Valuation Concepts

 EBIT = Earnings before interest and taxes. This represents a company’s

GAAP-based operating profit.
 Tax rate = The tax rate the company is expected to face. When
forecasting taxes, we usually use a company’s historical effective tax rate
 D&A = depreciation and amortization.
 NWC = Annual changes in net working capital. Increases in NWC are
cash outflows while decreases are cash inflows.
 Capital expenditures represent cash investments the company must
make to sustain the forecast growth of the business. If you don’t factor in the
cost of required reinvestment into the business, you will overstate the value of
the company by giving it credit for EBIT growth without accounting for the
investments required to achieve it.

Components of DCF
1 Free Cash Flow estimation (FCF)
The DCF approach involves forecasting earnings and forecasting FCF.This is
the net cash generated by the firm through its assets. BIT and EBITDA are only
earning figure as they do not really reflect cash position so they need to be
adjusted in order to find the cash flow to the firm may be categorized as :
1.FCFF-Free cash flow to the firm
FCFF=EBIT(1-Tax) +DEP-Capex-Working capital
FCFF=Cash from Operation (CFO)+Interest(1-Tax)-Capex
CFO=Net Income+Dep+Amortization-Increase in WC
FCFF=FCFE+Interest(1-T)-Net Borrowings
2.FCFE-Free cash flow to the equity
FCFF=FCFF-Interest(1-T) +Net borrowings
FCFE=CFO-Capex+Net borrowings
2.Period of estimation-Generally ranges from 5-10 years
3.Growth in FCF
FCFF is based on the operating income before debt payment so we need to
gauge growth in operating income.
FCFE is based on the net income or earnings per share which is calculated after
payment of all dues and obligations of the firm.
Growth in net income=Equity reinvestment rate (ERR)*Return on equity (ROE)
Growth in operating income (EBIT)=Reinvestment rate (RR)*ROC(Return on
Capital
ROE=ROC+D/E*(ROC-Kd post tax)
ROC=EBIT(1-T)/Equity Value Debt Value-cash
4.Perpetuity Value beyond FCF Period
Perpetuity value is also called the continuing value or terminal value.
TV=FCFFn+1/WACC-stable growth rate
This growth rate cannot be more than Economic growth rate. In stable state the
firm will have beta as 1
5 Discount rates
The discount rate is used to calculate the PV of FCF.
For FCFF discount rate is WACC
For FCFE discount rate is Cost of Equity.
Calculation of Cost of Equity (Ke)-It is calculated by the
following methods
1.Dividend Capitalization Approach (DDM)
According to this approach the cost of equity capital is measured by the rate of
return required by the equity holder
Ke=D1/(Po-f)+g
F is flotation cost.
Flotation cost is defined as the cost incurred by the company when they issue
new stocks in the market as the process involves various stages and participants.
It includes audit fees, legal fees, accounting fees, investment bank’s share out of
the issuance, and the fees to list the stocks on the stock exchange that needs to
be paid to the exchange.
 It is expressed as a percentage of the issue price since the capital that is
raised after the sale of the new stocks will be after the deduction of the flotation
cost.

2.Capital Assets Pricing Model

 CAPM was developed in the early 1960s by William Sharpe (1964), Jack
Treynor (1962), John Lintner (1965) and Jan Mossin (1966). The CAPM is
based on the idea that not all risks should affect asset prices. The CAPM gives
us insights about what kind of risk is related to return.
There is liner relationship between risk and expected return. It also considers B
(Beta) to specify the relationship between market and individual equity.
Cost of Equity (Ke)=Rf+B(Rm-Rf)
3.Arbitrage Pricing theory
APT was developed out of CAPM by Steven Ross in 1977.Unlike the CAPM it
considers various independent factors which tend to influence the security in
market. CAPM considers Beta while APT considers inflation
4.Three factor Fama Model
Fama and French in Year 1992 extended the CAPM model and specified that
three risks factors determine the portfolio return
Beta
Market Size
Market to Book Value