RESEARCH PROJECT

On

“Models for Corporate Valuation”

Submitted in partial fulfillment of the requirement for MBA
Degree of Bangalore University
BY

SMITHA.P.PAI
Registration Number
04XQCM6091
Under the guidance of

Prof.B.V.Rudra Murthy

M.P.Birla Institute of Management

Associate Bharatiya Vidya Bhavan
Bangalore-560001
2004-2006
 DECLARATION

I hereby declare that this report titled “MODELS FOR CORPORATE VALUATION”
is a record of independent work carried out by me, towards the partial fulfillment of
requirements for MBA course of Bangalore University at M.P.Birla Institute of

Management. This has not been submitted in part or full towards any other degree.

PLACE: BANGALORE

DATE: SMITHA.P.PAI
 PRINCIPAL’S CERTIFICATE

This to certify that this report titled “Models for Corporate Valuation” has been
prepared by SMITHA.P.PAI bearing the registration no.04 XQCM 6091 under the
guidance and supervision of PROF. B.V.RUDRA MURTHY, MPBIM,
Bangalore.

Place: Bangalore (Dr.N.S.Malavalli)

Date: Principal

MPBIM, Bangalore
 GUIDE’S CERTIFICATE

This is to certify that the Research Report entitled “MODELS FOR CORPORATE
VALUATION”, done by SMITHA.P.PAI bearing Registration No.04 XQCM 6091
is a bonafide work done carried under my guidance during the academic year
2005-06 in a partial fulfillment of the requirement for the award of MBA degree by
Bangalore University. To the best of my knowledge this report has not formed the
basis for the award of any other degree.

Place: Bangalore PROF.B.V.RUDRA MURTHY

Date:
 ACKNOWLEDGEMENT
It’s my special privilege to extend words of the thanks to all of them who have helped me
and encouraged me in completing the project successfully.

I would thank Prof. B.V Rudra Murthy for giving me valuable inputs required for
completing this project report successfully. I owe my sincere gratitude to him for
spending his valuable time with me and for his guidance.

I also wish to express my gratitude to Dr T.V.N Rao for his valuable guidance and ideas
during the project.

It would be improper if I do not acknowledge the help and encouragement by my friends

and well wishers who always helped me directly or indirectly.

My gratitude will not be complete without thanking the almighty god and my loving
parents who have been supportive through out the project.

Smitha.P.Pai
 TABLE OF CONTENTS
CHAPTERS PARTICULARS PAGE NO.
ABSTRACT

1. INTRODUCTION
1.1 Introduction
1.2 Role of Valuation
1.3 Approaches to Valuation
1.4 Stumbling Blocks in Valuation
2. REVIEW OF LITERATURE
2.1 Dark side of Valuation
2.2 Internalization and evolution of corporate valuation
2.3 Investor protection and corporate valuation
2.4 Valuation of bankrupt firms
2.5 Technological innovation approach to valuation
2.6 The cost of distress
3. RESEARCH METHODOLOGY
3.1 Problem Statement
3.2 Objectives
3.3 Scope of study
3.4 Sample Size
3.5 Valuation parameters
3.6 Research Methodology

4. DATA ANALYSIS AND INTREPRETATION

4.1 Saurashtra Cement Ltd

4.2 Victoria Mills Ltd

 4.3 Snowcem India Ltd

4.4 Tata Tele services Ltd

4.5 Odyssey Technologies Ltd

5. CONCLUSION

GLOSSARY

BIBLIOGRAPHY
 Abstract

Valuation is the process of determining the real value (intrinsic value) as opposed to the
observed market price of a security.

In traditional valuation models, we begin by forecasting earnings and cash flows and
discount these cash flows back at an appropriate discount rate to arrive at the value of a
firm or asset. This task is simpler when valuing firms with positive earnings, a long
history of performance and a large number of comparable firms. In this research project,
we look at valuation when one or more of these conditions do not hold. We begin by
looking ways of dealing with firms with negative earnings, and note that the process will
vary depending upon the reasons for the losses.

There are various reasons for the earnings becoming negative and these reasons vary
across firms.

For some firms, it is too much debt that creates the potential for failure to make debt
payments and its consequences (bankruptcy, liquidation, reorganization).

For other firms, negative earnings may arise from the inability to meet operating
expenses.

This project stresses that while estimation of cash flows and discount rates is more
difficult for these firms, the fundamentals of valuation continue to apply.

The intrinsic value, or value determined using a valuation method, can then be compared
to the current market price to determine whether the security appears overvalued or
undervalued.
 INTRODUCTION

In the wake of economic liberalization, companies are relying more on the capital market,
acquisitions and restructuring are becoming common place, strategic alliances are gaining
popularity, employee stock option plans are proliferating, and regulatory bodies are
struggling with tariff determination. In these exercises a crucial issue is: how should the
value of a company or a division thereof is appraised.

The goal of such an appraisal is essentially to estimate a fair market value of a company.
The fair market value is the price at which the property would change hands between a
willing buyer and a willing seller when the former is not under any compulsion to buy
and the latter is not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts. When the asset being appraised is a company, the property
the buyer and the seller are trading consists of the claims of all the investors of the
company; this includes outstanding equity shares, preference shares, debentures and
loans.
 T H E R O L E O F V A L UA T I O N

Valuation is useful in a wide range of tasks. The role it plays however is different in
different arenas. The following section lays out the relevance of valuation in portfolio
management, in acquisition analysis, and in corporate finance.

V A L UA T I O N AN D PO RT FO L I O MA N AG E ME N T
The role that valuation plays in portfolio management is determined in large part by the
investment philosophy of the investor. Valuation plays a minimal role in portfolio
management for a passive investor, whereas it plays a larger role for an active investor.
Even among active investors, the nature and the role of valuation is different for different
types of active investment. Market timers use valuation much less than investors who
pick stocks and the focus is on market valuation rather than on firm-specific valuation.
Among security selectors, valuation plays a central role in portfolio management for
fundamental analysts and a peripheral role for technical analysts.

