Valua on & 3 Approaches

Intrinsic Valua on (DCF) Rela ve Pricing Real Op on Valua on

Mul ple Based Regression Based

Value of Asset =
å E (CFn ) Pricing Pricing
n
(1 + rn )
E (CF ) = Expected Cash Flow
Op on to Op on to
rn = Discount rate reflecting riskness of a bond on delay
estimated CF .
n = life of asset
 Intrinsic Valua on

Enterprice Value Equity Value

free cashflows free cashflows

é FCFF ù to firm to equity
é FCFF ù
åê 1+ k n ú åê 1+ k n ú
êë ( 0) ú êë (
û e) ú
û
weighted avg.
cost of equity
cost of capital
(using CAPM)

é E ù é D ù
êëKe ´ D + E úû + êëKd ´ D + E úû Ke = RF + (ERP )´ Beta
 Risk

Non diversifible Diversiflable

Rewarded Not Rewarded

Who ? Marginal Investors

Adequate no. of stocks to Unseeingness to trade

influence the price
How Rewarded ?
- Expecta on of cost of equity.
- Beta of an asset
Risk Free Rate Free From

Default Risk Reinvestment Risk

3 ways to calculate RF Match the horizon

Note:
1. Govt. Bond Spread
* Time horizon ma ers RF depends upon
RF = local currency govt. bond yield - default spread ma ers Life of CFS.
of the country (over v/s bond) * Currency ma ers RF of country in what
currency valua on is performed.
2. CDS Spread
* Net all govt. securi es all RF.
RF = local currency govt. bond yield - CDS of the What if no default free en ty exist
country
3. Ra ng based Spread Bulid up Approach Differen al Infla on
RF = local currency govt. bond yield - Spread basis RF = Expected Infla on (1 + RFus )
in currency + expected RF = ´ (1 + Inf lnFC )
(1 + Inf lnUS )
country risk ra ng. real in . rate
Equity Risk Premium

Country’s Default Spread Country’s Equity Default Spread MNC YES

Exposure of country ERP to

ERP NO
our company
ERP

Survey Approach Historical ERP Implied ERP Country DRP to Country ERP

Interview large investor for

their expecta on
Arthema c Average Geometric Average

Country Default Spread Geldman’s Approach Melded Approach

US ERP + Default Spread USERP Default Spread s CountryEq .
ERP = ´ s Country Eq. ´
of Company s USEq . of Country Bond s CountryBond
ERP for MNCS

Loca on Based CRP Opera on Based CRP Lambda (l ) - Measure of

Country Risk
Where Located Where Opera on (l ) = % of domes c Revenue of
company
% of domes c Revenue of
average firm
Beta

Measure of Systema c RISK Uncertainty in Returns

Should be Rewarded
Rewarded only
As per risk percep on
Risk Not diversified of investor
Not all risk and not all investors should be
Who ? Marginal Investors rewarded
 Systema c Risk
Not all Risk should be rewarded for. Marginal Investors are very well DIVERSIFIED

Should only be rewarded for UNDIVERSIFIABLE/ SYSTEMATIC RISK

- Macro Economic Uncertainty

- Con nious Risk - forex, Interest rate risk
REWARDED Through BETA
- Geopoli cal Risk
- Country Risk

CAPM BETA

Regress stock returns (Rj) against Mkt Returns (Rm). Rj = a + b (Rm) where a = Intercept;
b = SLOPE OF REGRESSION

Corresponds to the both of stock & measures its riskiness against market.
3 Problems with Beta

High Standard Error Reflect Capital Structure Reflect firm’s average financial
over period of regression leverage ever the period rather
& net current mix current leverage

Bo om up Beta Why Bo om up Beta

Starts with unleavened beta of sector Standard error lower than regression Beta.
Std error (bo om up) =
Adjust sector beta with firms Avg. Std. error across beta
opera ng leverage No. of firms in sample

Use financial leverage of firm to Reflect current mix of opera ng & financial
es mate equity beta of firm. leverage
Eq. beta = unleavened beta This Beta can be es mated without
(1 + (1 - T) D/E) historical stock prices, eg. IPO, Pvt. Co.
divisons of company.
Cost of Debt (Kd) Sensi ve to

Current Interest Rate/RF. Default Risk of Company Tax advantage over the debt.

Cost of Debt 3 Approaches

For Traded Debts For Rated Debt For neither traded nor rated debt

For Traded Debts Look up ra ngs Es mate systhe c ra ng of firm

using interest coverage ra o

Es mate default spread

 Cost of Debt Emerging Mkt Countries

Kd = Risk Free Rate + Country default spread + Company default spread (synthe c/market ra ng)

Value of Debt

We Mkt value not Book Value Consider In bearing debt only both
short 3 long term.
How to calculate Mkt value from Book Value ? Capitalize opera ng leases & treat
them as Debt.

