Business Valuation Using Financial Statements (BVFS) Prof. Vaidya Nathan Term 6, February 2022

Business Valuation using Financial
Statements (BVFS)
Prof. Vaidya Nathan
Term 6, February 2022
Price and Value are different
Do not confuse Price and Value. They are not the same.
Price
Value
Price is what you pay, Value is what you get.

If Price paid is less than Value derived, it’s a good investment.
Some of the many uses of valuation
Divestitures Fairness opinions

How much should we sell Is the price offered for the
our company or division company fair from a
for? financial point of view?
Hostile defense
Acquisitions Is our company
How much should we pay to undervalued and therefore
buy the company? vulnerable to a corporate
takeover?
Valuation
Research New business presentations
Should our clients buy, sell How much is a start-up
or hold positions in a given worth? (from an
security? Entrepreneur’s or VC/PE’s
perspective)
Debt offerings Public equity offerings

What is the asset value of For how much should we
firm against which debt is sell our company for in the
being issued? public market?
Misconceptions about Valuation
Myth: A valuation is an objective search for “true” value.

Truth: All valuations are biased. The only questions are how
much and in which direction.
Truth: The direction and magnitude of the bias in your
valuation is directly proportional to who pays you and how
much you are paid.
Myth: A good valuation provides a precise estimate of value.

Truth: There are no precise valuations.
Truth: The payoff to valuation is greatest when valuation is
least precise.
Myth: The more quantitative a model, the better the valuation.

Truth: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
Truth: Simpler valuation models do much better than complex
ones.
The Roadmap Techniques for valuing Start-ups & Conclude (Lecture 8)
Intrinsic Valuation: FCFF and FTE Method (Lecture 7)
Earnings Power Value and Optimal WACC (Lecture 6)
Story of Five Friends: 2V3G Framework (Lecture 5)
Economic Value Add (Lecture 4)
Residual Income Valuation

(Lecture 3)
Piotroski Score
(Lecture 2)
Valuation & Business Valuation
Roadmap uses the natural steps in Integrated ISBS

(Lecture 1)
the valuation process
Modular approach in the Course
If the valuation process has a story, think of having the story told in “chapters”
i.e., in separate distinct modules.
In this modular approach, the blocks of the valuation process perform
interrelated but distinct operations within them.
More often that not, each block’s results are read by the next block, and so on.
This makes it easy to put together a logical/structured process to learn valuation.
It also makes the valuation process easier to implement, since we can work
within one module in each lecture.
We implement the modular approach in the course and learn hands-on using
in-class exercises so that the course is not mere theory.
In the valuation process, the devil lies in the details, so the focus will be on the
details as much as on the big picture.
Best Practices: Berk DeMarzo
Statements (BVFS)
Prof. Vaidya Nathan
Lecture 1, 1 February 2022
Questions we answer in this lecture
How to forecast the financial statements of any corporation?
How to make sure that the forecasted balance sheet balances?
How to determine the future financing need of a corporation next year or say,
three years from now?
How aggressively (both from lender’s and borrower’s perspective) can a
company repay debt? (loan structuring)
How much dividends or share buyback can a corporation afford to do given its
current cash position?
How much equity does a start-up need to raise to survive for the next couple of
years?
How much cash burn can a Startup afford, say, next year or the year after next?
Historical Balance Sheets are
balanced by definition
Except, valuation is not done using historical cash flows:)

Historical Financial Statements
(₹ crores) Actual Projected--> Actual Projected-->
Income Statement 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24
Revenues ₹ 100.00 10% 10% 10% ₹ 100.00
COGS % of Revenues 60% 60% 60% 60% ₹ 60.00
EBITDA ₹ 40.00
Depreciation % of last year’s Net Fixed
Assets ₹ 6.50 10% 10% 10% ₹ 6.50
EBIT ₹ 33.50
Interest Income on Surplus Funds ₹ 0.00 5% 5% 5% ₹ 0.00
Interest Expense on Debt & NTF ₹ 5.00 10% 10% 10% ₹ 5.00
Profit Before Tax ₹ 28.50
Effective Tax Rate 25% 25% 25% 25% ₹ 7.17
Net Income ₹ 21.33
Dividend payout ratio (% of Net Income) 10% 10% 10% 10%
Addition to Retained Earnings
Capex (% of last year’s Revenues) 20% 25% 30%
Balance Sheet 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24
Surplus Funds (SF) ₹ 0.00 ₹ 0.00
Operating Cash ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00
Accounts Receivable ₹ 18.00 60 60 60 ₹ 18.00
Inventory ₹ 7.00 40 40 40 ₹ 7.00
Net Fixed Assets ₹ 70.00 ₹ 70.00
Total Assets ₹ 100.00 ₹ 100.00
Accounts Payable ₹ 5.00 30 30 30 ₹ 5.00

Necessary to Finance (NTF)
Long Term Debt ₹ 45.00 ₹ 40.00 ₹ 35.00 ₹ 30.00 ₹ 45.00
Equity ₹ 50.00 ₹ 50.00
Total Liabilities ₹ 100.00 ₹ 100.00
Projected Balance Sheet
Liabilities & Shareholder Equity Assets
Accounts Payable Excess Cash
Other Current Liabilities Operating Cash
Current Liabilities Short-term Investments
Revolver Accounts Receivables
Short-term Debt Inventory
Long-term Debt Other Current Assets
Other Long-term Liabilities such as DTL Current Assets
Total Liabilities
Preferred Stock Net PPE
Common Stock Intangibles
Retained Earnings Long-term Assets
Total Shareholders’ Equity Total Assets
Forecasted Balance Sheet need not
necessarily balance!
Surplus Funds Need To Finance
Liabilities
Liabilities
Assets Assets
Shareholders’ Shareholders’
Equity Equity
Necessary to Finance (NTF)/ Surplus Funds (SF)
First method of balancing called the Balance Sheet Method: Calculate the difference of Total
Liabilities & Equity and Total Assets.
Positive number is a Surplus Funds (SF) and negative number is a Necessary to Finance (NTF).
Surplus Funds Need to Finance
Liabilities
Liabilities
Assets Assets
Equity Equity
Project a Balance Sheet
(₹ crores) Actual Projected--> Actual Projected-->
Income Statement 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24
Revenues ₹ 100.00 10% 10% 10% ₹ 100.00
COGS % of Revenues 60% 60% 60% 60% ₹ 60.00
EBITDA ₹ 40.00
Depreciation % of last year’s Net Fixed
Assets ₹ 6.50 10% 10% 10% ₹ 6.50
EBIT ₹ 33.50
Interest Income on Surplus Funds ₹ 0.00 5% 5% 5% ₹ 0.00
Interest Expense on Debt & NTF ₹ 5.00 10% 10% 10% ₹ 5.00
Profit Before Tax ₹ 28.50
Effective Tax Rate 25% 25% 25% 25% ₹ 7.17
Net Income ₹ 21.33
Dividend payout ratio (% of Net Income) 10% 10% 10% 10%
Capex (% of last year’s Revenues) 20% 25% 30%
Balance Sheet 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24
Surplus Funds (SF) ₹ 0.00 ₹ 0.00
Operating Cash ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00
Accounts Receivable ₹ 18.00 60 60 60 ₹ 18.00
Inventory ₹ 7.00 40 40 40 ₹ 7.00
Net Fixed Assets ₹ 70.00 ₹ 70.00
Total Assets ₹ 100.00 ₹ 100.00
Accounts Payable ₹ 5.00 30 30 30 ₹ 5.00

Necessary to Finance (NTF)
Long Term Debt ₹ 45.00 ₹ 40.00 ₹ 35.00 ₹ 30.00 ₹ 45.00
Equity ₹ 50.00 ₹ 50.00
Total Liabilities ₹ 100.00 ₹ 100.00
Schematic of balancing method
Income Statement
Net Income
Liabilities
Net Income
flows into the Assets
Retained
Earnings
account in SH
Equity
Shareholders’
Equity
Integrated Model: Iteration 0
Balance Sheet Income Statement
Revolver₹10
Revolver ₹0
Liabilities
₹60 Interest Expense
+₹0
Assets
₹100
Shareholders’ Net Income

Equity −₹0
₹30
Start Here Balance Sheet Income Statement
Revolver Begin ₹10
Revolver End ₹11
Liabilities
₹60
Interest Expense
+₹1
Assets
₹100

Equity −₹1
₹29
Beginning Equity Assuming 10% interest cost

₹30 No Income Tax
Revolver End ₹11.1
Liabilities
₹60
Interest Expense
+₹1.1
Assets
₹100

Equity −₹1.1
₹28.9

₹30 No Income Tax
Revolver Begin ₹11.1
Liabilities
₹60
Interest Expense
+₹1.11
Assets
₹100

Equity −₹1.11
₹28.89

₹30 No Income Tax
Results of Iterations (without taxes)
Iteration Beginning Interest at 10% (B) = Ending Revolver Incremental change
Revolver (A) 10% x (A) (C) = ₹10 + (B) in Revolver
0 ₹0 ₹0 ₹0 ₹0
1 ₹10 ₹1 ₹11 ₹1
2 ₹11 ₹1.1 ₹11.1 ₹0.1
3 ₹11.1 ₹1.11 ₹11.11 ₹0.11
4 ₹11.11 ₹1.111 ₹11.111 ₹0.111
5 ₹11.111 ₹1.1111 ₹11.1111 ₹0.1111

You need Circularity for more
accurate Financial Forecasting
What is a Circular Error?
A formula that includes itself in its formula.
Surplus Circular Error, See CIRC Necessary to

Funds CIRC, See Circular Error Finance
The two warning signs:

▪ 0 in a formula when you know the answer
should be some other number.
▪ The Circular message on the status bar.
Why do you need circularity?
involving Circularity
2. Which creates interest income 3. Interest income adds to net income
1. SF plug appears 4. Net income adds to retained earnings
Surplus Funds
Liabilities 5. Which adds to Shareholder Equity
Assets
Shareholders’
6. Which makes SF increase even more
Equity
involving Circularity
2. Which creates interest expense 3. Interest expense reduces net income
1. NTF plug appears 4. Less net income flows to retained earnings
NTF
Liabilities 5. Which reduces Shareholder Equity
Assets
Shareholders’
6. Which makes NTF increase even more
Equity
Circularity in financial forecasting
PROS
Elegant solution to NTF and Cash Balances
Allows accumulative formulas in NTF and SF
Interest Rate rd <=> Interest Coverage Ratio
Gets the Balance Sheet to balance accurately
CONS
Hides accidental CIRC’s
Doesn’t always resolve CIRC’s
Destabilizes the financial model
If you incorporate circularity, be wary of
‘The #REF! problem’
#REF!
“I need a reference.”
Occurs when you:
▪ Delete cells, rows, columns, worksheets.
▪ Move/Cut formulas.
A #REF! that occurs when iteration is ON cannot be
fixed with UNDO (Ctrl-Z).
To correct the #REF! problem:
▪ Find the circular reference (typically in SF and NTF).
▪ Break it (Link interest earned on Cash to previous
years’ Cash Balance).
▪ Resolve the #REF! cells.
Solving ‘The #REF! problem’
#DIV/0! is carried in loop.
#DIV/0! ISERROR = TRUE, so formula becomes a 0 and

message breaks the loop.
No error message in loop.

Source of
ISERROR = FALSE
error is
formula reverts to original reference
cleared
and reconnects the loop.
Error corrected.
Circularity: Averaging Interest Expense
Balance Sheet Year 0 Income Statement
Revolver ₹10
Balance Sheet Year 1

Liabilities
₹60
Avg Interest Expense
+₹0.5
Assets
₹100 Liabilities
₹60
Shareholders’ Assets Net Income

Equity ₹100 −₹0.5
₹30
Shareholders’
Assuming 10% interest cost
Equity
No Income Tax
₹29.5
Beginning Equity ₹30

Variations on Balancing Plugs
The plug is typically viewed as debt because in the real world, when a company needs
funding, the easiest thing to do is to borrow money, rather than issue stock. Likewise,
revolver debt is readily repayable when the company has cash on hand.
Revolver lines of credit allow for this: the company can draw down if it needs financing,
and then repay when it has excess cash. In this way, the revolver is best viewed as a
short-term debt of the revolving kind.
If we want to use the plug as an equity plug, the main difference is that the equity plug
should increase when there is a need for additional financing mostly in the long-term.
This is because, companies (mostly start-ups and young companies) issue equity to meet
financing needs, although not for short-term needs. In general, companies use equity
when the sources of debt financing are limited.
Mature companies use excess cash to buy back their equity as a short-term response to
low stock price and also as a way to payback shareholders.
Payback in the form of dividends historically hasn’t happened in India given the high
dividend distribution tax (20.56%) which was removed in the Feb 2020 budget.
We usually consider the plug on the liabilities side as debt, but a more useful way of thinking
about this plug is that it is a shortfall in financing.
From the business point of view, the plug does not have to be debt, as long as it provides the
necessary financing for the company. The plug can as well be equity.
Need to Finance
Liabilities
Liabilities
Assets Assets
Equity Plug
Equity Equity
Another way to balance a projected balance sheet is to reduce the liabilities and equity side, by
dividending out the excess cash-plug out of the retained earnings account.
We can also do a partial dividending out, where a percentage of the excess cash-plug remains on
the balance sheet. However, it is not a preferred option given the high dividend distribution tax.
Surplus Funds
Liabilities
Liabilities
Assets
Assets
Shareholders’
Equity Shareholders’
Equity
Dividend Payout
Key Take-aways
We learnt how to forecast the financial statements of any corporation
and make sure that the forecasted balance sheets balance.
We know how to determine the future financing need of a
corporation for any given horizon.
We understood how to ascertain if and when, a corporation may be
able to repay its debt.
We grasped how much dividends or share buyback can a corporation
afford, given its current cash position.
We figured out how much equity does a start-up need to raise to
survive for the next couple of years and how much cash burn can a
start-up afford, say, next year or the year after next.
Statements (BVFS)
Prof. Vaidya Nathan
How to verify that Surplus Funds or Necessary to Finance is right
and reasonable?
Why does the balancing figure in the balance sheet actually add
up to the cash flows from different activities?
How to know if a company is doing well in its core activity?
How much of the company’s money is going into financing cost?
How much cash is going to the Liabilities side and how much to
the Asset side of the balance sheet?
How to assess the financial strength of a corporation?
Second Method: Cash Flow balancing method
Cash Flow balancing method: An Net income from Income Statement
alternate analytical approach, in
which cash flow statement is viewed +
as the method by which balance sheet Changes in every Asset account
is balanced. (increases in Assets are negative flows;
decreases are positive flows)
In Cash Flow balancing method,
excess cash or revolver plug that is +
calculated for each forecast year is
Changes in every Liability and Equity
calculated by the cash flow statement, account, except Retained Earnings account
and then used by the balance sheet. (increases are positive flows;
decreases are negative flows)
Compatible with Indian Accounting
Standard Ind AS 7. =
Traditionally used by Investment Net Cash available:

Banks and Consulting firms for Positive number is Surplus funds plug
valuation. Negative number is NTF plug
Check NTF/SF: Cash Flow Statement
Cash Flow Statement: how much cash is coming in and how it is being used.
A source of cash is:
▪ Any decrease in asset’s components.
▪ Any increase in liabilities and shareholders’ equity components.
Conversely, a use of cash is:
▪ Any increase in asset’s components.
▪ Any decrease in liabilities and shareholders’ equity components.
Flows fall into three categories
Cash flow statement’s flows fall into three categories:
Cash flow from Operations.
Cash flow from Investments.
Cash flow from Financing.
Cash Flow from CFO indicates the amount of money a company

Operations (CFO) brings in from ongoing, regular business activities.
Cash Flow from Cash from all investment activities, importantly,