V A L UA T I O N I N A CQ UI S I T I O N A N A L Y S I S
Valuation should play a central part in acquisition analysis. The bidding firm or
individual has to decide on a fair value for the target firm before making a bid, and the
target firm has to determine a reasonable value for itself before deciding to accept or
reject the offer. There are also special factors to consider in takeover valuation. First the
effects of synergy on the combined value of the two firms (target plus bidding firm) have
to be considered before a decision is made on the bid. Those who suggest that synergy is
impossible to value and, therefore should not be considered in quantitative terms are
wrong. Second the effects on value of changing management and restructuring the target
firm will have to be taken into account in deciding on a fair price. This is of particular
concern in hostile takeovers. Finally there is a significant problem with bias in the
takeover valuations. Target firms may be overoptimistic in estimating value, especially
when the takeover is hostile and they are trying to convince their shareholders that the
offer price is too low. Similarly if the bidding firm has decided, for strategic reasons, to
do an acquisition, there may be strong pressure on the analyst to come up with an
estimate of value that backs up the acquisition.

V A L UA T I O N I N C O R PO R AT E F I N A N CE
In recent years, management consulting firms have started offering companies advice on
how to increase value. This has been possible because of the fear of hostile takeovers.
Companies have increasingly turned to “value consultants” to tell them how to
restructure, increase value, and avoid being taken over. The consultants’ suggestions have
often provided the basis for the restructuring of these firms. The value of a firm can be
directly related to decisions that it makes: on which projects it takes, on how it finances
them, and on its dividend policy. Understanding this relationship is key to making value
increasing decisions and to sensible financial restructuring.
 APPROACHES TO VALUATION

There are four broad approaches to appraising the value of a company namely

1. Adjusted book value approach

2. Stock and debt approach
3. Direct comparison approach and
4. Discounted cash flow approach.

ADJUSTED BOOK VALUE APPROACH

The simplest approach to valuing a firm is to rely on the information found on its balance
sheet. There are two equivalent ways of using the balance sheet information to appraise
the value of a firm. First, the book values of investor claims may be summed directly.
Second, the assets of a firm may be totaled and from this total non-investor claims (like
accounts payable and provisions) may be deducted. The accuracy of the book value
approach depends on how well the net book values of the assets reflect their fair market
values.

STOCK AND DEBT APPROACH

When the securities of a firm are publicly traded, its value can be obtained by merely
adding the market value of all its outstanding securities. This simple approach is called
the stock and the debt approach by property tax appraisers. It is also referred to as the
market approach.

DIRECT COMPARISON APPROACH

One can value an asset by looking at the price at which a comparable asset has changed
hands between a reasonably informed buyer and reasonably informed seller. This
approach referred to as the direct comparison approach, is commonly applied in real
estate.
STEPS IN APPLYING THE DIRECT COMPARISON METHOD

The comparable company approach involves valuing a company on the basis of how
similar publicly held companies are valued. It is typically a top down approach and
involves the following steps.

1. Analyze the economy

2. Analyze the industry
3. Analyze the subject company
4. Select comparable companies
5. Analyze subject and comparable companies
6. Analyze multiples
7. Value the subject company

DISCOUNTED CASH FLOW APPROACH

Valuing a firm using the discounted cash flow approach is conceptually identical to
valuing a capital project using the present value method. Valuing a firm using the
discounted cash flow approach calls for forecasting cash flows over an indefinite period
of time for an entity that is expected to grow.

Value of the firm = present value of cash flow during an explicit forecast period+
present value of cash flow after the explicit forecast period.

During the explicit forecast period which is often a period of 5 to 15 years –the firm is
expected to evolve rather rapidly and hence a great deal of effort is expended to forecast
its cash flow on an annual basis. At the end of the explicit forecast period, the firm is
expected to reach a” steady state” and hence a simplified procedure is used to estimate its
continuing value.
Thus, the discounted cash flow approach to valuing a firm involves the following steps:-

1. Forecast the cash flow during the explicit forecast period.

2. Establish the cost of capital.
3. Determine the continuing value at the end of the explicit forecast period.
4. Calculate the firm value and interpret results.

STUMBLING BLOCKS IN VALUATION

Following are the stumbling blocks in valuing young companies with negative earnings
and no or few comparable firms.

NEGATIVE EARNINGS

Firms that are losing money currently create several problems for the analysts who are
attempting to value them. While none of these problems are conceptual, they are
significant from a measurement standpoint:

1. Earnings growth rates cannot be estimated or used in valuation:

The first and most obvious problem is that we can no longer estimate an expected growth
rate to earnings and apply it to current earnings to estimate future earnings. When current
earnings are negative, applying a growth rate will just make it more negative. In fact,
even estimating an earnings growth rate becomes problematic, whether one uses
historical growth, analyst projections or fundamentals.

 2. Estimating historical growth when current earnings are negative is difficult, and
the numbers, even if estimated, often are meaningless.

3. An alternative approach to estimating earnings growth is to use analyst estimates

of projected growth in earnings, especially over the next 5 years. For firms with
negative earnings in the current period, this estimate of a growth rate will not be
available or meaningful. A third approach to estimating earnings growth is to use
fundamentals and estimate the growth rate as follows:

Expected growth rate in EBIT = Return on Capital * Reinvestment Rate

This approach is also difficult to apply for firms that have negative earnings, since the
two fundamental inputs – the return made on investments (return on equity or capital) and
the reinvestment rate (or retention ratio) are usually computed using current earnings.
When current earnings are negative, both these inputs become meaningless from the
perspective of estimating expected growth.

Tax computation becomes more complicated:

The standard approach to estimating taxes is to apply the marginal tax rate on the pre-tax
operating income to arrive at the after-tax operating income:

After-tax Operating Income = Pre-tax Operating Income (1 – tax rate)

This computation assumes that earnings create tax liabilities in the current period. While
this is generally true, firms that are losing money have the option to carry these losses
forward in time and apply them to earnings in future periods. Thus, when valuing firms
with negative earnings, we have to keep track of the net operating losses and remember to
use them to shield income in future periods from taxes.

 The Going Concern Assumption:

The final problem associated with valuing companies that have negative earnings is
the very real possibility that these firms will go bankrupt if earnings stay negative,
and that the assumption of infinite lives that underlies the estimation of terminal value
may not apply in these cases.

