Topic Time (Hrs)

Introduction to Valuation 1
Valuing Assets and Liabilities 1
Equity - Discounted Cash Flow 2
Equity - CAPM, Fama French Model and WACC 1
Equity - Dividend Discount Model 1
Equity - Relative Valuation Models 1
IPO Valuation - tips and tricks 1
M&A valuation 1
Net Asset Value 1
Debt Valuation - techniques 1
Preference Share - overview 1
Options - Introduction 1
Conclusion 1
14
 Introduction To Valuation

x What is Valuation?
x Why is Valuation required?
x Who is allowed to do valuation?
x What do you value?
x Real Life Applications of Valuation

What is Valuation?

Look up Ashwath Damodaran!

Valuation is a quantitative process of determining the fait value of an asset ot liability.

Valuation is very subjective - which means there are a lot of assumptions baked into the philosophy and calcula

Imagine you have a house in South Delhi - in one of the posh areas.

If I saw the house from Bangalore - I would say the house is valued at a minimum of 1 cr.

But if a real estate valuer comes to your house, values your land and assess the neighborhood, he might say it is

Real estate valuer has a more expert opinion on the value of the house.
But I, in BLR, have a more fabled opinion.
But if I ask you, Mr X - or I ask Ishaan - minimum 5 cr

Value is always subjective - it differs by the person!

DDLJ - everyone has seen it? The movie!

This movie is still running in a theater in Mumbai - this movie is also available for free in Amazon prime!
Or Netflix.
Pirated copy (illegal) - FREE

Why would someone pay 350/- for a movie if the same film is available for free?

The experience - there is an intangible value associated with watching it in theater.

The value of an asset = subject + intangible

But as valuation experts - as people who are going to learn valuation - I am not going to worry about intangibles
What can be put on paper, what can be estimated. What can be evaluated, what can be quantified - I am only w

For me, DDLJ in OTT > DDLJ in theater. Same product.

For me, South Delhi house = the best price it will fetch if I sell it. All emotions can go to hell!

Same product will have multiple valuation techniques - which will give multiple values. What will you use? Up to
I will teach you every technique - I will tell you how this can be used!
 For eg - tell me what are the different ways you can get a value for the house you stay in (3 different ways)

Simplest Way Ask your neighbor!

Complex Way Ask an expert!
Most Complex Way Find out about economy, how much inflation, cost of construction, how much people will

All three values will probably give you the right number. Because - if someone is buyng the house, they wont bu
They will also check with an expert, and the expert will also use the formula you used in point 3.

THE END
he philosophy and calculations.

borhood, he might say it is only valued at 70L.

in Amazon prime!

to worry about intangibles and sentiments.

be quantified - I am only worried about that - everything else can go to hell!

s. What will you use? Up to you! But use the correct technique!
y in (3 different ways)

on, how much people will be ready to pay, apply a discount for age, etc.

g the house, they wont buy it without checkign the neighbors house ka price!
in point 3.
x Why is Valuation required?

Price =/ Value

Price as a concept is different, and value as a concept is different.

We need to know the value of a product, and only then can we decide whether to buy that product or not.

The price of the product is on the sticker.

But the value will never be mentioned - we need to find that out!
And once we know the value we need to know whether the price of the product is less than or greater than the val

For EG - we go to a grocery story! We ask for a soap.

The storekeeper gives us two soaps -
Dove 50 MRP
Cinthol 15 MRP

What is the value of a product? Is the Dove soap really worth 50, or is it just intangibles.
How will you find out the value of soap?
Does it kill all germs?
Does it remove odour.
Does it cause any skin reaction
Does it cause dry skin/ oily skin
Are there any chemicals?

Once we check all this, we will see that Dove probably has more value than Cinthol - but does Dove have 3x value?

Therefore, I will go with Dove - else, go with Cinthol.

Another example - Nivia - sells its shoes at 400/

Adidas sells their shoes at 4000/

What is the extra value that Adidas brings to the table?

does it last longer?
is it lighter?
is it more comfortable?

Investment decision - whenever you buys a share or bond in the market, you need to know whether you are overpa
You need to first find out the value of the share or bond you are buying, and then figure out what price it is being so
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07
RELIANCE (REL) 346.46 394.56 983.97 485.42 570.44 166.28 544.07
Decision BUY BUY DON’T BUY DON’T BUY DON’T BUY BUY DON’T BUY
Tell me if you will buy REL or NOT

1200.00

1000.00

800.00
 1200.00

1000.00

800.00

600.00

400.00

200.00

0.00
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

VALUE 425

Anything above this value, REL is overvalued, anything below, REL is undervalued.
Undervalued - it means it is coming cheap - > BUY
Overvalue - it means it is expensive - > DON’T BUY, SELL

x Who is allowed to do valuation?

