EQUITY RESEARCH

&
INVESTMENT BANKING
VALUATION
Misconceptions about Valuation

 Myth 1: A valuation is an objective search for “true” value

 Truth 1.1: All valuations are biased. The only questions are how much and
in which direction.
 Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise estimate of value
 Truth 2.1: There are no precise valuations
 Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
 Myth 3: . The more quantitative a model, the better the valuation
 Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
 Truth 3.2: Simpler valuation models do much better than complex ones.
Basis for all valuation approaches

 The use of valuation models in investment decisions (i.e., in

decisions on which assets are under valued and which are over
valued) are based upon
 a perception that markets are inefficient and make mistakes in
assessing value
 an assumption about how and when these inefficiencies will get
corrected
 In an efficient market, the market price is the best estimate of
value. The purpose of any valuation model is then the
justification of this value.
 Business Valuation Techniques
 Discounted cash flow (DCF) approaches
 Dividend discount model
 Free cash flows to equity model (direct approach)
 Free cash flows to the firm model (indirect approach)

 Relative valuation approaches

 P/E (capitalization of earnings)
 Enterprise Value/EBITDA
 Other: P/CF, P/BV, P/S
 Control transaction based models (e.g. value based on acquisition premia
of “similar” transactions)
 Contingent claim valuation approaches
 Using option valuation techniques to value corporate finance projects and
assets (“real options”)
Approaches to Valuation

Valuation Models

Asset Based Discounted Cashflow Relative Valuation Contingent Claim

Valuation Models Models

Liquidation Equity Sector Option to Option to Option to

Value delay expand liquidate
Stable Current Firm
Market
Young Equity in
Replacement Two-stage firms troubled
Cost Normalized firm
Three-stage
or n-stage Earnings Book Revenues Sector Undeveloped
Value specific land

Equity Valuation Firm Valuation

Models Models
Patent Undeveloped
Dividends Reserves

Cost of capital APV Excess Return

Free Cashflow approach approach Models
to Firm
DISCOUNTED CASH FLOW
Discounted Cash Flow Valuation

 What is it: In discounted cash flow valuation, the value of an asset is the
present value of the expected cash flows on the asset.
 Philosophical Basis: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash flows, growth
and risk.
 Information Needed: To use discounted cash flow valuation, you need
 to estimate the life of the asset
 to estimate the cash flows during the life of the asset
 to estimate the discount rate to apply to these cash flows to get present value
 Market Inefficiency: Markets are assumed to make mistakes in pricing
assets across time, and are assumed to correct themselves over time, as
new information comes out about assets.
Discounted Cash Flow Valuation

 What cash flow to discount?

 Investors in stock receive dividends, or periodic cash distributions from
the firm, and capital gains on re-sale of stock in future
 If investor buys and holds stock forever, all they receive are dividends
 In dividend discount model (DDM), analysts forecast future dividends for
a company and discount at the required equity return
 Problem with dividends: they are “managed” and not too many companies
pay them
Valuation: First Principles

 Total value of the firm

= debt capital provided + equity capital provided

+ NPV of all future projects project for the firm

= uninvested capital +
present value of cash flows from all future
projects for the firm

 Note: This recognizes that not all capital may be used to invest in
projects
The Valuation Process

 Identify cash flows available to all stakeholders

 Compute present value of cash flows

 Discount the cash flows at the firm’s weighted average cost of capital (WACC)

 The present value of future cash flows is referred to as:

 Value of the firm’s invested capital, or
 Value of “operating assets” or
 “Total Enterprise Value” (TEV)
The Valuation Process, continued

 Value of all the firm’s assets (or value of “the firm”)

= Vfirm = TEV + the value of uninvested capital

 Uninvested capital includes:

 assets not required (“redundant assets”)
 “excess” cash (not needed for day-to-day operations)

 Value of the firm’s equity

= Vequity = Vfirm - Vdebt

where Vdebt is value of fixed obligations (primarily debt)

Total Enterprise Value (TEV)

 For most firms, the most significant item of

uninvested capital is cash

Vfirm = Vequity + Vdebt = TEV + excess cash

TEV = Vequity + Vdebt - excess cash

TEV = Vequity + Net debt

where Net debt = Vdebt – excess cash

Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
cash flows Grows at constant rate
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Equity: Value of Equity
Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

