VALUATION OF

EQUITY
DCF and Relative Valuation
Financial Securities
• Financial securities are issued by a firm, called issuer, to
investors/subscribers as claims on the cash flows generated by the firm.
• These financial securities are listed/transferable making entry and exit
of the investment easy.
• Valuation of these securities implies that
• What price would these securities must be exchanged for between
seller and buyer, at any point of time, and
• What value could be attached to the future cash flows which are
inherently uncertain.

Rajiv Srivastava Valuing Equity 2

Firm Value Vs Enterprise Value

FIRM’s VALUE ENTERPRISE VALUE

LESS

Market value
Non Interest Non Interest
Market value of interest-
of equity bearing debt FIRM VALUE bearing Debt
bearing debt

Cash
Available

Rajiv Srivastava Valuing Equity 3

Discounted Cash Flow (DCF) Valuation
• As old as 1202 when Leonardo of Pisa (Fibonacci) used it.
• Appears very simple but has many contentious issues

Project future cash flows

Find appropriate discount rate

Find NPV (Net Present Value)

Rajiv Srivastava Valuing Equity 4
Dividend Discount Model – Constant Dividend
• The value of the stock is the present value of the cash flows i.e. the
dividends, D for all times to come, that it offers to the investor.
• If a dividend Dn is distributed in nth period, then value of the stock, V0 is
𝐷1 𝐷2 𝐷3
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = 1
+ 2
+ 3
+ ⋯….
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
Where r = Return expectations of the investor

• If a) if earnings are assumed constant for all time to come, and b) all
earnings, E are distributed as dividend D (per share) then value of the
stock, V0 is
𝐷 𝐷 𝐷 𝐷 𝐸
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = 1
+ 2
+ 3
+⋯= =
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) 𝑟 𝑟
Rajiv Srivastava Valuing Equity 5
Dividend Discount Model – Constant Growth
• Investors invest not only for dividend but they perceive the dividends to
grow with time.
• If the dividend in the immediate past in period 0 is D0, and if this grows
at g then the dividend for period 1, D1 = D0(1+g), for period 2, D2 =
D1(1+g) = D0(1+g)2 and so on, then value of the stock, V0 is

𝐷0 1 + 𝑔 1 𝐷0 1 + 𝑔 2 𝐷0 1 + 𝑔 3
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = 1
+ 2
+ 3
+⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝐷0 (1 + 𝑔) 𝐷1
= =
(𝑟 − 𝑔) (𝑟 − 𝑔)

Rajiv Srivastava Valuing Equity 6

Dividend Discount Model – Constant Growth
• The growth in dividend comes from additional investment. This can
come from debt or equity.
• Assuming that firm is an all equity firm no debt is taken. Hence from the
earnings a part of it is distributed as dividend while remaining is used
for funding the growth opportunities.
• If firm retains a fixed proportion, b of earnings to implement projects
providing a return of k, and distributes the remaining proportion, (1 – b)
then the growth, g would be equal to b x k.
• The value of firm, V0 is
𝐸0 (1 + 𝑔)(1 − 𝑏) 𝐸1 (1 − 𝑏)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = =
(𝑟 − 𝑔) (𝑟 − 𝑏𝑘)

Rajiv Srivastava Valuing Equity 7

Dividend Discount Model – Constant Growth
Example
• A firm is likely to earns Rs 10 in the coming year. If all earnings are
distributed as dividend and no growth is possible, what would be the value
of the stock of the firm?
𝐷 𝐸 10
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = = = = 𝑅𝑠 50
𝑟 𝑟 0.2
• If the firm has projects that earns 25% and decides to implement them
with retaining 40% of the earnings what would be the value of the stock?
Growth g = bk = 0.4 x 25 = 10%
𝐸1 (1 − 𝑏) 6𝑥(1 + 0.1)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 = = = 𝑅𝑠 66
(𝑟 − 𝑏𝑘) 0.2 − 0.1
• What is the present value of growth opportunities, PVGO.
PVGO = Value with growth – value w/o growth = 66 – 50 = Rs 16
Rajiv Srivastava Valuing Equity 8
Dividend Discount Model – Constant Growth
Example
• Under DDM the value of the stock grows by a factor of g in each period.
𝐷1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒, 𝑉0 =
𝑟−𝑔
𝐷2 𝐷1 (1 + 𝑔)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒 𝑎𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 1, 𝑉1 = = = 𝑉0 (1 + 𝑔)
𝑟−𝑔 𝑟−𝑔
• Confirm investor investing at t = 0 locks-in a return of 20% per annum.
𝐸1 1 − 𝑏 6𝑥 1 + 0.1
Buying price, 𝑉0 = = = 𝑅𝑠 66
𝑟 − 𝑏𝑘 0.2 − 0.1
Selling price, 𝑉1 = 𝑉0 1 + 𝑔 = 66𝑥1.1 = 𝑅𝑠 72.60
Capital gain = 72.60 – 66.00 = Rs 6.60
Dividend received = Rs 6.60
Return = 12.60/66 = 20%
Rajiv Srivastava Valuing Equity 9
DCF Techniques

