PRINCIPLES OF

VALUATION

ARINDOM

VALUE ITS DEFINITION

A SINGLE ITEM OF OWNERSHIP HAVING
EXCHANGE VALUE
IN GENERAL, THE VALUE OF AN ASSET IS
THE PRICE THAT A WILLING AND ABLE
BUYER PAYS TO A WILLING AND ABLE
SELLER
NOTE THAT IF EITHER THE BUYER OR
SELLER IS NOT BOTH WILLING AND ABLE,
THEN AN OFFER DOES NOT ESTABLISH THE
VALUE OF THE ASSET

KINDS OF VALUE
THERE ARE SEVERAL TYPES OF VALUE, OF WHICH WE
ARE CONCERNED WITH FOUR:
BOOK VALUE : (ECONOMICS, ACCOUNTING & FINANCE /
STOCK EXCHANGE) THE VALUE OF A SHARE IN A COMPANY
CALCULATED BY DIVIDING THE DIFFERENCE BETWEEN THE
TOTAL OF ITS ASSETS AND ITS LIABILITIES BY THE NUMBER OF
ORDINARY SHARES ISSUED (TOTAL ASSETS LESS TOTAL
LIABILITIES)
TANGIBLE BOOK VALUE : BOOK VALUE MINUS INTANGIBLE
ASSETS (GOODWILL, PATENTS, ETC)
MARKET VALUE : THE PRICE OF AN ASSET AS DETERMINED IN
A COMPETITIVE MARKETPLACE
INTRINSIC VALUE : THE PRESENT VALUE OF THE EXPECTED
FUTURE CASH FLOWS DISCOUNTED AT THE DECISION MAKERS
REQUIRED RATE OF RETURN

FACTORS DETERMINING INTRINSIC

VALUE OF AN ASSET
THERE ARE TWO PRIMARY DETERMINANTS
OF THE INTRINSIC VALUE OF AN ASSET TO
AN ENTITY:
THE SIZE AND TIMING OF THE EXPECTED
FUTURE CASH FLOWS.
THE ENTITYS REQUIRED RATE OF
RETURN (DETERMINED BY FACTORS
SUCH AS RISK/RETURN PREFERENCES,
RETURNS ON COMPETING
INVESTMENTS,, ETC.).
NOTE THAT THE INTRINSIC VALUE OF AN

MYTHS OF VALUATION
VALUATION IS OBJECTIVE
A WELL RESEARCHED VALUATION IS
TIMELESS
A GOOD VALUATION ESTIMATES ACCURATELY.
MORE QUANTITATIVE A MODEL BETTER
VALUATION
THE MARKET IS GENERALLY WRONG
VALUE IS WHAT MATTERS NOT THE PROCESS
OF VALUATION

FIRM VALUATION IN MERGERS AND

ACQUISITIONS
BALANCE SHEET VALUATION MODELS :
BOOK VALUE, LIQUIDATION VALUE,
REPLACEMENT COST
PRICE EARNING RATIO MODEL
ECONOMIC PROFIT MODEL
GORDON GROWTH MODEL
DIVIDEND DISCOUNT MODELS
SPREADSHEET ANALYSIS : DISCOUNTED
CASH FLOW MODELS FOR EQUITY &
FIRM VALUATION
COMPARATIVE COMPANIES MODEL

SEARCH FOR VALUE

DRIVERS
EARN A HIGHER RETURN ON EXISTING
INVESTED CAPITAL
1. INCREASE CUSTOMER DELIGHT THROUGH:
PRODUCT INNOVATIONS ,
DISTRIBUTION/DELIVERY
CUSTOMER SERVICES
2. INCREASE CONTRIBUTION FROM EXISTING
PRODUCT OFFERINGS

SEARCH FOR VALUE

DRIVERS(CONTD)
3.OPTIMISE PRODUCT MIX
4.INCREASE PRODUCTIVITY
5.INCREASE CAPACITY UTILISATION
6.OPTIMISE FIXED OVERHEADS
7.BENCHMARKING ITS VALUE
DRIVERS W.R.T ITS COMPETITORS

SEARCH FOR VALUE

DRIVERS(CONTD)
INCREASE THE RETURN ON NEW
CAPITAL INVESTMENT.
INCREASE ITS GROWTH RATE BUT
ONLY AS LONG AS THE RETURN
ON NEW CAPITAL EXCEEDS WACC.
REDUCE ITS COST OF CAPITAL.

LIVE EXAMPLES OF VALUE

DRIVERS

FIRM VALUATION IN M&A : BALANCE

SHEET VALUATION MODEL
EQUITY VALUATION FROM BALANCE SHEET
BOOK VALUE: THE NET WORTH OF A COMPANY AS
SHOWN ON THE BALANCE SHEET.

TANGIBLE BOOK VALUE

: BOOK VALUE MINUS

INTANGIBLE ASSETS (GOODWILL, PATENTS, ETC)

LIQUIDATION VALUE: THE VALUE THAT WOULD

BE DERIVED IF THE FIRMS ASSETS WERE
LIQUIDATED.

REPLACEMENT COST:

THE REPLACEMENT
COST OF ITS ASSETS LESS ITS LIABILITIES.

PRICE-EARNINGS RATIO MODEL FOR

VALUATION
THE EARNINGS MODEL SEPARATES
EARNINGS (EPS) INTO TWO
COMPONENTS:
CURRENT EARNINGS, WHICH ARE ASSUMED
TO BE CONSTANT WITH 100% PAYOUT.
GROWTH OF EARNINGS WHICH DERIVES
FROM FUTURE INVESTMENTS.

IF THE CURRENT EARNINGS ARE A

PERPETUITY WITH 100%
EPS1 PAYOUT, THEN
VCE
THEY ARE WORTH:
k
WHERE VCE IS THE VALUE OF EQUITY & k=WEIGHTED AVERAGE COST OF

PRICE-EARNINGS RATIO MODEL FOR

VALUATION(CONTD)
ASSUMING PROFITABLE GROWTH VCE ,THEREFORE,
REPRESENTS THE MINIMUM VALUE
IF THE COMPANY GROWS BEYOND THEIR CURRENT
EPS BY REINVESTING A PORTION OF THEIR
EARNINGS, THEN THE VALUE OF THESE GROWTH
OPPORTUNITIES IS THE PRESENT VALUE OF THE
ADDITIONAL EARNINGS IN FUTURE YEARS.
THE GROWTH IN EARNINGS WILL BE EQUAL TO THE
ROE TIMES THE RETENTION RATIO (1 PAYOUT
RATIO):
g br
WHERE b = RETENTION RATIO AND r = ROE
(RETURN ON EQUITY).

PRICE-EARNINGS RATIO MODEL FOR

VALUATION(CONTD)
IF THE COMPANY CAN MAINTAIN THIS
GROWTH RATE FOREVER, THEN THE
PRESENT VALUE OF THEIR GROWTH
NPV
OPPORTUNITIES
IS:
PVGO

t 1

1 k t

WHICH, SINCE NPV IS GROWING AT A

CONSTANT RATE CAN
r
r BE REWRITTEN
RE
1
RE1 RE1
1
NPV1
AS:
k
k
PVGO

kg

kg

kg

Where RE1=retained earnings ,r=ROE, g=growth in

earning & k=WACC

PRICE-EARNINGS RATIO MODEL FOR

VALUATION(CONTD)
THE VALUE OF THE COMPANY TODAY MUST
BE THE SUM OF THE VALUE OF THE
COMPANY IF IT DOESNT GROW AND THE
VALUE OF THE FUTURE GROWTH:
VCS

r
RE1 1
EPS1 NPV1 EPS1
k

k
kg
k
kg

WHERE RE1 IS THE RETAINED EARNINGS IN

PERIOD 1, r IS THE RETURN ON EQUITY, k IS
THE REQUIRED RETURN, AND g IS THE
GROWTH RATE

ECCONOMIC PROFIT MODEL

THE ECONOMIC PROFIT MODEL:

THE
VALUE OF A COMPANY EQUALS THE AMOUNT OF
CAPITAL INVESTED PLUS A PREMIUM EQUAL TO THE
PRESENT VALUE OF THE VALUE CREATED EACH YEAR
GOING FORWARD.
Economic Pr ofit Invested Capital x ( ROIC WACC )
where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital

Economic Pr ofit NOPLAT ( Invested Capital x WACC )

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

COMMON STOCK VALUATION

AS WITH ANY OTHER SECURITY, THE FIRST STEP
IN VALUING COMMON STOCKS IS TO DETERMINE
THE EXPECTED FUTURE CASH FLOWS AND
DETERMINE THE SUM OF THEIR FUTURE PRESENT
VALUES . TO PUT IT MATHEMATICALLY :

VCS
t 1

CFt
1 k t

FOR A STOCK, THERE ARE TWO CASH FLOWS:

FUTURE DIVIDEND PAYMENTS
THE FUTURE SELLING PRICE

ESTABLISHMENT OF DIVIDEND
DISCOUNT MODEL

WHERE:
Div t : Dividend received at the end of year t
Pt

: Value of share at the end of year t

DIVIDEND DISCOUNT MODEL

(DDM) FOR STOCK VALUATION
THE DDM MODEL OF VALUATION PERMITS USE OF MULTIPLE
DIVIDEND GROWTH RATE OVER TIME HORIZON
THE DIVIDEND GROWTH RATE CAN BE ESTIMATED IN THREE
WAYS:
USE THE HISTORICAL GROWTH RATE AND ASSUME IT WILL
CONTINUE

THE GROWTH IN EARNINGS WILL BE EQUAL TO THE ROE

g br
TIMES THE RETENTION
RATIO (1 PAYOUT RATIO):
WHERE b = RETENTION RATIO and r = ROE (RETURN ON
EQUITY).
GENERATE FORECAST WITH WHATEVER METHOD SEEMS APPROPRIATE

THE REQUIRED RATE OF RETURN IS OFTEN ESTIMATED BY

USING THE CAPITAL ASSET PRICING MODEL(CAPM) : ki = krf +
i(km krf) OR SOME OTHER ASSET PRICING MODEL.