Investments (CFI) spending on Capex.
Cash flow from Financing activities accounts for
Cash Flow from external activities that allow a firm to raise capital.
Financing (CFF) In addition to raising capital, financing activities
also include repaying investors, adding or
modifying existing loans, or issuing more stock.
Cash Flow from Operations
This includes:
Cash flow from
Any flows from income statement. Operations
Any changes in balance sheet accounts that are
related to operations.
All or most of the current assets, excluding cash
and cash equivalents, and all or most of current
liabilities, excluding any debt items such as
short-term notes or current portion of long-term
debt (which appear as “Cash from Financing”).
Cash Flow from Investments
This includes:
Cash flow from
Capital expenditures. Investments
Sale of assets.
Investments in Intangibles.
Any changes in the balance sheet accounts
that are related to investments.
Cash Flow from Financing
This includes:
Cash flow from
Any changes in the balance sheet Financing
accounts that are related to debt or
equity financing.
Dividends.
Share Buybacks.
Income Statement
Revenue
Cost of Goods Sold (CoGS)
Gross Profit
Gross Margin
Sales and General Admin Expenses (SG&A)
Other Operating Expenses
EBITDA
EBITDA Margin
Depreciation CFO
Amortization of Intangibles CFO
EBIT
EBIT Margin
Income Statement
Non-operating Expenses
Gain (Loss) from asset sales
Interest Income
Interest Expense
Profit Before Taxes
Provisions for Taxes
Net Income CFO
Net Margin
Extraordinary expense CFO
Net available to Common Stockholders
Common Dividends CFF
Balance Sheet
Liabilities & Shareholder Equity
Accounts Payable CFO
Other Current Liabilities CFO
Short-term Provisions CFO
Current Liabilities
Revolver (Need to Finance) [Result of total flows]
Short-term Debt CFF
Long-term Debt CFF
Other Long-term Liabilities such as DTL CFO
Other non-current Liabilities CFI
Long-term Provisions CFO
Total Liabilities
Common Equity CFF
Total Shareholders’ Equity
Balance Sheet
Assets
Surplus Funds (Excess Cash) [Result of total flows]
Operating Cash CFO
Short-term Investments CFI
Accounts Receivables CFO
Inventory CFO
Other Current Assets CFO
Current Assets
Other non-current Assets CFI
Net PPE CFI
Intangibles CFI
Long-term Assets CFO
Total Assets
Second Method: Cash Flow balancing method
Income Statement Balance Sheet
Liabilities Assets
Revenue
Current Liabilities
− Expenses
Short-term Debt Cash
= EBIT
Long-term Debt Current Assets
− Interest Expense
Net PPE
= Profit Before Tax
Common Stock Long Term Assets
− Taxes
Retained Earnings
= Net Income
Cash Flow Statement: Ties Income Statement and Balance Sheet together
Net Income
+ Depreciation
+/− Changes in Working Capital
+/− Changes in Investments
+/− Changes in Financing
= Change in Cash
Beginning Cash + Change in Cash = Ending Cash
Understanding Cash Flow Statement
Cash flow to Debt Holders
Cash flow from Assets
Cash flow to Shareholders

Understanding Cash Flow Statement
Beginning Debt
Less Ending Debt
Plus Interest Expense
Cash flow from Operations +
Cash flow from Investments
Beginning Equity
Less Ending Equity
Plus Dividend
Analyse DuPont Style
Analyse
Operating Efficiency: Profit Margin
Asset Utilization Efficiency: Asset Turnover Ratio
Financial Efficiency: Equity Multiplier

Return on Net Profit Asset Equity
= x x
Equity Margin Turnover Multiplier
Return on Net Income Sales Avg Assets

= x x
Equity Sales Avg Assets Avg Equity
Components of Dupont Analysis
Profit Margin: The primary factor remains to maintain
healthy profit margins and derive ways to keep growing it by
reducing expenses, increasing prices, etc. which impacts ROE.
Total Asset Turnover: This ratio depicts the efficiency of the
company in using its assets. This ratio differs across industries
but is useful in comparing firms in the same industry.
Financial Leverage: This refers to the debt usage to finance the
assets. The companies should strike a balance in the usage of
debt. The debt should be used to finance the operations and
growth of the company. However, usage of excess leverage to
push up the ROE can turn out to be detrimental for the health
of the company.
DuPont Analysis Interpretation
RoE highlights the company’s strengths and pinpoints the area
where there is a scope for improvement. Say if the shareholders
are dissatisfied with lower ROE, the company with the help of
DuPont Analysis formula can assess whether the lower ROE is
due to low-profit margin, low asset turnover or poor leverage.
The lower ROE may not always be a concern for the company
as it may also happen due to normal business operations. For
instance, the ROE may come down due to accelerated
depreciation in the initial years.
The DuPont equation can be further decomposed to have an
even deeper insight where the net profit margin is broken
down into EBIT Margin, Tax Burden, and Interest Burden.
Piotroski’s Financial Strength Score
Profitability & Quality of Leverage & Operating

Margin Cash Flows Liquidity Efficiency
• Net Income is • Free Cash Flow • Lower Leverage • RoA this year
positive is positive • Higher Current more than RoA
• Free Cash Flow • Higher Free Ratio last year
/Total Assets Cash Flow/TA • No Net Equity • Higher Asset
(TA) > ROA • Higher Gross Issuance Turnover ratio
Margin
FS_Score = FS_ROA + FS_FCFTA + FS_ACCRUAL + FS_ΔLEVER +
FS_ΔLIQUID + FS_NEQISS + FS_ΔROA + FS_ΔFCFTA + FS_ΔMARGIN
+ FS_ΔTURN
Current Profitability: FS_ROA, FS_FCFTA and FS_ACCRUAL.
ROA and FCFTA are net income and free cash flow, respectively,
divided by most recent total assets. If the stock’s ROA or FCFTA is
negative, the respective variables FS_ROA and FS_ FCFTA are 0,
and 1 if otherwise.
ACCRUAL is current year’s free cash flow minus net income,
scaled by most recent year total assets. The variable FS_ACCRUAL
is marked 0 if FCF is less than net income, and 0 if otherwise.
Piotroski’s Financial Strength Score: Stability
Financial Stability: FS_ΔLEVER, FS_ΔLIQUID and FS_NEQISS.
ΔLEVER is the change in the ratio of total long-term debt to
total assets. FS_ΔLEVER is marked 0 if leverage increased
and 1 otherwise.
ΔLIQUID is defined as the year-over-year change in the
ratio of current assets to current liabilities. The variable
FS_ΔLIQUID is marked 0 if liquidity deteriorated (a lower
ratio), and 1 otherwise.
NEQISS is equity issuance minus equity repurchases, or net
equity issuance. FS_NEQISS is set to 0 if equity issuance
exceed repurchases, and 1 otherwise.
Piotroski’s FS Score: Operational Improvements
Operational Improvements: FS_ΔROA, FS_ΔFCFTA, FS_ΔMARGIN,
FS_ΔTURN
ΔROA is current year’s ROA less prior year’s ROA. If ΔROA is
negative, the variable FS_ΔROA scores a 0, and 1 otherwise.
ΔFCFTA is current year’s FCFTA less prior year’s FCFTA. If ΔFCFTA
is negative, the variable FS_ΔFCFTA is 0, else 1.
ΔMARGIN is current gross margin ratio (gross margin divided by
total sales) less prior year’s gross margin ratio. The variable
FS_ΔMARGIN equals 0 if ΔMARGIN is negative, and 1 if otherwise.
ΔTURN is current year asset turnover ratio (total sales scaled by
total assets) less prior year’s asset turnover ratio. The indicator
variable FS_ΔTURN equals 0 if ΔTURN is negative, else 1.
Piotroski’s FS Score: Financial Performance
Key Take-aways
We learnt how to verify if Surplus Funds or Necessary to Finance
is right and reasonable.
We reviewed how the balancing figure in the balance sheet
actually adds up to the cash flows from different activities.
We understood how to assess if a corporation is doing well in its
core activity.
We learnt to evaluate if investment is commensurate with the
operations of the business.
We know to measure how much cash is going to the Liabilities
side and how much to the Asset side of the balance sheet.
We comprehended a methodology to assess financial strength of
a corporation.
Financial Sales Growth Operating Profits
Analysis
Gross/Net Margin Operating Leverage
Working Capital
Sales Growth
Sales is analysed by studying sales growth.
Sales growth shows increase in sales over a specific period
of time.
This is important because, as an investor, you want to know
that the demand for a company’s products or services will
be increasing in the future.
Growth rates differ by industry and company size.
Sales growth should be analysed year on year and quarter
on quarter. QoQ allows for a more in-depth analysis.
However, it should be noted that there is seasonality in most
company’s businesses, so YoY is also important.
Trident Group: Sales Data QoQ
SALES
SALES SALES GROWTH Moving Average
QTR END GROWTH
(₹ million) QoQ growth
YoY
202012 12,899 14.1% 10.1% -18.12%

202009 11,714 -11.3% 65.5% -24.77%
202006 7,079 -45.8% -28.5% -23.21%
202003 9,905 -29.5% -12.4% -7.92%
201912 11,304 -12.5% -14.4% 4.11%
201909 13,208 -5.1% 1.2%
201906 13,053 15.4% -7.1%
201903 14,054 18.6% 8.8%
Trident Group: Sales Data YoY
Sales
Year End Sales Growth (%) CAGR 3 Year Sales Growth (%)
(₹ million)
202012 41,598 -19.4% -4.2%
201912 51,619 3.3% 5.2%
201812 49,991 5.7% 10.4%
201712 47,287 6.8% 7.6%
201612 44,296 19.2% 5.3%
201512 37,159 -2.1% 5.3%
201412 37,964 0.2% 10.6%
201312 37,896 18.9%
201212 31,860 13.6%
201112 28,051
Operating Ratio
The operating ratio is used to measure the operational
efficiency of the management.
It shows whether or not the cost component in the sales
figure is within the normal range.
A low operating ratio means a high net profit ratio (i.e.,
more operating profit) and vice versa.
Operating Ratio = Operating Expenses / Net Sales
Trident Group: Operating Expenses
Particulars 202003 201903 201803 201703 201603
Operating Revenue 93.13% 93.49% 92.75% 97.39% 97.51%
Other Operating Revenue 6.87% 6.51% 7.25% 2.61% 2.49%
Total Operating Revenue 100.00% 100.00% 100.00% 100.00% 100.00%
Cost of materials consumed 46.05% 46.50% 49.58% 47.56% 46.94%
Purchase of stock in trade 0.04% 0.46% 0.01% 0.06% 0.40%
Changes in Inventories -0.62% -0.52% 0.25% 0.61% -0.19%
Employee Benefit Expenses 12.45% 11.39% 11.18% 12.53% 11.72%
Finance Costs 2.35% 2.26% 2.59% 3.05% 3.96%
Depreciation 7.06% 6.94% 8.86% 8.92% 9.18%
Other Expenses 24.12% 23.33% 20.31% 20.10% 21.22%
Other Income 0.43% 0.83% 1.36% 2.30% 0.91%
Tax 1.72% 3.40% 2.75% 2.20% 1.07%
EBITDA 8,490 9,890 8,513 8,855 7,297
Sales 47,277 52,486 45,594 46,252 36,657
Gross Margin
Gross margin is a company’s net sales revenue minus its
cost of goods sold (COGS).
In other words, it is the sales revenue a company retains
after incurring the direct costs associated with producing
the goods it sells, and the services it provides.
Gross Margin = (Sales - COGS) / Sales
EBITDA Margin
EBITDA margin helps a company assess its operational
profitability and efficiency, and is calculated by dividing
the company’s earnings before interest, taxes, depreciation
and amortization by total revenue.
EBITDA Margin = EBITDA / Sales.
EBITDA margin is typically used to give investors or

business owners a better idea of the operating profitability
and cash flow of a company.
Trident Group: EBITDA
Quarterly EBITDA Analysis
EBITDA
QUARTER EBITDA EBITDA EBITDA Moving Average
GROWTH
END (₹ million) GROWTH YoY MARGIN EBITDA Margin
QoQ
202012 2,952 105.0% 22.9% 31.9% -3.0%
202009 2,238 -11.2% 19.1% 97.6% -40.8%
202006 1,133 -61.8% 16.0% -22.0% -38.9%
202003 1,452 -43.9% 14.7% 0.8% -10.6%
201912 1,440 -46.4% 12.7% -42.8% 5.3%
201909 2,520 -3.5% 19.1% -14.9%
201906 2,962 51.5% 22.7% 14.4%
201903 2,589 19.4% 18.4% -3.6%

Operating Leverage
Operating leverage measures a company’s fixed costs as a
percentage of its total costs. It is used to evaluate the
breakeven point of a business, as well as the likely profit
levels on sales.
High operating leverage: A large proportion of the company’s
costs are fixed.
In this case, the firm earns a large profit on each incremental
sale but must attain sufficient sales volume to cover its
substantial fixed costs.
If it can do so, then the entity will earn substantial profits on
all sales after it has paid for its fixed costs.
Operating Leverage
Low operating leverage. A large proportion of the
company’s costs are variable, so it only incurs these costs
when there is a sale.
In this case, the firm earns a smaller profit on each
incremental sale but does not have to generate much sales
volume in order to cover its lower fixed costs.
It is easier for this type of company to earn a profit at low
sales levels, but it does not earn outsized profits if it can
generate additional sales.
Degree of Operating Leverage =

% Change in EBIT / % Change in Sales
Trident Group: Operating Leverage
Calculate the 3-year average operating leverage of Trident:
Particulars 202003 201903 201803 201703
EBIT (₹ million) 5,153 6,250 4,472 4,730
% change in EBIT -17.6% 39.8% -5.5%
Sales (₹ million) 47,277 52,486 45,594 46,252
% change in Sales -9.9% 15.1% -1.4%
Operating Leverage 1.77 2.63 3.84
Average 2.74
Particulars (₹ million) 202012 202009 202006 202003 201912 201909 201906 201903
Operating Revenue 12,899 11,714 7,079 9,905 11,304 13,208 13,053 14,054
Other operating revenue 0 0 0 0 0 0 0 0
Total Operating Revenue 12,899 11,714 7,079 9,905 11,304 13,208 13,053 14,054
Cost of materials consumed 5,750 5,397 2,990 4,653 5,002 5,829 6,289 5,985
Purchase of stock in trade 133 69 0 0 0 0 0 79
Changes in Inventories -92 -365 177 -262 166 296 -559 754
Employee Benefit Expenses 1,636 1,471 985 1,399 1,454 1,493 1,486 1,429
Finance Costs 132 123 231 278 234 271 358 343
Depreciation 830 831 824 815 822 849 846 886
Other Expenses 3,091 2,904 1,794 2,663 2,756 3,070 2,877 3,219
Other Income 50 32 54 68 97 70 78 111
Tax 443 313 31 31 61 99 603 545
EBITDA 2,381 2,238 1,133 1,452 1,927 2,520 2,962 2,589
Reported Profit 1,598 1,002 101 396 419 1,371 1,232 926
Common Size
Particulars 202012 202009 202006 202003 201912 201909 201906 201903
Operating Revenue 100.00%100.00%100.00%100.00%100.00%100.00%100.00%100.00%
Other operating revenue 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Total Operating Revenue 100.00%100.00%100.00%100.00%100.00%100.00%100.00%100.00%
Cost of materials consumed 44.57% 46.07% 42.24% 46.98% 44.25% 44.13% 48.18% 42.58%
Purchase of stock in trade 1.03% 0.59% 0.00% 0.00% 0.00% 0.00% 0.00% 0.56%
Changes in Inventories -0.71% -3.12% 2.50% -2.64% 1.47% 2.24% -4.29% 5.37%
Employee Benefit Expenses 12.69% 12.56% 13.92% 14.12% 12.86% 11.31% 11.38% 10.17%
Finance Costs 1.02% 1.05% 3.26% 2.80% 2.07% 2.05% 2.75% 2.44%
Depreciation 6.43% 7.09% 11.64% 8.23% 7.28% 6.43% 6.48% 6.31%
Other Expenses 23.97% 24.79% 25.34% 26.88% 24.38% 23.24% 22.04% 22.90%
Other Income 0.39% 0.27% 0.77% 0.68% 0.86% 0.53% 0.60% 0.79%
Tax 3.43% 2.67% 0.44% 0.31% 0.54% 0.75% 4.62% 3.88%
Degree of Combined Leverage (DCL)
Degree of Combined Leverage (DCL) is a leverage ratio that
captures the combined effect that the Degree of Operating
Leverage (DOL) and the Degree of Financial Leverage have
on Earnings Per Share (EPS), for a given change in sales.
DCL = % change in EPS / % change in Sales.
DCL = Degree of Operating Leverage x Degree of Financial
Leverage.
A firm with a relatively high level of combined leverage is
seen as riskier than a firm with less combined leverage
because high leverage means more fixed costs to the firm.
PAT versus CFO
Cash Flow from Operations (CFO) should be compared to the
profit from operations to show the quality of the profit.
Typically, good companies will generate strong cash flows
equivalent to the profit shown in the income statement.
A good measure is to calculate this ratio based on the
cumulative figure of the last three years CFO to cumulative
figure of the last three years profit. The closer these two are
together, the better the quality of profit. If the profit from
operations is significantly larger than the cash generated from
operations, it shows that the business is not able to turn that
profit into cash, which could lead to problems with short-term
liquidity, over investment in working capital or capex.
Trident Group: PAT
Moving Average
QUARTER END PAT (₹ million) PAT GROWTH YoY PAT MARGIN (%)
Growth
202012 2,526 -43.0% 6.10 0.9%