Cash Flow to Firm Cash Flow to Equity

(FCFF) (FCFE)
Cash flow available to all
Cash flow to equity
capital suppliers (Equity
holders alone
and Debt)

Discount at Weighted
Discount at Cost OF
Average Cost of Capital, r
Equity, re
(WACC)

Rajiv Srivastava Valuing Equity 10

Discounted Cash Flow (DCF) Valuation
FCFE FCFF
(FREE CASH FLOW TO EQUITY) (FREE CASH FLOW TO FIRM)
Cash flows To equity holders only To equity as well as debt holders
Discount rate Cost of equity WACC
Currency (Risk free rate
Same as that of cash flows
and risk premium)
Real vs Nominal If inflation < 10% NOMINAL If inflation > 10% REAL
When to use Stable leverage Leverage varying over time
Dividend Use DDM if dividends are known and
have constant pay-out, else use FCFE
Growth rate Large firm with growth rate same as that of economy: Single stage
Large firm with moderately higher than economy: Two-stage
Small firm with very high growth rate: Multi-stage

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PROJECTING CASH FLOWS
Free Cash Flow to Firm (FCFF), and
Free Cash Flow to Equity (FCFE)

Rajiv Srivastava Valuing Equity 12

Projecting Cash Flows
• Relevant Cash flows:
• Differential/Incremental
• Sunk cost
• Interest exclusion (Taken care of in discount rate by using post tax cost of debt)
• Post tax

• Conservative vs Optimistic:
• Depends on purpose, entrepreneurs are highly optimistic
• Suppliers of capital like conservative estimates

• Cash flow to equity holders or all capital suppliers:

• Treatment of interest and tax shields
• Dividend vs cash flow available

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Free Cash Flow To Equity (FCFE)
FOR UNLEVERED FIRM (ZERO DEBT FIRM)
• While valuing equity the cash flow to the shareholders need to be
discounted at cost of equity to arrive at present value.
• These cash flows must account for taxes, capital expenditure, and
changes in working capital.
FCFE = EBIT (1 – T) + D – CAPEX – ΔWC
Or
FCFE = EBITDA (1 – T) + TD – CAPEX – ΔWC

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Free Cash Flow To Firm/Equity (FCFF/FCFE)
FOR LEVERED FIRM
• When the valuation perspective is to find enterprise value the perspective of
debt holders too have to be considered besides those of shareholders.
• These cash flows must account for taxes, capital expenditure, and changes in
working capital.
FCFF = EBIT (1 – T) + D – CAPEX – ΔWC Or
FCFF = EBITDA (1 – T) + TD – CAPEX – ΔWC
• FCFE for levered firm:
FCFE (Levered) = FCFF – CF to Debt holders
= EBIT (1 – T) + D – CAPEX – ΔWC – I (1 – T) - Repayment
of Debt, R + Net proceeds from fresh debt issued, NB
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Projecting Cash Flows To Firm and Equity:
Three Ways
From Net Income
FCFF = NI + D + I (1 – T) – CAPEX – Δ WC FCFE = NI + D – CAPEX – Δ WC + NB
NI = (EBITDA – D – I) (1 – T) NI = (EBITDA – D – I) (1 – T)

From EBIT/EBITDA
FCFF = EBIT (1 – T) + D – CAPEX – Δ WC FCFE = EBIT (1 – T) + D – CAPEX – Δ WC
Or = EBITDA (1 –T) + TD –CAPEX – Δ WC + NB - I (1 – T)

From Cash Flow from Operations (CFO)

FCFF = CFO + I (1 – T) – CAPEX FCFE = CFO – CAPEX + NB

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Projecting Cash Flows To Firm and Equity
Three Ways – Same Result – Example
From Net Income
NI = (EBITDA –D – I)(1 – T) = (1000 – 400 -150) 0.7 = 315
GIVEN FCFF = NI + D + I (1 – T) – CAPEX – Δ WC
EBITDA 1000 = 315 + 400 + 150 x 0.7 – 500 – 50 = 270
D 400 FCFE = NI + D – CAPEX – Δ WC + NB = 315 + 400 – 500 – 50 + 80 = 245

