ACF

UNIT 1ST

Business Valuation: A business valuation is a general process of determining the economic value of a
whole business or company unit. Business valuation is typically conducted when a company is looking to
sell all or a portion of its operations or looking to merge with or acquire another company. The valuation
of a business is the process of determining the current worth of a business.

Why Business Valuation-

1. To set a basis of value for a business when no valuation has been previously performed.

2. To understand the value (worth) of the business.

3. To develop a strategy to improve the profitability of the business.

4. To evaluate an offer and negotiate a strategic sale of a business (For exit strategy).

5. To determine the annual per share value of an Employee Stock Ownership Plan (ESOP).

6. To justify the per share equity value in a company for annual shareholder meetings.

7. To identify weaknesses in a business.

8. For shareholder or partnership disputes.

9. For shareholder or partnership investments or buyouts.

10. To obtain bank financing or alternative investment.

11. For financial reporting purposes – to allocate the purchase price to appropriate equity classes.

12. To allocate the purchase price after an acquisition of a business (During Mergers/Acquisitions).

13. For Expanding the Business.

14. For gift tax planning purposes – transferring an interest to family members, donation to a charity, etc.

15. To determine the value of the assets in a marital dissolution action.

16. To value a business for a business bankruptcy.

17. To determine the IP value in a business.

18. For litigation support purposes, to determine economic damages, lost profits, uncover fraud or value
of a business in a shareholder or partnership dispute, IP damage from infringement, etc.

19. To identify whether the business is growing, stagnant or declining in value to restructure the business.
Topic: Valuation Techniques

During the valuation of a business few factors like profitability, associated risk, and valid Information are
highly considered by the evaluators. The following three main methods are used during the valuation of
a firm:

1. DCF Method

2. Relative valuation method

3. Book value approach

1.DCF: A discounted cash flow model ("DCF model") is a type of financial model that values a company
by forecasting its' cash flows and discounting the cash flows to arrive at a current, present value.

In simple words, Discounted Cash Flow or DCF analysis is a process of evaluating the attractiveness of an
investment opportunity in the future at present. As such, discounted cash flow valuation analysis tries to
calculate the value of a company today, based on forecasts of how much money the company is going to
make in the future.

DCF Value-

Present Valuet=0 = Cash Flow t=1 / (1+r)t

The DCF theory describes money received in the current time has more worth than money received in
future.

Steps-DCF

Step 1: Project the company’s Free Cash Flows: Typically, a target’s FCF is projected out 5 to 10 years in
the future.

Step 2: Choose a discount rate

Step 3: Calculate the TV

Step 4: Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present
value. (EV = Present value of UFCF plus Present value of TV)

Step 5: Calculate the equity value by adding debt and subtracting cash from EV (Note: Debt – Cash is
called Net Debt)

Assumption- DCF

1. Free cash flow (FCF) – Cash generated by the assets of the business (tangible and intangible)
available for distribution to all providers of capital. FCF is often referred to as unlevered free
cash flow, as it represents cash flow available to all providers of capital and is not affected by
 the capital structure of the business. All cash flows are treated as though they occur at the end
of the year.

2. DCF methods treat cash flows associated with investment projects as though they were known
with certainty.

3. All cash inflows are reinvested in other projects that earn monies for the company.

4. DCF analysis assumes a perfect capital market.

5. Terminal value (TV) – Value at the end of the FCF projection period is calculated.

6. Discount rate and growth rate – The rate used to discount projected FCFs and terminal value to
their present values. This is also called WACC. The growth rate is also known. This is the
expected rate of growth in earnings.

Terminal value (TV): Terminal value (TV) is the value of a business or project beyond the forecast period
when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth
rate forever after the forecast period. Terminal value (TV) determines a company's value into perpetuity
beyond a set forecast period—usually five years.

TV = (FCF * (1 + g)) / (d - g)

{Note: d is also called WACC or discounting rate which is highly influenced by a firm’s cost of debt, cost
of equity and cost of preference share.

g is growth rate.}

2. Relative Valuation Model

A relative valuation model is a business valuation method that compares a firm's value to that of its
competitors to determine the firm's financial worth.

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 buy.