ABSENCE OF HISTORICAL DATA

In valuation, we often use data from years prior to the current year to estimate inputs
more precisely. Consider the following areas in valuation where past data is useful:

In estimating risk parameters, such as betas, we use stock returns from past periods.
Many regression services use 5 years of data for beta estimates, and most services
require, at the minimum, two years of data for reliable estimates. When a firm has been
listed for a period less than 2 years, it may still be possible to estimate betas, but the betas
are unlikely to be reliable.

For estimating variables that vary significantly from year to year, we often look at
averages over longer periods. A typical example is working capital, a number that tends
to increase dramatically in some years and drop significantly in others. In valuing firms,
we often get better estimates of expected working capital changes over time by looking at
the average working capital as a percent of revenues over the last few years.
Even analysts who do not use historical growth rates to estimate future growth measure
their estimates of expected growth against past growth to check for reasonability. Thus,
an analyst who estimates growth of 40% for a firm over the next 5 years may modify that
estimate after finding out that the firm has reported earnings growth of 5% over the last 5
years. In conclusion, having a long history of prices and earnings on a firm allows us
access to more information than is available in the current year, and increases the comfort
zone on estimates.

ABSENCE OF COMPARABLE FIRMS

In addition to using data from past periods, analysts use information on comparable firms
frequently in valuation. Thus, the beta of a firm may be estimated by looking at firms of
similar size in the same business. Estimates of capital expenditure requirements and
working capital needs are often based upon the averages for comparable firms in the
same business. The use of comparable firm data becomes much easier when there are a
significant number of comparable firms in the same business as the firm being valued.
When the firm being valued is unique or if the other firms in the sector are different in
their fundamental business characteristics, it is far more difficult to use cross-sectional
information in valuation.
“Review of literature “means examining and analyzing the various literatures available in
any field either for references purposes or for further research.

Further research can be done by identifying the areas which have not been studied and in
turn undertaking research to add value to the existing literature.

For the purpose of literature review various sources of information have been used.
Sources include books, journals as well as some literature papers.

Aswath Damodaran:-The Dark Side of Valuation: Firms with no

Earnings, no History and no Comparables

In traditional valuation models, we begin by forecasting earnings and cash flows and
discount these cash flows back at an appropriate discount rate to arrive at the value of a
firm or asset. This task is simpler when valuing firms with positive earnings, a long
history of performance and a large number of comparable firms. In this project, we look
at valuation when one or more of these conditions do not hold. We begin by looking
ways of dealing with firms with negative earnings, and note that the process will vary
depending upon the reasons for the losses. We will argue that while estimation of cash
flows and discount rates is more difficult for these firms, the fundamentals of valuation
continue to apply.

The value of a firm is the present value of expected cash flows generated by it,
discounted back at a composite cost of capital that reflects both the sources and costs of
financing used by it. This general statement applies no matter what kind of firm we look
at, but the ease with which cash flows and discount rates can be estimated can vary
widely across firms. At one end of the continuum, we have firms with a long history,
positive earnings and predictable growth, where growth rates in earnings can be
estimated easily and used to forecast future earnings. The task is made simpler still if the
firm has comparable firms, where by “comparable” we mean firms in the same line of
business, with similar characteristics. The information on these firms can then be used to
estimate risk parameters and discount rates. The real test of valuation is at the other end
of the continuum, where we have young firms with negative earnings and limited, and
noisy, information. Often, the problem is compounded because these are firms in sectors
where there are either no comparable firms, or the comparable firms are at the same stage
in the life cycle as the firm being valued. Here, the estimation of cash flows and discount
rates becomes difficult, to put it mildly, and valuation often seems to be a stab in the
dark. All too often, we give up and assume that these are firms that cannot be valued
using valuation models. This project focuses on firms that do not lend themselves easily
to valuation, either because they have negative earnings, or because they have a short
history or because they have no comparable firms.
Ross Levine, Sergio L. Schmukler: - INTERNATIONALIZATION AND
THE EVOLUTION OF CORPORATE VALUATION

This paper provides evidence on the bonding, segmentation, and market timing theories
of internationalization by documenting the evolution of Tobin's “q” before, during, and
after firms internationalize. Using new data on 9,096 firms across 74 countries over the
period 1989-2000, they find that Tobin's “q” does not rise after internationalization, even
relative to firms that do not internationalize. Instead, “q” rises significantly one year
before internationalization and during the internationalization year. But, then “q” falls
sharply in the year after internationalization, relinquishing the increases of the previous
two years. To account for these dynamics, this paper shows that market capitalization
rises one year before internationalization and remains high, while corporate assets
increase during internationalization. The evidence supports models stressing that
internationalization facilitates corporate expansion, but challenges models stressing that
internationalization produces an enduring effect on “q” by bonding firms to a better
corporate governance system.
This paper examines the evolution of the corporate valuation of firms that cross-listed,
issued depositary receipts, or raised equity capital in international markets over the period
1989-2000. This paper documents the time-series patterns of q before, during, and after
internationalization and compares these patterns to firms that never internationalized and
also examines the individual components of q in assessing what happens during the
process of internationalization.

The paper reports four key findings:-

First, international firms tend to have higher valuations than domestic firms. More
specifically, the average q of firms that at some point in the sample internationalize is
higher than the q of firms that never internationalize.

Second, corporations do not experience an enduring increase in q after they

internationalize. This paper finds that (a) valuations are not higher after
internationalization and (b) valuations of firms that internationalize do not increase
relative to those of domestic firms (i.e., the relative q does not increase after
internationalization). Thus, although there are large cross firm differences in q, their
results are consistent with the view that these differences are not affected by
internationalization.

Third, in terms of the year-by-year dynamics, q rises before internationalization, but then
falls rapidly in the year after internationalization. They find that one year after
internationalization the q of international firms is not significantly higher than it was two
years (or even three years) before they internationalized. Furthermore, the relative
Tobin’s q of international firms (q divided by the average q of domestic firms from the
same home country) follows the same pattern: rising in the year before
internationalization and during the internationalization year, but relinquishing these
increases by the year after internationalization.
Finally, in terms of the components of q, a firm’s market capitalization tends to rise prior
to internationalization and remains high thereafter, while the firm’s assets increase during
internationalization as the firm expands. Thus, firms that internationalize expand relative
to domestic firms.