I 150 From EBIT/EBITDA

T 30% FCFF = EBIT (1 – T) + D – CAPEX – Δ WC

= 600 x 0.7 + 400 – 500 – 50 = 270
CAPEX 500 Or FCFF = EBITDA ( 1 – T) + TD – CAPEX – Δ WC
Δ WC 50 = 1000 x 0.7 + 0.3 x 400 - 500 – 50 = 270
NB 80 FCFE = FCFF – I (1 – T) + NB = 270 – 150 x 0.7 + 80 = 245

Dividend 200 From “Cash Flow from Operations” (CFO)

CFO = NI + D – Δ WC = 315 + 400 – 50 = 665
FCFF = CFO + I (1 – T) – CAPEX = 665 + 150 x 0.7 -500 = 270
FCFE = CFO – CAPEX + NB = 665 – 500 + 80 = 245
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FINDING THE DISCOUNT RATE
WACC and COST OF EQUITY
UNLEVER AND RELEVER BETAS

Rajiv Srivastava Valuing Equity 18

Firm’s Cost of Capital
𝑊𝐴𝐶𝐶, 𝑟 = 𝑟𝑑 1 − 𝑇 𝑤𝑑 + 𝑟𝑝 𝑤𝑝 + 𝑟𝑒 𝑤𝑒
• Weight needs to be based on market values and not book values.
• From shareholders’ perspective the effective cost of debt is net of tax as
interest is tax deductible though debt holders receive rd.
• Cost of preferred debt is not tax deductible.
• The weights must be forward-looking.
• The cost of each component of capital too must be market based and
forward-looking.

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Present Value of Firm
With an EBIT level of Rs 700 perennial with no growth, T = 20%,
Depreciation, D = 500 rd = 5% and re = 14%, Debt ratio D/V= of 0.40
Particulars Amount, (Rs)
WACC
EBIT 700.00
= 14 x 0.6 + 5 (1 – 0.2) x 0.4 = 10%
Tax, 20% 140.00
NOPAT 560.00
Value of Firm for perennial constant
cash flow
Add: Depreciation 500.00 (Rs)
Less: CAPEX 500.00 FCFF/WACC = 560/0.10 5,600
Less: Increase in WC - Debt (Assumed) 2,240
FCFF 560.00
Value of Equity 3,360

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Present Value of Equity – Direct Method
Particulars Amount, Rs
EBIT 700.00
Interest 5% on 2240 112.00 Find cash flows to equity holders
EBT 588.00 and then discount them with cost
Tax, 20% 117.60
of equity (for a levered firm)
Net Income 470.40 Value of Equity
Add: Depreciation 500.00 = 470.40/0.14 = Rs 3,360
Less: CAPEX 500.00
Less: Increase in WC -
FCFE 470.40

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Cost of Equity – Direct and Indirect Methods
• Finding value of equity directly or indirectly from the value of the firm
leads to same valuation.
• For M & A analysts focus on FCFF valuation (enterprise value), then
subtract value of debt to arrive at value of equity.

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Cost of Equity
• Most difficult to find, as there is no promised payment.
• Only residual belongs to the shareholders.
Traditional

CAPM with size

Using CAPM
premium
Cost of Equity
French and Fama
Using Gordon’s
DDM – 3 Factor Model

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Cost of Equity – Traditional CAPM
• Cost of equity as determined by only systematic risk, using portfolio approach.
r = rf + β (rm – rf )
Selecting risk free rate:
• Which security:
• Current yield on government securities.
• What maturity:
• Most analyst wrongfully take return on ST government securities.
• Must match maturity of benchmark with the cash flows of the instrument being
evaluated.
• Equity is long term and hence yield on 10-year G-Sec is more appropriate proxy of risk
free rate.

Rajiv Srivastava Valuing Equity 24

Cost of Equity – Traditional CAPM
Measuring Beta
• Represents variability of the return with respect to market.
• Found by regression between excess returns i.e. (r – rf ) and (rm – rf ).
Some prefer to use r and rm.
Use risk free return on long term bond because stocks are long term securities.
• Use of historical return but what is required is the future returns.
Use geometric average or arithmetic average: Must use arithmetic average.
• Tendency of beta to regress towards mean.
Bloomberg Model for forward-looking Beta = 0.33 + 0.67 (Historical beta)
• For non-traded firms: Use beta of similar firms and take an average to reduce
estimation errors.
Need to unlever and relever betas for capital structure/financial risk.

