will not be
risk-free.
 A Risk-free Rate

• For a AAA rated country, the yield of a 10-year bond coupon

bond is taken to be the risk-free rate.

• For a country (say BBB) rated below AAA, one should first
compute the default spread (Yield of bonds rated BBB-Yield of
AAA rated bond).

• This default spread is reduced from the yield of 10-year rupee

bond to get to the risk-free rate.
 A Risk-free Rate in Indian Rupees

The Indian government had 10-year Rupee bonds outstanding, with a

yield to maturity of about 6.0% on Jul 1, 2020.

In Jul 2020, the Indian government had a local currency sovereign

rating of Baa3. The typical default spread (over a default free rate) for
Baa3 rated country bonds in 2018 was 2.58%.

The risk-free rate in Indian Rupees is

a) The yield to maturity on the 10-year bond (6%)
b) The yield to maturity on the 10-year bond + Default spread =8.58%
c) The yield to maturity on the 10-year bond – Default spread
=3.42%
d) None of the above
 Measuring Risk Premium

1. Historical Premium
Average premium earned by stocks over T-bonds

2. Implied Premium

Based on how equity market is priced today and a simple valuation model.

3. Premium in developed markets + Country risk premium

Country risk premium = Country default spread*Sigma (Equity)/sigma (bond)

 1. Historical Premium

• Average premium earned by stocks over T-bonds

Issues

• Time period used: Using data for last 25 years could produce high standard errors.
Historical data exceeding 50 or more years would produce more reliable premiums.

• Using short term premium is better reflection of risk aversion of investors but it is noisy
while using long term premium may not reflect the current market reality.
 2. Computing Implied risk Premium

Inputs for the computation

• Index level = 15446
• Dividend yield on index = 3.05%
• Risk free rate=7%
• Expected growth rate - next 5 years = 14%
• Growth rate beyond year 5 = 6.76%

Solving for the expected return:

537.06 612.25 907.07 * (1.0676)

15446    ... 
(1  r ) (1  r ) 2
(r  0.0676)(1  r ) 5

Expected return on stocks = 11.18%

Implied equity risk premium= 11.18% - 7% = 4.18%
 More on Implied Risk Premium (IRP)

• Assumes that
• Markets are correctly priced
• Right model is being used

• Past data analysis has revealed that IRPs are much lower than the historical premiums.
 3. Using default spreads to estimate Risk Premium

• Premium in developed markets + Country risk premium

• Country risk premium = Country default spread*Sigma (Equity)/sigma (bond)

• Default spread is estimated as follows (through an example):

• For example India is rated Baa3 as per Moody’s while U.S. sovereign bond is rated AAA.

• The difference is taken between the interest rate of bonds with Baa3 rating and AAA.

• This gives the default spread. This is multiplied by the ratio of standard deviations for
equity and bond market to get a measure of country risk premium.

• The above is added to Premium in developed markets (obtained using Historical risk
premiums) to get the Risk premiums.
 Computing Risk premium

• Given premium for US market is 5.23% (computed using the historical approach)

• Default spread for India (Rated Baa3) is 2.58%.

• Ratio of standard deviation of equity to bond markets is 1.25 (for emerging economies in
general)

• Risk Premium=5.23% + 2.58%*1.25 = 8.46%

 Estimating Beta

The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns Rm i.e. Rj = a + b Rm

where a is the intercept and b is the slope of the regression.

• The slope of the regression corresponds to the beta of the stock, and
measures the riskiness of the stock.

This beta has three problems:

• It has high standard error
• It reflects the firms business mix over the period of the regression, not the
current mix
• It reflects the firm average financial leverage over the period rather than the
current leverage.
 Relationship: Levered Vs Unlevered Beta

𝐷
𝛽𝐿 = 𝛽𝑢 ∗ (1 + ∗ 1 − 𝑡 ቇ
𝐸
Where ‘t’ is the tax rate

• Thus with the increase in financial leverage the value of levered beta of a company
will go up implying that the company will become more risky.

• However how to resolve the issue of high standard errors?