201912 4,435 33.8% 8.60 20.9%
201812 3,314 6.0% 6.60 36.8%
201712 3,125 6.8% 6.60 23.5%
201612 2,926 37.1% 6.60 532.9%
201512 2,134 97.0% 5.70
201412 1,083 -46.8% 2.90
201312 2,037 2044.2% 5.40
201212 95 -85.8% 0.30
201112 671 2.40
Working Capital
Working Capital represents the amount of money invested
in operating assets.
While there are many items which are part of working
capital computation, for a manufacturing company it is
typically computed as Inventory + Debtors − Creditors.
Here, Debtors and Creditors are from operations and not
from financing.
In this, Inventory + Debtors = Current Assets and Creditors
whether from suppliers or for other operating assets are
part of Current Liabilities.
Working Capital
Working capital is commonly assessed as the number of
days of sales. And the formula for this is:
Working Capital Days = (Inventories + Debtors -
Creditors)/Average Sales x 365
Working capital days are negative means that the company
is funding its day to day operating expenses from supplier
advances and other short term borrowed funds.
Negative Working Capital
Negative Working capital days is a good situation in the
following circumstances:
When the company suppliers are funding the raw
materials used by the company.
When the company’s customers pay in advance for the
products.
Typically, companies like D-Mart, Maruti, etc. have
negative working capital. However, working capital being
negative is bad if the company uses short term funds for
meeting day-to-day operating expenses and in addition the
company has a large amount of loan or if the profitability is
very poor.
Positive Working Capital
Most companies belong to this category where working
capital days are positive. This means that the company is
funding its day to day operating expenses from its own
resources.
Typically, every industry has an operating cycle which is
used as benchmark working capital days. For example, a
consumer product company will have 20-40 days as
working capital days. This can be considered to be good.
A very high working capital days in a consumer product
space can be considered to be a red flag.
Positive Working Capital
Typically, a real estate company tends to have 150-200+
days of working capital.
This is because real estate companies sell large value
products which take a long time to create and sell.
Each industry’s working capital should be viewed in the
context of its peers in the same industry space.
Large working capital days are generally not healthy. Such
companies can have serious liquidity issues.
But this should be viewed in the context of the industry
peers and the overall balance sheet of the firm.
Inventory Turnover
High inventory turnover generally means that goods are
getting sold faster while a low turnover rate indicates weak
sales and excess inventories, which may be challenging for
a business.
Inventory turnover can be compared to historical turnover
ratios, planned ratios, and industry averages to assess
competitiveness and intra-industry performance.
Inventory turns can vary significantly from industry to
industry.
Importance of Inventory Turnover
One way to assess business performance is to know how
fast inventory sells, how effectively it meets the market
demand, and how its sales stack up to other products in its
class category.
Businesses rely on inventory turnover to evaluate product
effectiveness, as this is the business’ primary source of
revenue.
Higher stock turns are favourable because they imply
product marketability and reduced holding costs, such as
rent, utilities, insurance, theft, and other costs of
maintaining goods in inventory.
Trident Group: Working Capital
Particulars 202003 201903 201803
Current Assets
Inventories 9,164 10,121 9,226
Financial Assets
(i) Investments - 669 109
(ii) Trade Receivables 2,754 6,577 4,604
(iii) Cash and Bank balances 3,379 257 1,666

(iv) Other Current Assets including Short
term loans and advances 2,223 2,745 2,701
Total current assets 17,519 20,369 18,305

Current Liabilities (Rs. million)
Particulars 202003 201903 201803
Financial Liabilities
(i) Borrowings 9,009 11,420 11,084
(ii) Trade Payables 2,023 1,866 1,690

Provisions 5,939 4,086
4,930
Total current liabilities 16,970 18,216 16,861

Working Capital
Year No. of days
202003 4.24
201903 14.97
201803 11.56
201703 5.56
201603 (6.41)
201503 (24.65)
201403 (26.09)
201303 (45.25)
201203 (43.16)
201103 (40.53)
Total current assets 17,519 20,369 18,305

Total current liabilities 16,970 18,216 16,861
Working Capital 549 2,153 1,444
Inventories 9,164 10,121 9,226
Sales 47,277 52,486 45,594

Inventory turnover ratio
5.16 5.19 4.94
Trident Group: Financial Insights
SUMMARY OF ANALYSIS
Sr No. Parameters Improving Flat Alarming
(A) SALES
Sales Performance of the Company in the recent
1
quarter
2 Projected Sales of Next Quarter
3 3 Year Sales CAGR (TTM performance)
4 5 Year Sales CAGR (TTM performance)
5 Projected Sales of Next Year
OVERALL SALES PERFORMANCE
(B) OPERATING EXPENSES

1 Interest Coverage Ratio
2 Expense Ratio
OVERALL OPERATING EXPENSES PERFORMANCE
SUMMARY OF ANALYSIS
( C) EBITDA
1 Quarterly EBITDA Growth
2 Quarterly EBITDA Margin
3 Projected EBITDA Growth for the Quarter
4 EBITDA Margin (TTM)
5 3 Year EBITDA CAGR
6 Projected EBITDA Growth for the Year
OVERALL EBITDA PERFORMANCE
(D) PAT and EPS

1 PAT Margin (TTM)
2 PAT Growth (TTM)
3 Quarterly EPS Growth
4 Earning's quality
5 Projected EPS of next year
OVERALL, PAT AND EPS PERFORMANCE
SUMMARY OF ANALYSIS
( E) WORKING CAPITAL
1 Inventory turnover ratio
Working Capital Days of the Company
2
v/s Industry
Working Capital Days v/s Company's
3
average Working Capital Days
4 Working Capital Management
5 Short term solvency
OVERALL PERFORMANCE
(F) CAPEX GROWTH

1 Fixed Assets turnover
OVERALL PERFORMANCE
(G) CASHFLOW
1 Average Operating Cashflows
OVERALL PERFORMANCE
SUMMARY OF ANALYSIS
(H) CAPITAL STRUCTURE
1 Promoter's Contribution
2 Institutional Holding
3 Debt to Equity Ratio
Debt to Equity Ratio v/s Average Debt
4
to Equity Ratio
5 Debt to EBITDA ratio
6 Financial Risk
7 Du Pont Analysis
OVERALL PERFORMANCE
Thus, fundamentally the Company is

Statements (BVFS)
Prof. Vaidya Nathan
Lecture 3 & 4, February 2022
What is Residual Income Model (RIM) and how can it be used to
estimate intrinsic value of a stock?
How to determine if earnings of a corporate is sufficient to meet
its cost of capital?
How to measure internal corporate performance?
Are the diverse approaches to estimate value such as RIM, DDM
and FTE equivalent or different?
Is the integrated financial statement model an estimator or a
predictor?
How to ‘double-click’ on modules such as Revenue and COGS and
‘staple’ those worksheets to the core model?
What is Economic Value Add (EVA) and Market Value Add
(MVA) that Consultants talk about?
All companies show different profits as per Books of Accounts
and as per Income Tax Act. How to model this differential tax?
How to make sure that the balance sheet balances with
Deferred Tax Liabilities (DTL)?
How to precisely calculate the cost of debt (rD)?
Almost all start-ups make losses initially and have Net
Operating Losses (NOL) to shield taxes in future years. How to
forecast cash-flows for valuation of start-ups making losses
which hopefully will make profits eventually?
Residual Income Model
Residual Income a.k.a. Edwards Bell Ohlson (EBO) Model is Net
Income (NI) less an equity capital charge (deduction) for common
shareholders’ opportunity cost in generating net income.
Recent years have seen a resurgence in its use as a valuation
approach, also under such names as economic profit, abnormal
earnings and Economic Value Added®.
Primary uses of Residual Income:
– Measurement of internal corporate performance.
– Estimation of intrinsic value of common stock.
– Our focus on EBO Model would be to find intrinsic value of
common stock and not on corporate performance.
Ohlson, J. A. (1995). "Earnings, Book Values and Dividends in Equity Valuation", Contemporary Accounting Research, 11 (Spring), 1995.
Residual vs. Traditional Accounting Income
Traditional financial statements are prepared to reflect earnings
available to owners.
Net Income includes an expense to represent the cost of debt
capital (interest expense).
Traditional accounting leaves to the owners the determination
as to whether the resulting earnings are sufficient to meet the
cost of equity capital.
The economic concept of Residual Income, on the other hand,
explicitly considers the opportunity cost of equity capital. It can
also be thought of as the hurdle rate for equity.
Example: Residual Income
Dr. Lal Pathlabs has total capital invested of ₹2,000 crores financed 50% with debt and 50% with
equity capital. The cost of debt capital is 10% pre-tax (7.5% after tax) and the cost of equity capital
(hurdle rate or opportunity cost) is 15%. Net income for Dr. Lal can be determined as follows:
EBIT ₹200 crores
Less: Interest Expense ₹100 crores
Pre-Tax Income ₹100 crores
Income Tax Expense ₹25 crores
Net Income ₹75 crores
What is its residual income? One approach is to compute the cost of equity capital in rupee terms,
which is termed as equity capital charge, and subtract this from net income:
Equity Capital Charge = Equity Capital х Cost of Equity Capital
Equity Capital Charge = ₹1,000 crores х 15% = ₹150 crores
Net Income ₹75 crores
Equity Capital Charge ₹150 crores
Residual Income -₹75 crores
– The firm did not earn enough to cover cost of equity capital. So, it has negative Residual Income.
Residual Income Model of valuation
In Residual Income Model (RIM) of valuation, the intrinsic value of the firm has
two components:
The current book value of equity, plus the present value of future residual income.
This can be expressed algebraically as:
∞ ∞
𝑅𝐼𝑡 𝑁𝐼𝑡 − 𝑟𝐸 𝐵𝑡−1
𝐸0 = 𝐵0 + ෍ = 𝐵0 + ෍
(1 + 𝑟𝐸 )𝑡 (1 + 𝑟𝐸 )𝑡
𝑡=1 𝑡=1
In the model,
E0 is the market value of equity,
B0 is the current book value of equity, Bt-1 is the book value of equity at time t-1,
rE is the required rate of return on equity, NIt is the net income during period t,
RIt is the residual income in future periods: RIt = Et – rEBt-1.
Valuing a perpetuity with the RIM
A company will earn ₹100 per share (EPS) forever, and the
company also pays out all of this as dividends, ₹100 per share.
The equity capital invested (book value) is ₹600 per share.
Because the earnings and dividends will offset each other, the
future book value of the stock will always stay at ₹600. The
required rate of return on equity (or the percent cost of equity)
is 10%.
Calculate the value of this stock using the dividend discount
model.
What will be the residual income each year? Calculate the value
of the stock using a residual income valuation model.
Valuing a perpetuity with the RIM
Solution to 1: Since the dividend is a perpetuity,
𝐷𝑖𝑣1
𝐸0 = = ₹100 / 10% = ₹1,000 per share.
𝑟𝐸
Solution to 2: The net income is ₹100 each year, the book value is always ₹600,
and the required return is 10%, so the residual income in every year will be:
RIt = NIt – rEBt-1 = ₹100 – 10%* ₹600
= ₹100 – ₹60 = ₹40.
The value, using a residual income approach, is the current book value plus the
present value of future residual income. The residual income is a perpetuity:
E0 = Book value + PV of Residual income
= ₹600 + (₹40 /10%) = ₹600 + ₹400 = ₹1,000 per share.
RIM valuation versus other DCF models
The stylized example presented above demonstrates that conceptually
valuation is not all that different whether a discounted cash flow
approach or residual income model are used. In simple cases such as
the perpetuity, both DDM and RIM are easily applied. For other
examples, there are two important differences.
Timing of recognition of value: One key advantage to a residual income
model over other DCF models is the timing of the recognition of value.
In other DCF approaches, most of the value is found in the terminal
value computation. The longer the forecast period, the higher the
uncertainty that will exist regarding the terminal value.
Terminal value: In residual income valuation context, the terminal
value is deemed to be zero. Book value today is known while the
terminal value five or ten years hence is a lot more uncertain.
When to use Edwards Bell Ohlson (EBO) Model
Edwards Bell Ohlson (EBO) Model is most appropriate when:
A firm is not paying dividends or if it exhibits an unpredictable
dividend pattern.
A firm has negative free cash flow many years out but is
expected to generate positive cash flow at some point in the
future such as in the case of a young or rapidly growing firm
where capital expenditures are being made to fuel future
growth.
There is a great deal of uncertainty in forecasting terminal
values.
Valuation using RIM
Start with the DDM:
𝐷𝑖𝑣1 𝐷𝑖𝑣2 𝐷𝑖𝑣3

𝐸0 = + 2
+ 3
+⋯
1 + 𝑟𝐸 1 + 𝑟𝐸 1 + 𝑟𝐸
The relationship between earnings, dividends and book value is

given by the clean surplus equation as:
𝐵𝑡 = 𝐵𝑡−1 + 𝑁𝐼𝑡 − 𝐷𝑖𝑣𝑡

This means that:
𝐷𝑖𝑣𝑡 = 𝑁𝐼𝑡 − 𝐵𝑡 − 𝐵𝑡−1 = 𝑁𝐼𝑡 + 𝐵𝑡−1 − 𝐵𝑡

Valuation using RIM
Substituting this into the DDM:
𝑁𝐼1 + 𝐵0 − 𝐵1 𝑁𝐼2 + 𝐵1 − 𝐵2 𝑁𝐼3 + 𝐵2 − 𝐵3

𝐸0 = + 2
+ 3
+⋯
1 + 𝑟𝐸 1 + 𝑟𝐸 1 + 𝑟𝐸
This equation can be simplified as:
∞ ∞
𝑁𝐼𝑡 − 𝑟𝐸 𝐵𝑡−1 (𝑅𝑜𝐸𝑡 − 𝑟𝐸 ) × 𝐵𝑡−1
𝐸0 = 𝐵0 + ෍ 𝑡
= 𝐵0 + ෍
1 + 𝑟𝐸 1 + 𝑟𝐸 𝑡
𝑡=1 𝑡=1
This can also be expressed as:
∞
𝑅𝐼𝑡
𝐸0 = 𝐵0 + ෍ 𝑡
1 + 𝑟𝐸
𝑡=1
since 𝑅𝐼𝑡 = 𝑅𝑜𝐸𝑡 − 𝑟𝐸 𝐵𝑡−1

Constant growth residual income model
A firm’s intrinsic value under a residual income model can be
expressed as:
𝑅𝑜𝐸 − 𝑟𝐸 𝑅𝑜𝐸 − 𝑔
𝐸0 = 𝐵0 + 𝐵0 = 𝐵0
𝑟𝐸 − 𝑔 𝑟𝐸 − 𝑔
The first term, B0, reflects the book value of equity i.e., book value
of assets owned by the firm less its liabilities.
The second term
𝑅𝑜𝐸 − 𝑟𝐸
𝐵0
𝑟𝐸 − 𝑔
represents additional value that is expected due to the firm’s
ability to generate returns in excess of its cost of equity. The
second term represents the value of the firm’s economic profits.
If a firm earns exactly the cost of equity, the market value of
equity should equal the book value of equity.
Residual Income, DDM, and FTE models
Residual Income Model (RIM), Dividend Discount Model (DDM), and
Flow to Equity (FTE) models are all theoretically similar.
The difference is that DDM and FTE models forecast future cash flows
and find the value of stock by discounting them back to the present
using the required return on equity.
RIM approaches this process differently. It starts with a beginning
value, the book value or investment in equity, and then makes
adjustments to this value by adding the present values of future
residual income (which can be positive or negative).
The recognition of value is different, but total present value of these
values (whether future dividends, future free cash flow, or book value
plus future residual income) is logically consistent.
Residual Income and Balance Sheet Model
Sales less COGS,

