MODULE 3-VALUATION OF SECURITIES

THE VALUE OF A BUSINESS IS A FUNCTION OF HOW WELL THE FINANCIAL CAPITAL AND INTELLECTUAL CAPITAL
ARE MANAGED BY THE HUMAN CAPITAL-DAVE BOOKBINDER.
VALUATION-INTRODUCTION

 Valuation is an estimation of an asset’s value based on variables

perceived to be related to future investment returns ,on comparisons with
similar assets ,or, when relevant, on estimates of immediate liquidation
proceeds.
 Following are the different perspectives of Valuation:
 Intrinsic Value
 Going Concern Value and Liquidation Value
 Fair Market Value and Investment Value
APPLICATIONS OF VALUATION

 Selecting Stocks
 Inferring/Extracting Market expectations
 Evaluating Mergers/Acquisitions
 Rendering Fair opinion
 Evaluating Business Strategies and Models
 Communicating with analysts and shareholders
 Appraising private businesses
VALUATION PROCESS

 Purpose
 Valuation Date
 Common Standards of Value
 Gathering Company Data
 Researching Economic and Industry Information
 Financial Statements Analysis
 Selection of Valuation Model
 Reporting
APPROACHES TO EQUITY VALUATION

Approaches to Equity Valuation

Discounted Relative
Cash Flow Valuation
techniques techniques

Price/Earnings Ratio(P/E)
Present Value of Dividend(DDM)
Price/Cash Flow Ratio(P/CF)
Present Value of Residual Income
Price/Book Value Ratio (P/BV)
Present Value of Free Cash Flow
Price/Sales Ratio(P/S)
VALUATION MODELS

 Discounted Cash Flow(DCF) Model applied to equity valuation derives the value of
common stock as the present or discounted value of its expected future cash flows.
 Present Value Models based on dividends are called Dividend Discount Models(DDM)
 Residual Income Model is based on accrual accounting earnings in excess of the opportunity
costs of generating those earnings.
 A Relative Valuation Model estimates an asset’s value relative to that of another
asset.It is typically implemented using price multiples or enterprise multiples.
 A valuation that sums up the estimated values of each of the company’s businesses as
if each business were an independent going concern is known as Sum of the Parts
Valuation.
DIVIDEND DISCOUNT MODEL-ZERO GROWTH MODEL

 The zero dividend growth model assumes that the stock will pay the same
dividend each year, year after year.
 Formula:P0=D1/r

P0=Current Market Price of Share

D1=Expected Dividend
R or Ke=Expected Return on shareholders equity
 Note: The zero growth model is an appropriate model for valuing preferred stock.
DDM-ONE YEAR HOLDING VALUATION MODEL
DDM FOR INFINITE PERIOD

 Infinite period model assumes a constant growth rate for estimating future
dividends

 Vo=Current Value of Share

 r = Requires rate of return from an investment in equity.
 g =expected constant growth rate in dividends.
DDM-H MODEL

 H model is similar to two stage model, but differs by attempting to smooth out the
high growth rate period over time.
GROWTH PATTERNS IN DIVIDEND

 A key assumption in all discounted cash flow models is the period of high growth,
and the pattern of growth during that period. In general, we can make one of three
assumptions:
 There is no high growth, in which case the firm is already in stable growth
 There will be high growth for a period, at the end of which the growth rate will
drop to the stable growth rate (2-stage)
 There will be high growth for a period, at the end of which the growth rate will
decline gradually to a stable growth rate(3-stage)
TERMINAL VALUE

 Terminal value can be calculated several ways:

 Use the constant growth perpetuity model with a long-term growth closer to economy
growth rates.
 Works for mature industries
 Estimate a two-or three-stage model,
 Higher growth rate(s) in the initial stage(s) (for about 10 years)
 A lower long-term growth for the final stage
 Use a Enterprise value to EBITDA multiple based on industry averages to estimate
terminal value.
DISCOUNTED CASH FLOW MODEL-DEFINING FREE CASH FLOW