Treat all Debts as one coupon bond

Coupon Amount Maturity Discount Rate

Kd
} Pvot this bond should be
considered as mkt value and
use as weights for K0
M

Interest Exp. Weighted avg. monthly of all debt

Cashflows Measured to

All claimholders for Firm For Equity holders only

EBIT (1 - T)
Net Income Dividend + Stock Buyback
(-) Capex - Deprecia on
(-) Change in non cash working capital - (Capex - Deprecia on)
free cash flow to firm (FCFF) - Change in non cash working
capital Poten al
- (Principal repaid - new debt FCFF
infmed)
- Preferred Dividend
free cashflow to eq. (FCFE)
Reported Earning to Actual Earning

Firm’s Comparable Opera ng Leases R & D Expenses

History Firm - Convert into debt - Convert into asset
- adjust opera ng income - adjust opera ng income

Normalize
Earnings
Cleanse Opera ng Items of
- Financial Expenses
- Capital Expenses
- Non - Recurring Expenses
Measure Pure Earning - Update for
- Trailing Earnings
- Unofficial Numbers
Dealing with Nega ve/Adnormally Low Earnings

Why earnings are Nega ve/Abnormally Low ?

Temporary Cyclicity Eg - Anto Life cycle reason Leverage problems Long term opera ng
Problems Commodity eg. startup young eg - debt laden problem
firms

Value the firm with detailed cashflow forecast

Normalize Earnings
star ng with revenue and reduce eliminate
the problem over me.

It firms size has not charged
significantly over me
Average Dollar Earnings (Net
income it equity & EBIT if firm)
made by firm over me
Firm’s size changed over * If problem is structural - Target with opera ng
the period of me margins of stable firm in sector.
* If problem is leverage - Target for a debt ra o
that firm will be comfortable with by end of period
use firm’s avg ROC/ROE which could be its own op mal or industry avg.
on current value of * If problem is opera ng - Target for industry avg.
capital/equity opera ng margin.
Growth Higher Growth translates into higher value

Double Edged Sword

Good Side Bad Side

Pushes up revenue and For growth - Need to set aside

opera ng income money to reinvest

Net effect of growth = Goo Side > Bad Side

Reinvestment vs. Growth

Growth 1. Young companies/startup 2. Low growth company

Reinvestment 3. Emerging market company 4. CRED, Flipkart

Growth 1. Old companies/mature co. 2. High growth company

Reinvestment 3. Developed country company 4. Ne le, walmart
How to es mate Growth

Look at the past Look what others are es ma ng Look at fundamental

Fundamental Growth
Arithme c Median Growth Rate of Available
v/s economic Analyst Reports
average Sustainable Growth
Sensi ve to - Invest with analyst es mates
* periods used
in es ma on * Tunnel Vision - too much sec. focussed. How much reinvestment How well it is
* metric that in Business reinvested
* Stockholder syndromes - too much
growth is dependency on mgmt informa on.
es mated in * Limmingi s - urge to change recomm. Reten on Ra o × ROE = Growth
when other analysts do so.
* High dependency on pvt. informa on Enterprise value - Growth in opera ng income
than public info. Equity value - Growth in Net Income
 Fundamental Growth - 3 Varia ons
Earnings Measure Reinvestment Measure
1. Earning Per Share Reten on Ra o = % of net
income retained by business
= 1 - payout ra o
2. Net income from non Equity reinvestment rate =
cash assets Net Capex + non cash WC +
Debt
Net Income
3. Opera ng Income Reinvestment rate =
(Net Capex + non cash WC)
A er tax opera ng income
Return Measure
Return on Equity =
Net income
Book value of equity
Non cash ROE =
Net Income from non -
cash asset
Book value of equity - cash
Return on Invested Capital
(ROIC) =
(A er tax opera ng income)
(BV of equity + BV of debt - cash)
FCFF K0 DCF VALUE

Value of Cash
Value of operating asset XX
(+) cash/mkt securities XX
Keep cash out of valua on Once opera ng assets have
(+) value of c ross holding XX
(+) value of other non - operating XX
been valued
asset
Value of Firm XXX Add back the value of cash/mkt securi es
(-) Value of debt (XX)
Value of Equity XXX
(-) Value of Equity Option (XX) Should cash be discounted ? ONLY IF
Value of common stock XXX
No. of shar e (X)
Value/ asset XXX

Cash held by firm is invested Management is not trusted

at rate lower than mkt rate with the large cash balance
given riskiness of investment. because of its part track record
on investment.
Value of Holdings

Minority Passive Holding Minority Ac ve Holding Majority Ac ve Holding

Only dividend from holding Share of equity income of Full consolida on of holding
shown in balance sheet holding shown in income and subsidiary
statement
How to Value Cross Holdings

Step 1 - value parent Step 2 - value each cross Step 3 - The final value of equity in parent
company without any holding individually company with holdings will be:-
cross holding. = value of unconsolidated parent company
(Unconsolidated) (-) value of debt of unconsolidated parent company
(+) % of holding × (value of holding - debt of holding)