NOPAT
SG&A, R&D, Taxes
Earnings
Net Financial Financial Income less
Expense (NFE) Financial Expense
Return on Equity
(RoE)
Net Operating Assets Operating Assets less
(NOA) Operating Liabilities
Equity
Net Financial Cash plus
Obligations (NFO) Investments less Debt
Residual Income and Balance Sheet Model
Operating Profit
Margin: NOPAT/Sales
Return on Net
Operating Assets
(RoNOA)
Net Operating asset
turnover: Sales/NOA
Return on Equity
(RoE)
Leverage: NFO/Equity
Leverage Effect
Spread: RoNOA –
(NFE/NFO)
Modular Approach
If the valuation process has a story, think of the story being told
in “chapters”—in separate distinct modules.
In this modular approach, the modules of our model perform
discrete operations within them; each module’s results are read
by the next module, and so on.
This makes it easy to put a model together and audit and check
it later.
It makes changes easier to implement, since we can work
within the modules and not have to roam over the whole model
to change formulas.
An Estimator not a Predictor
Integrated financial statements projections is not a crystal ball and its
output does not dictate what the future will be.
It is a model to estimate what a company’s future financial profile might
be, given certain assumptions about its future performance.
Its main utility is to test what needs to happen for the performance goals
to be achieved. For example, a chief financial officer may say, “Our
intrinsic valuation is ₹5,000 crores” or “We will accumulate enough
cash reserves in the next three years to retire ₹1,000 crores of our debt.”
How can we test the validity of such valuation claims?
One way is to use analytical financial statements and use reasonable
assumptions of company’s financial performance and check if we can
arrive at such conclusions. Alternatively, we can also evaluate what
needs to happen for those performance goals to be achieved.
Forecasting Guidelines
Key Principles of financial forecasting:
Good forecasts must be consistent with historical performance
and the current economic and industry outlook.
All forecasts are estimates and approximations. So, we should
spend maximum time thinking and developing our ideas about
the big picture that affects valuation and not the trivial details.
Avoid “hockey stick” projections. They happen when historical
trends show modest growth rates, but once the forecast begins,
the rates grow at a much steeper rate, looking like a hockey stick.
If the forecasts look too good to be true, they probably are…
in which case, re-examine assumptions.
Analytical Workhorse: Flexibility
Apart from checking validity of claims (from hyperbolic CFOs!),
an integrated financial statements model is meant to be used as
an analytical workhorse.
One good way to extend the reach of an analytical financial
statements model is to enable additional sheets to the modelling
engine and ‘staple’ them to the core model.
The sheets can be added to the back of the model in the sense of
the inputs, so that they can be made more granular.
The sheets can also be added to the front of the model to
organize and supplement the output that the model is capable of
producing on its own.
‘Double-clicking’ on Modules
The core model should have only the ‘Bare Necessities’—details
that are absolutely required.
So, what to do if we need to have additional details on revenues,
COGS, depreciation, taxes, etc.
This approach of ‘double-clicking’ on modules or adding
scratchpad sheets becomes useful then.
On the new sheet, we can lay out the detailed assumptions and
drivers for each of the line items. We can then simply ‘staple’ i.e.,
reference the worksheet back to the standard model.
This approach of ‘stapling’ worksheets can be similarly repeated
for all the inputs in the analytical financial forecasting template.
‘Stapling’ Scratchpad Sheets: Revenues
Revenues are the result of three main components: price, industry growth,
and market share.
Isolating the price growth from inflation will give us the measure for
volume growth. We need to understand that in the context of the economic
cycle (such as during a pandemic), and then concentrate on what the
drivers for future industry growth and market share might be.
We need to add back the inflation component (typically 2%–6% in the
Indian context) to get the full estimate of future revenues growth.
Think drivers, drivers, drivers. To forecast revenues, for example, it is
useful to break down the components that drive the revenues, and in turn
to analyze what are the drivers behind those drivers.
Except new industries, most businesses that are mature on average would
grow at around the nominal growth of the economy (real GDP growth rate
plus inflation).
‘Stapling’ Scratchpad Sheets: Margins
Analyze the trends in the historical accounts, such as cost of
goods sold as percentage of sales or SGA (sales, general &
administrative) as percentage of sales.
Our forecasts should be consistent with these trends, while
bearing in mind what we know of any improvements or
changes in the company’s operating systems.
If there have been striking changes in the margins, we
should understand the reason.
Look at the trends in the context of the economic and
product cycles. This way the forecast can capture the market
dynamics. Mostly not required for companies with stable
historical data. A must for companies otherwise.
‘Stapling’ Scratchpad Sheets: Depreciation
Although it can be convenient to forecast depreciation as a percentage of
revenue, the relationship to revenue is indirect.
Depreciation is determined by Net PPE (Plant, Property, and Equipment), which
in turn is affected by Capital Expenditure (Capex).
Capex typically varies with revenues.
If some precision is required, the best way to forecast depreciation is to lay out
the depreciation that is associated with each year’s new capital investments.
This creates a “depreciation triangle.” The longer the forecast period, the
“deeper” the triangle would be.
That being said, it is generally acceptable to use the recent relationship
between depreciation and the net PPE of the prior year.
Depreciation for tax purposes and for book purposes are almost always
different. This leads to the creation of Deferred Taxes.
‘Stapling’ Scratchpad Sheets: DTL
Deferred Tax Liability (DTL) is a Provision for Future Taxation
and arises due to the difference between Profit as per Books of
Accounts (P&L Account) and profit as per Income Tax Act.
DTL occurs usually because of different book-basis and tax-
basis depreciation schedules that the company has adopted.
Additionally, it can get extended if there is NOL.
As valuation is done with a long horizon, DTL becomes zero
eventually.
Change in DTL is therefore set to zero in normalized cash flow
for calculating Terminal Value (Kaplan and Ruback method).
‘Stapling’ Scratchpad Sheets: NOL
According to Indian Income tax laws, a Net Operating Loss
(NOL) is a loss arising in a period when tax-deductible expenses
exceed taxable revenues.
This loss can be carried forward in future to set off future profits
allowing corporates to pay lesser tax then required.
Net operating loss can be a blessing in disguise.
But forecasting tax liability because of NOL can get tricky.
NOL is an important component for valuation of start-ups who
may now be poised for an IPO as they mostly would have made
losses in the initial years.
Net Operating Loss or NOL: US
In the US, the regulatory provisions allow for the carrybacks of
net operating losses.
Net operating losses can be carried back two years and can be
carried forward twenty years for set off against the income in
past and future periods, respectively.
Beyond and after two and twenty years, any remaining net
operating losses pending set off expires.
Net Operating Loss or NOL: India
According to Indian Income tax laws, unabsorbed business
losses can be carried forward and set off against the business
profits of any business for a maximum of eight years.
Losses from “speculation business” (as defined in the law) can
be set off only against income from “speculation businesses” for
a maximum of four years.
Losses are not allowed to be carried forward unless the return
of income is filed in time. Unlisted companies could lose the
right to carry forward the business loss if there is a substantial
change in shareholding.
Capital losses may also be carried forward for eight years. Carry
back of losses in not permitted in India.
‘Stapling’ Scratchpad Sheets: Operating Leases
Operating leases: A company that chooses to lease its assets will
have artificially high capital productivity because the assets do
not appear on the lessee’s balance sheet.
The value of leased assets via operating leases does not appear
on the balance sheet, either as an operating asset or as a debt.
Therefore, operating assets and debt are understated.
This causes capital turns (revenue to capital) to be distorted
upward and debt to EBITDA to be distorted downward versus
peers.
While getting cash flows for valuation, we should try to
recapitalize operating leases in debt to have a more accurate
picture of liabilities.
LIFO Reserve
The LIFO reserve measures the difference between FIFO and
LIFO cost of inventory.
The LIFO reserve is an account used to bridge the gap between
FIFO and LIFO costs, when a company uses the FIFO method to
track its inventory but reports under the LIFO method in the
preparation of its financial statements.
In periods of rising prices, constant increases in costs can create
a credit balance in the LIFO reserve, which results in reduced
inventory costs when reported on the balance sheet.
EVA is like Residual Income but for entire capital
Residual Income represents income after deducting equity cost while EVA of the firm
is calculated after deducting cost of all capital: debt plus equity.
The term Economic Value Add is used because over the long term the firm is expected
to earn its cost of capital (from all sources). So, any earnings in excess of the cost of
capital is termed as Economic Value Add.
One example of several competing commercial implementations is trademarked by

Stern Stewart & Company.
EVA® is computed as
EVA = NOPAT – 𝑟𝑊𝐴𝐶𝐶 ∗ 𝑇𝐴𝐶
NOPAT is the firm’s Net Operating Profit After Taxes,
𝑟𝑊𝐴𝐶𝐶 is the Weighted Average Cost of Capital and
TAC is Total Adjusted Capital.

EVA and MVA—the Stern Stewart Model
Market
Premium
Value Added
Enterprise
Value
(market Debt &
value) Equity Book Value
capital of Equity and
Debt Capital
EVA and MVA—the Stern Stewart Model
MVA = Present value of all future EVAs Expected

improvement
in EVA
MVA
Enterprise
Value
(market Current level
Debt &
value) of EVA
Equity
Capital
EVA & Market Value
Market value of a company reflects:
Value of invested capital
Value of ongoing operations
Present value of expected future economic value-adds
Captures improvement in operating performance
EVA related to market value by:
Measuring all the capital
Seeing what the firm is going to do with the capital
Turn FCF forecasts into EVA forecasts
Discount EVA
Components of Economic Value Add
NOPAT or NOPLAT (Net Operating Profit Less Adjusted Taxes)
▪ EBIT(1-t): EBIT after adjustments times (1− effective tax rate)
Total Adjusted Capital (TAC)
▪ Total Debt plus Equity capital with suitable adjustments
Cost of Capital:
▪ Weighted Average Cost of Capital
Total Capital Charge
▪ Cost of Capital * Total Adjusted Capital
Economic Value Added
▪ NOPAT less Total Capital Charge.
Calculating Economic Value Add
Return on invested operating capital (ROIC) = NOPAT/TAC
Spread = ROIC − Weight Average Cost of Capital (𝑟𝑊𝐴𝐶𝐶 )
Economic value added (EVA) = (ROIC − 𝑟𝑊𝐴𝐶𝐶 ) * TAC
In other words,
Economic value added (EVA) =
Net operating profit after tax (NOPAT)
− Total Capital charge (or 𝒓𝑾𝑨𝑪𝑪 * TAC)
EVA and ROIC
𝑁𝑂𝑃𝐴𝑇1
𝑅𝑂𝐼𝐶1 =
𝐵𝑉0
𝐹𝐶𝐹𝐹1
𝑉0 =
𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹𝐹
𝑉0 = 𝐵𝑉0 + 𝑃𝑅0
𝐹𝐶𝐹𝐹1 = 𝑁𝑂𝑃𝐴𝑇1 − ∆𝐴1
𝑃𝑅0 ∆𝐴1
𝑅𝑂𝐼𝐶1 = 1 + 𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹𝐹 +
𝐵𝑉0 𝐵𝑉0
∆𝐴1 𝐵𝑉1 − 𝐵𝑉0
= = 𝑔𝐵𝑉
𝐵𝑉0 𝐵𝑉0
𝑔𝐹𝐶𝐹𝐹 = 𝑔𝐵𝑉 = 𝑔
𝑃𝑅0
𝑅𝑂𝐼𝐶1 = 𝑟𝑊𝐴𝐶𝐶 + 𝑟𝑊𝐴𝐶𝐶 − 𝑔
𝐵𝑉0
EVA and FCFF Valuation
∞
𝐹𝐶𝐹𝐹𝑡
𝑉0 = ෍ 𝑡
1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1
𝐹𝐶𝐹𝐹𝑡 = 𝑁𝑂𝑃𝐴𝑇𝑡 − ∆𝐴𝑡
𝑁𝑂𝑃𝐴𝑇𝑡 = 𝑅𝑂𝐼𝐶𝑡 ∗ 𝐵𝑉𝑡−1

∞
𝑅𝑂𝐼𝐶𝑡 ∗ 𝐵𝑉𝑡−1 − ∆𝐴𝑡
𝑉0 = ෍
1 + 𝑟𝑊𝐴𝐶𝐶 𝑡
𝑡=1
∞ ∞
𝑅𝑂𝐼𝐶𝑡 ∗ 𝐵𝑉𝑡−1 ∆𝐴𝑡
𝑉0 = ෍ 𝑡
−෍ 𝑡
1 + 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1 𝑡=1
EVA
∞
and MVA ∞ ∞
∆𝐴𝑡 𝐵𝑉𝑡 − 𝐵𝑉𝑡−1 𝑟𝑊𝐴𝐶𝐶 ∗ 𝐵𝑉𝑡−1
෍ 𝑡
=෍ 𝑡
=෍ 𝑡
− 𝐵𝑉0
1 + 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1 𝑡=1 𝑡=1
∞ ∞
𝑅𝑂𝐼𝐶𝑡 ∗ 𝐵𝑉𝑡−1 𝑟𝑊𝐴𝐶𝐶 ∗ 𝐵𝑉𝑡−1
𝑉0 = ෍ 𝑡
−෍ 𝑡
+ 𝐵𝑉0
1 + 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1 𝑡=1
∞
𝑅𝑂𝐼𝐶𝑡 − 𝑟𝑊𝐴𝐶𝐶 ∗ 𝐵𝑉𝑡−1
𝑉0 = 𝐵𝑉0 + ෍
1 + 𝑟𝑊𝐴𝐶𝐶 𝑡
𝑡=1
𝐸𝑉𝐴𝑡 = 𝑅𝑂𝐼𝐶𝑡 − 𝑟𝑊𝐴𝐶𝐶 ∗ 𝐵𝑉𝑡−1

∞
𝐸𝑉𝐴𝑡
𝑉0 = 𝐵𝑉0 + ෍ 𝑡
= 𝐵𝑉0 + 𝑀𝑉𝐴0
𝑡=1
MVA, EVA
∞
and EVA Differences
𝐸𝑉𝐴𝑡 𝐸𝑉𝐴1 𝐸𝑉𝐴2
𝑀𝑉𝐴0 = ෍ 𝑡
= 1
+ 2
+⋯
𝑡=1
∞ ∞
𝐸𝑉𝐴𝑡 𝐸𝑉𝐴0 𝐸𝑉𝐴𝑡 − 𝐸𝑉𝐴𝑡−1
= +෍ 𝑡
1 + 𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1 𝑡=1
𝐸𝑉𝐴𝑡 = 𝐸𝑉𝐴𝑡−1 + 𝐸𝑉𝐴𝑡 − 𝐸𝑉𝐴𝑡−1 = 𝐸𝑉𝐴𝑡−1 + ∆𝐸𝑉𝐴𝑡

∞ ∞
𝐸𝑉𝐴𝑡 𝐸𝑉𝐴0 ∆𝐸𝑉𝐴𝑡
= +෍ 𝑡
1 + 𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1 𝑡=1
∞
𝐸𝑉𝐴0 ∆𝐸𝑉𝐴𝑡
𝑉0 = 𝐵𝑉0 + 𝑀𝑉𝐴0 = 𝐵𝑉0 + +෍ 𝑡
𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶
𝑡=1
EVA & Market Value
Market value is based on establishing the economic investment
made in the company (capital), making a best guess about what
economic profits (EVA) will happen in the future, and discounting
those EVAs to the present to get market value added.
EVA EVA EVA
Year 1 Year 2 ... Year n ...
MVA 𝐸𝑉𝐴1 𝐸𝑉𝐴2 𝐸𝑉𝐴𝑛