Rajiv Srivastava Valuing Equity 25

Cost of Equity – Traditional CAPM
Measuring Risk Premium
• Determination future spread over risk free rate.
• Ibbotson Associates: Risk premium is function of size of firm; 4
categorisations based on market cap
Large Cap,
Mid-cap,
Low cap,
Micro cap

Rajiv Srivastava Valuing Equity 26

Cost of Equity – French & Fama 3-Factor Model
• Returns are dependent on multi-factors (just as taken in Arbitrage Pricing Theory).
• Three factors: 1. Equity risk premium, 2. Risk premium for size, 3. Risk premium for
book value
Beta Coefficient Product
Equity risk premium 1.17 5.00 5.850
(Excess of market return over risk free rate)
Size risk premium 0.17 3.50 0.595
(Large cap return less small cap returns)
Book value premium - 0.70 4.40 -3.08
(High book value less low book value portfolios)
Risk premium, % 3.365
Risk free rate, % 5.000
Cost of equity, % 8.365
Rajiv Srivastava Valuing Equity 27
Cost of Equity – Using DDM
• Imputed cost of equity.
• Multiple growth periods may be used when initial growth is high and
subsequent growth settles to a lower and more reasonable manner as
competition grows.
𝐷1
𝑟𝑒 = +𝑔
𝑃0
• A very good tool to find terminal value in FCFF and FCFE approaches.

Rajiv Srivastava Valuing Equity 28

Levered and Unlevered Firm - Risk
• Firms face risk from two sources:
1. Those emanating from business environment, called business risk, and
2. those emanating from borrowing, called financial risk.
• A firm with no debt faces only the business risk and no financial risk i.e.
risk due to borrowing.
• When a firm borrows the claims of the borrowers precede those of
shareholders making cash flows to shareholders more uncertain.
• As debt replaces equity the returns to shareholders get magnified.

Rajiv Srivastava Valuing Equity 29

Levered and Unlevered Firm – Cost of Equity
• When firm does not borrow shareholders have complete freedom in managing
business. They expect returns commensurate with the business risk, r0.
• With debt certain covenants are imposed restricting the freedom of
management and rights of shareholders.
• With prior and superior claims of the debt holders over the cash flows of the
firm the returns to shareholders are threatened, even though cost of debt, rd is
lesser.
• For increased risk with debt, the shareholders raise aspirations of desired
return, and therefore cost of equity for levered firm is higher.
• The cost of equity in a levered firm, re is
𝐷(1 − 𝑇)
𝑟𝑒 = 𝑟0 + (𝑟0 − 𝑟𝑑 )
𝐸
Rajiv Srivastava Valuing Equity 30
Unlever and Relever Beta
𝐸 𝐷(1−𝑇)
𝛽𝑈 = 𝛽𝐿 +𝛽𝑑
𝐸+ 1−𝑇 𝐷 𝐸+ 1−𝑇 𝐷

βL is observed beta of the comparable taking into account

a) business risk and b) financial risk of the firm.
Unlevering the observed beta:
To estimate what amount of risk a particular business carries the observed beta must
be segregated for the financial risk. The unlevered beta would represent only the
business risk i.e. the risk faced by a pure equity firm in the same line of business.
Relevering beta:
The unlevered beta must be superimposed with the financial risk of the firm depending
upon the capital structure proposed.
𝐸(𝑛)+ 1−𝑇 𝐸(𝑛) 𝐷(𝑛)(1−𝑇)
𝛽𝐿 = 𝛽𝑈 - 𝛽𝑑
𝐸(𝑛) 𝐸(𝑛)

Rajiv Srivastava Valuing Equity 31

2-Stage FCFE Model
PHASE High Growth Stable
Period, years 5 After 5 years
Beta 1.2 1.1
Debt Ratio, d 40.00% 37.60%
RoE 25.00% 16.00%
Retention ratio 65.00% NA
Growth 16.25% 4.00%
WC 9.00% 8.00%
Capex/Dep Current 1.50
Risk Free rate 4.00% 4.00%
Risk Premium 5.26% 5.26%
Cost of equity 10.31% 9.79%
Rajiv Srivastava Valuing Equity 32
FCFE – High Growth Period
HIGH GROWTH PERIOD
YEAR 0 1 2 3 4 5
Revenue 1,820.00 2,115.75 2,459.56 2,859.24 3,323.86 3,863.99
a) Net Income 110.00 127.88 148.65 172.81 200.89 233.54
CAPEX 115.00 133.69 155.41 180.67 210.02 244.15
Dep 75.00 87.19 101.36 117.83 136.97 159.23
CAPEX/Dep 1.53 1.53 1.53 1.53 1.53 1.53
Net Capex 46.50 54.06 62.84 73.05 84.92
b) Net CAPEX (From Equity) 27.90 32.43 37.70 43.83 50.95
WC 163.80 190.42 221.36 257.33 299.15 347.76
Change in WC 26.62 30.94 35.97 41.82 48.61
c) WC (From equity) 15.97 18.57 21.58 25.09 29.17
FCFE (a + b + c) 84.00 97.66 113.52 131.97 153.42
PV at cost of equity,
10.31% 76.15 80.25 84.57 89.12 93.92
PV of FCFE Year 1-5 424.02