Discounted Cashflow Valuation

t = n CF
Value =  t
t
t = 1 (1+ r)

where CFt is the cash flow in period t, r is the discount rate appropriate
given the riskiness of the cash flow and t is the life of the asset.
Proposition 1: For an asset to have value, the expected cash flows
have to be positive some time over the life of the asset.
Proposition 2: Assets that generate cash flows early in their life will
be worth more than assets that generate cash flows later; the latter
may however have greater growth and higher cash flows to
compensate.
Equity Valuation versus Firm Valuation

Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business
Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

Firm Valuation

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has
reinvested to create growth financing, in proportion to their
assets use
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.
Measuring Cash Flows

 Free Cash Flow to the Firm (FCFF)

 represents cash flows to which all stakeholders make claim

FCFF = EBIT  (1 - tax rate)

+ Depreciation and amortization (non cash items)
- Capital Expenditures
- Increase in Working Capital
 What is working capital?
Non-cash current assets - non-interest bearing current liabilities
(e.g. A/P & accrued liab.)
n
FCFFt
 Ultimately: Value  
t 1 (1  WACC ) t
Two Stage FCFF Valuation

 The number of periods necessary to forecast is usually 

 Impossible to forecast cash flow indefinitely into the
future with accuracy
 Typical solution: break future into “stages”
 Stage 1 : firm experiences high growth

 Sources of extraordinary growth:

 product segmentation
 low cost producer
 Period of extraordinary growth:
 based on competitive analysis / industry analysis
 Stage 2: firm experiences stable growth
DISCOUNT RATE
(COST OF DEBT, COST OF EQUITY,
CAPM)
Cost of Capital (WACC)
 After tax cost of capital is the weighted average of required returns on
different types of liabilities used to finance the assets under
consideration. Formally:

kc = (D/V ) * kd * (1-t) + ( E /V ) * k e

kd = cost of debt D=value of debt

ke = cost of equity E=value of equity
kc = overall cost of capital V=D+E
t = firm’s marginal tax rate
Capital Structure

 Use market rather than book values of debt and

equity if available

 “Target” capital structure:

 Estimate the firm’s current capital structure
 Review the capital structure of comparable firms
 Review management’s plans for future financing

 What if capital structure is expected to change over

time?
Cost of Debt (kd)

 Match with term of projects (generally long-term)

 Focus on “permanent” debt (can include short term)
 Use same rate for all types of debt (short and long-term)
 Use current as opposed to past yields
 Take government yields and add a risk “premium”
 Historic spread for issuer (long-term best but use short term
spread if no better data)
 Spread given bond rating, if available
 1-3%, if no other information
Cost of Equity (ke): the CAPM

 Relevant measure of risk:

 Contribution a stock makes to the risk of a well diversified portfolio
(the “market” portfolio)
 Formally, this contribution is given by an asset’s “beta”

 The CAPM relates the cost of equity for an individual stock

to that asset’s beta (b). Formally:

ke = rf + b RP
The CAPM: Inputs
 b - beta
 Beta for an asset of similar risk to the market portfolio = 1.
 Typical range of betas: 0.5 - 2.0
 If you cannot measure for firm, use beta of comparable firm(s). Be
consistent with capital structure assumptions (may need to unlever /
relever)

 rf - risk free rate

 Current yield on long-term government bonds


RP - expected market risk premium
 Historic average of difference between the return on the market (e.g.
Sensex) and long-term government bonds
 4-6% if no better data available
Special Cases in DCF Valuation

 Capital raising (e.g. IPO)

 Do cash flow projections account for capital raised?
 If so, value of existing equity equals total equity value less
amount raised in the IPO
 Share price for equity offering = value of existing equity / number
of existing shares
 If lower price, wealth transfers from original share owners
 Private firms
 “Liquidity discount” ~40%
 28

RELATIVE VALUATION :

EQUITY VALUE MULTIPLES

 Relative vs. Fundamental Valuation
29

The DCF (WACC, FTE, APV) model of valuation is a fundamental method.

 Value of firm (equity) is the PV of future cash flows.

 Ignores the current level of the stock market (industry).

 Appropriate for comparing investments across different asset classes

(stocks vs. bond vs. real estate, etc).
 In the long run, fundamental is the correct way of value any asset.
 Relative vs. Fundamental Valuation
30

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

 Extremely popular with the press, CNBC, Stock brokers

 Used to value one stock against another.

 Can not compare value across different asset classes (stocks vs. bond vs.

real estate, etc).