Market 𝑀𝑉𝐴0 = + + ⋯+
Value of 1 + 𝑟𝑊𝐴𝐶𝐶 1 + 𝑟𝑊𝐴𝐶𝐶 2 1 + 𝑟𝑊𝐴𝐶𝐶 𝑛
Equity Book
and = Value of
Debt Equity &
Capital Debt
Capital
EVA drives MVA
Companies that consistently earn profits in excess of their required return...
EVA
NOPAT Capital
Charge
… are typically valued at premiums to book value.
Market MVA
Value of
Book Value
E+D
of E + D
Fundamental Strategies
NOPAT
EVA = − Cost of Capital ∗ TAC
TAC
Operate: Improve the Decrease: WACC

return on existing
operating capital Build: Invest as long as returns
exceed the cost of capital
Harvest: Re-deploy capital when returns

fail to achieve the cost of capital.
EVA: Creating and Destroying Value
ROIC - 𝑟𝑊𝐴𝐶𝐶
EVA Spread:
Create value
𝑟𝑊𝐴𝐶𝐶
Destroy value
EVA Components Sales
₹ 133.10
Contribution -
₹ 72.48
Variable Cost of
Pre-tax NOPAT
- Goods Sold
₹ 49.15 ₹ 60.62
NOPAT x Overhead
₹ 36.78 ₹ 23.33
(1-Rate of
NOPAT Margin
Income Tax)
:
27.63% 74.83%
RoNOA Sales
x
20.27% ₹ 133.10 Fixed Assets
Total Net Asset
NOPAT Assets ₹ 128.28
x Turnover :
₹ 36.78 73.36% ₹ 163.89 +
EVA Net Assets Net Assets
- -
₹ 4.83 ₹ 181.42 ₹ 181.42 Current Assets
Interest Free
Capital Cost ₹ 35.61
x Liabilities
₹ 31.95 ₹ 9.86
WACC
17.61%
Key Take-aways
We saw how to ‘double-click’ on modules such as in-depth
revenue and cost forecasts and ‘staple’ them to the analytical
financial statements template,
We understood how to account for differential tax reporting
that happens due to different profits being reported as per
Books of Accounts and as per Income Tax Act.
We saw how to make the balance sheet balance with Deferred
Tax Liabilities (DTL).
We learnt to precisely estimate the cost of debt (rD)?
We learnt to forecast Net Operating Losses (NOL) used to
shield future taxes for valuation of start-ups making losses.
Key Take-aways
We learnt that an integrated financial statement model is an
estimator and not a predictor.
We understood the concept of Residual Income that can be
used to both measure internal corporate performance and to
estimate intrinsic value of a stock.
We learnt to determine if earnings of a corporate is sufficient
to meet the cost of capital.
We learnt that RIM, DDM and FTE are different approaches to
estimate value but are all equivalent.
We learn the concept of EVA and MVA for valuation.
Statements (BVFS)
Prof. Vaidya Nathan
1 2
Story of Mr. Value Stock Mr. Value Trap

Five Friends
Mr. Growth Stock Mr. Good Business
3 4
Mr. Great Business
5
Mr. No Growth aka Mr. Value Stock
Particulars Year 0 Year 1 Year 2 Year 3 Year 4
Sales ₹100 ₹100 ₹100 ₹100 ₹100
COGS ₹60 ₹60 ₹60 ₹60 ₹60
Gross Profit ₹40 ₹40 ₹40 ₹40 ₹40
Gross Profit Margin 40.0% 40.0% 40.0% 40.0% 40.0%
Opex ₹30 ₹30 ₹30 ₹30 ₹30
EBIT ₹10 ₹10 ₹10 ₹10 ₹10
EBIT Margin 10.0% 10.0% 10.0% 10.0% 10.0%
Revenue Growth 0% 0% 0% 0%
EBIT Growth 0% 0% 0% 0%
EV ₹100
EV/EBIT 10 10 10 10 10
Mr. Value Trap: No Growth + Cost Increase
Sales ₹100 ₹100 ₹100 ₹100 ₹100
COGS ₹60 ₹61.2 ₹62.4 ₹63.7 ₹64.9
Gross Profit ₹40 ₹38.8 ₹37.6 ₹36.3 ₹35.1
Opex ₹30 ₹30.6 ₹31.2 ₹31.8 ₹32.5
EBIT ₹10 ₹8.2 ₹6.4 ₹4.5 ₹2.6
EBIT Margin 10.0% 8.2% 6.4% 4.5% 2.6%
EBIT Growth -18% -22% -29% -43%
EV ₹100
EV/EBIT 10 12.2 15.7 22.3 38.7
Mr. Growth Business a.k.a. Mr. Growth Stock
Sales ₹100 ₹105 ₹110.3 ₹115.8 ₹121.6
COGS ₹60 ₹63 ₹66.2 ₹69.5 ₹72.9
Gross Profit ₹40 ₹42 ₹44.1 ₹46.3 ₹48.6
Opex ₹30 ₹31.5 ₹33.1 ₹34.7 ₹36.5
EBIT ₹10 ₹10.5 ₹11 ₹11.6 ₹12.2
EBIT Margin 10.0% 10.0% 10.0% 10.0% 10.0%
EBIT Growth 5% 5% 5% 5%
EV ₹100
EV/EBIT 10 9.5 9.1 8.6 8.2
Mr. Good Business: Growth, Operating Leverage
Sales ₹100 ₹105 ₹110.3 ₹115.8 ₹121.6
COGS ₹60 ₹63 ₹66.2 ₹69.5 ₹72.9
Gross Profit ₹40 ₹42 ₹44.1 ₹46.3 ₹48.6
Opex ₹30 ₹30 ₹30 ₹30 ₹30
EBIT ₹10 ₹12 ₹14.1 ₹16.3 ₹18.6
EBIT Margin 10.0% 11.4% 12.8% 14.1% 15.3%
EBIT Growth 20% 18% 16% 14%
EV ₹100
EV/EBIT 10 8.3 7.1 6.1 5.4
Mr. Great Business: Growth & Pricing Power
Sales ₹100 ₹105 ₹110.3 ₹115.8 ₹121.6
COGS ₹60 ₹60 ₹60 ₹60 ₹60
Gross Profit ₹40 ₹45 ₹50.3 ₹55.8 ₹61.6
Opex ₹30 ₹30 ₹30 ₹30 ₹30
EBIT 10 15 20.3 25.8 31.6
EBIT Margin 10.0% 14.3% 18.4% 22.3% 26.0%
EBIT Growth 50% 35% 27% 22%
EV ₹100
EV/EBIT 10 6.7 4.9 3.9 3.2
An incredible dispersion of Earnings
40
35
Mr. Great Business
30
Mr. Good Business
25 Mr. Growth Business

Mr. No Growth
20 Mr. Value Trap
15
10
-
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Statements (BVFS)
Prof. Vaidya Nathan
How to estimate beta?
How to estimate the confidence level around beta?
How to know if CAPM is a good enough model to use for cost of equity
estimation?
How to calculate risk-free rate in India?
Which index to use in India for market return?
How do Equity Researcher’s game beta?
How to un-lever/re-lever beta when debt is constant?
How to un-lever/re-lever beta when D/E is constant?
Does beta change with operating leverage?
How to calculate the change in beta of a firm with change in operating leverage?
Beta
Beta provides a method to estimate an asset’s systematic risk.
Beta is the coefficient of excess market return when regressed by excess return of the
stock. When the risk-free rate is constant, it equals the covariance between expected
returns on the asset and on the stock market, divided by the variance of expected
returns on the stock market.
A company whose equity has a beta of 1.0 is “as risky” as the overall stock market and
should therefore be expected to provide returns to investors that rise and fall as fast as
the stock market; a company with an equity beta of 2.0 should see returns on its
equity rise twice as fast or drop twice as fast as the overall market.
The beta determines how much of the market risk premium will be added to the risk-
free rate.
Like the cost of capital, the beta is an expected value as well.
Although the CAPM analysis, including the use of beta, is the overwhelming favourite
for DCF analysis, other capital asset pricing models exist, such as multi-factor models
like the Arbitrage Pricing Theory.
Using the capital asset pricing model
The yield-to-maturity on the longest maturity risk-free rate available (30-year
G-Sec) is generally used to approximate the risk-free rate.
– Long-term cost of debt is used, because the cost of capital is normally
applied to long-term cash flows.
– Obtain from Bloomberg or a similar source.
Projected betas can be obtained from Barra or an online database.
– Bloomberg betas are of two kinds—raw beta and adjusted beta. The
adjusted beta is Bloomberg’s way of estimating the long-run beta of a
company.
– Impute unlevered beta for private company from public comparables.
The market risk premium 𝑟𝑚 − 𝑟𝑓 i.e., the spread of market return over the
risk-free rate is periodically estimated based on analysis of historical data.
Estimating cost of equity
A full development of the CAPM was done in CFIN-I and so is omitted here.
There are, however, a couple of econometric issues in CAPM that need a revisit
from a valuation perspective: 𝑟𝑖 − 𝑟𝑓 = 𝛼𝑖 + 𝛽𝑖 𝑟𝑚 − 𝑟𝑓 + 𝜖𝑖
where 𝑟𝑖 , 𝑟𝑓 , and 𝑟𝑚 are returns to security i, the risk-free asset and the market
return, respectively. Also, 𝛼𝑖 is an intercept term, and 𝜖𝑖 is an i.i.d. stochastic
error term with mean zero.
The CAPM relates the sensitivity of an individual company’s stock returns to
the returns of the market as a whole. Estimating a model for a particular firm
requires data on the market rate of return (typically an index such as the
SENSEX), the risk-free rate of return (usually 30-year G-Sec), and stock
returns from the company of interest (Infosys).
The data for our example consists of daily observations from 3 January 2000
through 16 February 2022 on the market return, the risk-free rate, and the
return on Infosys stock.
Risk-free Security: G-Sec
Determining the risk-free rate:
The yield on Government of India Securities (G-Sec).
Most practitioners use 30-year G-Sec; currently at 7.11%.
Don’t use traded
returns of risk-free
security because that
has risk and is not
risk-free.
Use long-term
investment (buy and
hold) returns of G-Sec.
Robustness of CAPM
The output provides information about the appropriateness of CAPM for a
given stock.
The parameter estimate for intercept is usually not significantly different
from zero.
The estimate for beta should ideally be highly significant. This is because
and, not altogether unexpectedly, the market risk premium is a factor in the
risk premium for stocks such as Infosys.
R-square measures the proportion of the total variation of stock’s risk
premium (Y) explained by the regression of Y on the independent variable
(X), the market risk premium.
An R2 value of say, 0.34 means that about 34% of the variation in the risk
premium of Infosys stock can be explained by the risk premium of market.
Or, put another way, 66% of risk premium of Infosys stock is firm specific.
Daily Excess Returns of Infosys & Sensex
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
Jan 2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan 2012 Jan 2014 Jan 2016 Jan 2018 Jan 2020 Jan 2022
-2.00%
-4.00%
-6.00%
-8.00%
-10.00%
R_i - R_f R_m - R_f
CAPM: Regression Statistics
Regression Statistics
Multiple R 0.585045
R Square 0.342277
Adjusted R Square 0.342154
Standard Error 0.019264
Observations 5349
ANOVA
df SS MS F Significance F
Regression 1 1.032624 1.032624 2782.567 0
Residual 5347 1.984297 0.000371
Total 5348 3.016921
Coefficients Standard Error t-stat P-value Lower 95% Upper 95%

Intercept 0.000246 0.000263 0.932393 0.351175 -0.00027 0.000762
R_m - R_f 0.948581 0.017983 52.75004 0 0.913328 0.983834
Using CAPM
Using the data from for January 2000 – February 2022 and
applying the CAPM equation, the estimated beta of 0.9485
implies an equity cost of capital of:
𝐸 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝐸 𝑟𝑚 − 𝑟𝑓
= 10% + 0.9485 ∗ 10% = 19.485%
But our estimate of beta is uncertain, and the 95% confidence
interval for Infosys’ beta of 0.9133 and 0.9838 gives a range of
Infosys’ cost of capital from
10% + 0.9133 ∗ 10% = 19.133%
to
10% + 0.9838 ∗ 10% = 19.838%
Beta is both financial risk & business risk
The measure of risk that we obtain in the real world for
companies is 𝛽𝐸 (levered beta) which contains both historical
financial risk and systematic business risk.
If the firm changes its financial mix in future, risk of the firm
would change and hence beta would change.
Business Financial Levered

Risk Risk Beta
Un-levering Beta: Removing financial risk
The way we go about calculating the new beta for a
new financing mix is to first remove the financial risk
(in which case, beta represents only business risk).
This process of removal of financial risk is called
un-levering of beta.
Un-
Business
Levered
Risk
Beta
Re-levering: Adding back financial risk
We then calculate the equity cost of capital of the firm
with the new financing mix by adding back financial risk
(which depends on the mix of debt and equity capital).
This process of adding back new financial risk (with new
Debt + Equity combination) is called re-levering of beta.
New Re-
Business
Financing Levered
Risk
Mix Beta
Beta Un-levering
When we un-lever the firm, firm value decreases because we
lose interest tax shields.
Assume a firm with EBIT of ₹100 is being financed using ₹200
of debt and ₹200 of equity. Cost of debt is 10%.
Levered Firm Unlevered Firm
Operating Profit (EBIT) ₹100 ₹100
Interest on debt ₹20 ₹0
Profit before Tax (PBT) ₹80 ₹100
Tax @ 25% ₹20 ₹25
Profit after Tax (PAT) ₹60 ₹75
Return on Equity (RoE) More Less
Interest Tax Shields (ITS)
When a company makes money (operating profit), three
entities make money—Debt holders (Interest), Government
(Taxes) and Equity holders (PAT).
When the firm’s financial risk is removed i.e., it becomes
an all-equity company, the firm ends up paying more taxes
to the government.
In the previous example, the same firm when it is
unlevered starts paying ₹5 more taxes.
So, interest payment to debt holders shields the firm
against taxes. This is called Interest Tax Shield (ITS).
Interest Tax Shields (ITS)
When we un-lever the firm, we do not just lose one year’s
interest tax shield. We actually lose ITS continuously in
perpetuity because a corporation, theoretically, has infinite life.
In the previous example, the same firm when it is unlevered,
loses in present value terms ₹50 (assuming discount rate of ITS
is 10% and that debt remains constant in perpetuity).
The present value of ITS is denoted by 𝑆.
The value of a levered firm 𝐴 = 𝐸 + 𝐷 is the value of an
unlevered firm 𝑈 plus the present value of its ITS 𝑆 :
𝐴 =𝑈+𝑆 =𝐸+𝐷
⇒ 𝑈 =𝐸+𝐷−𝑆
Beta Un-levering
Systematic risk within a firm is conserved:
𝐴𝛽𝐴 = 𝑈𝛽𝑈 + 𝑆𝛽𝑆 = 𝐸𝛽𝐸 + 𝐷𝛽𝐷
The above equation gives us a general relationship between 𝛽𝐸 ,
𝛽𝑈 , 𝛽𝐷 , and 𝛽𝑆 for any arbitrary debt policy.
The present value and risk of ITS 𝑆 depends on the assumption
we make about debt of the firm going forward.
There are two assumptions that are commonly made for the
financing of a firm—either rupee amount of debt is constant, or
the proportion of debt is constant.
Un-levering: Constant amount of Debt
We will now see how to obtain unlevered beta—business
risk of a firm if it has a constant rupee amount of debt.
If there is a constant rupee amount of debt 𝐷 , constant
interest rate 𝑟𝐷 , and constant effective tax rate 𝜏 , the
interest tax shield each year is a constant and is known
in advance every year (in expectation), forever.
So, we can calculate the present value of ITS 𝑆 using
the perpetuity formula.
The risk of ITS 𝑆 is the same as that of debt of the firm
i.e., 𝛽𝑆 = 𝛽𝐷 .
This is because, the chance (risk) of not benefitting from
the interest tax shield in any given year is captured by
the cost of debt.
If the firm defaults on its debt, the debt ceases to exist, in
which case, the interest tax shield also is gone.
So, we can get the present value of interest tax shields by
discounting future interest tax shields at the cost of debt
capital 𝑟𝐷 .
Each year, the firm pays interest of 𝑟𝐷 𝐷.
In our example, interest of 𝑟𝐷 𝐷 is ₹20 = 10%* ₹200.
The interest tax shield each year is 𝑟𝐷 𝐷𝜏.
In our example, interest tax shield each year is
₹5 = 25%* ₹20 and its present value 𝑆 is ₹50 assuming
₹200 of debt remains constant in perpetuity.
In general, the present value of Interest Tax Shield (ITS)
is each year’s ITS in perpetuity discounted at 𝑟𝐷 .
∞
𝐼𝑇𝑆 𝑟𝐷 𝐷𝜏
𝑆=෍ 𝑡
= = 𝐷𝜏
1 + 𝑟𝐷 𝑟𝐷
𝑡=1
If we assume constant amount of debt going forward, the
unlevered firm value 𝑈 is:
𝑈 = 𝐸 + 𝐷 − 𝑆 = 𝐸 + 𝐷 − 𝐷𝜏 = 𝐸 + 𝐷 1 − 𝜏
In our example, 𝐴 is ₹400, 𝐸 is ₹200, 𝐷 is ₹200 and 𝑈 is
₹350 because when we un-lever the firm, we lose ₹50 in
PV to the government in taxes (i.e., present value of ITS).
The equation for conservation of systematic risk is:
𝑈𝛽𝑈 = 𝐸𝛽𝐸 + 𝐷𝛽𝐷 − 𝑆𝛽𝑆
⇒ 𝐸 + 𝐷 1 − 𝜏 𝛽𝑈 = 𝐸𝛽𝐸 + 𝐷𝛽𝐷 1 − 𝜏
𝐸 𝐷 1−𝜏
⇒ 𝛽𝑈 = 𝛽𝐸 + 𝛽𝐷
𝐸+𝐷 1−𝜏 𝐸+𝐷 1−𝜏
Hamada Equation
If we assume 𝛽𝐷 = 0, we get the below equation (called
the Hamada equation) that is used to un-lever betas
when the absolute rupee amount of Debt is constant:
1
𝛽𝑈 = 𝛽𝐸
𝐷
1+ 1−𝜏
𝐸
Hamada equation to re-lever betas when the absolute
rupee amount of Debt is constant:
𝐷
𝛽𝐸 = 1 + 1 − 𝜏 𝛽𝑈
𝐸
Un-levering: Constant Proportion of Debt
The other assumption that we normally work with is constant
proportion of debt (constant leverage ratio).
This assumption of constant proportion of debt is also useful in
determining firm’s future cost of capital.
We assume that a firm changes the amount of debt each year to
𝐷
keep the proportion of debt constant.
𝐸
Using a similar process as in the first assumption, we will