Rajiv Srivastava Valuing Equity 33

FCFE – High Growth Phase
WORKING NOTES
Item Formula Used Year 1 Values
Revenue (1+0.1625) x Rev(t-1) 1.1625 x 1820 = 2115.75
Net Income (1+0.1625) x NI(t-1) 1.1625 x 110 = 127.88
Capex 0.5333 x Dep 0.53 x 87.19 = 46.50
Capex (From Equity) (1 – d) x Capex (1 – 0.4) x 46.50 = 27.90
Working Capital 9% x Revenue 0.09 x 2115.75 = 190.42
Δ in Working Capital WCt – WC (t- 1) 190.42 – 163.80 = 26.62
Δ in Working Capital (1 – d) x Δ WC (1 – 0.4) x 26.62 = 15.97
(From equity)

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FCFE – Stable Growth and Total Value

STABLE GROWTH PERIOD FCF to Equity

EPS in Year 6 242.88 242.88
Net CAPEX 82.80 51.67
Δ WC 12.36 7.72
FCFE Year 6 183.50
Terminal Value I Year 6 3,171.39
Terminal Value I Year 0 1,941.49
TOTAL PRESENT VALUE OF EQUITY 2,365.51

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Equivalence of DCF Approaches
• All the approaches (FCFF, FCFE) provide identical result.
• Need to use right cash flows and right discount rates.
• It is the convenience of data and analyst to determine which method to use.
• Given:
EBIT = 180 (depends upon potential of assets and not the way they are financed).
Tax, T = 40%
Cost of debt, rd = 10%
Cost of equity (Opportunity cost), r0 = 20%
Cost of project = 550, Financing Equity = 400, Debt = 150
Debt ratio D/V = 25% or D/E = 1/3, (Perennial) NPV accrues to shareholders’ wealth.

Rajiv Srivastava Valuing Equity 36

Equivalence of Three DCF Approaches
FCFE FCFF
EBIT 180 180
Interest, 10% of 150 15 15
EBT 165 165
Tax, 40% 66 66
Cash Flow to Equity 99 99
Cash Flow to Debt - 15(1-T) = 9
Total Cash Flow 99 108
Discount Rate* 22% 18%
PV of Cash Inflows 99/0.22 = 450 108/0.18 = 600
Value of Tax Shield - -
Initial Cash Outflow 400 550
Net Present Value 50 50
Rajiv Srivastava Valuing Equity 37
Cash Flows and Discount Rates

Cash Flow to Firm (FCFF) Cash Flow to Equity (FCFE)

Cash flow available to

Cash flow to equity
all capital suppliers
holders alone
(Equity and Debt)
Discount at Weighted Average Discount at Cost of Equity,
Cost of Capital, (WACC)
re = r0 + (r0 – rd) (1 –T)D/E
𝐸 𝐷
𝑟𝑒 = 𝑟𝑒 + 𝑟𝑑 1 − 𝑇 = 20 + 10 x 0.6 x 1/3
𝑉 𝑉
= 22%
3 1
𝑟𝑒 = 22 + 10 1 − 0.4
4 4
= 18%

Rajiv Srivastava Valuing Equity 38

RELATIVE
VALUATION
Same as DCF Yet Different
Relative Valuation
• Used as substitute to DCF but is not really so, instead it is
complementary.
• Treated as different than DCF valuation because it uses different
information than the cash flows and discount rate.
• Uses market prices of observed transactions as basis of determining the
value of an asset (financial security).

Rajiv Srivastava Valuing Equity 40

Steps for Relative Valuation
• Four steps to do relative valuation
1. Find a comparable
2. Calculate the valuation metric
3. Make estimate of value
4. Refine valuation for differences
• Appears simple but indeed very complex and requires substantial
expertise and experience.

