Session 1:

Valuation of small/large or public/private or emerging/developed market

Every good valuation has a story behind it.

“They must know something that you don't” – 7 most deadly worlds in investing.

Types of investors:
● Proud Lemmings: Momentum Investors- they look for a crowd and they join it. Don’t care
why
● Yogi Bear Lemmings: Smarter than the average bear- someone who can stop just shy of the
cliff and have the benefits of upside while no downside. Difficult to do.
● Lemming with a life-vest: something to hold on to when everybody is running towards the
cliff. It’s a life vest. Gives your rational side a chance to mount an argument.

Bermuda Triangle of Valuation: why valuations fail?

● Bias: Most people have a preconceived notion about the company. Ask these questions:
○ Who did this valuation?
○ Who paid for this valuation?
● Uncertainty: Valuation is not science. Numbers are estimates. Those estimates come with a
lot of uncertainty. The more uncomfortable you feel valuing a company, the greater the
payoff to do a valuation.
● Complexity: Bigger models are not necessarily better. Complex models are black boxes.
Garbage in, garbage out.

Tips:
Be Parsimonious: Less is more.

Approaches:
● Intrinsic: based on fundamentals, cash flows, growth, risk. It's all about the business.
○ Discounted Cash Flow is the most common tool for intrinsic valuation
○ All about the business
● Relative: What similar assets are being priced at right now and use that to value
● Option Pricing Model: Valuing assets that have contingent (only if something happens) cash
flows. More sophisticated.

Each approach has assumptions about how markets work and how markets don't work, about how
market made mistakes

Discounted Cash Flows: PV of cash Flows. Components- CFs, discount rate, life of asset.
The longer your time horizon of investment, the better off you are as the markets may take time to
correct their valuations.
Relative Valuation:
● Find a multiple
● Look for comparables
● Control for differences across investments – growth, risk, etc.

Assume that markets are right on average but wrong on individual companies. And these mistakes
will get corrected sooner rather than later.

Option Pricing:
Options derive their value from the underlying assets. They also have a finite life. Similarly some
companies have contingent cash flows that are useful only under certain conditions and they have a
finite life, like natural resource company with undeveloped reserves, the company can choose to
develop that only if the price is right.

Session 2:

Intrinsic Valuation: function of Cash flows, growth, risk. Can value either equity or entire business.
Designed for cash flow generating assets, not possible for assets like paintings, gold etc.

The expected value of an asset is written as the present value of the expected cash flows on the
asset, with either the cash flows or the discount rate adjusted to reflect the risk.

Expected cash flows across all scenarios.

Discount rate is used to adjust risk, the higher the risk higher the discount rate

E(CF) is the expected cash flow.

Note that here, the discount rate is risk-free rate.

Here risk is adjusted in cash flows, so CE(CF) is the certainty equivalent of E(CF), Rf is the risk-free
rate. Certainty Equivalent is the guaranteed cash flows we would have accepted as an alternative.
Suppose you have 100$ as expected cash flows, your risk adjusted cash flows would be anything you
take as a replacement which would act as a guarantee for $100. Usually a smaller number.

Proposition 1: For an asset to have value, the expected cash flows have to be positive some point of
time over the life of the asset.
Proposition 2: For a business to have positive cash flows at a later stage in life, it has to have
disproportionately large positive cash flows in the future.
Accounting Balance Sheet vs Financial Balance Sheet

Growth assets: investments that you are expected to make in the future that you haven't made yet.
Giving credit based on expectations and hope.
Either value the equity or the entire business.

Equity Valuation: cash flows that equity investors get out of business. These are after meeting
interest and debt payments.

Dividend discount model is a special case of Equity Valuation model. Usually the only cash flows that
equity investors receive.

Firm Valuation: can be thought of as valuing the asset side of balance sheet.
CFE: cash flow to equity holders
CFF: cash flow to the firm (includes debt holders as well). Discount rate is the weighted average of
cost of equity and cost of debt.

figure
Consistency Principle: Your discount rate should match up to your cash flows.
● Discounting cash flows to equity at the weighted average cost of capital will lead to an
upward bias in estimate of value of equity.
● Discounting cash flows to the firm at the cost of equity will lead to a downward biased
estimate of value of firm.

Session 3:

Risk Free Rate: look at govt bond rate

Nominal vs Real terms:

If cash flows being discounted are nominal cash flows (i.e. reflect expected inflation), the discount
rate should be nominal. Currency becomes an issue only when the cash flows are nominal.

Real terms means you are not considering inflation effects.

Cost of Equity:
It should be higher for riskier investments and lower for safer investments.
For risk, we use the Standard deviation of the stock prices as there is ample data available for us. We
don't use cash flows because earnings are reported at most on a quarterly basis and even less for
some companies in some other countries.

How risky is the company for the marginal investor in this investment?
Marginal investors are those who tend to affect the stock price. They own a lot of shares(millions)
and they trade them. Marginal investors have diversified investment. So the risk for them is that of a
diversified portfolio.
Arbitrage Pricing Model and Multi-factor models gives multiple Betas to asses expected return. The
APM leaves these betas as unnamed while the MFM gives economic names to it like interest rate or
inflation etc. Proxy models don't measure risk. Due to large data we are able to use proxy. They are
used individually or with other models. E.g. smaller companies grow faster and hence have more
risk.