extract the business risk of a firm.
We now un-lever beta when proportion of debt is constant.
Appendix: Constant Proportion of Debt
Split 𝑆 into two pieces:
𝑟𝐷 𝐷𝜏 𝑟𝐷 𝐷𝜏
𝑆𝛽𝑆 = 𝛽𝑆 + 𝑆 − 𝛽𝑆
1 + 𝑟𝐷 1 + 𝑟𝐷
In our numerical example, 𝑟𝐷 𝐷𝜏 = ₹5 is the interest tax shield
in the first year and 𝑟𝐷 = 10%.
The first piece is the present value (PV) of the first year’s tax
shield 𝑡 = 1.
The first part of the tax shield is a multiple of the first period’s
interest payment and has a beta of 𝛽𝐷 .
The second piece is the PV of all remaining years’ tax shields
𝑡>1 .
The second part of the tax shield goes up or down in proportion
to the value of the firm, and therefore has a beta of 𝛽𝑈 .
Substituting 𝛽𝑆 = 𝛽𝐷 for the first part of the interest tax shield
and 𝛽𝑆 = 𝛽𝑈 for the second part, we get
𝑆𝛽𝑆 = 𝛽𝐷 + 𝑆 − 𝛽𝑈
1 + 𝑟𝐷 1 + 𝑟𝐷
𝑈𝛽𝑈 + 𝑆𝛽𝑆 = 𝐸𝛽𝐸 + 𝐷𝛽𝐷
⇒ 𝐸 + 𝐷 − 𝑆 𝛽𝑈 + 𝛽𝐷 + 𝑆 − 𝛽𝑈
1 + 𝑟𝐷 1 + 𝑟𝐷
= 𝐸𝛽𝐸 + 𝐷𝛽𝐷
𝑟𝐷 𝜏 𝑟𝐷 𝜏
⇒ 𝐸+𝐷 1− 𝛽𝑈 = 𝐸𝛽𝐸 + 𝐷 1 − 𝛽𝐷
1 + 𝑟𝐷 1 + 𝑟𝐷
𝐷 𝑟𝐷 𝜏
1 1 −
𝐸 1 + 𝑟𝐷
𝛽𝑈 = 𝛽𝐸 + 𝛽𝐷
𝐷 𝑟𝐷 𝜏 𝐷 𝑟𝐷 𝜏
1+ 1− 1+ 1−
𝐸 1 + 𝑟𝐷 𝐸 1 + 𝑟𝐷
Beta: Constant Proportion of Debt
If we assume 𝛽𝐷 = 0, we get the below equation that is
used to un-lever betas with constant proportion of Debt:
1
𝛽𝑈 = 𝛽𝐸
𝐷 𝑟𝐷 𝜏
1+ 1−
𝐸 1 + 𝑟𝐷
Equation to re-lever betas when the proportion of Debt
is constant:
𝐷 𝑟𝐷 𝜏
𝛽𝐸 = 1 + 1− 𝛽𝑈
𝐸 1 + 𝑟𝐷
Unlevered beta for constant proportion of debt (constant leverage ratio) is
𝛽𝑈
1
𝐷 1+ 𝑟𝐷 𝑘 −1 𝜏
1− 1
𝐸
1 1+ 𝑟𝐷 𝑘
= 𝛽𝐸 + 𝛽𝐷
1 1
𝐷 1+ 𝑟𝐷 𝑘 −1 𝜏 𝐷 1+ 𝑟𝐷 𝑘 −1 𝜏
1+ 1− 1 1+ 1− 1
𝐸 𝐸
1+ 𝑟𝐷 𝑘 1+ 𝑟𝐷 𝑘
𝐸 𝐷
lim 𝛽𝑈 = 𝛽𝐸 + 𝛽𝐷
𝑘→∞ 𝐸+𝐷 𝐸+𝐷
𝐸 𝐷
𝐸+𝐷 𝐸+𝐷
Un-levering betas
If the proportion of debt is rebalanced continuously, only then
we get this simplistic formula:
𝐸 𝐷
𝐸+𝐷 𝐸+𝐷
We can un-lever the betas only under these two assumptions.

We derive the formula for un-levering beta so that you not
confused when to use what.
Un-levering and Re-levering betas
Our firm cost of capital is a combination of debt and equity cost
of capital of the firm.
The equity cost of capital going forward depends on the
financing mix which need not necessarily be the same as the
current mix.
To find the new cost of equity (with new financing mix), we add
back financial leverage (new financing mix).
This process is called re-levering of beta.
The determine the cost of capital of the firm we have to assume
the financing mix going forward.
Example of Un-levering and Re-levering
Let’s say that a firm has Assets of 𝐴= ₹400, 𝐸 = ₹200, 𝐷 = ₹200.
The CFO asks the finance team to run a regression to find the
beta of the firm to obtain the historical financial risk and
systematic business risk. The team finds the beta of equity 𝛽𝐸 =1
and beta of debt 𝛽𝐷 = 0.20.
The CFO wants to un-lever the beta to segregate the business
risk from the historical financial risk.
What is systematic business risk if the team finds that the
absolute rupee amount of debt (₹200) has been constant in the
last 5-years (the time-period of running regression).
Un-levering: Constant Amount of Debt
In our example, 𝐴 is ₹400, 𝐸 is ₹200, 𝐷 is ₹200.
𝑈 = 𝐸 + 𝐷 1 − 𝜏 = ₹350 because when we un-lever the firm,
we lose ₹50 in PV to the government in taxes (i.e., present value
of ITS).
If the rupee amount of debt is constant, then unlevered beta
(systematic business risk) is:
𝐸 𝐷 1−𝜏
𝐸+𝐷 1−𝜏 𝐸+𝐷 1−𝜏
₹200 ₹150
𝛽𝑈 = 1+ 0.20 = 0.657
₹350 ₹350
What is the systematic business risk if the team finds instead
that the proportion of debt (1:1) has been constant in the
last 5-years (the time-period of running the regression).
Assume risk-free rate 𝑟𝑓 = 10% and market risk premium
𝑟𝑚 − 𝑟𝑓 = 10%.
The cost of equity 𝑟𝐸 =20% and cost of debt 𝑟𝐷 =12% using
CAPM.
𝐷 𝑟𝐷 𝜏
1 1 −
𝐸 1 + 𝑟𝐷
𝐷 𝑟𝐷 𝜏 𝐷 𝑟𝐷 𝜏
1+ 1− 1+ 1−
𝐸 1 + 𝑟𝐷 𝐸 1 + 𝑟𝐷
𝛽𝑈
3%
1 1 1 − 1 + 12%
= ∗1+ ∗ 0.2
3% 3%
1+1 1− 1+1 1−
1 + 12% 1 + 12%
𝛽𝑈 = 0.605
From cost of equity to cost of capital
We can determine the cost of capital looking into the future
reliably only under the assumption of constant proportion of
debt.
So, to be consistent we should un-lever and re-lever betas using
the assumption of constant proportion of debt so that our cost of
equity is consistent with firm’s cost of capital.
The cost of equity is, more often than not, the most important
component of firm’s cost of capital.
So, both should be determined under the same set of
assumption—constant proportion of debt.
Discounting consistent with assumptions
We will now understand why do we have to make the
assumption of constant proportion of debt to determine the
firm cost of capital.
Only under this assumption do we get a consistent discount
rate for the firm i.e., the firm’s cost of capital.
The firm’s cost of capital is called WACC (Weighted Average
Cost of Capital) and is consistent only under the assumption
of constant proportion of debt.
Investor’s return on Assets 𝑟𝐴
Consider buying both the equity and debt of a levered firm

𝐴 = 𝐸 + 𝐷 today at time t and holding them for one
period, then selling both positions.
If we invest 𝐴 at time t, then we receive next period’s free
cash flow of the levered firm 𝐹𝐶𝐹𝐿,𝑡+1 and next period’s
value of the equity plus debt 𝐴𝑡+1 = 𝐸𝑡+1 + 𝐷𝑡+1 .
Assets 𝐴 of levered firm is sum of equity 𝐸 and debt 𝐷. Asset
return 𝑟𝐴 i.e., the expected return on 𝐴 is the expected
return of its components:
𝐸 𝐷
𝑟𝐴 = 𝑟𝐸 + 𝑟𝐷
𝐸+𝐷 𝐸+𝐷
Levered Cash Flow discounted at 𝑟𝐴
Let 𝐹𝐶𝐹𝐿,𝑡 be the cash flow of levered firm.
Here 𝐹𝐶𝐹𝐿,𝑡+1 is the total cash flow paid to debt and
equity holders combined. The price we pay today must
equal the present value of the future cash flows, so
𝐹𝐶𝐹𝐿,𝑡+1 + 𝐴𝑡+1
𝐴=
1 + 𝑟𝐴
𝐹𝐶𝐹𝐿,𝑡+1 𝐹𝐶𝐹𝐿,𝑡+2 𝐹𝐶𝐹𝐿,𝑡+3

𝐴= + 2
+ 3
+⋯
1 + 𝑟𝐴 1 + 𝑟𝐴 1 + 𝑟𝐴
Levered and Unlevered Cash Flow
However, 𝐹𝐶𝐹𝐿,𝑡+1 , 𝐹𝐶𝐹𝐿,𝑡+2 , 𝐹𝐶𝐹𝐿,𝑡+3 , … depend on the

firm’s financing choice in all future years which we don’t
know, nor can we reliably forecast.
We segregate levered cash flow into unlevered cash flow
𝐹𝐶𝐹𝑈,𝑡+1 which is independent of firm’s financing
choice and interest tax shield 𝑟𝐷 𝐷𝜏 , which is dependent
of firm’s financing choice.
𝐹𝐶𝐹𝐿,𝑡+1 = 𝐹𝐶𝐹𝑈,𝑡+1 + 𝑟𝐷 𝐷𝜏
In our example, 𝐹𝐶𝐹𝐿,𝑡 is ₹80 (₹60 of PAT to Equity and
₹20 of Interest to Debt holders), 𝐹𝐶𝐹𝑈,𝑡 is ₹75 and interest
tax shield 𝑟𝐷 𝐷𝜏 is ₹5.
Assumption on firm’s future financing
𝐹𝐶𝐹𝐿,𝑡+1 𝐹𝐶𝐹𝐿,𝑡+2 𝐹𝐶𝐹𝐿,𝑡+3

𝐴= + 2
+ 3
+⋯
1 + 𝑟𝐴 1 + 𝑟𝐴 1 + 𝑟𝐴
In the above equation, both the numerator 𝐹𝐶𝐹𝑈,𝑡+1 and
denominator 𝑟𝐴 are a function of financing choice.
We need to know the size of the tax shields each period.
The tax shields depend on the amount of debt, which in
turn is a function of 𝐴 = 𝐸 + 𝐷 .
However, 𝐴 is what we are trying to calculate.
We are going in circles now. But there is a way around this
problem if we assume constant proportion of debt.
Going from 𝑟𝐴 to 𝑟𝑊𝐴𝐶𝐶
To see this, we rewrite as follows
𝐷
𝐹𝐶𝐹𝑈,𝑡+1 + 𝑟𝐷 𝐴 𝜏 + 𝐴𝑡+1
𝐴= 𝐴
1 + 𝑟𝐴
Collecting terms of 𝐴 we get,
𝐷
1 + 𝑟𝐴 − 𝑟𝐷 𝜏 𝐴 = 𝐹𝐶𝐹𝑈,𝑡+1 + 𝐴𝑡+1
𝐴
𝐸 𝐷
1+ 𝑟𝐸 + 𝑟𝐷 1 − 𝜏 𝐴 = 𝐹𝐶𝐹𝑈,𝑡+1 + 𝐴𝑡+1
𝐸+𝐷 𝐸+𝐷
Weighted Average Cost of Capital
𝐹𝐶𝐹𝑈,𝑡+1 + 𝐴𝑡+1
𝐴=
𝐸 𝐷
where 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 1 − 𝜏
𝐸+𝐷 𝐸+𝐷
𝐹𝐶𝐹𝑈,𝑡+1 𝐹𝐶𝐹𝑈,𝑡+2 𝐹𝐶𝐹𝑈,𝑡+3

𝐴= + 2
+ 3
+⋯
Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC)
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 1 − 𝜏
𝐸+𝐷 𝐸+𝐷
𝜏 is effective tax rate and not the marginal tax rate.
𝐷
is the target capital structure which may be different
𝐸
from the current capital structure.
The Weighted Average Cost of Capital is the firm’s cost of
capital, often just called by its acronym WACC.
WACC is the rate that we use to discount firm-level free
cash flows. WACC is the firm’s cost of capital.
Equity Risk and Operating Leverage
An important factor that affects the (systematic) risk of a
corporation is its degree of operating leverage.
Operating leverage is the relative proportion of fixed costs
versus variable costs. It is calculated as follows:
Revenue − Variable Costs
Operating Leverage =
Revenue − Variable Cost − Fixed Costs
A higher proportion of fixed costs increases the operating
leverage, and therefore, sensitivity of the firm’s cash flows to
systematic risk i.e.,
– The firm’s beta will be higher.
– The firm’s cost of capital would be higher.
Consider a firm that is entirely equity funded. It has expected
annual revenues of ₹2,400 crores and costs of ₹600 crores
per year in perpetuity. The profit margin remains constant.
The costs are completely variable i.e., Operating Leverage is 1.
The risk-free rate (𝑟𝑓 ) is 10%. The market risk premium
(𝑟𝑚 − 𝑟𝑓 ) is 10%. To keep the example simple, we ignore
taxes, working capital, depreciation, capital expenditure, etc.
Suppose the firm has a beta (𝛽𝐸 ) of 1. What is the valuation
of this firm?
What is the value and beta of the firm if the entire annual
costs are completely fixed at ₹600 crores?
Equity Cost of Capital
The expected free cash flow of the firm each year is
₹2,400 − ₹600 crore = ₹1,800 crore.
Given a beta of 1, the firm’s equity cost of capital is
= 10% +1.0 * 10% = 20%.
Value of the firm if costs are completely variable is
₹2,400 ₹600
= ₹1,800/20% = ₹9,000 crore = − .
20% 20%
If the costs are completely fixed instead, then we can