 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?”
 Can answer the question, “Which one of these overpriced IPO’s is the best

buy?”
 Relative Valuation
31

Prices can be standardized using a common variable such as earnings, cashflows, book
value, or revenues.
 Earnings Multiples
 Price/Earning ratio (PE) and variants
 Value/EBIT
 Value/EBDITA
 Value/Cashflow
 Enterprise value/EBDITA
 Book Multiples
 Price/Book Value (of equity) PBV
 Revenues
 Price/Sales per Share (PS)
 Enterprise Value/Sales per Share (EVS)
 Industry Specific Variables (Price/kwh, Price per ton of steel, Price per click, Price
per labor hour)
Price Earnings Ratio

PE = Market Price per Share / Earnings per Share

 There are a number of variants on the basic PE ratio in use. They are based
upon how the price and the earnings are defined.
 Price: is usually the current price
is sometimes the average price for the year
 EPS: earnings per share in most recent financial year
earnings per share in trailing 12 months (Trailing PE)
forecasted earnings per share next year (Forward PE)
forecasted earnings per share in future year
PE Ratio: Fundamentals

To understand the fundamental start with the basic equity

discounted cash flow model.

 With the dividend discounted model

Div1
P0 
re  g
 Dividing both sides by EPS

P0 Payout ratio  (1  g )

EPS 0 re  g
33
PE Ratio: Fundamentals

Holding all else equal

 higher growth firms will have a higher PE ratio than lower growth
firms.
 higher risk firms will have a lower PE ratio than low risk firms.
 Firms with lower reinvestment needs will have a higher PE ratio than
firms with higher reinvestment needs.

Of course, other things are difficult to hold equal since high growth firms,
tend to have high risk and high reinvestment rates.

34
 Graph PE ratio
35 1 50
1 00
V W _P E
50
0

1975q1 1980q1 1985q1 1990q1 1995q1 2000q1 2005q1

stata_qtr
 Is low (high) PE cheap (expensive)?
36

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

 Yes
 No

 If you do not agree, what factor might explain the high PE ratio today?
 A Question
37

You are reading an equity research report on Informix, and the analyst claims
that the stock is undervalued because its PE ratio is 9.71 while the average
of the sector PE ratio is 35.51. Would you agree?

 Yes
 No
 Why or why not?
P/BV Ratio

The measure of market value of equity to book value of

equity.

P MV equity

B BVequity

38
P/BV Ratio: Stable Growth Firm
 Going back to dividend discount model,
Div1
P0 
re  g
 Defining the return on equity (ROE)=EPS0/BV0 and realizing that
div1=EPS0*payout ratio, the value of equity can be written as
BV0  ROE  payout ratio  (1  g )
P0 
re  g

P0 ROE  payout ratio  (1  g )

 PVB 
BV0 re  g

 If the return is based on expected earnings (next period)

P0 ROE  payout ratio
 PVB 
BV0 re  g 39
Price Sales Ratio
 The ratio of market value of equity to the sales

P MV equity

S Total Revenue

 Though the third most popular ration it has a fundamental problem.

- the ratio is internally inconsistent.

40
Price Sales Ratio
 Using the dividend discount model, we have
Div1
P0 
re  g
 Dividing both sides by sales per share and remembering that
Earnings per share
Profit margin 
Sales per share

 We get

P0 Profit margin  payout ratio  (1  g )

 PS 
sales0 re  g

41
Price Sales Ratio and Profit Margin

 The key determinant of price-sales ratio is profit margin.

 A decline in profit margin has a twofold effect
 First, the reduction in profit margin reduces the price-sales ratio
directly
 Second, the lower profit margin can lead to lower growth and
indirectly reduce price-sales ratio.

Expected growth rate = retention rate * ROE

 retention ratio *(Net profit/sales)*( sales/book value of equity)

 retention ratio * (profit margin) * (sales/ BV of equity)

42
Inconsistency in Price/Sales Ratio
 Price is the value of equity
 While sales accrue to the entire firm.
 Enterprise to sales, however, is consistent.
EV0 MV equity  MV debt - Cash

sales0 re  g

 To value a firm using EV/S

 Compute the average EV/S for comparable firms
 EV of subject firm = average EV/S time subject’s firm projected sales
 Market value = EV – market debt value + cash

43
Example: Valuing a firm using P/E ratios
 In an industry we identify 4 stocks which are similar to the stock we want to
evaluate.
Stock A PE=14
Stock B PE=18
Stock C PE=24
Stock D PE=21

 The average PE = (14+18+24+21)/4=19.25

 Our firm has EPS of $2.10
 P/2.25=19.25 P=19.25*2.25=$40.425
 Note – do not include the stock to be valued in the average
 Also do not include firm with negative P/E ratios

44
Alternatives to FCFF : EBDITA and EBIT
 Most analysts find FCFF to complex or messy to use in multiples.
They use modified versions.