DIVIDEND DISCOUNT MODEL FOR

VALUATION OF A FIRM
STEP 1 : ESTIMATE FUTURE DIVIDEND
PAYMENT: CONSTANT THROUGH OUT
GROWS AT A CONSTANT RATE g THROUGH
OUT
GROWS AT DIFFERENTIAL RATES IN 2 OR
MULTIPLE STAGES , SETTLING DOWN TO A
CONSTANT RATE
STEP2 : ESTIMATE REQUIRED RATE OF
RETURN kcs THROUGH CAPM OR ALLIED
PROCEDURE

GORDON MODEL FOR STOCK

VALUATION
AT CONSTANT GROWTH RATE g THE GORDON MODEL
VALUES THE STOCK AT :
VCS

D 0 1 g
k CS g

D1
k CS g

NOTE IF DIVIDEND IS CONSTANT THROUGH OUT i.e

g=0,

Vcs =D1/kcs

THIS MODEL GIVES US THE PRESENT VALUE OF AN

INFINITE STREAM OF DIVIDENDS THAT ARE GROWING
AT A CONSTANT RATE.

DETERMINATION OF STOCK
VALUE IN NTH YEAR THROUGH
GORDON MODEL

WE CAN USE THE DDM TO CALCULATE THE

PRICE THAT A STOCK SHOULD SELL FOR IN N TH
YEARS AS FOLLOWS:
VN

D N 1 g
k CS g

D N 1
k CS g

FOR EXAMPLE, TO VALUE A STOCK AT YEAR 2, WE

SIMPLY USE THE DIVIDEND FOR YEAR 3 (D3).
REMEMBER , THE VALUE AT PERIOD 2 IS SIMPLY
THE PRESENT VALUE OF D3, D4, D5, , D

GORDON MODEL : AN
EXAMPLE
FIND THE STOCK VALUE WHEN THE
CURRENT YEAR DIVIDEND IS Rs 1.85
per share,THE GROWTH RATE OF 8%
& DESIRED RATE OF RETURN IS 15%
THE VALUE OF THE STOCK WILL BE :
VCS

1.85 1.08
.15.08

2.00
28.57
0.15.08

WHAT IF GROWTH ISNT CONSTANT?

THE GORDON GROWTH MODEL ASSUMES THAT
DIVIDENDS WILL GROW AT A CONSTANT RATE FOREVER,
BUT WHAT IF THEY DONT?
IF WE ASSUME THAT GROWTH RATE OF DIVIDEND
PAYMENT WILL EVENTUALLY BE CONSTANT, THEN WE CAN
MODIFY GORDON GROWTH MODEL TO DIVIDEND
DISCOUNT MODEL(DDM)
WE CAN DETERMINE THE VALUE OF THE STOCK AT SOME
FUTURE PERIOD WHEN GROWTH IS CONSTANT. IF WE
CALCULATE THE PRESENT VALUE OF THAT PRICE AND THE
PRESENT VALUE OF THE DIVIDENDS WITH ALTERNATE
GROWTH PATTERN UP TO THAT POINT, WE WILL HAVE THE
PRESENT VALUE OF ALL OF THE FUTURE CASH FLOWS
ALLOWING DIFFERENTIAL DIVIDEND GROWTH.

WHAT IF GROWTH ISNT CONSTANT?

(AN EXAMPLE)
LETS TAKE OUR PREVIOUS EXAMPLE,
BUT ASSUME THAT THE DIVIDEND
WILL GROW AT A RATE OF 15% PER
YEAR FOR THE FIRST THREE YEARS
BEFORE SETTLING DOWN TO A
CONSTANT 8% PER YEAR.
2.1275 2.4466
3.0387
WHATS THE
VALUE OF2.8136
THE STOCK
NOW?
0

g = 15%

g = 8%

WHAT IF GROWTH ISNT CONSTANT?

(AN EXAMPLE CONTD.)
FIRST, NOTE THAT WE CAN CALCULATE THE VALUE OF THE
STOCK AT THE END OF PERIOD 3 USING D4 OF GORDON
MODEL:3.0387
V3

.15 .08

43.41

NOW, FIND THE PRESENT VALUES OF THE FUTURE SELLING

PRICE AND D1, D2, AND D3:
V0

2.1275 2.4466 2.8136 43.41

34.09
2
3
1.15
1.15
1.15

SO, THE VALUE OF THE STOCK IS $34.09 AND WE DIDNT

EVEN HAVE TO ASSUME A CONSTANT GROWTH RATE. NOTE
ALSO THAT THE VALUE IS HIGHER THAN THE ORIGINAL
VALUE BECAUSE THE AVERAGE GROWTH RATE IS HIGHER.

TWO-STAGE DDM VALUATION

MODEL
THE PREVIOUS EXAMPLE SHOWED STEP BY STEP
WAY TO VALUE A STOCK WITH TWO (OR MORE)
GROWTH RATES.
WE CAN ALSO USE THE FOLLOWING TWO-STAGE
GROWTH MODEL WHICH IS NOT AS INTIMIDATING
AS IT LOOKS:
THE FIRST TERM IS SIMPLY THE PRESENT VALUE
OF THE FIRST N DIVIDENDS (THOSE BEFORE
THE CONSTANT GROWTH PERIOD)
THE SECOND TERM IS THE PRESENT VALUE OF
THE FUTURE STOCK PRICE.
n

VCS

D0 1 g1

kCS g1

D0 1 g1 1 g 2
n
kCS g 2
1 g1

n
1 kCS

k
CS

GRAPHICAL REPRESENTATION OF
DIVIDEND GROWTH MODEL

source:

STEPS IN VALUATION OF
DISCONTED CASH FLOW MODEL
ANALYZE HISTORICAL PERFORMANCE.
IDENTIFY VALUE DRIVERS OF THE CO. & ITS
BUSINESSES
FORECAST FREECASH FLOWS TO EQUITY & TARGET
FIRM CONSIDERING BENEFITS OF SYNERGY &
ESTIMATING GROWTH PROSPECT.
ESTIMATE THE WEIGHTED AVERAGE COST OF CAPITAL
CALCULATE EQUITY AND FIRM VALUE
CARRY OUT A SENSITIVITY ANALYSIS
INTERPRET THE RESULTS FOR DECISION

COST OF CAPITAL
MEASUREMENT
STEPS INVOLVED IN CALCULATION OF COST OF CAPITAL
CALCULATE COST OF EQUITY CAPITAL FROM CAPM
CALCULATE COST OF PREFERENCE CAPITAL FROM
BALANCE SHEET
CALCULATE COST OF DEBT FROM BALANCE SHEET
DATA
FORMULATE APPLICABLE DEBT EQUITY RATIO
FINAL RESULT IS WEIGHTED COST OF CAPITAL
WACC=KD(1-T)*B/V+KP*P/V+KE*S/V
WHERE WACC= WEIGHTED AVERAGE COST OF CAPITAL,
KD= COST OF DEBT, KP= COST OF PREFERENCE
CAPITAL, KE= COST OF EQUITY
,V=B+P+S VALUE OF ENTERPRISE

DETERMINATION OF COST OF
CAPITAL

CAPITAL ASSET PRICING MODEL(CAPM)

ARBITRAGE PRICING MODEL(APM)
AVERAGE BOND YIELD MODEL
ESTIMATE COST OF EQUITY USING MULTIPLES
SURVEY GENERAL EQUITY MARKET
UNCERTAINTY
CONSIDER ESTIMATES FOR OTHER
COMPANIES IN SAME INDUSTRY
USE JUDGMENT TO ARRIVE AT AN ESTIMATE

CAPITAL ASSET PRICING

MODEL
COST OF EQUITY IS DETERMINED FROM CAPM AS PER
FOLLOWING FORMULA :
KS = RF + [RM - RF] J
RISK-FREE RATE (RF) : RELATES TO RETURNS ON
LONG TERM GOVERNMENT BONDS
MARKET PRICE OF RISK (RM) : IT IS ESTIMATED BY
REGRESSING STOCK INDEX(BSE100 /S&P500) WITH
GOVT. BOND RATE
BETA ( J ) : MEASURES HOW RETURNS ON THE FIRM'S
COMMON STOCK VARIED WITH RETURNS ON THE
STOCK INDEX. HIGH BETA STOCKS EXHIBIT HIGHER
VOLATILITY THAN LOW BETA STOCKS IN RESPONSE TO
CHANGES IN MARKET RETURNS

MAJOR ASSUMPTIONS OF
CAPM
ALL INVESTORS:
AIM TO MAXIMIZE ECONOMIC UTILITIES.
ARE RATIONAL AND RISK-AVERSE.
ARE BROADLY DIVERSIFIED ACROSS A RANGE OF
INVESTMENTS.
ARE PRICE TAKERS, I.E., THEY CANNOT INFLUENCE PRICES.
CAN LEND AND BORROW UNLIMITED AMOUNTS UNDER THE
RISK FREE RATE OF INTEREST.
TRADE WITHOUT TRANSACTION OR TAXATION COSTS.
DEAL WITH SECURITIES THAT ARE ALL HIGHLY DIVISIBLE
INTO SMALL PARCELS.
ASSUME ALL INFORMATION IS AVAILABLE AT THE SAME TIME
TO ALL INVESTORS.

E VALUE OF AN INVESTMENT OF $1 IN 19
Real returns

613
Index

203
6.15
4.34
1.58

Source: Ibbotson Associates

FGS

Year End
34

CAPITAL ASSET PRICING

MODEL
CAPM ESTIMATES THE COST OF FIRM
EQUITY AS PER THE FOLLOWING
FORMULA :-

The Security Market Line, seen here

in a graph, describes a relation
between the beta and the asset's
expected rate of return.

1. TOTAL RISK = DIVERSIFIABLE RISK +

MARKET RISK
2. MARKET RISK IS MEASURED BY BETA, THE
SENSITIVITY TO MARKET CHANGES.

