VIZGYAN GUIDE TO EQUITY

ANALYSIS
Methods of

Valuation
 Methods of
Valuation
No Arbitrage pricing Intrinsic Valuation
The price of an asset is set Measures the value of
as the price of another asset an asset based on the
or portfolio that replicates discounted cash flow
the same benefits principle
No Arbitrage Pricing
The price of the asset is set at the same level as the
value of the replicating portfolio

Selling price based approach

Price is determined based on selling price of
replicating portfolio or similar assets

Cost based approach

Price is determined based on the
amount it may create the same
asset
 No Aribitrage Approach

Selling price based

approach
Cashflow replication
Applicable for bonds and derivatives whose
contractual cash flows can be replicated
through an alternative set of assets

Relative valuation
Appropriate for assets such as equity or
real estate that do not have fixed
contractual cash flows

P/E ratio (equity) or Price/Sqft kind of

metrics are used to compare prices
No Aribitrage Approach

Cost based valuation

Asset is valued based on the amount
it costs to create it

Requires physical valuation of assets

Suitable for strategic buyers who are

evaluating green field expansion vs
acquisitions
Intrinsic valuation
Based on the first principles of valuation
PV of expected outflows = PV of expected inflows

Real world approach

Most likely cash flows are discounted at expected
rate of return; expected rate of return includes risk
premium

Risk neutral approach

Expected cash flows (i.e.
probability weighted average of
cash flows) is discounted at risk
free rate
Intrinsic valuation

Real world approach

Estimated Cashflow
Analyst estimate of most likely outcome

Expected returns
Risk-free rate plus risk premium;
higher the risk, higher the premium

Face of zero coupon bond (A): CR 100

Time to maturity (B): 2 years
Risk free rate (C): 4%
Risk premium (D): 2%
Expected return (E) = (C) + (D): 6%

Bond value (F) = A/(1+E)^B: CR 89

Intrinsic valuation

Risk Neutral Approach

Expected Cashflow
Possible cash flows * Probability

Risk free rate

No risk premium added as cash flows are
adjusted for risk

Face of zero coupon bond (A): CR 100

Time to maturity (B): 2 years
Risk free rate (C): 4%
Possibility 1 (D): Rs.100 with 95% probability
Possibility 2 (E): Rs.20 with 5% probability
Expected CF(F): (100*95% + 20*5%) = Rs.96
Bond value (G) = F/(1+C)^B: CR 89
Intrinsic valuation

Hybrid Approach
It is a fundamentally flawed principle but it is
used by many PE firms
Under this approach, the cost of capital is
calculated based on fixed risk premium
(irrespective of risk)
For safer business, cash flows are forecasted
with optimistic assumption while pessimistic
assumptions are taken for riskier businesses
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