 Solutions to the Regression Beta Problem

Modify the regression beta by

• changing the index used to estimate the beta
• adjusting the regression beta estimate, by bringing in information about the
fundamentals of the company

Estimate the beta for the firm from the bottom up without employing the regression
technique. This will require:

• understanding the business mix of the firm

• estimating the financial leverage of the firm
 Computing Bottom-up Beta

• Find the businesses that your firm operates in.

• Find publically traded firms (in the same businesses and obtain their regression
betas)

• Compute the simple average beta for each industry.

• Un-lever this beta by using average debt to equity ratio

• Use the business proportions to compute the weighted average beta of the business.

• Compute the levered beta for your firm by using your debt to equity ratio
You are trying to estimate the beta of a private firm that
manufactures home appliances. You have managed to obtain betas
for publicly traded firms that also manufacture home appliances.
MV of
beta debt equity
A 1.4 2500 3000
B 1.2 5 200
C 1.2 540 2250
D 0.7 8 300
E 1.5 2900 4000

The private firm has a debt equity ratio of 25% and faces a tax rate of
40%. The publicly traded firms all have marginal tax rates of 40%as
well.

a. Estimate the beta for the private firm

b. What concerns, if any, would you have about using betas of
comparable firms?
 beta debt MV of equity D/E

A 1.4 2500 3000 0.83

B 1.2 5 200 0.03

C 1.2 540 2250 0.24

D 0.7 8 300 0.03

E 1.5 2900 4000 0.73

Average 1.2 0.37

Beta (unlevered) 0.98

Beta (private) 1.13

A company has four different kinds of businesses. In the table below provided the details
of companies falling into similar businesses. Compute the bottom-up beta for the
company
Business Average levered Average Business
Type No. beta D/E proportion
1 24 1.22 20.45% 50%
2 9 1.58 120.76% 20%
3 11 1.16 27.96% 25%
4 77 1.06 9.18% 5%

Tax rate=35%, D/E of the company=0.26

Business Average levered Average Business Unlevered
Type No. beta D/E proportion beta

1 24 1.22 20.45% 50%1.08

2 9 1.58 120.76% 20%0.89

3 11 1.16 27.96% 25%0.98

4 77 1.06 9.18% 5%1.00

Unleverd beta 1.01

Levered beta 1.18
 Estimating the Cost of Debt

The cost of debt is the rate at which you can borrow at currently, It will reflect not only
your default risk but also the level of interest rates in the market.

The three most widely used approaches to estimating cost of debt are:

1. Looking up the yield to maturity on a straight bond outstanding from the firm.

The limitation of this approach is that very few firms have long term straight bonds that
are liquid and widely traded

2. Recent Borrowing History

3. Estimate Synthetic Rating:

Assign a rating to a firm based upon its financial ratios; this rating is called a synthetic
rating. One of the ratio’s that can be used is Interest coverage ratio.
Interest Coverage Ratios, Ratings and Default Spread for
USA Companies, (For example)
more than less than Rating is Spread is
-100000.0 0.2 D 12.00%
0.2 0.6 C 10.50%
0.7 0.8 CC 9.50%
0.8 1.2 CCC 8.75%
1.3 1.5 B- 6.75%
1.5 1.7 B 6.00%
1.8 2.0 B+ 5.50%
2.0 2.2 BB 4.75%
2.3 2.5 BB+ 3.75%
2.5 3.0 BBB 2.50%
3.0 4.2 A- 1.65%
4.3 5.5 A 1.40%
5.5 6.5 A+ 1.30%
6.5 8.5 AA 1.15%
8.5 100000.0 AAA 0.65%
 Weights for the Cost of Capital Computation

In computing the cost of capital for a publicly traded firm, the general rule for
computing weights for debt and equity is that you use market value weights
(and not book value weights). Why?

a) Because the market is usually right

b) Because market values are easy to obtain
c) Because book values of debt and equity are meaningless
d) None of the above
You have been asked to estimate cost of capital for Newtel, a telecom firm. The
firm has the following characteristics:

