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INVESTMENT BANKING
VALUATION
Misconceptions about Valuation
Valuation Models
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
= 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
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
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
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
Present value is value of the entire firm, and reflects the value of
all claims on the firm.
Measuring Cash Flows
kc = (D/V ) * kd * (1-t) + ( E /V ) * k e
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)
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
RELATIVE VALUATION :
Can not compare value across different asset classes (stocks vs. bond vs.
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
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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
Div1
P0
re g
Dividing both sides by EPS
P0 Payout ratio (1 g )
EPS 0 re g
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PE Ratio: Fundamentals
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
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
P MV equity
B BVequity
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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
P MV equity
S Total Revenue
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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
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Price Sales Ratio and Profit Margin
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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
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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
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Alternatives to FCFF : EBDITA and EBIT
Most analysts find FCFF to complex or messy to use in multiples.
They use modified versions.
45
Value/EBDITA multiple
The no-cash version
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”.
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Enterprise Value
The multiple can be computed even for firms that are reporting net
losses, since EBDITA are usually positive.
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What to control for...
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)
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
Customer relationships
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
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
QUALITATIVE ISSUES
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
Valuation Models
Can you estimate cash flows? Are the current earnings What rate is the firm growing
positive & normal? at currently?
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
No
Yes
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