 After tax operating income: EBIT (1-t)

 Pre tax operating income or EBIT
 EBDITA, which is earnings before interest, tax, depreciation and
amortization.

Value MV equity  MVdebt


EBDITA EBDITA

45
Value/EBDITA multiple
 The no-cash version

Value MV equity  MVdebt  cash


EBDITA EBDITA

 When cash and marketable securities are netted out of the value,
none of the income from the cash or securities should be reflected
in the denominator.
 The no-cash version is often called “Enterprise Value”.

46
Enterprise Value

 EV = market value of equity + market value of debt – cash and

marketable securities
 Many companies who have just conducted an IPOs have huge amount of
cash – a “war chest”
 EV excludes this cash from value of the firm
 Cash +MV of non-cash assets = MV debt + MV equity
 MV of non-cash assets = MV debt + MV equity - Cash

For example: XYZ (did IPO in 2009)

Its 2009 cash was $31.1 million, Total assets = $40.1 million, Debt=0 
EV=$9 million.

For young firms it is common to use EV instead of Value.

47
Reasons for increased use of Value/EBDITA
48

 The multiple can be computed even for firms that are reporting net
losses, since EBDITA are usually positive.

 More appropriate than the PE ratio for high growth firms.

 Allows for comparison across firms with different financial leverage.

Choosing between the Multiples

 There are dozen of multiples

 There are three choices
 Use a simple average of the valuations obtained using a number of
different multiples
 Use a weighted average of the valuations obtained using a number
of different multiples (one ratio may be more important than
another)
 Choose one of the multiples and base your valuation based on that
multiple (usually the best way as you provide some insights why
that multiple is important )

49
 What to control for...

MultipleVariables that determine it…

PE Ratio Expected Growth, Risk, Payout Ratio
PBV Ratio Return on Equity, Expected Growth, Risk, Payout
PS Ratio Net Margin, Expected Growth, Risk, Payout Ratio
EVV/EBITDA Expected Growth, Reinvestment rate, Cost of capital
EV/ Sales Operating Margin, Expected Growth, Risk, Reinvestment
 Relative Value and Fundamentals
Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio PEG=Payout ratio PBV=ROE (Payout ratio) PS= Net Margin (Payout ratio)
(1+g)/(r-g) (1+g)/g(r-g) (1+g)/(r-g) (1+g)/(r-g)

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

Equity Multiples

Firm Multiples

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

Value/FCFF=(1+g)/ Value/EBIT(1-t) = (1+g) Value/EBIT=(1+g)(1- VS= Oper Margin (1-

(WACC-g) (1- RIR)/(WACC-g) RiR)/(1-t)(WACC-g) RIR) (1+g)/(WACC-g)

Value of Firm = FCFF 1/(WACC -g)

COST BASED METHODS
 Cost based methods
Book value - Historical cost valuation
 All assets are taken at historical book value
 Value of goodwill is added to this above figure to arrive at the
valuation

Replacement value
 Cost of replacing existing business is taken as the value of the business

Liquidation value
 Value if company is not a going concern
 Based on net assets or piecemeal value of net assets
 Book value method

Current cost valuation

 All assets are taken at current value and summed to arrive at value

 This includes tangible assets, intangible assets, investments, stock, receivables

VALUE = ASSETS – LIABILITIES

Current cost valuation: Difficulties

 Technology valuation – whether off or on balance sheet

 Tangible assets – valuation of fixed assets in use may not be a straightforward or
easy exercise
 Could be subject to measurement error
 Book value method
55

Current cost valuation: More difficulties

 The company is not a simple sum of stand alone elements in the balance sheet
 Organization capital is difficult to capture in a number – this includes
 Employees

 Customer relationships

 Industry standing and network capital

Valuation of goodwill
 Based on capital employed and expected profits vs. actual profits
 Based on number of years of super profits expected
 May be discounted at suitable rate
Going Concern versus Liquidation Valuation

In liquidation valuation, we value only investments already made

Figure 1.1: A Simple View of a Firm

Assets Liabilities
Assets in Place Borrowed money
Existing Investments Investments already Debt
Generate cashflows today made