STANDARD DEVIATION AS A
MEASURE OF VOLATILITY

VOLATILITY IN STOCK
RETURNS CAN BE MEASURED
THROUGH STANDARD
DEVIATION

THE AVERAGE &

STANDARD DEVIATION OF
ONE-YEAR S&P 500
RETURNS DURING 1926-94
PERIOD IS 12.45 & 22.28%
RESPECTIVELY. IF S&P
RETURNS ARE NORMALLY
DISTRIBUTED, THIS MEANS
THAT ABOUT 2/3 OF THE
TIME WE SHOULD

ESTIMATING BETA
THE STANDARD PROCEDURE FOR ESTIMATING
BETAS IS TO REGRESS STOCK RETURNS (RJ)
AGAINST MKT RETURNS (RM) :
RJ = A + B R M
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 FIRMS PAST & NOT CURRENT
BUSINESS MIX

SIGNIFICANCE OF BETA VALUE

THE SLOPE OF THE REGRESSION LINE DRAWN
BY PLOTTING COMPANY RETURN &MARKET
RETURN IS CALLED THE BETA OF THAT STOCK.
THE STEEPER THE SLOPE, THE MORE
SYSTEMATIC RISK, THE SHALLOWER THE
SLOPE, LESS EXPOSED THE COMPANY IS TO
THE MARKET VARIATION .
FOR INSTANCE, CONSIDER A COMPANY WITH
A BETA OF 1.5. IF THE MARKET RETURN IS 20
PERCENTAGE POINTS OVER THE T-BILL RATE IN
ONE YEAR, THEN WE EXPECT THE STOCK
RETURN TO BE 30 PERCENTAGE POINTS OVER
T-BILLS IN THAT YEAR.
BETAS TEND TO BE RELATED TO INDUSTRY.
HIGH-TECHNOLOGY, FOR INSTANCE, IS A
HIGH-BETA INDUSTRY. THE FOOD INDUSTRY IS
A LOW BETA INDUSTRY

DETERMINANTS OF BETAS
Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta)

Nature of product or
service offered by
company :
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.

Operating Leverage (Fixed

Costs as percent of total
costs):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.

Implications
1. Cyclical companies should
have higher betas than noncyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Implications
1. Firms with high infrastructure
needs and rigid cost structures
should have higher betas than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms should have higher
betas than more mature firms.

Financial Leverage:
Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
equity beta will be

Implciations
Highly levered firms should have highe betas
than firms with less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

THE SOLUTION: BOTTOM-UP

BETAS
Step 1: Find the business or businesses that your firm operates in.
Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly
traded firms. Unlever this average beta using the average debt to
equity ratio across the publicly traded firms in the sample.
Unlevered beta for business = Average beta across publicly traded
firms/ (1 + (1- t) (Average D/E ratio across firms))

Step 3: Estimate how much value your firm derives from each of
the different businesses it is in.

Step 4: Compute a weighted average of the unlevered betas of the

different businesses (from step 2) using the weights from step 3.
Bottom-up Unlevered beta for your firm = Weighted average of the
unlevered betas of the individual business
Step 5: Compute a levered beta (equity beta) for your firm, using
the market debt to equity ratio for your firm.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

If you can, adjust this beta for differences

between your firm and the comparable
firms on operating leverage and product
characteristics.

While revenues or operating income

are often used as weights, it is better
to try to estimate the value of each
business.
If you expect the business mix of your
firm to change over time, you can
change the weights on a year-to-year
basis.
If you expect your debt to equity ratio to
change over time, the levered beta will
change over time.

ARBITRAGE PRICING MODEL

WHERE :
RPK IS THE RISK PREMIUM OF THE FACTOR,
RF IS THE RISK-FREE RATE,

ECONOMIC FACTORS GENERALLY USED IN APM

ESTIMATES:
INFLATION RATE;
INDUSTRIAL PRODUCTION INDEX;
CHANGES IN DEFAULT PREMIUM IN CORPORATE
BONDS;
YIELD CURVE.
SHORT TERM INTEREST RATES;
THE DIFFERENCE IN LONG AND SHORT-TERM
INTEREST RATES;

AVERAGE BOND YIELD MODEL

COST OF EQUITY = AVERAGE YIELD TO
MATURITY OF BONDS FOR THE INDUSTRY
WITH SAME RATING AS THE FIRM'S DEBT
PLUS HISTORICAL AVERAGE OF FIRM'S
EQUITY RISK PREMIUM OVER ITS BOND
YIELD
FOR THE INDUSTRY, ANALYZE HISTORICAL
YIELD ON EQUITY AS COMPARED WITH
AVERAGE YIELD TO MATURITY ON BONDS
FOR THE INDUSTRY

COMPUTATION OF COST OF
DEBT
COST OF DEBT IS CALCULATED ON AN AFTER-TAX
BASIS BECAUSE INTEREST PAYMENTS ARE TAX
DEDUCTIBLE
AFTER-TAX COST OF DEBT = KB(1 - T )
BEFORE-TAX COST OF DEBT, KB

CAN BE OBTAINED FROM A WEIGHTED AVERAGE OF THE

YIELDS TO MATURITY OF ALL THE FIRM'S OUTSTANDING
PUBLICLY HELD BONDS

CAN BE OBTAINED FROM PUBLISHED PROMISED YIELDS

TO MATURITY BASED ON BOND RATING CATEGORY

COMPUTATION OF WEIGHTED
AVERAGE COST OF CAPITAL(WACC)
K = KB(1-T)(B/V)+KS(S/V)

WHERE:

KB = COST OF DEBT
COST OF EQUITY
TAX RATE
VALUE OF DEBT
VALUE OF EQUITY
TOTAL VALUE OF FIRM = B + S

KS =
T =
B =
S =
V =
OR
K = KU(1-TL) WHERE:

KU = COST OF CAPITAL OF AN UNLEVERED FIRM

L = B/V

LIMITATIONS IN USE OF
DISCOUNTED CASH FLOW
VALUATION
A TROUBLED FIRM
CYCLICAL FIRMS
FIRMS WITH UNDER UTILISED
ASSETS
FIRMS WITH PATENTS OR
PRODUCT OPTIONS
FIRMS IN THE PROCESS OF
RESTRUCTURING

FIRM VALUATION IN M&A :

SPREADSHEET APPROACH TO
VALUATION
STEP1 : DETAILED FINANCIAL ANALYSIS IS PERFORMED
BASED ON HISTORICAL DATA FOR 7 TO 10 YEARS FOR EACH
ELEMENT OF BALANCE SHEET, INCOME STATEMENT, AND
CASH FLOW STATEMENT TO DISCOVER UNDERLYING VALUE
DRIVERS & FINANCIAL PATTERNS OF THE FIRM
STEP2 : ADDITIONAL ANALYSIS OF BUSINESS ECONOMICS
OF INDUSTRY IN WHICH THE FIRM OPERATES, ITS
COMPETITIVE POSITION AND ASSESSMENTS OF INDUSTRY
VALUE DRIVERS FINANCIAL PATTERNS, STRATEGIES, AND
ACTIONS OF COMPETITORS
STEP3: BASED ON STEPS1&2 AS ABOVE IDENTIFY VALUE
DRIVERS, POTENTIAL FOR SYNERGY & PROJECT
RELEVANT CASH FLOWS TAKING INTO CONSIDERATION
SYNERGY & VALUE DRIVERS

FIRM VALUATION IN M&A :

SPREADSHEET APPROACH TO
VALUATION

STEP4: AN ACQUISITION IS
FUNDAMENTALLY A CAPITAL BUDGETING
PROBLEM. NPV OF ACQUISITION IS
OBTAINED FROM SUM OF FREE CASH
FLOWS DISCOUNTED AT APPLICABLE COST
FCF
NPV
where :
OF CAPITAL.
(1 k )
n

t 1

FCFt = free cash flows in period t = X t ( 1 T) I t

X t before - tax cash flows in period t
T = tax rate
I t investment outlays in period t
k = cost of capital

SOURCES OF SYNERGY
Synergy is created when two firms are combined and can be
either financial or operating

Operating Synergy accrues to the combined firm as

Strategic Advantages
Higher returns on
new investments

More new
Investments

Higher ROC

Higher Reinvestment

Higher Growth
Rate

Higher Growth Rate

Economies of Scale
More sustainable
excess returns

Cost Savings in
current operations

Longer Growth
Period

Higher Margin
Higher Baseyear EBIT

Financial Synergy
Tax Benefits
Lower taxes on
earnings due to
- higher
depreciaiton
- operating loss
carryforwards

Added Debt
Capacity
Higher debt
raito and lower
cost of capital

Diversification?
May reduce
cost of equity
for private or
closely held
firm

THE PATHS TO VALUE

CREATION

USING THE DCF FRAMEWORK, THERE ARE FOUR BASIC

WAYS IN WHICH THE VALUE OF A FIRM CAN BE ENHANCED:
INCREASE CASH FLOWS FROM EXISTING ASSETS
INCREASE AFTER-TAX EARNINGS FROM ASSETS IN
PLACE
REDUCE REINVESTMENT NEEDS
INCREASE GROWTH RATE OF NET CASH FLOWS
INCREASE THE RATE OF REINVESTMENT IN THE FIRM
IMPROVE THE ROC ON THOSE REINVESTMENTS
EXTEND LENGTH OF THE HIGH GROWTH PERIOD
REDUCE THE COST OF CAPITAL
REDUCING THE DEBT EQUITY RATIO
REDUCING THE OPERATING & FINANCIAL LEVERAGE
CHANGING THE FINANCING COMPOSITION

WAYS OF INCREASING CASH FLOWS

FROM ASSETS IN PLACE
More efficient
operations and
cost cuttting:
Higher Margins
Divest assets that
have negative EBIT
Reduce tax rate
- moving income to lower tax locales
- transfer pricing
- risk management

Revenues
* Operating Margin
= EBIT
- Tax Rate * EBIT
= EBIT (1-t)
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF

