Valuation FM 2

8/2/2019 Valuation FM 2

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VALUATION

Jasjit BhatiaAssistant ProfessorSIBM Bangalore


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Valuation How much is the business worth?


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Valuation

The value of an asset is equal to the present value of theexpected cash flows an investor will receive from owning it .Basic valuation model the value of an asset is the present value

of its expected future cash flows

The process of valuation requires estimates of Stream of expected returns(cash flows) Required rate of return


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Basic Valuation Model A publicly traded firm potentially has an infinite

life. The value of the firm should be equal to the

present value of the cash flows forever

Since we cannot estimate cash flows forever, we

estimate cash flows for a growth period andthen estimate a terminal value, to find value at theend of the period:

n=t

1=tt

t

r)+(1

FirmtoCF =Firmof Value

Value =CFt

(1+r) tTerminal Value

(1+ r) Nt = 1

t = N


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Cash flowsExpected GrowthFirm: Growth inOperating Earnings

CF 1 CF 2 CF 3 CF 4 CF 5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal ValueCF n.........

Discount RateFirm:Cost of Capital

: Value of Firm

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Growth


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Estimating Inputs- Estimating Cash Flows

Free cash Flows to Firm FCFF = EBIT(1-t)

+Depreciation-CAPEX-Increase in Non Cash working Capital


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Estimating Working Capital Changes in non cash working capital Projections should not be a result of unusual base year Tie the changes in working capital to expected changes in

revenues Non cash working capital-percentage of revenues of firm /

industry


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Estimating discount rate Discount rate can be calculated with WACC Kc=? Cost of equity(CAPM)

Cost of debt (after tax)


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Estimating Growth Firms reinvestment rate Quality of the reinvestments gEBIT = Reinvestment Rate * ROC

Or use analysts estimations?


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Getting Closure in Valuation A publicly traded firm potentially has an infinite life. The

value is therefore

Since we cannot estimate cash flows forever, we estimatecash flows for a growth period and then estimate aterminal value, to find value at the end of the period:

Value =CF

t(1+ r) tt = 1

t =

Value =CFt

(1+r) tTerminal Value

(1+ r) Nt = 1

t = N


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Terminal Value Stable Growth When a firms cash flows grow at a constant rate forever,

the present value of those cash flows= Expected Cash Flow Next Period / (r - g)

where,r = Discount rate (Cost of Equity or Cost of Capital)g = Expected growth rate

This constant growth rate is called a stable growth rateand as per DCF it should not be higher than the growthrate of the economy in which the firm operates.

While companies can maintain high growth rates forextended periods, they will all approach stable growth atsome point in time


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Growth Patterns 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 thegrowth rate will decline gradually to a stable growth rate(3-stage)


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Firm characteristics as growth changesVariable High Growth Firms Stable Growth

tend to Firms tend toRisk be above-average risk be average riskNet Cap Ex have high net cap ex have low net cap ex

ROC earn high ROC earn ROC closer to WACC


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Summary-DCF Estimate the discount rate to be used for valuation Estimate the current earnings and cash flows to all

stakeholders

Estimate the future earnings and cash flows Estimate the expected growth rate in earnings and cash

flows Estimate when the firm will reach stable growth phase

and what will be its risk and cash flows in that phase Use DCF model with these inputs to value the firm.


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Example Assume you have forecasted the following for Firm Abc Current debt-15 cr Tax rate-35%

WACC-12% Horizon period-following year-4 with growth rate of 4%Calculate Free Cash Flows

Rs(inCr)Year 1 Year 2 Year 3 Year4

Net Income 10 11 11.5 12

Depreciateion 3 3.5 4.5 5Cap EX 4 5 6.5 7

Inc in NC WC 1 1.5 2 2.5Interest 2 2.2 3 3.5


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EVA


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EVA Surplus left after making an appropriate charge for the

capital employed in the business EVA=NOPAT- (cost of capital *Capital)

Measures the extent o which the firm has added toshareholders value


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Example-Calculate EVA

Liabilities AssetsEquity 150 Fixed Assets 210debt 150 Net Current Aseets 90

300 300

PROFIT AND LOSS FOR THE YEAR ENDING 31.03.20XO Rs in crore

Net sales 450Cost of goods sold 387

PBIT 63

Interest 18

PBT 45

Tax(30%) 13.5

PAT 31.5

Cost of equity 18%Interest rate on debt 12%Proportion of debt 50%


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Stern Stewart Approach- EVA

An EVA will rise if the the operating efficiency is improvedi.e if value adding investments are made

Managers focus on EVA to to ensure maximization ofshareholders wealth

Can be determined for divisions


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EVA

Analyse?