 Free Cash Flow to Firm (FCFF) is the cash flow available to the
company’s suppliers of capital after all operating expenses (including
taxes) have been paid and necessary investments in working capital (e.g
inventory) and fixed capital ( e.g equipment) have been made.
 Calculation of FCFF from Net Income:
FCFF=NI+ NCC+ Int(1-t) - FC Inv- WC Inv
 Calculation of FCFF from EBIT:
FCFF = EBIT ( 1 –Tax rate ) + Dep – FCInv – WC Inv
CONTINUATION OF PREVIOUS SLIDE

 t= Tax Rate
 Int=Interest on Debt
 FCInv=Investment in Fixed Assets
 NCC=Non Cash Costs
 WCInv=Investment in Working Capital
APPLICABILITY OF FCFF

 The company does not pay dividends.

 The company pays dividends but the dividends paid differ significantly from the
company ’ s capacity to pay dividends.
 Free cash flows align with profitability within a reasonable forecast period with
which the analyst is comfortable.
 The investor takes a control perspective.
 This approach is easiest to use for assets (firms) whose :-
Cash flows are positive and
Can be estimated with some reliability for future periods
FREE CASH FLOW TO EQUITY

 Free Cash Flow to Equity (FCFE) is the cash flow available to the
company’s holders of common equity after all operating expenses ,interest, and
principal payments have been paid and necessary investments in working and
fixed capital have been made.
FCFF and FCFE are related to each other as follows:
FCFE=FCFF - Int(1-t)+Net Borrowing
Calculation of FCFE starting from Net Income:
FCFE=NI+ NCC- FCInv-WCinv+Net Borrowing
SINGLE STAGE FREE CASH FLOW MODELS
DCF MODEL-SUMMARY

To Sum up-
 Valuing a firm using DCF approach calls for forecasting cash flows over an indefinite
period of time for an entity that is expected to grow.This is indeed a daunting task.To
tackle this task,in practice,the value of the firm is separated in two time periods:
 Value of firm=PV of cash flows during an explicit forecast period+ PV of cash flows
after the explicit forecast period.
 During the explicit forecast period-which is a period of 5 to 15 years-the firm is expected
to revolve rapidly and hence a great deal of efforts is expended to forecasts its cash flow
on annual basis. At the end of the explicit period, the firm is expected to reach a steady
state and hence a simplified procedure is used to estimate its continuing value.
RESIDUAL INCOME MODEL OF VALUATION

Economic
Profit

Abnormal Residual
Income
Earnings

Economic
Value
Added
RESIDUAL INCOME-CALCULATION

Residua
Net Equity
l
Income Charge
Income
FORECASTING RESIDUAL INCOME

RIt  Et  re Bt 1

Residual Earnings Beginning

Required book value
income per per share return on
share (EPS) per share
equity (Re) (BVPS)
VALUING COMMON STOCK USING RESIDUAL INCOME


RIt
V0  B0   t
t 1 (1  r )

Et  rBt 1

V0  B0   t
t 1 (1  r )
DETERMINANTS OF RESIDUAL INCOME

RIt   ROE t  r  Bt 1

ROE >
RI > 0 V>B
r

ROE <
RI < 0 V<B
r
RESIDUAL INCOME VALUATION AND THE P/B

ROE  r
V0  B0  B0
rg

V0 ROE  r
 1
B0 rg
RESIDUAL INCOME VS DIVIDEND AND FCFE MODEL
VALUATIONS

Dividend and
Residual Income
FCFE Model
Model Valuation
Valuations

Value = Value =
Book value + PV (Early cash
PV (residual flows +
income) Terminal value)

Large weight on
Large weight on
current book
later cash flows
value
RESIDUAL INCOME MODEL-STRENGTH AND WEAKNESSES
Strengths
• Puts less weight on the terminal value
• Uses available accounting data
• Is useful for non-dividend-paying firms
• Is useful for firms without free cash
flows
• Is useful when cash flows are
unpredictable
• Is based on economic value
Weaknesses
• Relies on accounting data
• May require adjustments to accounting
data
• Relies on clean surplus relation
• Assumes that Cost of debt = Interest
expense
RESIDUAL INCOME-APPROPRIATENESS