Live off past overinvestment

Better inventory
management and
tighter credit policies

VALUE ENHANCEMENT THROUGH

GROWTH

Reinvest more in
projects
Increase operating
margins

Do acquisitions
Reinvestment Rate
* Return on Capital
= Expected Growth Rate

Increase capital turnover ratio

BUILDING COMPETITIVE ADVANTAGES:

INCREASE THE GROWTH PERIOD
Increase length of growth period
Build on existing
competitive
advantages

Brand
name

Legal
Protection

Find new
competitive
advantages

Switching
Costs

Cost
advantages

REDUCING COST OF
CAPITAL
Outsourcing

Flexible wage contracts &

cost structure

Reduce operating
leverage

Change financing mix

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Make product or service
less discretionary to
customers
Changing
product
characteristics

More
effective
advertising

Match debt to
assets, reducing
default risk
Swaps

Derivatives

Hybrids

CLAIM OF SYNERGY IN M&A : A

STUDY BY MCKINSEY & KPMG
MCKINSEY EXAMINED 58 ACQUISITIONS DURING
1972-83 TO DETERMINE
WETHER THE RETURN ON THE AMOUNT
INVESTED IN THE ACQUISITIONS EXCEEDED THE
COST OF CAPITAL?
WETHER THE ACQUISITIONS HELP THE PARENT
COMPANIES OUTPERFORM THE COMPETITION?
THEY FOUND THAT 28 OF THE 58 PROGRAMS
FAILED BOTH TESTS, AND 6 FAILED AT LEAST
ONE TEST
KPMG IN A MORE RECENT STUDY OF GLOBAL
ACQUISITIONS CONCLUDED THAT MOST
MERGERS (>80%) FAIL .THE MERGED

FACTORS CRITICAL FOR DETERMINING

FREE CASH FLOW TO THE FIRM

GROWTH RATE (G) IN REVENUE

NET OPERATING INCOME MARGIN (M)
ACTUAL TAX RATE (T)
INVESTMENT (IT) NECESSARY TO MAINTAIN
GROWTH MOMENTUM
PERIODS OF SUPERNORMAL GROWTH (N)
MARGINAL WEIGHTED COST OF CAPITAL (K)
VALUE DRIVERS FOR NET OPERATING INCOME
MARGIN (M) AND INVESTMENT (I) EXPRESSED
AS A PERCENTAGE OF SALES

FIRM VALUATION IN M&A :

SPREADSHEET APPROACH TO
VALUATION
ADVANTAGES OF SPREADSHEET APPROACH

PROVIDE GREAT FLEXIBILITY IN PROJECTIONS

HELPS TO UNDERSTAND UNDERLYING
GROWTH PATTERNS & ITS VALUE DRIVERS
INCORPORATES DESIRED DETAIL OF
INDIVIDUAL ITEMS OF BALANCE SHEET OR
INCOME STATEMENT ACCOUNTS
FLEXIBILITY AND JUDGMENT IN MAKING
PROJECTIONS
DISADVANTAGES OF SPREADSHEET APPROACH
NUMBERS USED IN PROJECTIONS MAY CREATE
ILLUSION
MAY BLUR LINK OF BUSINESS LOGIC &

DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets

+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Firm is in stable growth:

Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-g n)

FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

SOURCE :
ASWATH
DAMODARAN
Country Risk
Premium

Reinvestment:
Current
Revenue
$ 1,117

Cap ex includes acquisitions

Working capital is 3% of revenues

Current
Margin:
-36.71%

Sales Turnover
Ratio: 3.00

EBIT
-410m

Value of Op Assets $ 14,910

+ Cash
$
26
= Value of Firm
$14,936
- Value of Debt
$ 349
= Value of Equity
$14,587
- Equity Options
$ 2,892
Value per share
$ 34.32

Competitive
Advantages

Revenue
Growth:
42%

NOL:
500 m
Revenues
EBIT
EBIT(1t)
Reinvestment
FCFF

CostofEquity
CostofDebt
ATcostofdebt
CostofCapital

Expected
Margin:
-> 10.00%

$2,793 5,585
$373 $94
$373 $94
$559
$931
$931 $1,024

9,774
$407
$407
$1,396
$989

14,661 19,059
$1,038 $1,628
$871
$1,058
$1,629 $1,466
$758 $408

23,862
$2,212
$1,438
$1,601
$163

28,729
$2,768
$1,799
$1,623
$177

33,211
$3,261
$2,119
$1,494
$625

36,798
$3,646
$2,370
$1,196
$1,174

39,006
$3,883
$2,524
$736
$1,788
10

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
6.71%
12.83%

12.90%
8.00%
5.20%
12.81%

12.42%
7.80%
5.07%
12.13%

12.30%
7.75%
5.04%
11.96%

12.10%
7.67%
4.98%
11.69%

11.70%
7.50%
4.88%
11.15%

Cost of Debt
6.5%+1.5%=8.0%
Tax rate = 0% -> 35%

Beta
1.60 -> 1.00

Internet/
Retail

Operating
Leverage

10.50%
7.00%
4.55%
9.61%

Term.Year
$41,346
10.00%
35.00%
$2,688
$807
$1,881

Forever

Weights
Debt= 1.2% -> 15%

Amazon.com
January 2000
Stock Price = $ 84

Risk Premium
4%

Current
D/E: 1.21%

Stable
ROC=20%
Reinvest 30%
of EBIT(1-t)

Terminal Value= 1881/(.0961-.06)

=52,148

Cost of Equity
12.90%

Riskfree Rate :
T. Bond rate = 6.5%

Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 6%
10.00%

Base Equity
Premium

Country Risk
Premium

SOURCE :
ASWATH
DAMODARAN

RELATIVE VALUE MODELS

STOCKS CAN BE VALUED RELATIVE TO ONE ANOTHER.
A STOCK MAY BE UNDERVALUED BECAUSE OF LOWER
P/E RATIO DESPITE HIGHER EARNINGS GROWTH RATE.
THESE MODELS ARE POPULAR, BUT HAVE PROBLEMS:
COMPANIES ARE RARELY PERFECTLY COMPARABLE.
CORRECT PRICE MULTIPLE IS ELUSIVE
INDETERMINATE RELATIONSHIP BETWEEN EARNINGS
GROWTH AND PRICE MULTIPLES
A COMPANYS (OR INDUSTRYS) HISTORICAL
MULTIPLES MAY NOT BE RELEVANT TODAY DUE TO
CHANGES IN EARNINGS GROWTH OVER TIME.

THE P/E APPROACH

AS A RULE OF THUMB, OR SIMPLIFIED MODEL,
ANALYSTS OFTEN ASSUME THAT A STOCK IS
WORTH SOME JUSTIFIED P/E RATIO TIMES THE
FIRMS EXPECTED EARNINGS.
THIS JUSTIFIED P/E MAY BE BASED ON THE
INDUSTRY AVERAGE P/E, THE COMPANYS OWN
HISTORICAL P/E, OR SOME OTHER P/E THAT THE
ANALYST FEELS IS JUSTIFIED.
TO CALCULATE THE VALUE OF THE STOCK, WE
MERELY MULTIPLY ITS NEXT YEARS EARNINGS BY
P EPS1
THIS JUSTIFIED V
P/E:
CS
E

THE P/S APPROACH

IN SOME CASES, COMPANIES ARENT CURRENTLY
EARNING ANY MONEY AND THIS MAKES THE P/E
APPROACH IMPOSSIBLE TO USE (BECAUSE THERE
ARE NO EARNINGS).
IN THESE CASES, ANALYSTS OFTEN ESTIMATE THE
VALUE OF THE STOCK AS SOME MULTIPLE OF
SALES (PRICE/SALES RATIO).
THE JUSTIFIED P/S RATIO MAY BE BASED ON
HISTORICAL P/S FOR THE COMPANY, P/S FOR THE
INDUSTRY, OR SOME OTHER
ESTIMATE:
P

VCS

Sales1

DETAILED PROCEDURE ADOPTED

RELATIVE VALUE MODEL

SELECT GROUP OF COMPANIES COMPARABLE WITH

RESPECT TO SIZE, PRODUCTS, RECENT TRENDS &
FUTURE PROSPECTS.
IDENTIFY THE MOST REPRESENTATIVE KEY RATIOS FOR
THE BUSINESS OF THE TARGET FIRMFROM AMONGST
PRICE/EARNING, PRICE/BOOK VALUE , PRICE/SALES ,
PRICE/CASH FLOW , PRICE/DIVIDEND & MARKET
VALUE/REPLACEMENT VALUE RATIOS.
COMPUTE THE KEY RATIOS FOR EACH SELECT GROUP OF
COMPANIES
KEY RATIOS ARE AVERAGED FOR GROUP
AVERAGE RATIOS ARE APPLIED TO ABSOLUTE DATA FOR
TARGET COMPANY
INDICATED MARKET VALUES OBTAINED FROM EACH RATIO
VALUATION JUDGMENTS ARE MADE

FIRM VALUATION IN M&A

COMPARABLE COMPANIES MODEL
ADVANTAGES
COMMON SENSE APPROACH
MARKETPLACE TRANSACTIONS ARE USED
WIDELY USED IN LEGAL CASES, FAIRNESS EVALUATION,
AND OPINIONS
USED TO VALUE A COMPANY NOT PUBLICLY TRADED

LIMITATIONS
MAY BE DIFFICULT TO FIND COMPANIES THAT ARE
ACTUALLY COMPARABLE BY KEY CRITERIA
RATIOS MAY DIFFER WIDELY FOR COMPARABLE COMPANIES
DIFFERENT RATIOS MAY GIVE WIDELY DIFFERENT RESULTS

UNDERLYING THEME OF OPTION PRICING

MODEL: SEARCHING FOR AN ELUSIVE PREMIUM
TRADITIONAL DISCOUNTED CASH FLOW MODELS
UNDER ESTIMATE THE VALUE OF INVESTMENTS,
WHERE THERE ARE OPTIONS EMBEDDED IN THE
INVESTMENTS TO: DELAY OR DEFER
FLEXIBILITY
EXPANSION
ABANDONMENT
PUT ANOTHER WAY, OPTION VALUE ADVOCATES
BELIEVE THAT THERE SHOULD BE A PREMIUM ON
DISCOUNTED CASHF LOW VALUE ESTIMATES.