Year 2011 2010

EBIT 283.8 263

Tax Rate 40% 40%

NOPAT 170.28 157.8

Total Capital 1800 1455

WACC 11% 10.80%

EVA -27.72 0.66


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Source-Livemint-2009 Study conducted by Stern Stewart & Co for 500 Indian Companies for the 5 year period from 2004-2008


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Source-Livemint -2009 Study conducted by Stern Stewart & Co for 500 Indian Companies from yr 2004-2008


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RELATIVEVALUATION


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Valuation Discounted Cash flow Valuation -value based on

cash flowsgrowth and

risk characteristics. Relative valuation the value of a company is determined

in relation to how similar companies are priced in themarket


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Relative ValuationRelative valuation is based on P/E ratios and other

multiples. Extremely popular with the press Used to value one stock against another. Can not compare value across different asset classes

(stocks vs. bond vs. real estate, etc). Can answer the question, I want to buy a pharma stock,

which one should I buy?


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ExamplePiramal sells domestic formulation business at 8.3x

sales Piramal has announced that it has signed a definitive agreement with Abbott, USA to sell domestic formulation business. The deal values the domestic formulation business at 8.3x FY10 sales and 33x FY10 EBIDTA, a hefty premium to the current valuations. - Emkay GlobalFinancial Services Ltd


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Relative ValuationPrices can be standardized using a common variable such as earnings book

value, or revenues.- Earnings Multiples

Price/Earning ratio (PE) and variants Value/EBIT

Enterprise value/EBDITA- Book Multiples

Price/Book Value (of equity) PBV- Revenues

Price/Sales per Share (PS) Enterprise Value/Sales per Share (EVS)


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Relative Valuation To do relative valuation Identify a list of comparable companies, often industry

peers and obtain their market values. Convert these market values into comparable trading

multiples, such as P/E, price-to-book etc multiples. Compare the company's multiples with those of its peers

to assess whether the firm is over or undervalued


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Valuation Analysis For relative Valuation -choices to be made-multiple to be used-group of firms that will comprise the comparable firms

Given the firm that we are valuing, what is a comparable firm?


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Equity MultipleStandardization-for comparison of values of similar assetsEquity multiples can be stated in terms of earnings , book

values ,revenues i.e Values can be standardized relative to earnings generated (Earnings multiples )to book value(Book value multiples)to revenues (Revenue Multiples)


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Earnings Multiple- Price Earnings ratio Earnings multiple-Value of an asset as a multiple of its

earnings P/E Price paid as a multiple of earnings generated

by the company PE = Market Price per Share / Earnings per Share Variants Current P/E

Trailing PEForward PE


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Example: Valuing a firm using P/E ratios

In an industry we identify 4 stocks which are similarto the stock we want to evaluate.

The average PE = (14+18+24+21)/4=19.25 Our firm has EPS of Rs 2 P/2=19.25 P=19.25*2=Rs 38.5

Stock A PE=14

Stock B PE=18Stock C PE=24

Stock D PE=21

32


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Example Coorg Coffee is a manufacturer of coffee products and

has a earnings per share of Rs 25.If the average P/E ofcomparable coffee firms is 5.6, estimate the value ofCoorg Coffee using the P/E as a valuation multiple.


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Value Multiples Equity multiples -value of equity For valuing the firm Enterprise value and Firm

Value Multiples Inputs required-estimate of the value of the firm(numerator)-a measure of revenues , earnings / book

value(denominator)Eg -Value/EBIT

-Enterprise value/EBDITA


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Enterprise Value Common practice to use valuation multiple based on

Enterprise Value The enterprise value of the firm assess the value of the

underlying business assets unencumbered by debt andseparate from any cash .