• There are 100 million shares outstanding, trading at $250 per share.
• The firm has a book value of debt with a maturity of six years of $10billion
and interest expense of $600mn on the debt. The firm is not rated but it had
operating income of $2.5billion last year (Firms with an interest coverage
ratio of 3.5 to 4.5 were rated BBB, and the default spread was 1%)
• The tax rate for the firm is 35%
• The treasury bond rate is 6% and the unlevered beta of other telecom firms is
0.80. Risk-premium is 5.5%

a. Estimate the market value of debt for this firm.

b. Based on synthetic rating, estimate the cost of debt for this firm.
c. Estimate the cost of capital for this firm.
Interest Coverage=2.5/0.6=4.16

Kd=6% + 1%=7%

MV of debt (PV of debt at 7%)=9.523bn

BL=0.8*(1+9.523/25*(1-.35))=0.998

Ke=6+0.998*5.5=11.49%

K=11.49*0.725+7*(1-.35)*0.275=9.58%
 Dealing with Convertible Debt and Preference Shares

• When dealing with hybrids (convertible bonds, for instance), break the security down
into debt and equity and allocate the amounts accordingly.

• Thus, if a firm has Rs 100 cr in convertible debt outstanding, break the 100 cr into
straight debt and conversion option components. The conversion option is equity.

• When dealing with preference shares, it is better to keep it as a separate component.

The cost of preferred stock is the preferred dividend yield. (As a rule of thumb, if the
preferred stock is less than 5% of the outstanding market value of the firm, lumping it
in with debt will make no significant impact on your valuation).
 Decomposing a convertible bond…

Assume that the firm that you are analyzing has Rs.125 million in face value of
convertible debt with a stated interest rate of 4%, a 10 year maturity and a
market value of Rs.140 million. If the firm has a bond rating of A and the interest rate on
A-rated straight bond is 8%, you can break down the value of the convertible bond into
straight debt and equity portions.

• Straight debt = (4% of Rs.125 million) (PV of annuity, 10 years, 8%) + 125
million/1.08^10 = 91.45 million

• Equity portion = Rs140 million – Rs. 91.45 million = 48.55 million

Estimating Earnings
 Update Earnings

When valuing companies, we often depend upon financial statements for

inputs on earnings and assets.

Annual reports are often outdated and can be updated by using-

• Trailing 12-month data, constructed from quarterly earnings reports.
• Informal and unofficial news reports, if quarterly reports are unavailable.

Updating makes the most difference for smaller and more volatile firms, as
well as for firms that have undergone significant restructuring.
 Operating Income

• Operating Income usually is computed after adjusting for all non-operating income
and non-operating expense (interest cost/financing cost) as well as for misclassified
operating expense like Research & Development.

• It should also be adjusted for restructuring charges, extraordinary income or loss

and minority Interest.
• Consider the following cases: (Should they be part of operating income?)

• One time expense that is truly one time: for example restructuring charge

• Expense and income that do not occur every year but seem to occur at regular
intervals with or without volatility: gain/loss on sales of asset, inventory write-off, etc

• Items that recur every year with changed signs : forex losses

• Income from Investments: Other Income, Minority Interest

• Capital expense but considered as revenue in preparation of Income statement:

Research & Development
 Suggested Adjustments

• One time expense that is truly one time: may be ignored and added back to arrive at
adjusted income

• Expense and income that do not occur every year but seem to occur at regular
intervals with or without volatility : average can be taken. In case of income, the
actual income should be reduced and average income should be added back. Vice
versa in case of expense.

• Items that recur every year with changed signs : it may be ignored (if income then
reduce it and if expense then add it back)

• Income from Investments: Minority interest may be added back to arrive at the
adjusted income

• Capital expense but considered as revenue in preparation of Income statement:

should be capitalized and then amortized
 Minority Interest

• If the securities or assets owned in another firm represent more than 50% of the overall
ownership of that firm, that investment is termed as majority active investment.

• In this case the investment is not shown as a financial investment but is instead replaced
by the assets and liabilities of the firm in which the investment is made.

• This is termed as consolidation.