Most Appropriate
• At non-dividend-paying firms
• At firms without free cash flows
• When terminal values are highly uncertain

Least Appropriate
• When the clean surplus relationship does not hold
• When the determinants of residual income are not predictable
RESIDUAL INCOME VALUATION-SUMMARY

Residual Income = Income Leftover after All Capital Charges

• = Net income – (Equity required return × Book value)

• = (ROE – Equity required return) × Book value
• Related to EVA and MVA

Equity Value = Book Value + PV (Residual Income)

• Can be used with single-stage and multistage models

• Can be specified with a persistence factor
• Firms with stronger market positions will have greater persistence factors
RELATIVE VALUATION/MARKET BASED
VALUATION
RELATIVE VS. FUNDAMENTAL VALUATION

 Relative Valuation is based on “P/E” ratios and a host of other multiples.

 Used to value one stock against another.
 Can not answer the question-”Is the stock market over valued”
 Can answer the question-”I want to buy a tech stock,,which one should I buy?”
 In the long run, fundamental is the correct way of valuing any asset.
VALUATION USING MARKET MULTIPLES

 Method of Comparables
 P/B Ratios
 P/E Ratios
 P/S Ratio
 Enterprise Value/EBITDA
 Popular due to simplicity
 Forecasts of future performance not required
 Referred to as “method of comparables”
APPLYING MARKET MULTIPLES

 Step 1:Select target’s performance measures

 Step 2:Identify companies that are comparables
 Step 3:Compute market multiple as average of each comparable’s market value to
performance measure
 Step 4:Multiply target’s performance measure by market multiple to get target’s value
 Step 5:If equity performance measure, divide by outstanding shares; if company
performance measure, subtract net non operating obligations before dividing by
outstanding shares
P/E

 The price earnings ratio(PE) represents how much the market is willing to pay for
every Re.1 of earnings from the firm.
A higher than average PE may mean the market expects earnings to rise in the
future.
A high PE may also mean the market feels the firm’s earnings are at very low risk.
 The PE ratio can be used to estimate the value of a firm’s stock.
 The product of the PE ratio times the expected earnings is the firm’s stock price.
 (P/E) x EPS = MPS
MULTILPLES: P/E

 If valuation is being done for an IPO or a takeover,

◦Value of firm = Average Transaction P/E multiple * EPS of firm
◦Average Transaction multiple is the average multiple of recent transactions (IPO or takeover as the case may
be)
 If valuation is being done to estimate firm value
◦Value of firm = Average P/E multiple in industry *EPS of firm
 This method can be used when
◦firms in the industry are profitable (have positive earnings)
◦firms in the industry have similar growth (more likely for “mature” industries)
◦firms in the industry have similar capital structure
PRICE TO CASH FLOW RATIO
 Companies can manipulate earnings
 Cash-flow is less prone to manipulation
 Cash-flow is important for fundamental valuation and in credit analysis

Where:
 P/CFi= the price/cash flow ratio for firm j
 Pt= the price of the stock in period t
 CFt+1= expected cash low per share for firm j
PRICE TO BOOK VALUE RATIO

 Widely used to measure bank values (most bank assets are liquid (bonds and commercial
loans)

 Where:
 P/BVj= the price/book value for firm j
 Pt= the end of year stock price for firm j
 BVt+1= the estimated end of year book value per share for firm j
MULTIPLES METHODS:DRAWBACKS

 While Multiples methods are simple, all of them share several common disadvantages:
◦They do not accurately reflect the synergies that may be generated in a takeover.
◦They assume that the market valuations are accurate. For example, in an overvalued market, we
might overvalue the firm under consideration.
◦They assume that the firm being valued is similar to the median or average firm in the industry.
◦They require that firms use uniform accounting practices.