Growth Assets
Expected Value that will be Investments yet to Equity Owner’s funds
created by future investments be made

When valuing a going concern, we value both assets in place and growth assets
Merger Methods
 Comparable transactions:
 Identify recent transactions that are “similar”

 Ratio-based valuation
 Look at ratios to price paid in transaction to various target financials
(earnings, EBITDA, sales, etc.)
 Ratio should be similar in this transaction

 Premium paid analysis

 Look at premiums in recent merger transactions (price paid to recent stock
price)
 Premium should be similar in this transaction
COMPANY ANALYSIS:

QUALITATIVE ISSUES
Company Analysis: Qualitative Issues

 Sales Revenue (growth)

 Profitability (trend)
 Product line (turnover, age)
 Output rate of new products
 Product innovation strategies
 R&D budgets
 Pricing Strategy
 Patents and technology
Company Analysis: Qualitative Issues

 Organizational performance
 Effective application of company resources
 Efficient accomplishment of company goals
 Management functions
 Planning - setting goals/resources
 Organizing - assigning tasks/resources
 Leading - motivating achievement
 Controlling - monitoring performance
Company Analysis: Qualitative Issues

 Evaluating Management Quality

 Age and experience of management
 Strategic planning
 Understanding of the global environment
 Adaptability to external changes
 Marketing strategy
 Track record of the competitive position
 Sustainable growth
 Public image
 Finance Strategy - adequate and appropriate
 Employee/union relations
 Effectiveness of board of directors
Company Analysis: Quantitative Issues
 Operating efficiency
 Productivity
 Production function
 Importance of Q.A.
 Understanding a company’s risks
 Financial, operating, and business risks
 Financial Ratio Analysis
 Past financial ratios
 With industry, competitors, and
 Regression analysis
 Forecast Revenues, Expenses, Net Income
 Forecast Assets, Liabilities, External Capital Requirements
An Adage

“Financial statements are like fine perfume;

To be sniffed but not swallowed.”

APPENDIX
Approaches to Valuation

Valuation Models

Asset Based Discounted Cashflow Relative Valuation Contingent Claim

Valuation Models Models

Liquidation Equity Sector Option to Option to Option to

Value delay expand liquidate
Stable Current Firm
Market
Young Equity in
Replacement Two-stage firms troubled
Cost Normalized firm
Three-stage
or n-stage Earnings Book Revenues Sector Undeveloped
Value specific land

Equity Valuation Firm Valuation

Models Models
Patent Undeveloped
Dividends Reserves

Cost of capital APV Excess Return

Free Cashflow approach approach Models
to Firm
 Choosing the right Discounted Cashflow Model

Can you estimate cash flows? Are the current earnings What rate is the firm growing
positive & normal? at currently?

Yes No Yes No < Growth rate > Growth rate of

of economy economy

Use current Is the cause

Is leverage stable or Use dividend earnings as temporary? Stable growth Are the firm’s
likely to change over discount model base model competitive
time? advantges time
limited?
Yes No

Stable Unstable
leverage leverage Replace current Is the firm Yes No
earnings with likely to
normalized survive?
earnings 3-stage or
FCFE FCFF 2-stage n-stage
model model
Yes No

Adjust Does the firm

margins over have a lot of
time to nurse debt?
firm to financial
health

No
Yes

Value Equity Estimate

as an option liquidation
to liquidate value
Which approach should you use? Depends
upon the asset being valued..
Asset Marketability and Valuation Approaches

Mature businesses Growth businesses

Separable & marketable assets Linked and non-marketable assets

Liquidation & Other valuation models

Replacement cost
valuation
Cash Flows and Valuation Approaches

Cashflows currently or Cashflows if a contingency Assets that will never

expected in near future occurs generate cashflows

Discounted cashflow Option pricing models Relative valuation models

or relative valuation
models
Uniqueness of Asset and Valuation Approaches

Large number of similar

Unique asset or business assets that are priced

Discounted cashflow Relative valuation models

or option pricing
models
And the analyst doing the valuation….

Investor Time Horizon and Valuation Approaches

Very short time horizon

Long Time Horizon

Liquidation value Relative valuation Option pricing Discounted Cashflow value

models
Views on market and Valuation Approaches

Markets are correct on Asset markets and financial Markets make mistakes but
average but make mistakes markets may diverge correct them over time
on individual assets

Relative valuation Liquidation value Discounted Cashflow value

Option pricing models