Anybody who knows the concepts really well, and who is technically strong.
Technically strong - depends on the kind of product that is being valued!
But there is no licensing required, no proof required that you know something etc.

x What do you value?

ANYTHINGGGGGG@@@@@

Weather - there are weather derivatives in the market and these are being valued/ priced!
Shares
Bonds
Derivatives
consumer products
real estate
time valuation!

But what we will cover as part of our lessons in finance is only basic valuation for financial products.

x Real Life Applications of Valuation

When you are applying for an IPO - is the IPO price undervalued or ovevalued?
When you are buying shares from the market - is it undervalued or overvalued.
Merger arbitrage - whether the target/ acquiring companies are under/ over valued.
THE END
 product or not.

n or greater than the value.

es Dove have 3x value?

whether you are overpaying or underpayign for it.

t what price it is being sold and decide whether you are overpaying or underpaying.
Jan-08 Jan-09 Jan-10
204.73 108.51 85.70
BUY BUY BUY
 Row 40

Jan-09
 Valuing Assets and Liabilities

x Different types of assets and liabilities

x How do we value the different types of assets and liabilities?
x Time Value of Money - some examples
x Future Value of Money - Basics
x Future Value of Money - Complex
x Present Value of Money - Basics
x Present Value of Money - Complex

x Different types of assets and liabilities

Companies that are in service industries - will have very less fixed assets.
Companies that in manufacturing industries - will have greater amount of fixed assets.

Capital and Liabilities (REL) Price/ BS

Capital
Equity Share Capital 1,200
Preference Share Capital 950

Liabilities
Long Term Liabilities
Sundry Creditors > 1 year 15,000
Payables > 1 year 8,000
Debentures/ Bonds Issued 1,200
Loans Repayable 1,000

Short Term Liabilities

Sundry Creditors <1 year 28,000
Payables < 1 year 6,000

Assets
Long Term Assets
Fixed Assets 20,000
Intangible Assets 5,000
Investments 2,000

Current Assets
Cash 1,000
Sundry Debtors 50,000
Prepaid Expenses 5,500

THE END
of assets and liabilities?

es - will have very less fixed assets.

ustries - will have greater amount of fixed assets.

Value

Will be the present value of Assets - Liab / Divident Growth

Will be Divident Growth

estimated value of how much you can pay / wil pay!

estimated value of how much you can pay / wil pay!
Fair Value/ Present Value of bonds/ liabilities
estimated value of how much you can pay / wil pay!

estimated value of how much you can pay / wil pay!

estimated value of how much you can pay / wil pay!

What is the PV of utility from these assets?

What is the PV of utility from these assets?
Eq - you will value using DDV, etc. If Bonds - DCF etc.

Price = Value, unless the bank is YES Bank!

estimated value of how much you expect to receive.
estimated value of how much utility you plan to derive from these services.
 x How do we value the different types of assets and liabilities?

Sundry Creditors!

Who? These are people we owe money to! We owe them money because there are different services/ goods/ s
Why? We owe them money because we received services/ products from them! And we need to pay them back
How? This is the value of the services or products received. Generally - this is the price of the service or product
If we think we wont pay them - only in those cases, the price will not be equal to the value!

Example!
Reliance receives a lot of their upstream steel supplies from TATA Steels.
So who is the creditor? TATA Steels.
This is to be paid back by the end of 2021 - @1000/ kg of steel received minus any trade discounts.
Discounts are at 50/ kg if paid within the calendar year when the actual item was sold!

Price - 1000/ kg
What will be on the BS - 1000/ kg in the BS

What is the value of this item - this is more from a realistic perspective!

If you do not repay within the calendar year, price and value are the same! No discount!
But if you think you will repay within the calendar year, the value is only 950 of amounts payable!

Payables
Who? They are generally the rent payable guys, salary payable employees, wages payables, electricity payable e
Why? Because we received a good or service from them?
How? Rent payable is based on the invoice raised! So what you see as price or in the Balance Sheet will be the a
This is usually raised in advance!
For ex - you occupy a property on Jan 1, 2021 - you will have to pay them rent in advance and that will be called
But the concept we are looking at is rent payable! Which is after the invoice is raised! This is the actual amount
This is the value you will see on the Balance Sheet or as Price in our eg.
So what is the value? The value is actually the utility that you derive from it.
So for eg - they will raise an invoice for 30 days, but if you expect to vacate in 15 days - you will only derive a va
Therefore - rent payable in BS =/= the value of rent utility.