A relative valuation model can be used to assess the value of a company's stock price compared to other
companies or an industry average.

Methods of calculating Relative value (Multiples)-

Valuation Multiples

a. PE Ratio (studied earlier)

b. EV/EBITDA (1 & 2 are called Earning Multiples)

c. EV/Sales (is called Revenue Multiple, not given in our syllabus)

d. Price/Book Value (is called Book Value Multiple, not given in our syllabus but you should know)

a. Price to Earning Ratio (P/E Ratio)-

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.

In addition to providing a gauge 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.

b. EV/EBITDA multiple: EV/EBITDA multiple is also called Earning Multiples or Enterprise Multiple or EV
multiple. It is a ratio used to determine the value of a company. EV to EBITDA is the ratio between
enterprise value and Earnings Before Interest, Taxes, Depreciation, and Amortization. It helps
investor to compare a certain company to the parallel company in the industry as a whole, or other
comparative industries.

Enterprise Multiple = EV/EBITDA

Where,
EV=Enterprise Value
EBITDA = Earnings before interest, taxes, depreciation and amortization
Or
 EBITDA = Operating Profit + Depreciation + Amortization

(Note 1: EV = Market capitalization + total debt − cash and cash equivalents)

or
Note 2: EV = market capitalization + preferred shares + minority shares + debt -
cash and cash equivalents) (Source: Wallstreetmojo)

Sometimes it is also used to analyze and measure an organization’s ROI, i.e., return of
investment and its value. EBITDA is a Non-GAAP measure and is reported and used
internally to measure the company’s performance. After comparing a stock EV to
EBITDA multiple with average sector EV to EBITDA multiple, we can find out whether a
stock is overvalued or undervalued and what should be the stock’s target price.

Topic: Valuation of Bond

Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond
valuation includes calculating the present value of a bond's future interest payments, also known as its
cash flow, and the bond's value upon maturity, also known as its face value or par value. Because a
bond's par value and interest payments are fixed, an investor uses bond valuation to determine
what rate of return is required for a bond investment to be worthwhile.

Under the bond valuation, we discuss about the YTM and the Present Value of the bond.

Yield-To-Maturity (YTM) is the measure of returns accrued by an investor when his investment is held
till maturity. Therefore, YTM is an indicator of total returns that an investor would receive at the end of
the maturity period.

To calculate the Yield to Maturity of Bond , some key data about the Bond is required:

• Face Value: The price at which the bond was issued by the Bond Issuer

• Annual Coupon Rate: The annual Interest Rate promised to the Bond Holder by the Bond Issuer

• Time to Maturity: The time remaining before the Bond matures i.e. the time remaining till the
Bond Holder gets the original investment back

• Market Value: The price at which the Bond is being traded on Bond Markets

• The YTM formula for a single Bond is:

Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

Topic: Relationship among variables (price, maturity, etc.)

PV (Bond’s Value) = FV/(1+r)^t + FV (Redemption)/(1+r)^t

(PV : Present value of Bond)

Two basic properties of the PV of a bond are:

1. For any given fixed value to be received in future, Higher interest rate (i.e. higher discount rate)
means lower present value.

2. For any given interest rate, the present value of an investment (or a future cash flow) is lower, longer
the date of maturity.

• the price of a longer-term bond is more volatile than the price of a shorter-term bond, other
things being equal.

• A bond price moves inversely with its market discount rate.

Topic: Valuation of equity using Dividend discounting Model

There are three theories called:

M&M Approach, Walter Model and Gordon Model

A. Irrelevance Theory, (Means Dividend is irrelevant): This theory was developed by

MODIGLIANI and MILLER. It is called (M&M Approach). It is not given in your syllabus.

B. Relevance Theory, (Means Dividend is relevant): this theory was developed by 1. Walter, and
2. Gordon.

B. Dividend’s Relevance Theory

1. WALTER’S MODEL:

Assumptions of Walter’s Model

Walter’s approach is based on the following assumptions:

1. All investment proposals of the firm are to be financed through retained earnings only.

2. ‘r’ rate of return & ‘Ke’ cost of capital are constant

3. Perfect capital markets: The firm operates in a market in which all investors are rational and
information is freely available to all.