• Here the assets and liabilities of two firms are merged and presented as one balance
sheet (assuming as if the whole firm is owned)

• The share of equity in the subsidiary that is owned by other investors is booked as
expense (in the form of minority interest) in the income statement and as a
corresponding liability in the balance sheet.
 Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 20,000 21,000 22,050 23,153 24,310
Other Income 150 165 182 200 220
Forex gain/(loss) -20 40 -30 -30 -30
Total 20,130 21,205 22,202 23,323 24,500
Cost of goods 15,000 15,450 15,914 16,391 16,883
sold
SG&A 1,050 1,124 1,202 1,286 1,376
Depreciation 300 318 337 357 379
Finance Cost 100 108 117 126 136
Restructuring - - - - 6,000
charges
Loss of sale of 50 1,000 100 3,000 600
asset
Minority Interest 120 131 143 155 169
Total expense 16,620 18,131 17,813 21,315 25,543
PBT 3,510 3,074 4,389 2,008 -1,043
tax -1,065.00 -898.4 -1,334.90 -619.9 295
PAT 2,445 2,176 3,054 1,388 -748
Adjusted Earnings
PBT 3,550 2,995 4,450 2,066 -1043
Forex gain/loss: Ignore 20 -40 30 30 30
(Add back loss and reduce
the gain)
Add: loss on sale of asset 50 1,000 100 3,000 600
Less: Normalized Loss -950 -950 -950 -950 -950
Add: Restructuring charge - - 6,000
- -
Add: Minority Interest 120 131 143 155 169
Adjusted PBT 2,790 3,136 3,773 4,301 4,806
Less: tax - -898.4 - -619.9 295
1,065.00 1,334.90
Adjusted PAT 1,725 2,238 2,438 3,681 5,101
 Adjustment of Research & Development Expense

• R&D expenditures are classified as operating expense, even when they give
benefits over long term.

• This should be corrected by adjusting the operating income.

• This is done by adding back the research expense to the post tax EBIT
and

• Reducing the amortization from the post tax EBIT

• The above would be a better estimate of operating earnings

UFO Ltd had 100mn in R&D expenses in the current year.The following table provides R&D
expense over last 5 years. If R&D expense are amortizable over 5 years, then estimate the
following: (Assume the expense is made at the end of the year, so the current year
expense will not be amortized)

a. The value of the research asset

b. The amount of R&D amortization this year
c. The adjustment to operating Income

Year R&D Expense

-5 50
-4 60
-3 70
-2 80
-1 90
CY 100
 R&D Amortiz
Year Expense ation Value
-5 50 50
-4 60 10 100
-3 70 10 12 148
-2 80 10 12 14 192
-1 90 10 12 14 16 230
CY 100 10 12 14 16 18 260

a. Value of research asset=260

b. Amount of R&D amortization this year=70
c. Adjustment to operating income=100 (add back the research expense
deducted) -70 (Amortize the research expense)=30 (Addition)
 Tax Rate

The possible tax rates that can be considered:

• Effective Tax Rate i.e. (Income tax expense/Profit before tax)

• Marginal Tax rate i.e. statutory tax rate applicable. About 25.71% for Indian
companies

• Effective tax rate for initial period followed by marginal tax rate
 Computing Cash flows

The cash flow can be computed as:

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 + 𝐷𝑒𝑝 − ∆𝑁𝑊𝐶 − 𝐶. 𝐸.

the expression after EBIT*(1-T) is what is re-invested into the business. So expression of
FCFF can also be written as:

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 − 𝑁𝑒𝑡 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡

• Given re-investment rate i.e. re-investment as a % of EBIT*(1-T) is ‘RR’,
𝑁𝑒𝑡 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑅 =
𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇)
then FCFF can be reduced
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 ∗ 1 − 𝑇 (1 − 𝑅𝑅)
 Computing Net Re-investment

•Requires estimate of re-investment into the business in future.

•Both Working capital and capital expenditure tend to be lumpy i.e. higher in some years
than others.

•One method of doing that is to take an average of investment in Net capital expenditure and
working capital for last five years as a proportion of its EBIT(1-T).

•This can be assumed to be the re-investment rate for next 5 years.