Example Reliance is occupying Mr Shah's property for 2L/ year, Mr Shah has raised the invoice for the same! Reliance exp
What is the amount you will see for the below?
Price? 2L
Balance Sheet? 2L
Value? 1.5 L

You walk into a supermarket.

You pick up a coke from the refrigerator, and while waiting in the line, you drink half the coke, and throw out th
You arrive at the billing counter.
How much will you pay for the coke?
That’s the price. 50 You have to pay the entire amount, even though t
How much utility did you get from the Coke? That’s the value!
One tin = 50
Fixed Assets/ Intangibles

What? These are basically items that we purchased which have use for more than 1 year, therefore we do not c
We charge it over the life of the asset!

Why? This is the cost of the asset approtioned over the life!
How? Lot of techniques, SLM, WDV!

Examples
Reliance purchased a heavy duty machinery for manufacturing boxes, at 10L, 3 years ago. The expected life of t
Reliance uses SLM for depreciating.

This machinery is used to make boxes that get Reliance a profit of 3/ box. Every machinery is used to make 1000

Price? 10L - Depreciation (10L/ 10 = 1L/ year) 3L = 7L

B/S? 7L - 1L = 6L
Value? 3,000

All of this - mention for 2021 alone!

Why are we worried about calculating value and price for something?
The answer is that if you have to sell this machinery , and replace with something new, what you are letting go i
You are letting go the potential to earn 3000/ year!

How can we apply this to intangibles?

Examples
Haldirams has a copyright on its brand name worth 10L.
If Haldirams wants to sell the brand to Bikanerwala - it will sell it for 10C!
Amount For whom will this be relevant?
Price? 10L For anybody who is trying to understand a minimum value to pay for Haldirams brand nam
B/S? 10L For Haldirams' shareholdrs.
Value? 10C Is the max value anyone will pay if they are trying to buy Haldirams' brand name!

THE END
 re different services/ goods/ supplies that we received from them!
And we need to pay them back!
price of the service or product minus any discounts.

y trade discounts.

mounts payable!

payables, electricity payable etc.

he Balance Sheet will be the amount of invoice raised!

dvance and that will be called rent paid in advance.

ed! This is the actual amount of payable!

ays - you will only derive a value or get a utility for the 15 days that the property was occuped!

oice for the same! Reliance expects to utilize the property for only 9 months!

alf the coke, and throw out the rest!

entire amount, even though the utility that you got is far less!
25 Because you paid only half!
1 year, therefore we do not charge the entire amount to P/L same year!

ars ago. The expected life of the machinery when it was purchased was 10 year, with no scrap value.

achinery is used to make 1000 boxes per year.

new, what you are letting go is not just a random number in a random financial statement.

o pay for Haldirams brand name!

dirams' brand name!

 Discounted Cash Flows

x Time Value of Money - some examples

x Future Value of Money - Basics
x Future Value of Money - Complex
x Present Value of Money - Basics
x Present Value of Money - Complex

Question! If you had the option of receiving 1L rupees today vs receiving 10K rupees every month for the next 10 month

What is the answer?

Some people will say 1L today, why? A bird in hand is better than two in the bush - it basically means, it is bett
Why?
Because you might not be there in the future, the person who has to pay you might not be there in the future

Some people will say 10k per month is better. Why? Because it is more planned - what if I get 1L and spend th
Better to receive it in installments.

If you receive 1L today, you can invest the 1L and after 10 months you will get how much? Assume you put it
1.1L.

Or, you might spend the 1L, in which case you are left with nothing!

Compounding will tell us which is the better option!

Question You want to go to the supermarket and buy Lays chips for 20/-.
The supermarket guy tell you, pay me 40 Rupees today, take one lays chips now……come back after 20 years,

Which is the better option? Better option is to shut up and leave the shop!

Purchasing Power!