Rafael La Porta,Florencio Lopez-de-Silanes,Andrei Shleifer,Robert Vishny

:- INVESTOR PROTECTION AND CORPORATE VALUATION

This paper presents a model of the effects of legal protection of minority shareholders
and of cash flow ownership by a controlling shareholder on the valuation of firms and
then test this model using a sample of 371 large firms from 27 wealthy economies.
Consistent with the model, this paper finds evidence of higher valuation of firms in
countries with better protection of minority shareholders, and weaker evidence of the
benefits of higher cash flow ownership by controlling shareholders for corporate
valuation.

Their empirical analysis evaluates the influence on corporate valuation of investor

protection and ownership by the controlling shareholder using company data from 27 of
the wealthiest economies around the world. They use Tobin's Q and the price to cash
flow ratio to measure corporate valuation. They use the origin of a country's laws and the
index of specific legal rules as indicators of shareholder protection. To understand the
effects of ownership, they focus on companies which have controlling shareholders,
thereby hoping to keep the power to expropriate relatively constant. This restriction is in
line with the evidence and the theoretical work (Zingales 1995, LLS 1999, Bebchuk
1999) suggesting that, in countries with poor investor protection, it is efficient for the
entrepreneurs to retain control of their firms. Among these companies, they consider cash
flow ownership by the controlling shareholder as a measure of incentives. This finding
provides support for the quantitative importance of the expropriation of minority
shareholders in many countries, as well as for the role of the law in limiting such
expropriation. They also find some evidence that higher incentives from cash flow
ownership are associated with higher valuations.

This paper presented a simple theory of the consequences of corporate ownership for
corporate valuation in different legal regimes. They have also tested this theory using
data on companies from 27 wealthy countries around the world. The results generally
confirm the crucial prediction of the theory, namely that poor shareholder protection is
penalized with lower valuations. This evidence supports the importance of expropriation
of minority shareholders by controlling shareholders in many countries, and for the role
of the law in limiting such expropriation. As such, it adds an important link to the
explanation of the consequences of investor protection for financial market development.
The evidence is more mixed on some of the other implications of the theory. On the
incentive effects of cash flow ownership, the evidence provides some support for the
theory, and is consistent with the findings of Claessens et al. (1999b) on a larger sample
of companies from Asia. The evidence expands their understanding of the role of investor
protection in shaping corporate finance, by clarifying the roles which both the incentives
and the law play in delivering value to outside shareholders.
Stuart C. Gilson; Harvard Business School, Edith S. Hotchkiss; Boston
College; Richard S. Ruback;Harvard Business School:-Valuation of
Bankrupt Firms

This study compares the market value of firms that reorganize in bankruptcy with
estimates of value based on management’s published cash flow projections. They
estimate firm values using models that have been shown in other contexts to generate
relatively precise estimates of value. They find that these methods generally yield
unbiased estimates of value, but the dispersion of valuation errors is very wide and the
sample ratio of estimated value to market value varies from less than 20% to greater than
250%. Cross-sectional analysis indicates that the variation in these errors is related to
empirical proxies for claimholders’ incentives to overstate or understate the firm’s value.

Valuation plays a central role in Chapter 11 bankruptcy negotiations. The firm’s

estimated value determines the value of the assets to be divided among pre bankruptcy
claimants and drives projected payouts and recoveries. But bankruptcy is an
administrative process. The factors that lead to a reliable estimate of value in a market
process are absent in bankruptcy. There is no active market for control of the assets of the
bankrupt firm because it is strongly discouraged by the structure of Chapter 11. There is
no oversight from the capital markets because management has access to debtor-in-
possession financing. The securities of bankrupt firms often trade infrequently perhaps as
a result; there is very limited analyst coverage. This absence of market forces makes
valuation more complex and less precise.

This study explores the relation between the market value of 63 publicly traded firms
emerging from Chapter 11 and the values implied by the cash flow forecasts in their
reorganization plans. They estimate the value of the forecasts using the capital cash flow
approach. Kaplan and RubackŽ1995.show this approach yields relatively precise
estimates of value for a sample of highly leveraged transactions. They also use a
comparable companies approach. In addition, in 28 cases they have estimates of value
directly provided by management as required under ‘‘fresh start’’ accounting. They find
that estimates of value are generally unbiased, but the estimated values are not very
precise. The dispersion of valuation errors is very wide and the sample ratio of estimated
value to market value varies from less than 20% to greater than 250%. These large
valuation errors cannot be wholly attributed to their choice of models or potential errors
in our specific assumptions, such as the discount rate or long-term growth rate.

Their experimental design compares the value calculated from management’s cash flow
forecasts to the actual market value. The value implied by the forecasts is estimated using
discounted cash flow and comparable company multiple methods. These methods are
widely used by bankruptcy practitioners and investors .they also examine estimated
values based on Performa balance sheets for the reorganized firm in cases where the firm
implements fresh start accounting.
Z. P. MATOLCSY; UNIVERSITY OF TECHNOLOGY, SYDNEY A.
WYATT UNIVERSITY OF MELBOURNE:-WHAT ELSE DRIVES THE
VALUE OF COMPANIES A TECHNOLOGICAL INNOVATION
APPROACH

The objective of this study is to provide evidence on the relation between constructs
based on technological areas within which companies invest and market values of
equities. These constructs are technological potential, technological complexity and
technological development period. They argue that they are lead indicators of future
earnings and earnings growth, and hence, they provide additional insight into future
earnings and earnings growth beyond firm specific accounting numbers. Their results are
based on an average of 1531 US companies for the period of 1990- 2000. Their overall
results are that the three constructs based on technological areas, when interacted with
earnings, are associated with market values. They also conduct a number of additional
tests based on analyses of technological areas to evaluate the robustness of the main
results.

This paper provides a sound theoretical basis for utilizing non-firm specific information
sources in valuation. The technological innovation conditions are derived from the
economics of innovation literature. Based on this framework, they define technological
potential as the state of technological progress and knowledge within a technological
area. Second, they utilize a database, the CHI Research Tech-Line¤, which has limited
exposure in the valuation literature. This data includes the class to which examiners have
assigned the patent, citations to prior related patents and to scientific papers, patent
counts, and patent renewals.