Rajiv Srivastava Valuing Equity 41

Multiples in Popular Use
PE Multiple:
• Most Common; For established old firm with steady flow of income.
Book Value Multiple:
• Ideally stock must trade it its book value. Firms with large debt and low equity
have high P/BV ratio. Used for firms with high capital investment, and banks.
Can be used for firms with negative earnings because PE Ratio cannot be used
for these firms.
Sales Multiple:
• Can be used for firms not making profit e.g. Flipkart
Price to Cash Flow:
• For new firm with large depreciation in the beginning (when WDV is used).
Market Value to Replacement Value (Tobin’s Q):
• Used when going for brown-field expansion (Acquisitions).

Rajiv Srivastava Valuing Equity 42

Relative Valuation – A Case of RBL Bank Limited
• The Issue Price of Rs 225 was decided in the public issue of RBL Bank
Limited in August 2016 for its issue of about 5.39 crore shares of face
value of Rs 10 each in a book building process . Some of the qualitative
factors that formed the basis for the Issue Price are:
• Client focused approach to business resulting in growing brand
recognition;
• Robust multi-channel distribution system;
• Partnerships that expand reach in rural markets;
• Growing net interest and non-interest income;
• Risk management and balance sheet focus;
• Modern and scalable information technology systems infrastructure;
• Focus on operational quality and scalability;
Rajiv Srivastava Valuing Equity 43
Relative Valuation – RBL Bank Ltd
Besides qualitative factors following quantitative factors were considered
as below:
1. Basic and Diluted Earnings Per Share (EPS):
Year ended Basic EPS (Rs) Diluted EPS (Rs) Weight
March 31, 2014 3.63 3.61 1
March 31, 2015 7.23 7.00 2
March 31, 2016 9.60 9.43 3
Weighted Average 7.82 7.65

Rajiv Srivastava Valuing Equity 44

Relative Valuation – RBL Bank Ltd
2. Price/Earning (P/E) ratio in relation to Issue Price Rs 225 per
Equity Share:
P/E based on basic and diluted EPS for the year ended 31 March, 2016
at the Issue Price are 23.86 and 23.44 respectively.
Industry P/E*
(i) Highest: 40.42
(ii) Lowest: 14.65
(iii) Average: 24.13

Rajiv Srivastava Valuing Equity 45

Relative Valuation – RBL Bank Ltd
3. Average Return on Net Worth (RoNW):
Year Ended RONW % Weight
March 31, 2014 4.60 1
March 31, 2015 9.29 2
March 31, 2016 9.79 3
Weighted Average 8.76

Rajiv Srivastava Valuing Equity 46

Relative Valuation – RBL Bank Ltd
4. Minimum Return on Increased Net Worth required for maintaining
pre-Issue Basic / Diluted EPS for the financial year 2016:
To maintain pre-Issue Basic EPS : 9.29% at the Issue Price
To maintain pre-Issue Diluted EPS : 9.13% at the Issue Price

5. Net Asset Value (“NAV”) per equity share / Book Value per equity
share:
The adjusted NAV per equity share of face value of Rs 10 each is:
(i) As on March 31, 2016 : Rs 92.02
(ii) Issue Price per Equity Share : Rs 225
(iii) As on March 31, 2016 after the Issue : Rs 103.32

Rajiv Srivastava Valuing Equity 47

Relative Valuation – RBL Bank Ltd
Peer Comparison

Name of the Bank Face Total Basic P/E P/BV RoNW, NAV,
Value Income EPS Rs % Rs
Rs
million
RBL Bank Limited 10 32,348 9.60 23.44 2.45 9.79 92.02
Yes Bank Limited 10 162,628 60.39 19.59 3.61 18.38 327.26
Indusind Bank 10 148,776 39.68 29.14 3.97 13.20 291.02
Limited
Kotak Mahindra 5 279,745 18.91 40.42 4.20 10.37 181.86
Bank Limited
City Union Bank 1 33,541 7.44 16.85 2.46 14.57 51.02
Limited
DCB Bank Limited 10 19,189 6.86 14.65 1.64 11.18 61.19
Rajiv Srivastava Valuing Equity 48
EBITDA Multiple
• Enterprise value = Value of equity + Value of interest bearing net debt
= Value of equity + Value of debt – Cash available
• Enterprise value = EBITDA x EBITDA Multiple
• EBITDA multiple of similar companies may be used for valuing non-
traded companies.
• If EBITDA multiple of similar firms (average) is 10.48 and if non traded
firm has EBITDA of Rs 10 million , then enterprise value is
10.48 x 10 = Rs 104.80 million.