compute the value of the firm by discounting revenues and
costs separately. Revenues still have a beta of 1 (𝛽𝑅 = 1),
and thus a cost of capital of 20%. So, PV of revenues (R) is
₹2,400 crore/20% = ₹12,000 crore.
Because costs are completely fixed (𝛽𝐶 = 0), we should now
discount the costs at risk-free rate (𝑟𝑓 ) of 10%, so present
value of costs, 𝐶 is = ₹600/10% = ₹6,000 crore.
Thus, with completely fixed costs (operating leverage
increases from minimum to maximum), the firm has a value
of only ₹12,000 crore − ₹6,000 crore = ₹6,000 crore.
The expected cash flow of the firm when costs are completely
fixed is still ₹1,800 crore per year.
The value of the firm is reduced to ₹6,000 crore when risk of
cash flow increases even though the expected cash flows are
unchanged (= ₹2,400 crore/₹1,800 crore).
Operating Leverage and Beta
What is the beta of the firm now?
We can calculate the beta of the firm by thinking of it as a
portfolio that is long (receive) the present value of revenues
and short (pay) the PV of costs.
The firm’s beta is the weighted average of the betas of present
values of revenues and costs:
𝑅 − 𝐶 𝛽𝐸 = 𝑅𝛽𝑅 − 𝐶𝛽𝐶
₹12,000 − ₹6,000 𝛽𝐸 = ₹12,000 ∗ 1.0 − ₹6,000 ∗ 0
𝛽𝐸 = 2.0
Given a beta of 2.0, the firm’s equity cost of capital with fixed
costs of ₹600 crore is 10% + 2.0*10% = 30%. As the firm is
more risky now, discount rate is 30%.
Another way to get the same beta is to first calculate the firm’s
equity cost of capital:
𝐹𝐶𝐹𝐸 𝐹𝐶𝐹𝐸 ₹1,800
PV = ⇒ 𝑟𝐸 = = = 30%
𝑟𝐸 𝑃𝑉 ₹6,000
Given that the firm’s cost of capital is 30%, the firm’s beta can
in turn be imputed and thus verified.
𝑟𝐸 = 𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
𝑟𝐸 − 𝑟𝑓 30% − 10%
⇒𝛽= = = 2.0
𝑟𝑚 − 𝑟𝑓 20% − 10%
Higher cash flow risk (even though expected cash flow remains
the same) increases beta and reduces value. Operating leverage
can radically increase a firm’s beta and reduce its value.
As this example shows, increasing the proportion of fixed vis-
à-vis variable costs (revenues) can significantly increase
(decrease) a firm’s risk and reduce (increase) its value.
Initially, the firm’s costs were completely variable and
therefore the firm has minimum operating leverage of 1.
Once the firm has all its costs fixed, the operating leverage of
the firm increases.
Firms and industries which have high (low) operating
leverage tend to have higher (lower) risk and higher (lower)
equity cost of capital.
Key Take-aways
We understand the theory behind beta un-levering and re-levering.
We derive a general formula for the rate of equity and beta of equity
under minimal assumptions.
We then take into consideration:
➢ whether a firm has a constant amount of debt in rupee terms;
➢ whether a firm targets a constant proportion of debt in its capital
structure; and
➢ the frequency of debt rebalancing.
A firm’s equity beta increases with not just financial leverage but also
with operating leverage.
Sectors which have high fixed costs have high risk and their equity betas
should correspondingly reflect this risk of operating leverage.
Statements (BVFS)
Prof. Vaidya Nathan
How to incorporate changing financial leverage in WACC?
How to cognize for changing leverage and cost of debt?
Would the assumptions of D = constant and D /E = constant
give the same WACC?
If cost of debt depends on ratings, which in turn depends on
interest coverage ratio, how should we calculate the cost of
debt for changing financial leverage?
How to calculate WACC of the optimal capital structure?
Would the assumptions of D = constant and D /E = constant
necessarily give the same optimal WACC?
How to do firm valuation for the optimal capital structure?
Economic Value Add and Residual Income Valuation rely
heavily on book value of enterprise and equity respectively
while in FCFF and FTE valuation, bulk of the value comes from
Terminal Value (TV). Book value is based on historical numbers
while Terminal value is based on long-term future value. Is
there a valuation methodology which is somewhere in between
the past and future and exclusively uses the financial indicators
as of now (in the present)?
What is Earnings Power Value (EPV)?
What is Normalized Earnings?
How to calculate Normalized Earnings?
How is future growth accounted for in EPV valuation?
Changing financial leverage
By implementing an optimal capital structure, a CEO/CFO tries to maximize
returns without incurring undue risk.
Using an optimal capital structure when valuing a controlling interest avoids
one of the biggest drawbacks in valuation of a business: that a company’s
actual capital structure will frequently change as the value of its equity
changes and debt are issued and retired.
In choosing debt financing over equity, the cost
difference is all in the tax savings
Range of earnings with increase in leverage
Bond financing
Increase in Leverage
$6.00 (Levered Firm)
Stock financing
Crossover point (Unlevered Firm)
$4.00 (Financing Breakeven)
Increase in Equity
Bust EBIT
Expected EBIT
$2.00
Earnings per share (EPS)
Boom EBIT
$0.00
$0 $100 $200 $300 $400 $500 $600
-$2.00
Earnings before interest and taxes (EBIT)

-$4.00 ($ millions)
Effects of Financial Leverage
Assumption
 The above analysis assumes that the cost of

debt is constant no matter what the firm’s
debt-to-equity (D/E) ratio.
 Under such an assumption, the relationship
between earnings per share and pre-tax
operating income is linear. Real World
 Under normal circumstances, cost

of debt and cost of equity both tend
Cost of Debt and Cost of Equity to increase as firm’s D/E ratio rises.
 Cost of equity rises with increase in D/E
ratio because required return on equity
increases with risk, and a high D/E ratio
implies more financial risk.
 The cost of debt rises as D/E ratio rises
because the credit rating of bonds
decreases as D/E increases.
Optimal WACC
There are several ways in which to estimate a company’s optimal capital
structure.
One way is to assume that other companies in the industry are operating at
or near their optimal capital structures and to obtain published industry
statistics from sources such as Bloomberg, Thomson Reuters or Ibbotson
Associates’ Cost of Capital.
While useful in some cases, these industry statistics are conglomerates of
data and often include companies that are not sufficiently similar to the
subject company.
Moreover, the operating leverage of other comparable companies in the
industry could be different.
The time frame in which the data was collected may be unclear or may not
be in reasonable proximity to the date of valuation.
Synthetic Cost of Capital Curve
The most complex of the various methods for estimating an
optimal capital structure is through the construction of a cost of
capital curve.
The curve illustrates the company’s weighted average cost of
capital at all combinations of debt and equity financing.
We calculate cost of debt using the ratings framework.
Need for Circularity: The cost of debt depends on rating and the
rating depends on interest coverage ratio which in turn depends
on cost of debt.
A real-life example of a large company
optimizing WACC: Telstra Corporation
Key constraining factor was S&P/Moody’s investment grade rating beyond which the WACC would have
increased substantially due to exponential increase in cost of debt
WACC and Total Debt
A$ bn
10.00%
Current Post-tax Cost Weighting Estimated WACC 120
Equity1 9.27% 48.26%

Debt/ Capital 58.0%
9.50% Debt 4.25% 51.74% 100
WACC 8.26%
WACC 8.35%
9.00% 80
8.50% 60
8.00% 40
7.50% 20
7.00% 0
10% 14% 18% 22% 26% 30% 34% 38% 42% 46% 50% 54% 58% 62% 66% 70% 74% 78% 82% 86%
S&P
rating
AAA AA A BBB BB B CCC
Moody’s
Rating
Aaa Aa2 A2 Baa2 Ba2 B2 Caa2
1 Based on Australian risk free rate of 5.77%, market risk premium of 3.63% and beta estimate (from Barra) of 0.9640
Another one: Venture optimized WACC by
adding S$200mm additional debt
WACC and Debt/Capitalization S$mm
11.350% 1000
New debt (S$mm) WACC (%) 900
800
11.250%
Venture Venture
700
0.5%(FY2000)
Additional debt
30.0% 600
11.150% S$ 214 million 500
400
300
11.050% WACC
11.016% Min WACC
200
11.000% 100
10.950% 0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65%
AAA BBB BB
Increasing debt was a bit of a two-edged sword, especially in the volatile and
capital-intensive EMS industry
Analysis of Venture’s debt/capital mix
WACC was minimized at 11.000% WACC before optimization
with an additional S$200 million in
debt while maintaining strong Prior cost of equity 11.042%
investment grade ratios.
Observed levered Beta 1.06
However, the increase in WACC was Unlevered Beta 1.06
not very large as additional debt was
Local risk-free rate (Rf) 3.00%
added primarily due to Venture’s low
cost of equity. Excess return on local index 7.58%
(Rm - Rf)
Limiting factor was S&P/Moody’s Prior after-tax cost of debt 9.53%
investment grade threshold, beyond
Effective tax rate 9.26%
which financing costs were likely to
be higher in domestic and Prior WACC 11.016%
international markets.
Financials provide guidelines for debt capacity
SGD MM Historical Projected base case
FYt-1 FYt FYt+1 FYt+2 FYt+3
Operating results
Revenue 951.0 1456.4 1689.1 2043.1 2521.1
EBIT 81.9 116.0 116.1 145.5 181.3
D&A 13.4 19.9 28.7 33.9 36.9
EBITDA 95.3 135.9 144.8 179.4 218.2
Net income 82.9 128.3 106.7 133.7 166.7
Cash flow items
Cash from operations 63.5 (4.5) 100.1 121.3 140.6
Capex (36.4) (64.6) (51.8) (48.0) (48.6)
Free cash flow 27.2 (69.1) 48.3 73.3 91.9
Capitalization
Cash 292.9 199.8 245.1 311.2 393.4
Total debt 0 1.2 0 0 0
Net debt (292.9) (198.6) (245.1) (311.2) (393.4)
Shareholder’s equity 415.0 523.3 635.4 769.2 935.9
Book capitalization
Credit ratios
EBITDA interest coverage (X) 491x 15,078x 9,759x N.M. N.M.
EBIT interest coverage (X) 422x 12,864x 7,822 N.M. N.M.
Funds from operations/total debt N.M. 126% N.M. N.M. N.M.
Free cash flow/total debt N.M. -59% N.M. N.M. N.M.
Return on capital 20.81% 24.00% 19.32% 19.99% 20.49%
Total debt/total capitalization 0.0% 0.2% 0.0% 0.0% 0.0%
Ratings were an important consideration for
determining optimal capital structure
 Operating performance and financing need
Financial Profile – Determined the needed financing
– Projected operating cash flow
 Credit metrics
Debt Capacity – Acquired the sustainable coverage ratios based
on credit rating
– Determined the capacity of available funds
 Cost of capital
Minimizing WACC – Cost of equity
– Cost of debt
– Minimized WACC for optimal capital structure
 Getting there
Optimization Roadmap – Financing options
– Strategic events
With a credit rating by a top-three rating agency, the company had access
to a wide range of debt financing alternatives in the capital market
Universal measure of credit standing
Moody’s and Standard & Poor’s ratings scale and definition
Long Term Ratings3 Short Term Ratings3

Moody’s Standard & Poor’s Capacity to repay interest and Moody’s Standard & Poor’s
principal
Aaa AAA • Prime grade: extremely strong
Aa1 AA+
Aa2 • High grade: very strong A1+
AA
Aa3
AA- • Upper medium grade: strong but P1 or
A1 susceptible to adverse economic
A+ A1
A2 conditions
A
A3
A-
Baa1 BBB+ • Medium grade: adequate, but
Baa2 BBB more subject to adverse economic P2 A2
Baa3 BBB- conditions
Ba1 BB+ • Speculative grade: faces major
Ba2 BB ongoing uncertainties leading to P3 A3
Ba3 BB- inadequate capacity
B1 B+ • Distinctly speculative grade:
B2 B vulnerability to default but Not Prime B
B3 B- presently has capacity to meet
obligations
Caa1 CCC+ • Highly speculative grade: very
Caa2 CCC high probability of default
Caa3 CCC- C
Ca CC
C C
D D • Debt in default D
Investment Grade as defined by Moody’s and Standard and Poor’s

Non-Investment Grade as defined by Moody’s and Standard and Poor’s
3 Ratings are for senior unsecured foreign current debt obligations
Optimal Leverage
Unlike big companies where capital structure is a key variable that
is managed regularly, few Indian businesses, especially family
owned, understand it and very few manage it.
One can see from our in-class exercise that valuation is maximised
with a capital structure that has 75% equity and 25% debt (for D =
constant) and 80% equity and 20% debt (for D/E = constant).
Increasing the debt beyond this increases the cost of capital as
lenders charge more to cover the risk of default which goes up as
the same cash flows are used to fund increasing levels of debt.
A quick hack for firms without an analytical framework is to have
around 20-35% (1/5 to 1/3) of the firm’s capital funded by debt.
DCF Evolution: From EVA to EPV to NPV
NPV combines good forecasts with bad forecasts, i.e., it combines precise
estimates (good information) with imprecise estimates (bad information).
Historical: Quite Less Least
Precise Precise Precise ... Precise ...
𝐸𝑉𝐴1 𝐸𝑉𝐴2 𝐸𝑉𝐴𝑛

𝐸𝑉 = 𝐵0 + + 2
+ ⋯+ 𝑛
+0
Market
𝑁𝑜𝑟𝑚𝑎𝑙𝑖𝑧𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Value EPV: Earnings Power Value =
of 𝑊𝐴𝐶𝐶
Quite Less Least Large
Equity
Precise Precise ... Precise Portion
and
Debt
𝐹𝐶𝐹𝐹1 𝐹𝐶𝐹𝐹2 𝐹𝐶𝐹𝐹𝑛
𝐸𝑉 = + 2
+ ⋯+ 𝑛
+ 𝑇𝑉
DCF Evolution: From EVA to EPV to NPV
EVA EPV FCFF

• Tangible • Current Earnings • Growth changes
• Balance Sheet based • No explicit growth valuation drastically
• Not much assumption • Requires long-term
extrapolation • No Forecast forecasts
• Normalization is not • Normalization is • Normalization is
important somewhat important very important
EPV: Basic Concept
EPV popularized by Columbia faculty Bruce Greenwald in
the book ‘Value Investing’.
Enterprise value based on this year’s Normalized Earnings.
Measurement:
Normalized Earnings
Earnings Power Value =
𝑟𝑊𝐴𝐶𝐶
Second most reliable information is earnings today.
Calculation
▪ Normalized Earnings = NOPAT + Adjustments
▪ Enterprise Value = Normalized Earnings / 𝑟𝑊𝐴𝐶𝐶
▪ Equity Value = Enterprise Value using EPV – Net Debt
Accounting for growth in Normalized Earnings
NOPAT+Adjustments NOPAT
EPV formula is and not .
𝑟𝑊𝐴𝐶𝐶 𝑟𝑊𝐴𝐶𝐶 − g
So, where is growth accounted for in EPV calculation?

The growth term is moved to the numerator instead of it
being in the denominator.
g
Adjustments are approximately equal to NOPAT.
𝑟𝑊𝐴𝐶𝐶 − g
Capex is dichotomised into growth capex and maintenance

capex. In a ‘normal’ year, there is only maintenance capex.
This difference between depreciation and maintenance capex
is referred to as “excess depreciation” in the EPV context.
EPV: Calculation
Start with Operating earnings (EBIT).
Look at average margins over an economic/business/industry
cycle (at least five years… ideally seven years).
Multiply average margins by sustainable (usually current)
revenues. This yields normalized EBIT.
Multiply by one minus effective tax rate to get NOPAT.
Add back growth capex (Depreciation less Maintenance Capex),
also called ‘excess depreciation’. This yields normalized Earnings.
Discount normalized Earnings by 𝑟𝑊𝐴𝐶𝐶 to get Enterprise Value.
Subtract Net Debt from Enterprise Value to get Equity Value.
EPV Calculation: Maruti Suzuki
Maruti Suzuki India Ltd. Rs. Crores
Particulars FY20 FY19 FY18 FY17 FY16 FY15 FY14
Sales 7,566 8,607 7,981 6,809 5,759 5,080 4,445
EBIT 712 1,054 1,135 1,004 755 519 392
EBIT Margin 9.4% 12.3% 14.2% 14.8% 13.1% 10.2% 8.8%
7 Year Average EBIT Margin 11.83%
EBIT (Adjusted) 8, 950
Tax Rate 20.4%
Earnings After Tax (Adjusted) 7,124
Depreciation 3,528
Maintenance Capex (See Table Below) 3,644
Earnings After Tax (Normalized, A) 7,124
Maintenance Capex FY20 FY19 FY18 FY17 FY16 FY15 FY14