DETERMINANTS OF OPTION
VALUE
VARIABLES RELATING TO UNDERLYING
ASSET
VALUE OF UNDERLYING ASSET
VARIANCE IN THAT VALUE
EXPECTED DIVIDENDS ON THE ASSET

VARIABLES RELATING TO OPTION

STRIKE PRICE OF OPTIONS
LIFE OF THE OPTION

LEVEL OF INTEREST RATES; AS RATES

INCREASE, THE RIGHT TO BUY (SELL) AT A
FIXED PRICE IN THE FUTURE BECOMES
MORE (LESS) VALUABLE.

OPTION PRICING MODEL : THE BLACK SCHOLES

MODEL
VALUE OF CALL = S N (d1) - K e-rt N(d2)
WHERE,
2
S
ln + (r +
)t
K
2
d1 =
t

d2 = d1 - t

THE REPLICATING PORTFOLIO IS EMBEDDED IN THE

BLACK-SCHOLES MODEL. TO REPLICATE THIS CALL,
YOU WOULD NEED TO
BUY N(d1) SHARES OF STOCK; N(d1) IS CALLED THE
OPTION DELTA
BORROW K e-rt N(d2)

OPTION PRICING MODEL : VALUING

PRODUCT PATENT OF AVONEX
BIOGEN, A BIO-TECHNOLOGY FIRM, HAS A PATENT ON AVONEX, A
DRUG TO TREAT MULTIPLE SCLEROSIS, FOR THE NEXT 17 YEARS,
AND IT PLANS TO PRODUCE AND SELL THE DRUG BY ITSELF. THE KEY
INPUTS ON THE DRUG ARE AS FOLLOWS:
PV OF CASH FLOWS FROM INTRODUCING THE DRUG NOW = S = $ 3.422
BILLION
PV OF COST OF DEVELOPING DRUG FOR COMMERCIAL USE = K = $ 2.875
BILLION
PATENT LIFE = T = 17 YEARS
RISKLESS RATE = R = 6.7% (17-YEAR T.BOND
RATE)
VARIANCE IN EXPECTED PRESENT VALUES =2 = 0.224 (INDUSTRY AVERAGE
FIRM VARIANCE FOR BIO-TECH FIRMS)
EXPECTED COST OF DELAY = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076

CALL VALUE= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17) (0.2076)

= $ 907 million

SENSITIVITY ANALYSIS
PURPOSE
CHECK IMPACT OF A RANGE OF ALTERNATIVE POSSIBILITIES
PROVIDE FRAMEWORK FOR PLANNING AND CONTROL
SENSITIVITY ANALYSIS OF MODEL VARIABLES:
DECREASE IN REVENUES GROWTH RATE (G) LOWERS VALUATION
INCREASE IN INVESTMENT REQUIREMENT PERCENTAGE (I) LOWERS
VALUATION
OPERATING PROFIT MARGIN (M) IS A POWERFUL VALUE DRIVER WHEN M
IS INCREASED, VALUATION INCREASES
VALUATION IS VERY SENSITIVE TO THE COST OF CAPITAL (K) USED IN
ANALYSIS WHEN COST OF CAPITAL IS INCREASED, VALUATION FALLS
SENSITIVITY TO N AND T PREDICTABLE IN DIRECTION AND MAGNITUDE
WHEN PERIOD OF SUPERNORMAL GROWTH IS REDUCED, VALUATION IS
REDUCED
WHEN TAX RATE IS REDUCED, VALUATION IS INCREASED
IN MANY PRACTICAL CASES, SECOND TERM IN VALUATION MODEL REPRESENTS
A HIGHER PROPORTION OF VALUATION THAN FIRST TERM MUST BE
CAREFUL AS TO ASSUMPTIONS ABOUT FACTORS AFFECTING EXIT OR TERMINAL
VALUE

MERGER PREMIUM IN SHARE SWAP

OR SHARE PLUS CASH DEAL
IN SHARE SWAP DEAL THE PREMIUM PAID IS REFLECTED
THROUGH % OF OWNERSHIP EACH PARTY WILL CONTROL
IN THE MERGED ENTITY. HIGHER PREMIUM PAID MEANS :
GREATER THE PERCENTAGE OWNERSHIP OF THE NEW FIRM
BY THE SHAREHOLDERS OF THE ACQUIRED FIRM
GREATER THE VALUE PER SHARE DILUTION FOR ACQUIRER
SHAREHOLDERS
GREATER THE EPS DILUTION FOR ACQUIRER
SHAREHOLDERS
PRESENCE OF MERGER ECONOMIES FROM SYNERGIES,
COST SAVINGS, ETC. CAN RECOVER ACQUIRER PREMIUMS
PAID, COULD EVEN MAKE MERGERS ACCRETIVE

SUMMARY OF VALUATION
ANALYSIS
ALL VALUATION METHODS HAVE
STRENGTHS AND WEAKNESSES
EMPLOY MULTIPLE METHODS OF
VALUATION IN TAKEOVER ANALYSIS
VALUATION SHOULD BE GUIDED BY
A BUSINESS ECONOMICS OUTLOOK
FOR THE FIRMS
ULTIMATELY JUDGMENTS ARE
REQUIRED FOR VALUATIONS

EXTRA SLIDES

FORMULAE FOR FREE CASH

FLOW
FREE CASH FLOW=GROSS CASH OPERATING
INCOME-INCEASE IN NET FIXED ASSET(INCREASE IN CURRENT ASSET-NON INTEREST
BEARING DEBT)
GROSS CASH OPERATING INCOME IS EQUAL TO:
1.EBIDAT*(1-T)+T*D
2.(EBIT+D)*(1-T) +T*D
3.EBIT*(1-T)+D
4. (EBT+INTEREST)*(1-T)+D
5.PAT+D+INTEREST*(1-T)

SOME USEFUL FORMULAE IN

VALUATION
gt =ROE(1-pay out ratio)
ROE=ROC+D/E*{ROC-i(1-t)}
ROC=EBIT(1-t)/(BV of debt+BV
ofequity)
g=(1-payout ratio)*[ROC+D/E*{ROCi(1-t)}]
WACC=kd(1-T)*B/V+kp*P/V+ke*S/V
where WACC=weighted average cost
of capital, kd= cost of debt, kp= cost

SOME USEFUL FORMULAE IN

VALUATION
P = D / R WHERE P= PRICE, D=CONST DPS & R=RATE OF
RETURN
P = D1 / (R-G) WHERE P= PRICE, D1=NEXT YR DPS & R=RATE
OF RETURN
Z + Z2 + Z3 + . . . + ZN = [ZN+1 - Z]/[Z - 1]
Z + Z2 + Z3 + . . . + ZN + . . . = [ - Z]/[Z - 1] (FOR 0 <= Z < 1)
PV = FV / (1 + R)Y OR R = (FV / PV)1 / Y - 1 WHERE R= CAGR
(COMPOUND ANNUAL GROWTH RATE), FV=VALUE AT Y TH YEAR,
PV=PRESNT VALUE
P=C(1 + R)-1 + C(1 + R)-2 + . . . + C(1 + R)-Y + B(1 + R)-Y WHERE
P = PURCHASE PRICE ,C = ANNUAL COUPON PAYMENT (IN
RUPEES, NOT A PERCENT) , Y = NUMBER OF YEARS TO
MATURITY, B = PAR VALUE, & R=YIELD TO MATURITY

DEGREE OF CORRELATION
BETWEEN TWO VARIABLES

EFFICIENT FRONTIERS OF
PORTFOLIO INVESTMENT

EFFICIENT FRONTIERS OF
PORTFOLIO INVESTMENT
20
18
16
14
12
10
8
6
4
2
0

Y-Values

Y-Values

8 10 12 14 16 18 20 22 24 26 28

OPTION PRICING MODEL : INPUTS

FOR PATENT VALUATION
Input

EstimationProcess

1.ValueoftheUnderlyingAsset

PresentValueofCashInflowsfromtakingproject
now
Thiswillbenoisy,butthataddsvalue.

2.Varianceinvalueofunderlyingasset

Varianceincashflowsofsimilarassetsorfirms
Varianceinpresentvaluefromcapitalbudgeting
simulation.

3.ExercisePriceonOption

Optionisexercisedwheninvestmentismade.
Costofmakinginvestmentontheproject ;assumed
tobeconstantinpresentvaluedollars.

4.ExpirationoftheOption

Lifeofthepatent

5.DividendYield

Costofdelay
Eachyearofdelaytranslatesintoonelessyearof
valuecreating cashflows
Annualcostofdelay =

1
n

PRICE-EARNINGS RATIO MODEL

FOR VALUATION
P0 1
PVGO
1
E1 k
E / k
where PVGO = Present Value of Growth Opportunity

P0
E1 (1 b)

E1 k ROExb
Implying P/E ratio

P0
1 b

E1 k ROExb
where ROE = Return On Equity

Beta and Market Risk

Expected
1. Total risk
stock
=
return
diversifiable
risk + market
risk
-10%
+10%
2. Market
risk is
measured by
beta, the
sensitivity to -10%
market
changes.
10%

FGS

beta

+10%

80

Expected
market
return

Markowitz Portfolio Theory

Expected Returns and Standard Deviations

vary given different weighted combinations of
the stocks.
Expected Return (%)
McDonalds

45% McDonalds

Bristol-Myers Squibb
Standard Deviation
FGS

81

Markowitz Portfolio Theory

Price changes vs. Normal distribution

# of Days
(frequency
)

Microsoft - Daily % change 1986-1997

Daily % Change
FGS

82

 Dividend Signaling
-----------------------------------------------------------A theory that suggests company announcements of an increase in dividend payouts
acts as an indicator of the firm possessing strong future prospects. The rationale
behind dividend signaling models stems from game theory. A manager that has good
investment opportunities is more likely to "signal", than one who doesn't, because it
is in their best interest to do so.
Investopedia Says:
-----------------------------------------------------------Over the years the concept that dividend signaling can predict positive future
performance has been a hotly contested subject. Many studies have been done to
see if the markets reaction to a "signal" is significant enough to support this theory.
For the most part the tests have shown that dividend signaling
does occur when companies either increase or decrease the amount of dividends
they will be paying out.
The theory of dividend signaling is also a key concept used by proponents of
inefficient markets.