Rajiv Srivastava Valuing Equity 49

EBIDA Vs PE Multiples – An Example
• Rocky Shoes has EPS of Rs 2.30 and EBITDA of 30 crore and has 5 crore shares
outstanding. It also has debt of Rs 125 crore (Net of cash).
• Punky Shoes is comparable to Rocky Shoes. Punky shoes has no debt. It has PE
multiple of 14 and EBIDA to Enterprise value multiple of 7.5.
• What is the value of Rocky Shoes using both multiples? Which of the two is preferable
and why?
USING PE MULTIPLE USING EBITDA MULTIPLE
• Stock price of Rocky shoes using PE • Using EBITDA multiple of Punky Shoes
multiple of Punky Shoes the enterprise value of Rocky Shoes
= 14 x 2.30 = Rs 32.20 = 7.5 x 30 =Rs 225 crore.
Value of equity = 225 – Net Debt
Due to large difference in the leverage of two = 225 – 125 = Rs 100 crore.
firms the valuation based on enterprise • Estimated share price = 100/5 = Rs
value and EBITDA is more reliable. 20.00
Rajiv Srivastava Valuing Equity 50
DCF and Relative Valuation
(1+𝑔)
• 𝑉𝑎𝑙𝑢𝑒 = 𝐶𝐹0 as per DCF, with r = discount rate, and g = perpetual
(𝑟 −𝑔)
growth rate of cash flows
(1+𝑔)
• 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 = as multiple of present cash flow.
(𝑟 −𝑔)
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (𝑟 − 𝑔)
• 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 (1+𝑔)
Valuation Multiples
g = 3% r = 15% Valuation multiple = 8.58
g = 5% r = 15% Valuation multiple = 10.50
Implied Capitalisation rates
g = 3% r = 15% Captalisation rate = 11.65%
g = 5% r = 15% Capitalisation rate = multiple = 9.52%

Rajiv Srivastava Valuing Equity 51

Multiples and DCF
PE Ratio
𝐸(1 − 𝑏)(1 + 𝑔) 𝑃 (1 − 𝑏)(1 + 𝑔)
𝑃= 𝑜𝑟 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = =
(𝑟 − 𝑔) 𝐸 (𝑟 − 𝑔)
Price to Book Value (B) Ratio
𝐸(1 − 𝑏)(1 + 𝑔) 𝑃 𝐸/𝐵(1 − 𝑏)(1 + 𝑔) 𝑅𝑂𝐸(1 − 𝑏)(1 + 𝑔)
𝑃= 𝑜𝑟 = =
(𝑟 − 𝑔) 𝐵 (𝑟 − 𝑔) (𝑟 − 𝑔)
Price to Revenue per share (S)
𝐸(1 − 𝑏)(1 + 𝑔) 𝑃 𝐸/𝑆(1 − 𝑏)(1 + 𝑔) 𝑁𝑃𝑀(1 − 𝑏)(1 + 𝑔)
𝑃= 𝑜𝑟 = =
(𝑟 − 𝑔) 𝑆 (𝑟 − 𝑔) (𝑟 − 𝑔)

Rajiv Srivastava Valuing Equity 52

Getting Multiples from Fundamentals
Given : Current dividend pay-out, (1 – b) = 75%, Growth rate of earnings and
dividend, g = 6%, Rf = 7% , Beta = 0.8, Risk Premium (Rm – Rf) = 8%, Cost of
equity r = 7 + 0.80 x 8 = 13.4%
𝑃 (1 − 𝑏)(1 + 𝑔) 0.75 𝑥 (1.06)
𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 = = = = 10.74
𝐸 (𝑟 − 𝑔) (0.134 − 0.06)
Price to Book Value (B) Ratio, Return on Equity = 15% (Note: RoE is not same as
cost of equity)
𝑃 𝐸/𝐵(1 − 𝑏)(1 + 𝑔) 𝑅𝑂𝐸(1 − 𝑏)(1 + 𝑔) 0.15 𝑥 0.75 𝑥 (1.06)
= = = = 1.61
𝐵 (𝑟 − 𝑔) (𝑟 − 𝑔) (0.134 − 0.06)
Price to Revenue per share (S) Net Profit Margin = Net Income/Revenue = 5%
𝑃 𝐸/𝑆(1 − 𝑏)(1 + 𝑔) 𝑁𝑃𝑀(1 − 𝑏)(1 + 𝑔) 0.05 𝑥 0.75 𝑥 (1.06)
= = = = 0.54
𝑆 (𝑟 − 𝑔) (𝑟 − 𝑔) (0.134 − 0.06)
Rajiv Srivastava Valuing Equity 53
Multiple Approach - Advantages
• No need to make separate assumptions about
a) retention ratio, b
b) growth, g, and
c) required return, r as required under DCF.
• They are built-in into PE Ratio as combination of all three above
mentioned determinants of value.
• PE Ratio is observable and is a consolidated view of millions of
investors,.
• Therefore PE ratio removes individual biases about estimates of pay-out,
returns and growth.
Rajiv Srivastava Valuing Equity 54
PE Ratio and Growth Rate
A rule of thumb (Not applicable always)
“PE ratio of a fairly priced stock would be equal to its growth rate”.
• If PE ratio is 15 then growth rate of earning would be 15%.
CHECK:
• With rf = 8% beta = 1 and risk premium of 8% the cost of equity is 16%.
• Assuming ROE same as cost of equity, and retention ratio of 0.40 (a
typical value for growing firms) the growth rate is
g = ROE x b = 16 x 0.4 = 6.4%
• PE Ratio = (1 – b)/(r – g) = 0.6 /(0.16 – 0.064) = 6.26
(Close to growth rate %)