For something to be risk free, the entity has to have

● No default risk
● No reinvestment risk- the time horizon should match up with cash flows you are trying to
discount. If your cash flows are long term, your risk-free interest rate has to a long-term risk-
free rate. Maturity should match.

Important:
● Risk free has to come with a time horizon. Risk-free rates do not come in a vacuum.
● Not all government securities are risk free.

Instead of 30-years rates, 10-year bond rate is a good value to take as there are other inputs which
need to be considered while building a model and those inputs are easier to get for a 10-year bond
rate.

E.g.
In Europe, different governments have different bond rates for the same currency. This is so because
markets perceive some of these governments have default risks. So in Europe, you would choose the
Germany’s 10-year rate because we want to go as low as we can to make sure that this is the
minimum rate that we will get. We want to go as close as we can to a default-free rate.

Another way to get risk-free rate. Credit Rating agencies give ratings to governments as well based
on how they perceive the chances for that country to default are. We look at Sovereign Default
Spread. Subtract the 10-year bond rate with the default spread to get the risk-free rate for that
country.

To get the default spread,

 When the country has a dollar denominated bond, subtract the interest rates of Brazilian
Dollar denominated bond with US treasury bond rate.
 If the country has a CDS Spread, Credit Default Spread (CDS) market gives default spread of
different countries.
 Use the sovereign rating of a country to get the default spread of Credit rating agencies.

If any of the above is not present, the last step you can use a Country Risk Score and tally that
number with another country of same Score and use their default spread.

Session 4: Equity Risk Premium

Premium that investors demand above the risk-free rate. It is a function of
 How risk averse you are?
 How much risk you see in equity?

Two methods:
 Historical method: most common, premium that stocks have historically earned over riskless
securities. Depends of time frame, arithmetic or geometric, T-bills or T-bonds
o Has survivorship bias
o It is noisy, it has substantial standard error
o The crisis of 2008 makes it difficult to believe that things will revert to historical
norms. So forward looking model is better.
 Forward looking model
o This number will change daily based on growth rate estimates of analysts for S&P
500.
o At least know the implied premium.
Historical method cannot be used in emerging markets where there is not a lot of data. Some
methods that can be used are:
Start with mature market premium, look for default spread of the country, scale that spread based
of SD of stock index and government bond

Can also use implied premium approach but requires same inputs as the US.
Mature market: any country with a AAA rating
Now to calculate corporate risk premium

Now to calculate weights of Country Risk Premium, use revenue %.

Session 5:

Beta- to calculate relative to the market risk.

There are different kinds of beta. One of the most important ones is the CAPM beta.

CAPM beta:
The standard procedure to estimate beta is to regress stock returns against market returns.

Median Standard Error for a US company is 0.2. Beta estimate is a noisy estimate. The worst
estimates come from the best looking examples. Regression would depend on
 Period
 What index is chosen
 Returns are daily, weekly, monthly, or yearly

Instead look at the following: macroeconomic factors

● Discretionary products have higher beta.
● Greater the fixed costs, greater the beta. Everything becomes magnified, good times
become great and bad times become terrible.
● More you borrow, the higher the beta. This is because fixed costs in the form of interest
expenses rises.
Bottom-up Betas:
Basically, finding comparables, unlevering them, finding an average, relever it
For a company operating in multiple businesses, for each business find the industry of unlevered
beta. Then compute the company unlevered beta using revenue % as weights, then relever it.

Advantages:
● Standard Error of the bottom-up beta will be significantly lower than the standard error in a
single regression beta. This is because it is an average across many businesses so it is far
more precise.
 ○ Taking 100 rotten betas and finding the average will give a number which is very
precise because
■ SE of bottom-up beta = Average SE across beta / sqrt (no of firms in the
sample)
● Bottom-up betas can also be adjusted to reflect changes in firm’s business mix.
● You can also do bottom-up betas when you don't have historical data on stock prices as in
the case of IPOs or private businesses.

When you use Revenue as weights, you are assuming that a dollar of revenue in one business is
worth the same as a dollar of revenue in the other business. There could be margins or other factors.
Instead you could use the EV that market gives to each dollar of revenue. Using that we calculate the
weights.

Session 6: Cost of debt and capital

From the previous sessions we have calculated the cost of equity, now we are going to calculate the
cost of debt. Debt should
 Require contractual commitments
 Are tax deductible
 Failure to make commitment can cost you control over the business.

Accounts payable can be used as debt only if interest expenses are made explicit. This is difficult
because the company has to tell how much they lost in discounts because they used that credit.
Leases can meet the criteria. These are long term commitments.

Cost of debt: rate at which you can borrow long term today, reflects your default risk and the
interest rate levels in the market. Even if you took the money 3 years ago, the rate would that of
today. To get cost of debt:
 Pre-tax Cost of debt = Risk-free rate + default spread (from the credit rating agency)
 Equal to YTM of bond issued by you. Though this would be for a specific bond and not that
of entire debt. Risky companies can issue safe bonds by carving out safer assets to issue for
that bond.
Most companies do not come with a bond rating. So create a synthetic rating based on ratios.
We use Interest Coverage Ratio. Reverse engineer rating using other companies’ ratios.
Investors will also have to consider the country risk.

Cost of debt = Risk-free rate + Company default spread + a portion of country default spread

For WACC, we use weights as market value weights as that is what will cost you to buy that company
today.
Use marginal tax rate and not effective tax rate.

Hybrids like convertible debt is not included here. To include that, separate into conversion option
and debt and then calculate.
Keep preferred stock as separate