 Cost of equity
Capital Asset Pricing Model (CAPM)
ks = Rf + [RM - Rf] j
Risk-free rate (Rf)
Related to returns on U.S. government bonds
Rates on relatively long-term bonds should be used since
discount factor is used in valuation involving long periods

Market price of risk (RM - Rf)

For many years, estimated to be in range of 6.5 to 7.5%
For new economic paradigm since mid 1990s, estimated
to be in the range 4% to 5%

Beta (j )
Measures how returns on the firm's common stock vary
with returns on the market as a whole
High beta stocks exhibit higher volatility than low beta
stocks in response to changes in market returns
2001 Prentice Hall
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Dividend growth model

Cost of equity based on the constant-growth
dividend valuation model

D1
So
ks g

D1
ks
g
So

Required return on equity is expected

dividend yield (D1/S0) plus expected growth
rate of dividends in perpetuity (g)

2001 Prentice Hall

Takeovers, Restructuring, and
Corporate Governance, 3/e

 Estimating the cost of equity capital

Use information generated by financial
markets
Estimate cost of equity using multiple
methods
Consider general equity market
uncertainty
Consider estimates for other companies
in same industry
Use judgment to arrive at an estimate

2001 Prentice Hall

Takeovers, Restructuring, and
Corporate Governance, 3/e

 Methodology focuses on current

market opportunity costs, not book or
historical costs
May use book or market values to
provide guidelines
Use judgment to estimate target
financial proportions

2001 Prentice Hall

Takeovers, Restructuring, and
Corporate Governance, 3/e

 Merger premiums
It is wrong to conclude that number of
shares paid in a stock-for-stock deal is
unimportant just because it is a paperfor-paper deal
Premium paid decides the percentage
of combined ownership each party to
the merger will control

2001 Prentice Hall

Takeovers, Restructuring, and
Corporate Governance, 3/e

FIRM VALUATION IN MERGERS

AND ACQUISITIONS-2
DIVIDEND DISCOUNT MODELS

D3
D1
D2
V0

.......
2
3
1 k (1 k ) (1 k )
Where

Vo = value of the firm

Di

= dividend in year I

= discount rate

FIRM VALUATION IN MERGERS

AND ACQUISITIONS-3
THE CONSTANT GROWTH DDM
D0 (1 g ) D0 (1 g )2
V0

......
1 k
(1 k )2

And this equation can be simplified to:

V0

D0 (1 g )
D1

kg
kg

where g = growth rate of dividends.

FIRM VALUATION IN MERGERS

AND ACQUISITIONS-5

CASH FLOW VALUATION MODELS

THE ENTITY DCF MODEL : THE ENTITY DCF MODEL VALUES THE
VALUE OF A COMPANY AS THE VALUE OF A COMPANYS OPERATIONS LESS
THE VALUE OF DEBT AND OTHER INVESTOR CLAIMS, SUCH AS PREFERRED
STOCK, THAT ARE SUPERIOR TO COMMON EQUITY

VALUE OF OPERATIONS: THE VALUE OF OPERATIONS EQUALS THE

DISCOUNTED VALUE OF EXPECTED FUTURE FREE CASH FLOW.

Continuing Value =

. VALUE OF DEBT
. VALUE OF EQUITY

Net Operating Profit - Adjusted Taxes

WACC

STEPS IN VALUATION
ANALYZING
PERFORMANCE
Return on Investment Capital =

Economic Profit

FCF

HISTORICAL

NOPLAT
Invested Capital

NOPLAT (Invested Capital x WACC)

Gross Cash Flow Gross Investme nts

STEPS IN VALUATION-2
FORECAST PERFORMANCE
- EVALUATE THE COMPANYS STRATEGIC POSITION,
COMPANYS COMPETITIVE ADVANTAGES AND
DISADVANTAGES IN THE INDUSTRY. THIS WILL
HELP TO UNDERSTAND THE GROWTH POTENTIAL
AND ABILITY TO EARN RETURNS OVER WACC.
- DEVELOP PERFORMANCE SCENARIOS FOR THE
COMPANY AND THE INDUSTRY AND CRITICAL
EVENTS THAT ARE LIKELY TO IMPACT THE
PERFORMANCE.
- FORECAST INCOME STATEMENT AND BALANCE
SHEET LINE ITEMS BASED ON THE SCENARIOS.
- CHECK THE FORECAST FOR REASONABLENESS.

STEPS IN VALUATION-3
ESTIMATING THE COST OF CAPITAL
B
P
S
WACC kb (1- Tc ) k p k s
V
V
V
where

kb

= the pretax market expected yield to maturity on non-callable, non convertible debt

Tc

= the marginal taxe rate for the entity being valued

= the market value of interest-bearing debt

kp

= the after-tax cost of capital for preferred stock

= market value of the preferred stock

ks

= the market determined opportunity cost of equity capital

= the market value of equity

DEVELOP TARGET MARKET VALUE WEIGHTS

ESTIMATE THE COST OF NON-EQUITY FINANCING
ESTIMATE THE COST OF EQUITY FINANCING

STEPS IN VALUATION-4

ESTIMATING THE COST OF EQUITY FINANCING

CAPM
k s r f E ( rm ) r f
where rf

= the risk-free rate of return

E(rm)

= the expected rate of return on the overall market portfolio

E(rm)- rf

= market risk premium

= the systematic risk of equity

. DETERMINING THE RISK-FREE RATE (10-YEAR BOND RATE)

. DETERMINING THE MARKET RISK PREMIUM 5 TO 6 PERCENT RATE IS
USED FOR THE US COMPANIES
. ESTIMATING THE BETA

STEPS IN VALUATION-5
THE ARBITRAGE PRICING MODEL
(APM)
k s r f E ( F1 ) r f 1 E ( F2 ) r f 2 ....
where E(Fk ) = the expected rate of return on a portfolio that mimics the kth factor and is
independent of all others.
Beta k = the sentivity of the stock return to the kth factor.

STEPS IN VALUATION-6
ESTIMATING THE CONTINUING VALUE
- SELECTING AN APPROPRIATE TECHNIQUE
. LONG EXPLICIT FORECAST APPROACH
. GROWING FREE CASH FLOW PERPETUITY FORMULA
. ECONOMIC PROFIT TECHNIQUE

STEPS IN VALUATION-7
CALCULATING AND INTERPRETING
RESULTS
- CALCULATING AND TESTING THE
RESULTS
- INTERPRETING THE RESULTS WITHIN
THE DECISION CONTEXT

FIRM VALUATION : DIVIDEND

PAYOUT MODEL

USING CAPM TO ESTIMATE

EXPECTED RETURNS
EXPECTED RETURN DEPENDS ON:
RISK-FREE INTEREST RATE
EXPECTED MARKET RISK PREMIUM
BETA

EXAMPLE:
EXP. RETURN ON EXXON STOCK = 4.8% + (.61 X 9%) =
10.3%

COMPARE PROJECT RETURN AND OPPORTUNITY COST

OF CAPITAL
SECURITY MARKET LINE PROVIDES A STANDARD FOR
PROJECT ACCEPTANCE. IF PROJECT IRR ABOVE SML =>
ACCEPT THE PROJECT
FGS

103

Standard deviation of rates of return

(1926-1998)

(in %)
Standard deviation
T bills
3.2
Government bonds
9.2
Common stocks
20.3

FGS

104

Percentage Return

Rates of Return
1926-1997

Source: Ibbotson
FGS
Associates

Year
105

Average rates of return (1926-1998)

(in %)
Average return Av. Risk premium
T bills
3.80
Government bonds
5.70
1.90
Corporate bonds
6.10
2.30
Common stocks
13.20
9.40

FGS

106

Markowitz Portfolio Theory

Combining stocks into portfolios can
reduce standard deviation below the
level obtained from a simple
weighted average calculation.
Correlation coefficients make this
possible.
The various weighted combinations
of stocks that create this standard
deviations constitute the set of
efficient portfolios.
FGS

107

The Normal Distribution

d

N(d 1)

d1

-3.00
-2.95
-2.90
-2.85
-2.80
-2.75
-2.70
-2.65
-2.60
-2.55
-2.50
-2.45
-2.40
-2.35
-2.30
-2.25
-2.20
-2.15
-2.10
-2.05
-2.00
-1.95
-1.90
-1.85
-1.80
-1.75
-1.70
-1.65
-1.60
-1.55
-1.50
-1.45
-1.40
-1.35
-1.30
-1.25
-1.20
-1.15
-1.10
-1.05
-1.00

N(d)
0.0013
0.0016
0.0019
0.0022
0.0026
0.0030
0.0035
0.0040
0.0047
0.0054
0.0062
0.0071
0.0082
0.0094
0.0107
0.0122
0.0139
0.0158
0.0179
0.0202
0.0228
0.0256
0.0287
0.0322
0.0359
0.0401
0.0446
0.0495
0.0548
0.0606
0.0668
0.0735
0.0808
0.0885
0.0968
0.1056
0.1151
0.1251
0.1357
0.1469
0.1587

d
-1.00
-0.95
-0.90
-0.85
-0.80
-0.75
-0.70
-0.65
-0.60
-0.55
-0.50
-0.45
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00