•Growth then would be a because of re-investment and hence growth in FCFF would be
given as
𝑔 = 𝑅𝑅 ∗ 𝑝𝑜𝑠𝑡 𝑡𝑎𝑥 𝑅𝑂𝐶𝐸
 What is included in capital expenditures?

1. Research and development expenses,

2. Acquisitions of other firms or assets, since these are like capital expenditures. The
adjusted net cap ex will be

Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms -Amortization
of such acquisitions

Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of
acquisitions (looking at an average over time) should be used

2. The best place to find acquisitions is in the statement of cash flows, usually categorized
under other investment activities
 Computing Working Capital Requirement

• Defined as the difference between current assets (inventory, cash and accounts
receivable) and current liabilities (accounts payables, short term debt and debt due
within the next year)

• A cleaner definition of working capital from a cash flow perspective is the difference
between non-cash current assets (inventory and accounts receivable) and non-debt
current liabilities (accounts payable)

• Any investment in this measure of working capital ties up cash. Therefore, any increases
(decreases) in working capital will reduce (increase) cash flows in that period.

• It may be estimated as a proportion of revenue.

• If working capital is negative, a conservative estimate would be to assume working capital

requirement as nil.
 Estimating Re-investment and Growth Rate for GIPCL
2016 2017 2018 2019 NWC 2015 2016 2017 2018 2019
Reinvestment
Inventory
Capital Expenditure 18,553.00 56,284.00 37,835.00 25,280.00 14,786.00 15,069.00 15,980.00 15,159.00 16,557.00
Dep& Amor 12,316.00 13,162.00 16,735.00 15,765.00
Receivables 12,850.00 26,566.00 24,802.00 25,997.00 21,441.00

Trade Advance and deposits - - - - -

Change in NWC
Other Current Asset 4,432.00 2,823.00 1,389.00 6,883.00 2,601.00
PAT 18,827.00 22,925.00 24,452.00 25,475.00
Tax 6,144.00 7,173.00 7,297.00 5,188.00 Payables 8,933.00 8,472.00 10,375.00 10,139.00 15,181.00
PBT
Finance Cost 7,556.00 7,319.00 6,695.00 5,031.00 Others 13,458.00 16,166.00 14,775.00 11,358.00 1,444.00
Less: Other Income 3,624.00 7,105.00 5,126.00 11,680.00
Exceptional item (loss) 13,960.00 NWC
EBIT Change in WC
Adjusted EBIT*(1-T)
Reinvestment Rate
Assumed Reinvestment rate
Actual Tax Rate

Marginal Tax rate 25.71%

Capital Employed

Equity 203,337.00 223,610.00 238,068.00 257,073.00

Debt 32,658.00 27,146.00 36,128.00 36,658.00

ROCE

Growth -
 Growth Rate

1. Look at the past

• The historical growth in earnings per share is usually a good starting point for
growth estimation

2. Look at what others are estimating

• Analysts estimate growth in earnings per share for many firms. It is useful to
know what their estimates are.

3. Look at fundamentals

• Ultimately, all growth in earnings can be traced to two fundamentals - how

much the firm is investing in new projects, and what returns these projects are
making for the firm.
 Terminal Value

• Value of the firm at the end of the high growth rate period. It can be estimated
using the following approaches:

• Liquidation value

• Multiples approach

• Stable growth rate model

 Stable growth rate model

• Terminal Value=EBIT1*(1-T)(1-re-investment Rate)/(K-Stable growth rate)

• ‘g’ can-not be higher than the growth rate of the economy

the input of re-investment rate can be derived from the following equation:

• ‘g=re-investment rate*ROCE

• This makes sure that if one assumes high growth rate then one has to assume a
higher re-investment also (for a given ROCE).