For our purpose, the CHI Research Tech-Line¤ database enables the development of
quantitative constructs of differences in technological innovation conditions across
different technological areas. Then they are able to obtain high construct validity
measuring fundamental technology conditions in the economy (across different
technology areas) in this way because the underlying technology classification employed
to construct the database (Intellectual Property Classification or IPC) covers virtually all
technologies currently in existence (Narin 1995). Further, the data by construction is
synchronous with financial indicators in the economy (Narin 1995), thereby, providing a
powerful tool for evaluating the nature of the information correlated with the data
employed by investors to forecast future earnings and price the firm s equity.

Their results are based on an average of 1531 US companies for the period of 1990-2000
the overall results are that technological innovation conditions in concert with earnings
are associated with market values based on tests for individual years, pooled, and Fama-
McBeth regression estimates. They also conduct a number of additional tests based on
analyses of specific sectors and alternative specifications of their models to evaluate the
robustness of the main results. These sensitivity tests confirm their main findings.
This study builds upon and extends previous literature that examines the factors that drive
equity market value where that literature typically focuses on accounting-based
information and some non-financial metrics. In this paper, they examine the association
between market values and technological innovation conditions as a source of
information about the firm s expected future growth.

This study also introduces three technological innovation conditions: technological

potential, technological complexity, and technological development period. Their
constructs are based on technological areas rather than industry data or firm-level data.
Their contention is that financial analysts incorporate these technological innovation
conditions into their valuations because these are fundamental exogenous conditions
impacting the firm’s future earnings and earnings growth.

Aswath Damodaran: Stern School of Business:-The Cost of Distress

Survival, Truncation Risk and Valuation

Traditional valuation techniques- both DCF and relative - short change the effects of
financial distress on value. In most valuations, we ignore distress entirely and make
implicit assumptions that are often unrealistic about the consequences of a firm being
unable to meet its financial obligations. Even those valuations that purport to consider the
effect of distress do so incompletely. In this paper, they begin by considering how
distress is dealt with in traditional discounted cash flow models, and when these models
value distress correctly. Then they look at ways in which they can incorporate the effects
of distress into value in discounted cash flow models. At last they conclude by looking at
the effect of distress on relative valuations, and ways of incorporating its effect into
relative value.
In both discounted cash flow and relative valuation, they implicitly assume that the firms
that they are valuing are going concerns and that any financial distress that they are
exposed to is temporary. After all, a significant chunk of value in every discounted cash
flow valuation comes from the terminal value, usually well in the future. In this paper,
they will argue that they tend to over value firms such as these in traditional valuation
models, largely because is difficult to capture fully the effect of such distress in the
expected cash flows and the discount rate. The degree to which traditional valuation
models mis value distressed firms will vary, depending upon the care with which
expected cash flows are estimated, the ease with which these firms can access external
capital market and the consequences of distress. In this paper, they will begin by looking
at the underlying assumptions of discounted cash flow valuation.

Distressed firms, i.e., firms with negative earnings that are exposed to substantial
likelihood of failure, present a challenge to analysts valuing them because so much of
conventional valuation is built on the presumption that firms are going concerns. In this
paper, they have examined how both discounted cash flow and relative valuation deal
(sometimes partially and sometimes not at all) with distress. With discounted cash flow
valuation, they suggested four ways in which they can incorporate distress into value –
simulations that allow for the possibility that a firm will have to be liquidated, modified
discounted cash flow models, where the expected cash flows and discount rates are
adjusted to reflect the likelihood of default, separate valuations of the firm as a going
concern and in distress and adjusted present value models. With relative valuation, they
can adjust the multiples for distress or use other distressed firms as the comparable firms.
at last this paper examine two issues that may come up when going from firm value to
equity value. The first relates to the shifting debt load at these firms, as the terms of debt
get renegotiated and debt sometimes becomes equity. The second comes from the option
characteristics exhibited by equity, especially in firms with significant financial leverage
and potential for bankruptcy.
 RESEARCH PROPOSAL

PROBLEM STATEMENT

Why companies with negative earnings have market price of share greater than intrinsic
value.

OBJECTIVES

1. To analyze the parameters to evaluate or value a firm.

2. To analyze the valuation of the selected companies.
 3. To compare the value of the firm with that of market value of share.
4. To find out the strategic actions for the differences existing between the value of
the selected companies as per research valuation and the market values of the
aforesaid companies.

SCOPE OF STUDY

It is essential that strategic decisions for companies are based on accurate information.
Whether while buying, selling, merging, restructuring or raising additional capital, it is
imperative to know the value of a company. Accurate valuation helps in making prudent
investments and strategic decisions. Valuations are critical components of nearly all
financial transactions. The demand of corporations and industrial practitioners to
optimize value for commercial purposes has driven the need to utilize valuation as a
strategic corporate tool. Valuation or the estimate of the current market value of an asset
is found in all business and in all dimensions. For the purpose of valuation, models
suggested by Ashwat Damodaran in the book named Dark side of valuation have been
used.

SAMPLE SIZE

The Sample size considered for the research undertaken has a scope of five different
industries. One company each to represent each industry with three comparable
companies within the same industry which sets the market standards are considered to
validate the industry standards. These are as follows:-

Sl No. Companies for Industry Comparable companies

valuation
1 Saurashtra Cement Acc Ltd
Cement Ltd Dalmia Cement
 Gujarat Ambuja Cements Ltd
2 Victoria mills Textiles Arvind Mills
Ltd Century Textiles Ltd
Raymond Ltd
3 Odyssey Computer Infosys Technologies Ltd
Technologies Ltd Software Satyam Computer Services
Wipro Ltd
4 TateTele Telecom MTNL
Services VSNL
(Maharashtra)Ltd HFCL Infotel Ltd
5 Snowcem India Paints Asian Paints Ltd
Ltd Goodlass Nerolac Paints Ltd
Berger Paints Ltd

DATA REQUIRED AND PERIOD OF STUDY

Financial statements of the sample profile and their comparable companies are
considered for a period of 6 years from financial year 1999-2000 to 2004-05.

SOURCES OF DATA

The data relating to the study is taken from two databases namely prowess and capital
line plus.