N(d)
0.1587
0.1711
0.1841
0.1977
0.2119
0.2266
0.2420
0.2578
0.2743
0.2912
0.3085
0.3264
0.3446
0.3632
0.3821
0.4013
0.4207
0.4404
0.4602
0.4801
0.5000
0.5199
0.5398
0.5596
0.5793
0.5987
0.6179
0.6368
0.6554
0.6736
0.6915
0.7088
0.7257
0.7422
0.7580
0.7734
0.7881
0.8023
0.8159
0.8289
0.8413

d
1.05
1.10
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65
1.70
1.75
1.80
1.85
1.90
1.95
2.00
2.05
2.10
2.15
2.20
2.25
2.30
2.35
2.40
2.45
2.50
2.55
2.60
2.65
2.70
2.75
2.80
2.85
2.90
2.95
3.00

N(d)
0.8531
0.8643
0.8749
0.8849
0.8944
0.9032
0.9115
0.9192
0.9265
0.9332
0.9394
0.9452
0.9505
0.9554
0.9599
0.9641
0.9678
0.9713
0.9744
0.9772
0.9798
0.9821
0.9842
0.9861
0.9878
0.9893
0.9906
0.9918
0.9929
0.9938
0.9946
0.9953
0.9960
0.9965
0.9970
0.9974
0.9978
0.9981
0.9984
0.9987

VALUATION , PORTFOLIO
MANAGEMENT & INVESTMENT
PHILOSOPHY

FUNDAMENTAL ANALYST
FRANCHISE BUYER
CHARTISTS
INFORMATION TRADERS
MARKET TIMERS
EFFICIENT MARKETERS

BEST & THE WORST DECADE OF S&P

500 STOCK PERFORMANCE IN U.S.A

Courtesy :
Ibbotson Associates

ESTIMATION OF EQUITY RISK

PREMIUM PERIOD : 1926-1995

Investm geom.
ent
mean
S&P
total
10.30
return
U.S.
Small
12.28
Stock TR
U.S. LT
4.91
Govt TR
U.S. LT
5.49
Corp. TR
U.S. 30
day T3.70
Bills

arith.m
std
ean

high
ret.

low ret.

12.45

22.28

42.56

-29.73

17.28

35.94

73.46

-36.74

5.21

8.00

15.23

-8.41

5.73

7.16

13.76

-8.90

3.70

.96

1.35

-0.06

Summary Statistics of U.S. Investments from 1926 through March, 1995.

Source:Ibbotson Associates

M&A DRIVERS: A SURVEY

RESULT

3 HARD KEYS TO
SUCCESSFUL M&A

KEY AREAS TARGETED FOR

SYNERGY

3 SOFT KEYS FOR SUCCESSFUL

MERGERS

VALUATION OF FIRMS IN
MERGERS AND ACQUISITIONS
OKAN BAYRAK

Definitions
A merger is a combination of two or more
corporations in which only one corporation
survives and the merged corporations go
out of business.
Statutory merger is a merger where the
acquiring company assumes the assets
and the liabilities of the merged
companies
A subsidiary merger is a merger of two
companies where the target company
becomes a subsidiary or part of a
subsidiary of the parent company

Types of Mergers
Horizontal Mergers
- between competing companies
Vertical Mergers
- Between buyer-seller relation-ship companies
Conglomerate Mergers
- Neither competitors nor buyer-seller relationship

History of Mergers and Acquisitions

Activity in United States
The First Wave 1897-1904
-

After 1883 depression

Horizontal mergers
Create monopolies

The Second Wave 1916-1929

-

Oligopolies
The Clayton Act of 1914

The Third Wave 1965-1969

-

Conglomerate Mergers
Booming Economy

The Fourth Wave 1981-1989

-

Hostile Takeovers
Mega-mergers

Mergers of 1990s
-

Strategic mega-mergers

Motives and Determinants of

Mergers

Synergy Effect
NAV= Vab (Va+Vb) P E
Where Vab

= combined value of the 2 firms

Vb = market value of the shares of firm B.

Va = As measure of its own value

= premium paid for B

= expenses of the operation

Operating Synergy
Financial Synergy

Diversification
Economic Motives
Horizontal Integration
Vertical Integration
Tax Motives

HP-COMPAQ MERGER CASE

HP-COMPAQ MERGER CASE-2

Arguments About The Merger
- Supporters
. HP-COMPAQ will become the leader in most of the
sub-sectors
. Ability to offer better solutions to customers
demands
. New strategic position will make it possible to
increase R&D efforts and customer research
. Decrease in costs and increase in profitability
. Financial strength to provide chances to invest in
new profitable areas

HP-COMPAQ MERGER CASE-3

Arguments About The Merger
- Opponents
. Acquiring market share will not mean the

leadership
. No new significant technology capabilities added
to HP
. Large stocks will increase the riskiness of the
company (Credit rating of the HP is lowered after
the merger announcement)
. Diminishing economies of scale sector which both
companies have already a great scale.

HP-COMPAQ MERGER CASE-4

Valuation Process
- Relative Historical Stock Price Performance
Historical Exchange Ratios
Period ending August 31,

Average Exchange Ratio

Implied Premium (%)

2001
August 31 2001

0.532

18.9

10-Day Average

0.544

16.3

20-Day Average

0.568

11.3

30 Day Average

0.573

10.3

3 Months Average

0.557

13.7

6 Months Average

0.584

8.2

9 Months Average

0.591

7.1

12 Months Average

0.596

6.1

HP-COMPAQ MERGER CASE-5

Comparable Public Market Valuation Analysis
Firm Values As a Multiple of Revenue EBITDA and LTM EBIT
Firm Values as a Multiple of
Companies

LTM Revenue

LTM EBITDA

LTM EBIT

Compaq

0.5 X

5.7 X

9.8 X

HP

1.0 X

12.4 X

19.8 X

0.2-2.1 X

5.3-18.2 X

8.9-19.9 X

Selected Group

Closing Stock Prices As a Multiple of EPS

Closing Stock Price as a Multiple of
Companies

2001 EPS

2002 EPS

Compaq

34.3 X

18.4 X

14.0 X

HP

35.7 X

19.2 X

12.5 X

18.5-57.3 X

10.7-27.1 X

9.3-19.5 X

Selected Group

2003 EPS

HP-COMPAQ MERGER CASE-6

Similar Transactions Premium Analysis

Salomon Smith Barney's analysis resulted in a range of premiums
of:
- (8)% to 46% over exchange ratios implied by average prices for
the 10 trading days prior to announcement, with a median
premium of 23%.
- (7)% to 58% over exchange ratios implied by average prices for
the 20 trading days prior to announcement, with a median
premium of 23%.
- (12)% to (29) over exchange ratios implied by average prices for
the 1 trading days prior to announcement with a median premium
of 15%.
Based on its analysis, Salomon Smith Barney determined a range
of implied exchange ratios of 0.585x to 0.680x by applying the
range of premiums for other transactions to the closing prices of
Compaq and HP on August 31, 2001 and the average historical
exchange ratio for Compaq and HP for the 10-day period ending on
August 31, 2001, as appropriate.

HP-COMPAQ MERGER CASE-7

Contribution Analysis
Percentage Contribution Analysis
Period
Revenues

Net Income

At Market

LTM
2001 Estimated
2002 Estimated
2003 Estimated
LTM
2001 Estimated
2002 Estimated
2003 Estimated
2001 Estimated
Next Four Fiscal Q
2002 Estimated
2003 Estimated
Equity Value

Percentage
Contribution
Compaq
HP
46.0
54.0
44.0
56.0
44.0
56.0
44.0
56.0
45.7
54.3
38.1
61.9
36.9
63.1
32.7
67.3
32.3
67.7
31.6
68.4
32.7
67.3
29.2
70.8
31.7
68.3

HP-COMPAQ MERGER CASE-8

Pro Forma Earnings Per Share Impact to Compaq

Accretion/Dilution Analysis
EPS

EPS

Accretion/Dilution

2002

2003

Compaq stand-alone

0.67

0.88

HP stand-alone

1.21

1.86

Combined entity pro-forma, excluding proj. synergies

0.74

1.09

Combined entity pro-forma, including proj. synergies

1.05

1.51

Accretion/(Dilution) to Compaq, excluding proj. synergies

11%

24%

Accretion/(Dilution) to Compaq, including proj. synergies

57%

71%

MYTHS OF VALUATION
VALUATION IS OBJECTIVE
A WELL RESEARCHED VALUATION IS
TIMELESS
A GOOD VALUATION ESTIMATES
ACCURATELY.
MORE QUANTITATIVE A MODEL
BETTER VALUATION
THE MARKET IS GENERALLY WRONG
VALUE IS WHAT MATTERS NOT THE
PROCESS OF VALUATION

APPROACHES TO VALUATION
SINGLE PERIOD CAPITALISATION
MULTIPLE PERIOD DISCOUNTED
CASHFLOW
RELATIVE (COMPARABLE COMPANY)
VALUATION
ADJUSTED BOOK VALUE
LIQUIDATION VALUE
REPLACEMENT COST
OPTION PRICING MODEL

VALUATION OF COMMON STOCK

WITH CONSTANT DIVIDEND GROWTH
ASSUMPTION 1 : HOLDING PERIOD IS
INDEFINITE (THIS DISPENSES THE
NEED FOR FORECASTING A FUTURE
SELLING PRICE).
ASSUMPTION 2 : THE DIVIDEND
PAYMENT GROWS AT A CONSTANT
RATE
THE SECOND ASSUMPTION PREDICTS
EACH & EVERY FUTURE DIVIDEND,
SO LONG AS THE MOST RECENT
DIVIDEND & THE GROWTH RATE ARE
KNOWN

Two-Stage DDM Valuation Model (cont.)

The two-stage growth model is not a complex as it seems:

The first term is simply the present value of the first N

dividends (those before the constant growth period)
The second term is the present value of the future stock price.