• While high growth rate increases value, a high re-investment rate would decrease
the value

• Otherwise to influence value one might increase the growth rate without taking
care of the re-investment required.
XYZ ltd has EBIT of 100mn and is expected to have earnings growth of 10% for the
next five years. At the end of 5th year , you estimate terminal value using a multiple of
8times operating income (average for the sector)

a. Estimate the terminal value of the firm.

b. If the cost of capital for the firm is 10%, tax rate is 40% and you expect stable
growth rate to be 5%, what is the return on capital that you are assuming in
perpetuity if you use a multiple of 8 times operating income.

a. EBIT(5th Year)=100*(1.1)^5=161.05

TV=161.05*8=1288.41

b. 1288.41=161.05*(1-40%)*(1-5%/K)*1.05/(10%-5%)

K=13.7%
 Total Value of the Firm

• We used operating earnings to get to the value of the firm.

• To the above we need to add cash, marketable securities and other non-operating
assets of the company.

• One also needs to account for cross-holdings of the firm in other companies.
• Cross-holdings can be of the following types:

• Minority passive Investments: Holdings generally less than 20%. These are
shown as Investments in balance sheet. Dividends when received as
recognized as Income for the company

• Minority active Investments: holdings between 20% to 50%. These are

shown at the acquisition price. Profits/losses made by the company are used
to proportionately increase/decrease the acquisition price (in balance sheet).

• Majority active Investments: 50% and more. The financials of the company
are consolidated into the parent company. The investment is not shown as
financial investment but is replaced by the assets and liabilities of the firm in
which investment is made.

• In the above the share of investment owned by investors other than the
parent company (termed as minority interest) is recognized as expense and
also carried in the balance sheet as the liability
• The value is estimated by discounting the cash-flows as estimated above by the
WACC.

• To arrive at the firm value one also need to add/reduce from the above measure
the following:
• Add Cash and marketable holdings of the firm.
• Add Non-operating assets of the firm in the form of cross-holdings (minority
passive and minority active investments) if possible at market value,
otherwise at book value
• Reduce minority interest in holdings (majority active investment), if the
consolidated firm operating earnings have been considered for computation
of operating income

• To arrive at the equity value the following need to be reduced:

• Debt and other financial obligations of the firm.

• The value so obtained is divided by no. of shares to yield the value of equity per
share.
LML Ltd has EBIT of 250mn, is expected to grow at 5%a year forever and tax rate is
40%. The cost of capital is10%, reinvestment rate is 33.33% and it has 200mn shares
outstanding. If the firm has500mn in cash and marketable securities and 750mn in
debt outstanding, estimate the value of equity per share.

Firm Value=FCFF1 /(k-g)=250*(1-40%)*(1-33.33%)*(1+5%)/(10%-5%)=2097.9

Equity Value per share=(Firm value+cash-debt)/n=(2097.9+500-750)/200=9.23

DVD Ltd had 800mn in earnings before interest and taxes last year. It has just
acquired a 50% stake in NLD ltd, which had 400mn in EBIT last year. Since DVD Ltd
has a majority active stake, it has been asked to consolidate last year’s income
statement for two firms.

a. What EBIT would you see in the consolidated statements?

b. If both firms have a 5% stable growth rate, a 10% cost of capital, a 40% tax rate
and a return on capital of 11%, estimate the value of equity in DVD Ltd

a.1200mn

b. Value of DVD (standalone) =EBIT*(1-T)*(1-reinvestment rate)*(1+g)/(k-g)

=800*(1-40%)*(1-5%/11%)*(1+5%)/(10%-5%)=5498.2

Value of NLD=400*(1-40%)*(1-5%/11%)*(1+5%)/(10%-5%)=2749.1

Equity value of DVD=5498.2+ 50%*2749.1=6872.75

Relative Valuation
 What do we do in Relative valuation?

• Value a company by comparing it with other similar companies in the industry.

• Absolute values can-not be compared so value is computed relative to something i.e

earnings, book value, revenue, cash flows, etc

• For example assume DRL and Cipla have a market cap of Rs.72,000 cr and Rs.60,000 cr
respectively and are generating PAT of Rs.3600cr and Rs.2000cr as profit after tax so we
say while DRL is trading at a multiple of 20, CIPLA is trading at a multiple of 30.

• So relative to Cipla, DRL is underpriced.

 What are the popular ratio’s used in relative valuation?