VALUATION PARAMETERS
The following parameters are used for valuing the companies:-
1. Net operating profit less adjusted taxes(NOPLAT)
2. Return on capital employed(ROCE)
3. Growth rate
4. Weighted average cost of capital
5. Free cash flow(FCFF)

RESEARCH METHODOLOGY

As per the sample size five companies representing different industries are analyzed with
their comparable companies on the basis of financial statements.

PROJECTION OF SALES AND COST OF GOODS SOLD

The sales and the cost of goods sold of the sample company are projected for ten years.
Since the cost of goods sold is higher than sales which conclude to negative earnings, the
average of cost of goods sold is the benchmark used for the company being evaluated.

ESTIMATING GROWTH
The value of a firm is the present value of expected future cash flows generated by the
firm. The most critical input in valuation is the growth rate which is used to forecast
future revenues and earnings.

In this research project the average growth rates of benchmarks companies are considered
as the upper limit and the growth rate of the valuing company is considered as the lower
limit. This marks the range of growth for the sample company. Within the range three
distinguishing growth rates are chosen and financial statements are forecasted for ten
years using these growth rates.

Approach used for valuation: DISCOUNTED CASH FLOW (DCF)

APPROACH

There are several tried and true approaches to discounted cash flow analysis.
1. Dividend discount model (DDM) approach
2. Free cash flow to firm (FCFF) approach
3. Free cash flow to equity (FCFE) approach

For the purpose of valuation FCFF approach is used because this approach is commonly
used by analysts and valuation experts to determine the fair value of companies.

The General Valuation Model

Once the free cash flows to the firm have been estimated, the process of computing value
follows a familiar path. If valuing a firm or business with free cash flows growing at a
constant rate forever, we can use the perpetual growth equation:
E(FCFF 1 )
Value of Firm with FCFF growing at constant rate =
(k c - g n )

First of all we consider cash flows before debt payments in this model, and then discount
these cash flows back at a composite cost of financing, i.e., the cost of capital to arrive at
the value of the firm. To value firms where free cash flows to the firm are growing at a
rate higher than that of the economy, you can modify this equation to consider the present
value of the cash flows until the firm is in stable growth. To this present value, add the
present value of the terminal value, which captures all cash flows in stable growth.
tN
E(FCFF t ) Terminal Value of Business N
Value of high - growth business =  t
+
t =1 (1 + k c ) (1 + k c ) N

FREE CASH FLOWS OF THE FIRM

Free cash flow represents the actual amount of cash that a company has left from its
operations that could be used to pursue opportunities that enhance shareholder value-for
example, developing new products, paying dividends to investors or doing share
buybacks.

Forecasting Free Cash Flows (FCFF)

Free cash flows of the firm are worked out by looking at what s left over from revenues
after deducting operating costs, taxes, net investment and the working capital
requirements. Depreciation and amortization are not included since they are non cash
charges.

PARTICULARS AMOUNT
SALES XXX
LESS:-COGS XXX
EBIT XXX
LESS:-TAX XXX
EBIT (1-T) XXX
LESS: -CHANGE IN CAPEX XXX
LESS: - CHANGE IN WORKING CAPITAL XXX
FCFF XXX
TERMINAL VALUE

The terminal value of a security is the present value at a future point of all future cash
flows. It allows for the inclusion of the value of future cash flows occurring beyond a
several year projection period while satisfactorily mitigating many of the problems of
valuing such cash flows. The terminal value is calculated in accordance with a stream of
projected future free cash flows in discounted cash flow analysis.

Terminal value=final projected year cash flow/ (WACC-growth rate)

Once the terminal values and operating cash flows have been estimated, they are
discounted back to the present to yield the value of the operating assets of the firm.

ESTIMATING COST OF CAPITAL

Having projected the company’s free cash flow for the next ten five years, we want to
figure out what these cash flows are worth today. That means coming up with an
appropriate discount rate which we can use to calculate the Net Present Value (NPV) of
the cash flows. NPV compares the value of a rupee today to the value of the same rupee
in the future, taking inflation and returns into account. For this purpose we find of
WACC. WACC is the blend of the cost of equity and after tax cost of debt. An
assumption taken in the research valuation is that the average of ROCE of the benchmark
companies is taken as WACC for the sample profile.

To calculate the present value calculation of the future cash flows, we implement the
discount factor model to the cash flows and the terminal value. The amount generated by
each of these calculations will estimate the present value contribution of each year's
future cash flow. Adding these values together estimates the company's present value.
To come up with a fair value of the company’s equity we must deduct its net debt from
its value.

Fair value of equity = Total Enterprise value –Total Debt

The arrived value of equity as per valuation is divided by the total number of outstanding
shares of the company to attain the equity value per share which is the concluding result.
The concluded result mentioned above is then compared with its average of high and low
price and is analyzed and interpreted that off.
 CONCLUSION

Finding a value for a company is no easy task -- but doing so is an essential component of
effective management. If organizations are to achieve the ultimate corporate goal of
maximizing shareholder value, then understanding valuation is vitally important and is
the ultimate measurement of the health and prosperity of a company.

The research study undertaken for the valuation of negatively yielding companies is a
submarine part of corporate valuation. The research has identified five loss making
companies in different industries and to assist the valuation we had chosen three
benchmark companies of the same industry which sets the market standard.

The valuation identifies certain parameters on which the valuation is based such as
1. Net operating profit less adjusted taxes(NOPLAT)
2. Return on capital employed(ROCE)
 3. Growth rate
4. Weighted average cost of capital(WACC)
5. Free cash flow(FCFF)

The Parameters have helped to value the sample company and to evaluate its present
situation and strategic action to abandon the negative earning tradition.

The research provides insight into corporate valuation which provides a strategic action
plan to retrieve a loss making company and convert the company into a flourishing
organization.

Valuation, fundamentally, remains the same no matter what type of firm one is analyzing.
There are three groups of firms where the exercise of valuation becomes more difficult
and estimates of value noisier. The first group includes firms that have negative earnings.
Given the dependence of most models on earnings growth to make projections for the
future, analysts have to consider approaches that allow earnings to become positive, at
least over time. They can do so by normalizing earnings in the current period or by
adjusting margins from current levels to sustainable levels over time or by reducing
leverage. The approach used will depend upon why the firm has negative earnings in the
first place. The second groups of firms where estimates are difficult to make are young
firms, with little or no financial history. Here, information on comparable firms can
substitute for historical data and allow analysts to estimate the inputs needed for
valuation. The third group of firms where valuation can be difficult includes unique firms
with few or no comparable firms. If all three problems come together for the same firm –
negative earnings, limited history and few comparables – the difficulty is compounded. In
this project we can see a broad framework that can be used to value such firms.