D0 1 g1 1 g 2
n
1 g1
kCS g 2

n
1 kCS

k
CS

VCS

D0 1 g1
1

kCS g1

PV of the first N dividends + PV of stock price at period N

So, the model is just a mathematical formulation of the

methodology that was presented earlier. It is nothing more
than an equation to calculate the present value of a set of cash
flows that are expected to follow a particular growth pattern in

Three-Stage DDM Valuation

Model
One improvement that we can make
to the two-stage DDM is to allow the
growth rate to change slowly rather
than instantaneously.
The three-stage DDM is given by:
VCS

D0

kCS g 2

n1 n2

1 g 2 2 g1 g 2

Common Stock Valuation: An Example

Assume that you are considering the purchase of
a stock which will pay dividends of $2 (D1) next
year, and $2.16 (D2) the following year. After
receiving the second dividend, you plan on selling
the stock for $33.33. What is the intrinsic value
of this stock if your required return is 15%?
?

VC S

2.00

2.00

1.15

2.16 33.33

1.15

28.57

33.33
2.16

Some Notes About Common

Stock
In valuing the common stock, we have made
two assumptions:
We know the dividends that will be paid in the
future.
We know how much you will be able to sell the
stock for in the future.

Both of these assumptions are unrealistic,

especially knowledge of the future selling
price.
Furthermore, suppose that you intend on
holding on to the stock for twenty years, the
calculations would be very tedious!

The DDM Example (cont.)

In the earlier example, how did we know
that the stock would be selling for $33.33
in two years?
Note that the period 3 dividend must be
8% larger than the period 2 dividend, so:
V2

2.16 1.08
.15.0 8

2.33
0.15.08

33.33

Remember, the value at period 2 is simply

the present value of D3, D4, D5, , D

The Dividend Discount Model (DDM)

For a COMMON stock, there are two cash flows:

Future dividend payments
The future selling price

If we make the following assumptions, we can derive a simple model for common stock valuation:
Your holding period is infinite (i.e., you will never sell the stock so you dont have to worry about forecasting a future
selling price).
The dividends will grow at a constant rate forever.

Note that the second assumption allows us to predict every

future dividend, as long as we know the most recent dividend
and the growth rate.

VCS

D 0 1 g

D1
k CS g

With these assumptions, we can derive a model that is variously known as the Dividend Discount Model, the Constant
Growth Model, or the Gordon Model:
k CS g

This model gives us the present value of an

infinite stream of dividends that are growing
at a constant rate.

Estimating the DDM Inputs

The DDM requires us to estimate the dividend
growth rate and the required rate of return.
The dividend growth rate can be estimated in
three ways:
Use the historical growth rate and assume it will
continue
Use the equation: g = br
Generate your own forecast with whatever method
seems appropriate

The required return is often estimated by using

the CAPM: ki = krf + i(km krf) or some other
asset pricing model.

The DDM: An Example

Recall our previous example in which
the dividends were growing at 8%
per year, and your required return
was 15%.
The value of the stock must be (D0 =
1.85):
VCS

1.85 1 .08
.15.08

2.00
0.15.08

28.57

Note that this is exactly the same

value that we got earlier, but we
didnt have to use an assumed future

The DDM Extended

There is no reason that we cant use the
DDM at any point in time.
For example, we might want to calculate the
price that a stock should sell for in two years.
To do this, we can simply generalize the
DDM:
VN

D N 1 g
k CS g

D N 1
k CS g

For example, to value a stock at year 2, we

simply use the dividend for year 3 (D 3).

The DDM Example (cont.)

In the earlier example, how did we know
that the stock would be selling for $33.33
in two years?
Note that the period 3 dividend must be
8% larger than the period 2 dividend, so:
V2

2.16 1.08
.15.0 8

2.33
0.15.08

33.33

Remember, the value at period 2 is simply

the present value of D3, D4, D5, , D

What if Growth Isnt

Constant?
The DDM assumes that dividends will grow at a
constant rate forever, but what if they dont?
If we assume that growth will eventually be
constant, then we can modify the DDM.
Recall that the intrinsic value of the stock is the
present value of its future cash flows. Further, we
can use the DDM to determine the value of the
stock at some future period when growth is
constant. If we calculate the present value of
that price and the present value of the dividends
up to that point, we will have the present value of
all of the future cash flows.

What if Growth Isnt Constant?

(cont.)
Lets take our previous example, but
assume that the dividend will grow at
a rate of 15% per year for the next
three years before settling down to a
constant 8% per year. Whats the
value of the stock now? (Recall that
D0 = 1.85) 2.1275 2.4466 2.8136 3.0387
0

2
g = 15%

4
g = 8%

What if Growth Isnt Constant?

(cont.)
First, note that we can calculate the value of the
stock at the end of period 3 (using D4):
V3

3.0387
43.41
.values
15 .08 of the

Now, find the present

price and D1, D2, and D3:

future selling

2.1275 2.4466 2.8136 43.41

34.09
2
3
15 stock
1.15 is $34.09
1.15
of1.the
and we

V0

So, the value

didnt
even have to assume a constant growth rate.
Note also that the value is higher than the
original value because the average growth rate is
higher.

Two-Stage DDM Valuation

Model
The previous example showed one
way to value a stock with two (or
more) growth rates. Typically, such a
company can be expected to have a
period of supra-normal growth
followed by a slower growth rate that
we can expect to last for a long time.
1 gtwo
D 1 gthe
In these cases we can use
1 g
D 1 g
k g

1

stageV DDM:
n

CS

kCS g1

1 kCS

CS

2
n

1 kCS

Two-Stage DDM Valuation Model (cont.)

The two-stage growth model is not a complex as it seems:

The first term is simply the present value of the first N

dividends (those before the constant growth period)
The second term is the present value of the future stock price.

D0 1 g1 1 g 2
n
1 g1
kCS g 2

n
1 kCS

k
CS

VCS

D0 1 g1
1

kCS g1

PV of the first N dividends + PV of stock price at period N

So, the model is just a mathematical formulation of the

methodology that was presented earlier. It is nothing more
than an equation to calculate the present value of a set of cash
flows that are expected to follow a particular growth pattern in

Three-Stage DDM Valuation

Model
One improvement that we can make
to the two-stage DDM is to allow the
growth rate to change slowly rather
than instantaneously.
The three-stage DDM is given by:
VCS

D0

kCS g 2

n1 n2

1 g 2 2 g1 g 2

Other Valuation Methods

Some companies do not pay
dividends, or the dividends are
unpredictable.
In these cases we have several other
possible valuation models:
Earnings Model
Free Cash Flow Model
P/E approach
Price to Sales (P/S)

FIRM VALUATION IN M&A FORMULA

APPROACH
No real distinction between
spreadsheet approach and formula
approach
Both use discounted cash flow analysis
Spreadsheet approach expressed in
form of financial statements over
period of time
Formula approach summarizes same
data in compact form
Formula approach helps focus on
2001 Prentice Hall
Takeovers,
Restructuring,
and
underlyingCorporate
drivers
of valuation
Governance, 3/e

 Development of compact valuation

formulas
Valuation necessarily requires
forecasts
Usually assumes systematic relations
between time periods, variables

Key variables and relationships

Revenues (Rt)
Basic driver of a firm's value
Market value to revenue multiples usually
calculated for comparing values of firm in
same industry
2001 Prentice Hall
Takeovers, to
Restructuring,
and Internet stocks
Main approach
valuing
Corporate Governance, 3/e

 Growth rate (g)

Defined as rate of change in revenues
Growth rate will mirror various combinations
of cash flow patterns that reflect ebb and
flow of strategic and competitive factors

Net operating income margin (m) after

deducting operating costs from
revenues including:
Cost of goods sold
Selling, general, and administrative
expenses
Depreciation expenses

Actual tax rate (T)

2001 Prentice Hall
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Investment (It)
Investment as a ratio of revenues
Defined as the change in total capital over
the previous period
Change in total capital
Investment in working capital, gross or net
Investment in fixed assets, gross or net

Number of periods of supernormal

growth (n)
Defined by firm's competitive advantage
Supernormal growth period will end when
competition erodes the firm's competitive
advantage
2001 Prentice Hall
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Marginal weighted cost of capital (k)

Cost of equity
After-tax cost of debt
Weighted average of the two based on
target financing proportions

Value drivers for net operating income

margin (m) and investment (I) are
expressed as a percentage of sales
could be obtained through a linear
regression relationship with revenues
2001 Prentice Hall
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Sensitivity analysis
Purpose
Check impact of a range of alternative
possibilities
Provide framework for planning and control

Sensitivity analysis of model variables:

Decrease in revenues growth rate (g) lowers
valuation
Increase in investment requirement
percentage (I) lowers valuation
Operating profit margin (m) is a powerful
value driver when m is increased,
valuation increases
2001 Prentice Hall
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Valuation is very sensitive to the cost of

capital (k) used in analysis when cost of
capital is increased, valuation falls
Sensitivity to n and T predictable in
direction and magnitude
When period of supernormal growth is reduced,
valuation is reduced
When tax rate is reduced, valuation is increased

In many practical cases, second term

in valuation model represents a higher
proportion of valuation than first term
must be careful as to assumptions
about factors affecting exit or terminal
2001 Prentice Hall
value
Takeovers, Restructuring, and
Corporate Governance, 3/e

 Limitations of the formula

approach
Less flexibility in reflecting forecasts
for individual years
Calculations use financial statement
data not directly shown in the
formulas

2001 Prentice Hall

Takeovers, Restructuring, and
Corporate Governance, 3/e

The Free Cash Flow Model

Free cash flow is the cash flow thats
left over after making all required
investments in operating assets:
FCF NOPAT Op Cap

Where NOPAT is net operating profit

after tax
Note that the total value of the firm
equals the value of its debt plus
V VD VP VCS
preferred plus common:

The Free Cash Flow Model

(cont.)
We can find the total value of the
firms operations (not including nonoperating assets), by calculating the
present value of its future free cash
FCF0 1 g
flows:
VOps
kg

Now, add in the value of its nonoperating assets to get

FCF0 the
1 g total
V VOps VNonOps
VNonOps
kg
value of the firm:

The Free Cash Flow Model

(cont.)
Now, to calculate the value of its
equity, we subtract the value of the
firms debt and the value of its
preferred stock:
FCF 1 g
VCS

kg

VNonOps VD VP

Since this is the total value of its

equity, we divide by the number of
shares outstanding to get the per
share value of the stock.