• P/E
• P/B
• P/Revenue
• P/Cash flow
• P/g i.e. PEG ratio
• EV/EBDITA
• EV/EBIT
 Two components of relative valuation

• To value assets on relative basis the prices have to be standardized by converting prices
into multiples of earnings, book value or sales.

• Find similar firms. This is difficult since no two firms are identical and firms can differ on
risk, growth potential and cash flows
 What’s the process?

• Let’s say you are valuing Dr. Reddy Lab’s. What you do under relative valuation method is
the following:
• Identify a set of comparable companies (in industry parlance it is called as comp’s
analysis)
• Size similarity i.e. similar revenues
• Similar products i.e. therapeutic segments
• Similar leverages i.e. D/E ratio’s
• Similar margins i.e. EBDITA margin, Net profit margin
• Compute the relevant ratio for the comparable set and compute the average.
• For example if out of 5 identified companies 2 are more similar , then one may use a
weighted average
• Compare the multiple of your company with the average so computed. If the company
multiple is more than the company is said to be overpriced and vice-versa
Relative valuation is pervasive…
1. Most valuations are relative valuations.

• A lot of equity research reports are based upon a multiple and comparables.

• Many of the acquisition valuations are based upon multiples.

• Rules of thumb based on multiples are not only common but are often the basis for final
valuation judgments.

2. While there are more discounted cash flow valuations in consulting and corporate finance,
they are often relative valuations masquerading as discounted cash flow valuations.

• The objective in many discounted cash flow valuations is to back into a number that has
been obtained by using a multiple.

• The terminal value in a significant number of discounted cash flow valuations is estimated
using a multiple.
 …Relative valuation is pervasive

1. Even if you are a true believer in discounted cash-flow valuation, presenting your
findings on a relative valuation basis will make it more likely that your findings/
recommendations will reach a receptive audience.

2. In some cases, relative valuation can help find weak spots in discounted cash flow
valuations and fix them.

3. The problem with multiples is not in their use but in their abuse. If we can find ways
to frame multiples right, we should be able to use them better.
 The Four Steps to Understanding Multiples

1. Define the multiple

• It is critical that we understand how the multiples have been estimated.

2. Describe the multiple

• Look at its cross-sectional distribution

3. Analyze the multiple

• Fundamentals that drive the multiple

4. Apply the multiple

• Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.
 Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

1. There are a number of variants on the basic PE ratio in use. They are based upon how
the price and the earnings are defined.

Price: is usually the current price (though some like to use average price over last 6
months or year)

EPS:
• Time variants: EPS in most recent financial year (current), EPS in most recent four
quarters (trailing), EPS expected in next fiscal year or next four quarters (both called
forward) or EPS in some future year
• Primary or diluted
• Before or after extraordinary items
• Measured using different accounting rules (options expensed or not, pension fund
income counted or not…)
 Earning per Share (EPS)

PAT  Pr ef Div
EPS 
weighted no. of shares

A ltd has earned a profit of 30cr in the financial year 2016-17. At the
start of the financial year, the company had 10cr shares outstanding.
After 6months the company made a fresh offer for sale of 10cr
additional shares. Also the company issued around 2cr share to FI’s on
1st Feb’2017. Compute the EPS of the in 2016-17.

weighted shares  10 * (6 / 12)  20 * (4 / 12)  22 * (2 / 12)  15.33

EPS  30 / 15.33  1.96
 Price to Earnings (P/E) Ratio…..

Does it have any relation with the growth rate?

E1 (1  b) P (1  b)(1  g )

P0  E0 Kg
Kg
Thus two companies with similar profile and pay-out, the one having a higher
growth rate (assuming K>g) will have a higher P/E. Thus low growth firms tend to
have a low P/E
 PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher
PE ratios than lower growth firms.

Proposition: Other things held equal, higher risk firms will have lower PE
ratios than lower risk firms

Proposition: Other things held equal, firms with lower reinvestment needs
will have higher PE ratios than firms with higher reinvestment rates.