It should be noted again that the question is not whether these firms can be valued – they
certainly can- but whether we are willing to live with noisy estimates of value. To those
who argue that these valuations are too noisy to be useful, our counter would be that
much of this noise stems from real uncertainty about the future.
As we see it, investors who attempt to measure and confront this uncertainty are better
prepared for the volatility that comes with investing in these stocks. While some view
multiples as a painless way of analyzing these firms, we have pointed out some of the
inherent constraints while coming up with usable multiples and comparables for such
firms.
 INTERPRETATION
SAURASHTRA CEMENT LTD

The value calculated as per the valuation at three different growth rates are as follows:-

At 7% Rs (18)
At 10% Rs 41
At 12% Rs 200

The value per share of Saurashtra Cement Ltd as on 31/3/05 was Rs 30.

The above mentioned value when compared with that of the value at three assumed
growth rates shows that the market value is under priced.

The above mentioned intrinsic value of Saurashtra is near to that of value at growth rate
of 10 % i.e. Rs 41.So we can say that market might be expecting a growth rate of 10% as
compared to that of its present growth rate of 4%.
 SAURASHTRA CEMENT LTD

The company taken under research is Saurashtra Cement Ltd representing the Cement
industry which has yielded negative earnings in the past years.

Saurashtra Cement Ltd was incorporated in June 1956 as Saurashtra Cement and
Chemical Industries Ltd by N K Mehta. The Mehta Group has presence in countries like
Uganda, Canada, UK and US. In India, the group controls Gujarat Sidhee Cement Ltd
too.

This is evaluated and compared by three different companies namely ACC Ltd,Dalmia
LTD and Gujarat Ambuja Cements Ltd which are in the same industry has been
considered as benchmarks for evaluation.

The three companies mentioned above are top players in the cement industry holding a
major share in the cement market. They represent the parameters of power, commitment
and reliability.

The sample taken is observed in view of growth rate for which the industry standards are
measured (high point) and compared to the sample company in the present scenario to
eradicate the company from its present situation and three assumed growth rates are
calculated to recognize the significant growth required by the company.

To simplify the research an assumption has been taken in terms of WACC.We suppose
that the average of ROCE of the specified companies is assumed as a WACC. ROCE is
calculated as per PBIT/CAPITAL EMPLOYED *100 for individual years.
In the finalization stages we study the value of a firm as a whole to overview its worth in
the industry for which we study other parameters also, in continuation to growth rate such
as the debenture structure of the company and finally arriving at the value of equity.

The value of equity is then studied in terms of earnings to shareholders and analyzed to
the market earnings. The calculations and analysis are further highlighted in the research
analysis concluded further.
 VICTORIA MILLS LTD

The second company taken under research is Victoria Mills Ltd representing the Textiles
industry which has yielded negative earnings in the past years. The Company's principal
activity is to market cotton cloth, rags and yarn.

This is evaluated and compared by three different companies namely Century Textiles,
Raymond LTD and Arvind Mills which are in the same industry has been considered as
benchmarks for evaluation.

The three companies mentioned above are top players in the Textile industry holding a
major share in the Textile market. They represent the parameters of quality, durability
etc.

The sample taken is observed in view of growth rate for which the industry standards are
measured (high point) and compared to the sample company in the present scenario to
eradicate the company from its present situation and three assumed growth rates are
calculated to recognize the significant growth required by the company.

To simplify the research an assumption has been taken in terms of WACC.We suppose
that the average of ROCE of the specified companies is assumed as a WACC. ROCE is
calculated as per PBIT/CAPITAL EMPLOYED *100 for individual years.

In the finalization stages we study the value of a firm as a whole to overview its worth in
the industry for which we study other parameters also, in continuation to growth rate such
as the debenture structure of the company and finally arriving at the value of equity.

The value of equity is then studied in terms of earnings to shareholders and analyzed to
the market earnings. The calculations and analysis are further highlighted in the research
analysis concluded further.
 ODYSSEY TECHNOLOGIES LTD

The next sample company taken under research is Odyssey Technologies Ltd
representing the software industry which has yielded negative earnings in the past years.

This is evaluated and compared with three different companies namely Wipro Ltd,
Infosys Technologies Ltd, and Satyam computer services Ltd which are in the same
industry has been considered as benchmarks for evaluation.

The three companies mentioned above are top players in the software industry holding a
major share in the computer software market. They represent the parameters of
technology, innovation etc.

The sample taken is observed in view of growth rate for which the industry standards are
measured (high point) and compared to the sample company in the present scenario to
eradicate the company from its present situation and three assumed growth rates are
calculated to recognize the significant growth required by the company.

To simplify the research an assumption has been taken in terms of WACC.We suppose
that the average of ROCE of the specified companies is assumed as a WACC. ROCE is
calculated as per PBIT/CAPITAL EMPLOYED *100 for individual years.

In the process of calculating the value of firm , capital expenditure and change in
working capital is assumed to remain nil for all the years.

Since WACC in this case is 37.31 so we apply the FCFF model only to the growth rate of
30% as it is less than the cost of capital and we use Free Cash Flow to Equity (FCFE)
model to find out the value of equity at growth rates of 40%and 50%.

For this purpose we take the average of Return on Equity (ROE) of the benchmark
companies as the cost of equity for the sample company for the above mentioned rates.
Due to the usage of perpetuity model the sales for the first year are taken at 40% growth
and 50% growth rate respectively for the other two assumed growth rates as mentioned
above and there by assumed to remain constant for the future years.

In the finalization stages we study the value of a firm as a whole to overview its worth in
the industry for which we study other parameters also, in continuation to growth rate such
as the debenture structure of the company and finally arriving at the value of equity.

The value of equity is then studied in terms of earnings to shareholders and analyzed to
the market earnings. The calculations and analysis are further highlighted in the research
analysis concluded further.
 SNOWCEM INDIA LTD

Snowcem India Ltd belongs to the chemical industry and with the overview of the
companies past financial statements it has been observed that the company has been
yielding negative returns.