4. No taxes or no tax discrimination between dividend income and capital appreciation (capital
gain). It means there is no difference in taxation of dividend income or capital gain. This
assumption is necessary for the universal applicability of the theory, since, the tax rates may be
different in different countries.

5. No floatation or transaction cost: Similarly, these costs may differ country to country or
market to market.

6. The firm has perpetual life.

The relationship between dividend and share price based on Walter’s formula is:

Where,

Market Price of the share is denoted by P.

E = Earnings per share.

D = Dividend per share.

Ke = Cost of equity/ rate of capitalization/ discount rate.

r = Internal rate of return/ return on investment

The above formula is given by Prof. James E. Walter which shows how dividend can be used to
maximise the wealth of equity holders. He argues that in the long run, share prices reflect only
the present value of expected dividends. Retentions influence stock prices only through their
effect on further dividends.

A close study of the formula indicates that Professor Walter emphasises two factors which
influence the market price of a share.

• Dividend per share

• Relationship between Internal Rate of Return (IRR) and Cost of capital (K e) [i.e. Market
capitalization rate]

Walter has divided a firm into three types:

a. Growth firm (growing firm) where r > Ke,

b. Constant firm where r = Ke and

 c. Decline firm where r < Ke.

following can be concluded from this model:

Company Conditions of r Vs. Ke Optimum dividend payout

ratio
Growth r > Ke Zero
Constant r = Ke Every payout
ratio is optimum
Decline r < Ke 100%

• Growth Oriented Company: In this condition, a company is able to invest/utilize the

fund in a better manner. Therefore, shareholders can accept low dividend because their
value of share would be higher.

• Declining Company: In this condition, a company is not in a position to cover the cost of
capital. Therefore, shareholders would prefer a higher dividend so that they can utilize
their funds elsewhere in more profitable opportunities.

If the internal return of retained earnings is higher than market capitalization rate, the value of
ordinary shares would be high even if dividends are low. However, if the internal return within
the business is lower than what the market expects, the value of the share would be low. In such
a case, shareholders would prefer a higher dividend so that they can utilise the funds so obtained
elsewhere in more profitable opportunities.

2nd theory

Dividend’s Relevance Theory

2. GORDON’S MODEL:

Assumptions of Gordon’s Model

This model is based on the following assumptions:

1. Firm is all equity firm i.e. no debt.

2. IRR will remain constant, because change in IRR will change the growth rate and
consequently the value will be affected. Hence this assumption is necessary.

3. Ke will remains constant, because change in discount rate will affect the present value.

4. Retention ratio (b), once decide upon, is constant i.e. constant dividend payout ratio will be
followed.
5. Growth rate (g = br) is also constant, since retention ratio and IRR will remain unchanged and
growth, which is the function of these two variable will remain unaffected.

6. Ke > g, this assumption is necessary and based on the principles of series of sum of geometric
progression for ‘n’ number of years.

7. All investment proposals of the firm are to be financed through retained earnings only.

Price of share under the Gordon model:

Where,

P0 = Price per share

E1 = Earnings per share

b = Retention ratio; (1 - b = Payout ratio)

Ke = Cost of capital

r = IRR

br = Growth rate (g)

According to Gordon’s model dividend is relevant and dividend policy of a company affects its
value.

Company Conditions of r Vs. Ke Optimum dividend payout

ratio
Growth r > Ke Zero
Constant r = Ke There is no optimum ratio
Decline r < Ke 100%

According to Gordon’s model, when IRR is greater than cost of capital, the price per share
increases and dividend pay-out decreases. On the other hand when IRR is lower than the cost of
capital, the price per share decreases and dividend pay-out increases.
The “Bird-in-hand theory” – Gordon’s Revised Model

Myron Gordon revised his dividend model and considered the risk and uncertainty in his model.
The Bird-in-hand theory of Gordon has two arguments:

• Investors are risk averse and

• Investors put a premium on certain return and discount on uncertain return.

Gordon argues that what is available at present (Bird-in-hand) is preferable to what may be
available in the future (Bird in bush). As investors are rational, they want to avoid risk and
uncertainty. They would prefer to pay a higher price for shares on which current dividends are
paid. Conversely, they would discount the value of shares of a firm which postpones dividends.