Of course, other things are difficult to hold equal since high growth firms,
tend to have risk and high reinvestment rates.
National City Corporation, a bank holding company, reported earnings per share of
$2.40 in 1993 and paid dividends per share of $1.06. The earnings had grown 7.5% a
year over the prior five years and were expected to grow 6% a year in the long term
(starting in 1994). The stock had a beta of 1.05 and traded for ten times earnings. The
treasury bond rate was 7%. Risk-premium is 6%

a. Estimate the PE Ratio for National City Corporation.

b. What long term growth rate is implied in the firm's current PE ratio?
a. Approximately 6.41
b. Approximately 8.55%
 PEG Ratio: Definition

• The PEG ratio is the ratio of price earnings to expected growth in earnings per share.

• PEG = PE / Expected Growth Rate in Earnings

 Value/Earnings and Value/Cash-flow Ratios

While Price earnings ratios look at the market value of equity relative to
earnings to equity investors, Value earnings ratios look at the market value of
the operating assets of the firm (Enterprise value or EV) relative to operating
earnings or cash flows.

EV = Market value of equity + Debt – Cash

The form of value to cash flow ratios that has the closest parallels in DCF
valuation is the ratio of Firm value to Free Cash Flow to the Firm.
• FCFF = EBIT (1-t) - Net Cap Ex - Change in WC

In practice, what we observe more commonly are firm values as multiples of

operating income (EBIT), after-tax operating income (EBIT (1-t)) or EBITDA.
 Reasons for Increased Use of Value/EBITDA

1. The multiple can be computed even for firms that are reporting net losses, since
earnings before interest, taxes and depreciation are usually positive.

2. For firms in certain industries, such as cellular, which require a substantial investment
in infrastructure and long gestation periods, this multiple seems to be more appropriate
than the price/earnings ratio.

3. By looking at the value of the firm and cash flows to the firm it allows for comparisons
across firms with different financial leverage.
Market value of equity at ABC ltd is Rs.1529mn and debt outstanding is Rs.500mn.The firm
reported Rs.500mn as EBDITA

Compute the EV to EBITDA multiple

4.06
Castillo Cable is a cable and wireless firm with the following characteristics:
· The firm has a cost of capital of 10% and faces a tax rate of 36% on its operating
income.
· The firm has capital expenditures that amount to 45% of EBITDA and depreciation
that amounts to 20% of EBITDA. There are no working capital requirements
The firm is in stable growth and its operating income is expected to grow 5% a year in
perpetuity.

Compute the EV to EBITDA multiple

FCFF1=[(EBDITA-DA)*(1-T)-(0.45EBDITA-0.2EBDITA)]*(1+g)
Assuming no amortization
EV= FCFF1/(k-g)

Substituting the above

EV/EBDITA=[0.8*(1-36%)-0.25]*(1+5%)/(10%-5%)
=5.5
 Price-Book Value Ratio: Definition

The price/book value ratio is the ratio of the market value of equity to the book
value of equity, i.e., the measure of shareholders equity in the balance sheet.

Price/Book Value = Market Value of Equity/ Book Value of Equity

Consistency Tests:
• If the market value of equity refers to the market value of equity of common
stock
outstanding, the book value of common equity should be used in the
denominator.

• If there is more that one class of common stock outstanding, the market values
of all classes (even the non-traded classes) needs to be factored in.
 Price to Cash Flow (P/CF) ratio

• Cash-flow indicates the residual cash leftover after meeting principal payments,
providing for capital expenditures and working capital.
• Cash flow (actually cash flow to equity) is thus less dependent on accounting rules of
the company as against the earnings and for this reason it is a better measure of value
for equity shareholder.

• The determinants of Price to FCFE ratio are similar to the determinants of P/E ratio
 Price to Sales (P/S) ratio

• Fails the consistency Tests as the market value of equity is divided by the total revenues
of the firm.

• Available even for companies having negative earnings

• Less influenced by accounting decisions on depreciation, inventory and extraordinary

charges unlike earnings or book value.

• Less volatile than P/E ratio. This is true especially for cyclical firms where earnings are
more sensitive to economic changes than revenue.

• This ratio however does not give importance to cost control in a company as well as
profit margins.