Snowcem India limited- India’s No.1 exterior Paint Company has been in existence for
more than four decades and has remained the market leader for exterior paints in India.
The Company pioneered and propagated the concept of durable and economic protection
with beauty for national housing stock since 1959.

To identify the reasons for the depressed earnings of the company we evaluate it with
three different companies namely Goodlass Nerolac Ltd, Asian Paints and Berger Paints
Ltd which are in the same industry and considered as benchmarks for comparison with
Snowcem India Ltd.

The companies taken as benchmarks are holding a position in the market for quality and
durability and many more.

The sample taken is observed in view of growth rate for which the industry standards are
measured (high point) and compared to the sample company in the present scenario to
eradicate the company from its present situation and three assumed growth rates are
calculated to recognize the significant growth required by the company.

To simplify the research an assumption has been taken in terms of WACC.We suppose
that the average of ROCE of the specified companies is assumed as a WACC. ROCE is
calculated as per PBIT/CAPITAL EMPLOYED *100 for individual years.

In the process of calculating the value of firm , capital expenditure and change in
working capital is assumed to remain nil for all the years.
To arrive at the value of the firm in the industry we analyze other yard sticks also, such as
continuation in growth rate and the debenture structure of the company and finally
arriving at the value of equity.

The value of equity is then tested in terms of returns to shareholders and its market
earnings. The calculations and analysis are further highlighted in the research analysis
concluded further.
 TATATELE SERVICES LTD

The next sample company undertaken for valuation is TATATELE SERVICES LTD
representing the Telecom industry which has yielded negative earnings in the past years.

Tata Tele Services spearheads the Group's presence in the telecom sector. Incorporated in
1996, Tata Teleservices was the first to launch CDMA mobile services in India within the
Andhra Pradesh circle. Starting with the major acquisition of Hughes Telecom (India)
Limited (now renamed Tata Teleservices (Maharashtra) Limited) in December 2002, the
company has swung into expansion mode.

This is evaluated and compared by three different companies namely MTNL, VSNL and
HFCL Infotel Ltd which are in the same industry have been considered as benchmarks
for evaluation.

The three companies mentioned above are top players in the Telecom industry holding a
major share in the Telecom market. They represent the parameters of efficiency and
speed etc.

The sample taken is observed in view of growth rate for which the industry standards are
measured (high point) and compared to the sample company in the present scenario to
eradicate the company from its present situation and three assumed growth rates are
calculated to recognize the significant growth required by the company.

In the process of calculating the value of firm , capital expenditure and change in
working capital is assumed to remain nil for all the years.

Since WACC in this case is 15.31, we apply the Free Cash Flow to Equity (FCFE) model
to the growth rate of 18%, 28% and 48% as it is less than the cost of capital.
For this purpose we take the average of Return on Equity (ROE) of the benchmark
companies as the cost of equity for the sample company for the above mentioned rates.

Due to the usage of perpetuity model the sales for the first year are taken at respective
growth rates mentioned above and there by assumed to remain constant for the future
years.

In the finalization stages we study the value of a firm as a whole to overview its worth in
the industry for which we study other parameters also, in continuation to growth rate such
as the debenture structure of the company and finally arriving at the value of equity.

The value of equity is then studied in terms of earnings to shareholders and analyzed to
the market earnings. The calculations and analysis are further highlighted in the research
analysis concluded further.

GLOSSARY

CAPITAL EXPENDITURE (CAPEX)

Those are the expenditures which are used by a company to acquire or upgrade physical
assets such as equipments, property, industrial buildings etc.

FREE CASH FLOW TO FIRM (FCFF)

It measures a firm's cash flow remaining after all expenditures required to maintain or
expand the business have been paid off. It represents the net cash produced by a firm
during a given period on behalf of shareholders.
NET OPERATING PROFIT AFTER TAX OR NOPAT

It is a company's after tax operating profit for all investors, including shareholders and
debt holders

RETURN ON CAPITAL EMPLOYED (ROCE)

ROCE is a commonly used measure for comparing the performance between companies
and for assessing whether a company generates enough returns to pay for its cost of
capital.

RETURN ON EQUITY (ROE)

It shows the rate of return on the investment for the company’s common shareholders, the
only providers of capital who do not have a fixed return.

TERMINAL VALUE

It is the future discounted value of all future cash flows beyond a given date.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The WACC takes into account the relative weights of each component of preferred
equity, common equity and debt and presents the expected cost of new capital for a firm.

BIBLIOGRAPHY

BOOKS

1. Damodaran on valuation by ashwath damodaran

2. Valuation:-measuring and managing the value of companies by tom Copeland,tim
koller and jack murrin.
3. Dark side of valuation by ashwath damodaran
4. Company valuation:- icfai, dr niranjan swain
5. Valuation by geo gough.

WEBSITES
1. www.stern.nyu.edu/~adamodar
2. www.giddy.org

REFERANCES

1. Aswath Damodaran:-THE DARK SIDE OF VALUATION: FIRMS WITH NO

EARNINGS, NO HISTORY AND NO COMPARABLES

2. Ross Levine, Sergio L. Schmukler: -INTERNATIONALIZATION AND THE

EVOLUTION OF CORPORATE VALUATION
 3. Rafael La Porta,Florencio Lopez-de-Silanes,Andrei Shleifer,Robert Vishny :-
INVESTOR PROTECTION AND CORPORATE VALUATION

4. Stuart C. Gilson; Harvard Business School, Edith S. Hotchkiss; Boston College;

Richard S. Ruback;Harvard Business School:-VALUATION OF BANKRUPT
FIRMS

5. Z. P. MATOLCSY; UNIVERSITY OF TECHNOLOGY, SYDNEY A. WYATT

*UNIVERSITY OF MELBOURNE:-WHAT ELSE DRIVES THE VALUE OF
COMPANIES A TECHNOLOGICAL INNOVATION APPROACH

6. Aswath Damodaran: Stern School of Business:-THE COST OF DISTRESS

SURVIVAL, TRUNCATION RISK AND VALUATION

DATABASE
1. Prowess
2. Capital line plus.