Rajiv Srivastava Valuing Equity 55

EBITDA Valuation and FCFE/FCFF
• EBITDA is before tax measure and does not include CAPEX and changes
in working capital.
• EBITDA overstates FCFF
• EBITDA = FCFF + T x EBIT + CAPAEX + Δ WC
Enterprise value (10.48 x EBITDA) = 104.80
Plus: Cash = 2.40
Less: Value of Interest-bearing debt = 21.00
Value of Equity = 86.20

Rajiv Srivastava Valuing Equity 56

EBITDA Valuation – Advantages/Disadvantages
• EBITDA is a crude measure of firm’s cash flow with no growth
assumption. If CAPEX and working capital are not changing FCFF would
equal EBITDA.
• EBITDA is the earning potential of assets already in place. FCFF/FCFE
are applicable for growing firm. Due to discretionary expenditure on
CAPEX, FCFF/FCFE may be extremely volatile.
• Shall we ignore the value of growth. (Firm’s investments have zero NPV
on an average????).
• Add: Value of growth separately to the value produced by existing assets.
• Good measure for stable and matured businesses.

Rajiv Srivastava Valuing Equity 57

EBITDA Valuation
Liquidity Discount and Control Premium
DISCOUNT FOR LIQUIDITY
• A pure financial buyer with no interest may not like to pay the enterprise value
if the investment relates to a non-traded firm. (discount for liquidity) and
multiple used is of traded firms.
• A discount for liquidity is often placed at 20-30%.
• When a firm being valued is also traded, liquidity discount is subject to dispute.
PREMUIM FOR CONTROL
• A strategic buyer may pay more than enterprise value (Premium for control).
• Prices of stock and DVRs – Tata Motors, Jain Irrigation, Future Retail, Gujarat
NRE Coke trade at 25-40% discount to the value of common stock. The excess
can be attributed to the premium for control.
Rajiv Srivastava Valuing Equity 58
Difficulties of Relative Valuation
Distressed Firms:
Estimate potential cash flows.
Cyclical firms:
More dependent upon economic outlook
(Metals, Cement etc) (May have negative
cash flows in recessions but positive cash
flows in recovery
Underutilised of unutilised assets:
Project cash flows based on full utilisation
of assets if potential of firm is a concern.
Firms having patents:
Need to use option theory
Rajiv Srivastava
Firms under restructuring:
Dividend policy, capital structure etc. that
are determinants of value are likely to
change significantly. Using historical data
may be erroneous.
Firm involved in acquisitions: Estimation
of synergy, Hostile takeovers or leveraged
buyout change risk profile substantially.
Non-traded private firms:
While projection of cash flow would be
possible but estimation of discount rate is
questionable.
Valuing Equity 59
Pitfalls of Relative Valuation
• Difficulty of finding exact comparable.
How to attach value to differences in size, product mix, management
quality etc. which are subjective and could be biased.
• Carrying the errors: If market is causing error in valuation it is carried forward
in the valuation of the target (Advantage or Disadvantage)
• Earnings are subject to accounting policies, specifically relating to income
recognition, depreciation, inventory valuations. There are lot of leeway given
under GAAP.
(Firms with more conservative accounting policies have higher PE
multiples, because market seem to be recognising differences in
accounting treatment assuming markets are efficient enough)

Rajiv Srivastava Valuing Equity 60

Pitfalls of Relative Valuation
• Firm whose earnings are more volatile have lower PE ratio.
Firms a) high growth, b) stable earnings and c) conservative
accounting policies enjoy high PE multiples
• In times of high inflation multiples do not seem to work and fall
drastically.
• Leading vs trailing multiples.
• Extraordinary and one-time transactions of revenue, cost and profit.

Rajiv Srivastava Valuing Equity 61