Theoretical takeover price Enterprise Value = Market Value of Equity + Debt Cash

Holdings


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EV/EBITDAEBITDA- As the EV represents the entire value of the firm

EBITDA is most common measure (used in practice) as itaccounts for firms operating efficiency and is not affectedby leverage between firms.

Has advantages over P/E Multiple-EV/EBITDA


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Analysis of Multiples What variables/ fundamentals determine the multiple ? What is the relationship between each of the variable and

multiple ? What determines the equity Multiple-P/E ratioForward P/E=P0/EPS1=DIV1/EPS1

Re-g (Using Constant growth DDM )=Payout ratio (1+g)

re-gDetermining variables of P/E multiple-Growth , payout and

risk

38


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Is low (high) PE cheap (expensive)?

A market strategist argues that stocks are over pricedbecause the PE ratio today is too high relative to theaverage PE ratio across time. Do you agree?

Yes No If you do not agree, what factor might explain the high PE

ratio today?


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Controlling for differences The relationship that exists in the market at any point of time

between p/e ratios and the variables can be estimated usingregression analysis

Run regressions of the multiples against the variables for allthe comparable firms

For example a multiple regression, with the PE ratio as thedependent variable, and proxies for risk, growth and payoutforming the independent variables.

The regression equation is the theoretical P/E for any stock outof the data set.

Substitute the forecasted earnings growth rate , dividendpayout ratio and risk of the stock you want to value to get thepredicted P/E of the particluar stock.

Compare with the Market P/E for undervaluation / overvaluation.


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Alternate Multiples Price Earnings Growth (PEG) Ratio.

PEG = (P/E) / (projected growth in earnings)

Multiples of operational data. When financial data is sparse,

compute non-financial multiples, which compare enterprise value toone or more operating statistics, such as Web site hits, uniquevisitors, or number of subscribers.


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The right role of multiples in Valuation-MckinseyQuarterly-Marc Goedhart Timothy Koller David Wessels

Building Effective Multiples1. Choose comparables with similar prospects2. Use multiples based on forward looking data

3. Use enterprise value multiples4. Eliminate non-operating items


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Building Effective MultiplesThe right role of multiples in Valuation-MckinseyQuarterly-Marc Goedhart Timothy Koller David Wessels

1.Choosing Comparables Create an appropriate peer group

Ask questions like Why are the multiples different across thepeer group?Do certain companies in the group have superior products, betteraccess to customers, recurring revenues, or economies ofscale?

2. Use Forward Looking Multiples -building a multiple, the denominator should use a forecast of

profits, rather than historical profits.

consistent with the principles of valuation companys valueequals the present value of future cash flow, not past profits.


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Building Effective MultiplesThe right role of multiples in Valuation-MckinseyQuarterly-Marc GoedhartTimothy KollerDavid Wessels

3.Use Enterprise Value MultiplesP/e Ratio-affected by the capital structureEV/EBITA-EV includes debt and equity ,EBITA is the

profit available to all investors4. Adjust for Non-Operating Items-Operating leases

-Excess cash


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Sensitivity Analysis What if ? Financial valuation as accurate as the estimates Before the conclusion on the value -assess the

uncertainty through Sensitivity/ Scenario Analysis todetermine impact on value.


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Remember

Valuation has -No hard and fast rules asBased on current understanding you are projecting the future which is unknown


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AssignmentObjective To arrive at an estimate of value for a firm based on how similar firms are

currently priced in the market.Structure of the assignment1. Company Overview-2. Defining Comparable Firms

-No Of companies used as comparables-Justification for selecting comparables (eg firms selected based on their size,

growth etc)3. Choosing a standardized measure of value4. Value Prediction

a. Based on regression of the multiples against the determinant variables of themultiple and/orb. Based on the average multiple of comparable firms

5. Interpretation - After arriving at the value based on the companys peers, interpretthe results in terms of -- Comparison with current market value. Is the differencebetween the estimated value and current value random? Or you can think of somegood reasons because of which the valuations differ. Elaborate these reasons thatare causing the company to be priced differently from the valuations suggested bythe industry ratios.

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Valuation FM 2

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