Fixed Assets (PPE) 17,160 17,044 15,521 14,563 13,537 14,380 13,673
Sales 7,566 8,607 7,981 6,809 5,759 5,080 4,445
PPE/Sales 2.27 1.98 1.94 2.14 2.35 2.83 3.08
Change in Sales -1,041
Total Capex 3,644
Calculate the Average Property Plant and Equipment (PPE) / Sales ratio over 7 years. Multiply PPE/Sales
Growth Capex 0 ratio by increase in sales to arrive at Growth Capex. If change in sales is 0/negative, then enter 0 as the
Growth Capex value.
Maintenance Capex 3,644 Maintenance Capex = Total Capex - Growth Capex
Key Take-aways
We understood how to incorporate changing financial
leverage in WACC.
We learnt to calculate the cost of debt as a function of
changing leverage.
We found out that the assumptions of D = constant and D /E =
constant give us different WACCs and optimal WACC.
We learnt to calculate the cost of debt for changing financial
leverage when the cost of debt depends on ratings, which in
turn depends on interest coverage ratio.
We learnt to calculate WACC of the optimal capital structure
and the resulting firm value.
Key Take-aways
Economic Value Add and Residual Income Valuation rely
heavily on book value of enterprise and equity respectively
while in FCFF and FTE valuation, bulk of the value comes from
Terminal Value. Book value is based on historical numbers
while Terminal value is based on long-term future value. We
learnt the EPV valuation methodology which is somewhere in
between the past and future and exclusively uses present value.
We learnt to calculate Normalized Earnings by segregating
capex into maintenance capex and growth capex.
We learnt how normalized earnings accounts for future growth
in EPV valuation.
Statements (BVFS)
Prof. Vaidya Nathan
Valuation
Knowledge comes by taking things apart: analysis.
Wisdom comes by putting things together.
Estimates the value of an asset by looking
Comparable
at the pricing of ‘comparable’ assets
Valuation: relative to a common variable like
Trading Comps earnings, cash flows, sales or other
industry metrics
A good estimate of
Value
Discounted Residual
Cash Flow Income
(DCF) Valuation &
Valuation EVA
Measure of a company’s
Relates value of an financial performance based on
asset to present value the residual wealth calculated
of expected future by deducting its cost of capital
cashflows on that asset from its operating profit.
The valuation process
Determining a final valuation recommendation is a process of triangulation using insight from
each of the relevant valuation methodologies
(1) Discounted Cash Flow (2) Publicly Traded Comparable Companies
Analyses the present value of a Utilizes market trading multiples from

company’s free cash flow. publicly traded companies to derive value.
(3) Comparable Acquisition (4) Residual Income Valuation & EVA

Transactions
Measure of a company’s financial
Utilizes data from M&A performance based on the residual
transactions involving similar income and economic value add
companies. calculated by deducting its cost of
capital from its operating profit.
Valuation methodologies
Valuation Methodologies
Publicly traded Comparable Discounted

Residual Income
comparable transactions Cash Flow (DCF) Other
Valuation & EVA
companies analysis analysis analysis
◼ “Public Market ◼ “Private Market ◼ “Intrinsic” value of ◼ Measure of a ◼ EPV Approach

Valuation” Valuation” business company’s
◼ Historical trading
financial
◼ Value based on ◼ Value based on ◼ Present value of performance
performance based
market trading multiples paid for projected free cash on the residual ◼ Dividend discount
multiples of comparable flows wealth calculated
comparable companies in sale model
◼ Incorporates both by deducting its
companies transactions cost of capital from ◼ Pre-money/Post-
short-term and
◼ Applied using ◼ Includes control long-term expected its operating profit. money valuation
historical and premium performance ◼ This measure was ◼ LBO valuation
prospective devised by Stern
◼ Risk in cash flows
multiples Stewart and Co.
and capital
◼ Does not include a structure captured
control premium in discount rate
“Cash is king”
Accounting issues can impact the profit numbers of a

company and give a distorted picture of profitability.
Cash flows tell you the real story.
Do the analysis as if you were putting your own

money in the venture.
DCF Valuation methodologies: FCFF & FTE
DCF Valuation methodologies
FCFF Analysis FTE Valuation
◼ “Intrinsic” value of ◼ “Intrinsic” value of equity

the Enterprise. value of the business.
◼ Present value of ◼ Present value of projected

projected free cash free cash flows to equity
flows to the firm. holders.
◼ Incorporates both ◼ Incorporates both short-term

short-term and and long-term expected
long-term expected performance of FCFE.
performance of firm.
◼ Risk in cash flows and capital
◼ Risk in cash flows structure (through beta)
and capital structure captured in discount rate.
captured in WACC.
Enterprise Value: FCFF discounted @ WACC
Projected Income Statement Projected Balance Sheet
3, 5, 10 years explicit & perpetuity 3, 5, 10 years explicit & perpetuity
DCF = Valuation of firm’s or asset’s projected free cash
flows in perpetuity using its risk-adjusted Weighted
Average Cost of Capital (WACC)
Projected Free Cash Flows to

Firm (FCFF)
Debt
Cash equity
Enterprise Value - Minorities + investments = Equity
Preference Stock
Market values Value
Weighted Average Cost
of Capital (WACC) All market value
Weighted by current share

of Enterprise Value
Cost of Equity Cost of Debt
Normalization of FCFF in the last year of the horizon affects valuation considerably.
Leverage assumption (D = constant or D/E = constant) changes WACC estimates and
optimal leverage.
Cost of debt is found synthetically for future changes in leverage.
DCF: Levered and Unlevered free cash flow
DCF: The value of a productive asset is equal to the present value of all expected
future cash flows that can be removed without affecting the asset’s value
including an estimated terminal value (TV), discounted using an appropriate
Weighted Average Cost of Capital.
The cash-flow streams that are discounted include:
▪ Unlevered or levered free cash flows over the projection period.
▪ Terminal value at the end of the projection period.
These future free cash flows are discounted to the present at a discount rate
commensurate with their risk.
▪ If we are using unlevered free cash flows (preferred approach), the
appropriate discount rate is the weighted-average cost of capital for debt
and equity capital invested in the enterprise in optimal/targeted proportions.
▪ If we are using levered free cash flows, the appropriate discount rate is
simply the cost of equity capital, often referred to as flows to equity (FTE).
FCFF and FTE: Two basic approaches
FCFF Valuation: DCF of unlevered cash flows
▪ Projected income and cash-flow streams are free of the effects of
debt, net of excess cash.
▪ Present value obtained is the value of assets, assuming no debt or
excess cash (“Firm Value” or “Enterprise Value”).
▪ Debt associated with the business is subtracted (and excess cash
balances are added) to determine the present value of equity
(“Equity Value”).
▪ Cash flows are discounted at the Weighted Average Cost of Capital.
FTE Valuation: DCF of levered cash flows
▪ Projected income and cash-flow streams are after interest expense
and net of any interest income.
▪ Present value obtained is the value of equity.
▪ Cash flows are discounted at the cost of equity.
Kaplan and Ruback: Normalization
Kaplan, S., and R. Ruback. 1995. The Valuation of Cash Flow Forecasts: An Empirical Analysis. Journal of Finance 50/4: 1059-93.
Two flavours for normalization of cash flows:

First Flavour (D = Constant):
▪ Capex = Depreciation + Amortization
▪ Net working capital change is zero.
▪ New Borrowing or Repayment is zero.
Second Flavour (D / E = Constant):
▪ Capex = Depreciation + Amortization + g * Net PPE
▪ Net change in working capital = g * Working Capital
▪ Debt/Equity remains constant and so debt grows at g.
Growth rate of different financial statement numbers are different
as can be seen from the Story of Five Friends Framework.
Kaplan and Ruback: Normalization
Second Flavour (D / E = Constant):
Balance Sheet at time t
Liabilities Assets
Current Liabilities CL CA Current Assets
Debt D FA Net Fixed Assets
Equity E
Total Liabilities TL TA Total Assets
Balance Sheet at time t+1

Liabilities Assets
Current Liabilities (1+g)*CL (1+g)*CA Current Assets
Debt (1+g)*D (1+g)*FA Net Fixed Assets
Equity (1+g)*E
Total Liabilities (1+g)*TL (1+g)*TA Total Assets
DCF Valuation methodologies: FCFF & FTE
DCF Valuation methodologies
FCFF Analysis FTE Valuation
◼ “Intrinsic” value of ◼ “Intrinsic” value of equity

the Enterprise. value of the business.
◼ Present value of ◼ Present value of projected

projected free cash free cash flows to equity
flows to the firm. holders.
◼ Incorporates both ◼ Incorporates both short-term

short-term and and long-term expected
long-term expected performance of FCFE.
performance of firm.
◼ Risk in cash flows and capital
◼ Risk in cash flows structure (through beta)
and capital structure captured in discount rate.
captured in WACC.
Overview of FTE analysis
FTE analysis is based upon the theory that the equity value of a
business is the sum of expected future free cash flows to equity
holders, discounted at an appropriate rate.
FTE method is one of the most fundamental and commonly used
valuation techniques.
Widely accepted by bankers, consultants and corporations.
Corporate clients often use FTE analysis internally.
FTE analysis may be the only valuation method utilized,
particularly if no comparable publicly-traded companies or
precedent transactions are available.
Overview of FTE analysis
FTE analysis is a forward-looking valuation approach, based on several key
projections and assumptions.
– Free cash flows to equity:
▪ What is the projected operating and financial performance of the
business?
– Terminal value:
▪ What will be the value of equity at the end of the projection period?
– Discount rate:
▪ What is the cost of equity for the business?
The method is always the same, but there are no single “correct” assumptions
for performing FTE analysis. However, certain rules of thumb always apply
for financial statement assumptions.
– Do not simply plug numbers into equations.
– You must apply judgment in determining each assumption.
Discount FCFE at rE to get equity value
Projected Income Statement Projected Balance Sheet
3, 5, 10 years explicit & perpetuity 3, 5, 10 years explicit & perpetuity
FCFE = Valuation of firm’s projected free
cash flows to equity in perpetuity using
its cost of equity (re)
Projected Free Cash Flows to
Equity holders (FCFE)
Total value of equity - Minorities = Equity

Preference stock
Value
Cost of Equity All market value
The reason analysts and investors appear obsessed with quarterly earnings is
that these provide latest guide to trends in valuation projection models, as
well as full-year earnings for multiples comparison and not “short-termism”.
If quarterlies (or annuals) show deviation from analyst/investor assumptions,
stock price will move as long-term assumptions get revised.
Key for analysts and investors is to get best quality information to be able to
make reliable projections.
Process of Flow to Equity analysis
FCFE Projection Project FCFE over the forecast period depending on the horizon.
Terminal value Estimate the TV at the end of the forecast period.
Discount rate Estimate company’s rE to determine appropriate discount rate range.
Present value Determine value of equity by discounting FCFE and TV to today.
Adjustments Adjust the resulting valuation for minority interest.

Sensitivity analysis
Sensitivity analysis
▪ Remember that FTE valuations are based on assumptions
and are therefore only approximate and not exact
(remember true value is illusive!). Use several scenarios
to bound the valuation. Generally, the best variables to
sensitize are sales, EBITDA margin, rE and perpetuity
growth rate.
Reliability of projections
▪ FTE results are generally more sensitive to FCFE cash
flows (and terminal value) than to small changes in the
discount rate (rE). Care should be taken that assumptions
driving FCFE are reasonable.
Forecast Horizon
The duration of the financial projections is heavily dependent on the
forecasted performance of the valued entity.
The general rule is that the duration of financial projections should be at
least equal to the period in which the company is supposed to reach stable
growth in perpetuity.
Financial projections should be for a period long enough to estimate a
normalized or mature level of cash flows prior to estimating the terminal
value.
The residual value should be calculated no earlier than when steady state of
the business’ operations arrives. This implies that all the value drivers in the
financial projections would remain constant.
The period before steady state arrives is often known as the competitive
advantage period. The value drivers in the financial projections can change
each year during this period.
A, E, I, O, U Framework
A good valuation has all five of these characteristics:
Accurate: Is it technically sound? Are the financial statements properly
integrated? For example, is there consistency between revenues and
investment—Companies that want to grow revenues and free cash flows
usually have to invest in fixed assets and working capital.
Efficient: Is it easy to understand? Does it avoid ‘complication for the sake of it’?
For example, a thirty-sheet model which is difficult to understand or gives no
new insight is ‘complexity for the sake of it.’
Illuminating: Is it easy to see trends and anomalies in critical factors and key
financial metrics, and does it assist in spotting yellow flags?
Organised: Is it logically organised?
Useful: Does it allow for critical factors to be changed easily so that impact on
valuation can be analysed/assessed and/or new insights gleaned?
FaVeS Framework
The key to doing superior valuation is having a more accurate view about a
company’s stock price than the market:
Forecast: Financial forecast superior to the market.
Valuation: Valuation methodology or valuation multiple superior to the
market.
Sentiment: Forecast of investor sentiment superior to market.
EPIC Framework for critical factors

As a valuation expert, you should prioritise critical factors:
Exceeds the materiality threshold.
Probably going to happen in the forecast time horizon.
I am good at forecasting the factor/catalyst (else, don’t take on the ‘average’).
Consensus is poor at forecasting/spotting critical factors (based on track record).
Always remember…
Three key drivers:
▪ Projections and incremental cash flows (free cash flows: FCFF or FCFE).
▪ Residual value at end of the projection period (terminal value or exit multiple).
▪ Weighted Average Cost of Capital or Cost of Equity (discount rate).
Avoid pitfalls:
▪ Validate and test projection assumptions.
▪ Determine appropriate cash flow stream.
▪ Think about other value enhancers and detractors.
▪ Thoughtfully consider terminal value methodology.
▪ Use appropriate cost of capital approach.
▪ Carefully consider all variables in calculation of the discount rate.
▪ Sensitise base projection variables, discount rates, terminal values, etc.
▪ Footnote assumptions in detail.
Double-check and make sure valuation is logical & sensible. It should pass the smell-test!

Business Valuation Using Financial Statements (BVFS) Prof. Vaidya Nathan Term 6, February 2022

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Business Valuation Using Financial Statements (BVFS) Prof. Vaidya Nathan Term 6, February 2022

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Business Valuation using Financial

Price is what you pay, Value is what you get.

Divestitures Fairness opinions

Debt offerings Public equity offerings

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

Myth: A good valuation provides a precise estimate of value.

Myth: The more quantitative a model, the better the valuation.

Intrinsic Valuation: FCFF and FTE Method (Lecture 7)

Earnings Power Value and Optimal WACC (Lecture 6)

Story of Five Friends: 2V3G Framework (Lecture 5)

Economic Value Add (Lecture 4)

Residual Income Valuation

Valuation & Business Valuation

Roadmap uses the natural steps in Integrated ISBS

Except, valuation is not done using historical cash flows:)

Capex (% of last year’s Revenues) 20% 25% 30%

Accounts Payable ₹ 5.00 30 30 30 ₹ 5.00

Surplus Funds Need To Finance

Surplus Funds Need to Finance

Capex (% of last year’s Revenues) 20% 25% 30%

Accounts Payable ₹ 5.00 30 30 30 ₹ 5.00

Shareholders’ Net Income

Shareholders’ Net Income

Beginning Equity Assuming 10% interest cost

Shareholders’ Net Income

Beginning Equity Assuming 10% interest cost

Shareholders’ Net Income

Beginning Equity Assuming 10% interest cost

2 ₹11 ₹1.1 ₹11.1 ₹0.1

3 ₹11.1 ₹1.11 ₹11.11 ₹0.11

4 ₹11.11 ₹1.111 ₹11.111 ₹0.111

5 ₹11.111 ₹1.1111 ₹11.1111 ₹0.1111

Surplus Circular Error, See CIRC Necessary to

The two warning signs:

2. Which creates interest income 3. Interest income adds to net income

1. SF plug appears 4. Net income adds to retained earnings

Liabilities 5. Which adds to Shareholder Equity

2. Which creates interest expense 3. Interest expense reduces net income

1. NTF plug appears 4. Less net income flows to retained earnings

Liabilities 5. Which reduces Shareholder Equity

#DIV/0! ISERROR = TRUE, so formula becomes a 0 and

No error message in loop.

Balance Sheet Year 1

Shareholders’ Assets Net Income

Beginning Equity ₹30

Traditionally used by Investment Net Cash available:

Cash Flow from CFO indicates the amount of money a company

Cash Flow from Cash from all investment activities, importantly,

Cash flow to Debt Holders

Cash flow from Assets

Cash flow to Shareholders

Operating Efficiency: Profit Margin

Asset Utilization Efficiency: Asset Turnover Ratio

Financial Efficiency: Equity Multiplier

Return on Net Income Sales Avg Assets

Profitability & Quality of Leverage & Operating

202012 12,899 14.1% 10.1% -18.12%

EBITDA margin is typically used to give investors or

202012 2,952 105.0% 22.9% 31.9% -3.0%

202009 2,238 -11.2% 19.1% 97.6% -40.8%

202006 1,133 -61.8% 16.0% -22.0% -38.9%

202003 1,452 -43.9% 14.7% 0.8% -10.6%

201912 1,440 -46.4% 12.7% -42.8% 5.3%