Purchasing power is the ability to buy something today by spending cash. This will change over time and for d
Option A Option B
2021 20 20
2022 20 22
2023 20 24.2
2024 20 26.62
2025 20 29.282
2026 20 32.2102
2027 20 35.43122
2028 20 38.97434
2029 20 42.87178
2030 20 47.15895
2031 20 51.87485
2032 20 57.06233
2033 20 62.76857
 2034 20 69.04542
2035 20 75.94997
2036 20 83.54496
2037 20 91.89946
2038 20 101.0894
2039 20 111.1983
2040 20 122.3182

Option B is the correct answer. Why? The purchasing power of any commodity, or the value of money, will re

1960 A cup of tea cost 1 Rupee

2021 A cup of tea costs 50 rupees.

If in 1960, you kept 1 rupee under your pillow hoping to buy a cup of tea in 2021, you will be very disappointe

1960 Avg salary for a graduate was close to 100 rupees

2021 Avg salary for a graduate is close to 20000 rupees

What are we trying to say?

Time value of money is the value of 1 rupee over time!

Money value will change with inflation, growth of the economy and finally standard of living!

For example - you want to buy a mobile phone in 1996! What were the brands available? Nokia! Alcatel! Only two brands!
So if you had a budget, you might have to spend more because whatever price Nokia asks for you need to pay!

But today, if you look at mobile phones - you can get a good phone for 1,000 or 1L

How many people had cars in 2000? How many people had cars in 1950? How many people have cars today?

Money loses its value over time!

So why are we talking about all this? How is this even relevant? Very simple!
If I am valuing soemthing, I need to know how much it is valued at today!!!
Not 10 years down the line.

For example - I hold a zero coupon bond!

A zero coupon bond pays no interest. It will repay your principal and include all your interest payments within

For eg - I will pay 9000 when I buy the bond. The issuer will not pay me any interest, but will repay my princip

What does it mean? It means there is an interest component of 1000 in the bond!

2021 I buy a zero coupon bond for 95,000 (5 year bond, no interest, repayable at par!)
2022 No interest
 2023 No interest
2024 No interest
2025 No interest
2026 No interest, but principal is repaid at 1,00,000

Which means how much is your inherent interest?

Your inherent interest amount is 1L minus 95K that you paid initially, which is 5K rupees.

But what do I want to do? I am sitting in 2021, hoping to receive 1L in 2026. How do I know the value of this b

We use time value of money calculation.

What do we do?
We bring the value from 2026 to 2021 using a certain % rate.

2021 2022 2023 2024 2025 2026

1L

After doing this, if you notice that the value of 1L today is 98K, but you have to only pay 95K to buy this bond,
Yes, you will buy it!
Why, you are only paying 95K for a bond that is worth 1L (98K).
Which is good! You are paying less for something that has more value!

Therefore, buy! This is basic common sense!

THE END
th for the next 10 months, which one would you prefer?

basically means, it is better to receive something today than getting it in the future.

ot be there in the future etc.

t if I get 1L and spend the entire amount on junk?

uch? Assume you put it in a bank

ome back after 20 years, and buy whatever you want for the remaining 20 rupees at that time!

ange over time and for different product in different ways!

e value of money, will reduce/ change over time!

will be very disappointed today!

lcatel! Only two brands!

need to pay!

people have cars today?

nterest payments within it.

but will repay my principal at 10,000

know the value of this bond as of today?????????/

ay 95K to buy this bond, will you buy this bond or not?
 Future Value of Money - Basics

What does future value of money mean? It means we are going to try and understand how to predict the future

If I have 10K today, what is the value in real terms of this 10K in 10 years time, 2030?

What value of money in 10 years will equal 10K rupees today?

Question Will you need more money 10 years down the line, or less money to have equivalent of 10,000 rupees today.
I can buy a good refrigerator today with 10K.
If I need to buy a good refrigerator in 2030, will I need more than 10K, or less than 10K?

The answer is I will need more than 10K to buy a good refrigerator in 2030,
Don’t believe me?

How much did you need to buy a car in 1960? Around 1,000 rupees!
How much do you need to buy a car in 2020? You need atleast 5L.

Therefore, as time goes on, you will need more amount of money to buy the same things.
How do you know how much more money!

In order to understand how much more money is required to match the 10K we have today, we make use of a r

This rate = rate at which money grows!

You can call it inflation, you can call it government interest (bond rates) etc.
We will discuss this more closely later!

Rate = interest + inflation

Sometimes, we assume interest is 0, and only inflation, and soemtimes its vice versa.

FV = PV x (1 + Rate)^T

PV = what value you have today, in our example it is 10,000

1 + R = multiplicative factor to grow our money
^T = exponential factor, that tells you how many times should you grow your money!

End OF 0 1 2 3 4
10,000 11,000 12,100 13,310 14,641

Assumption: the rate we are looking at is 10%

This means that I need to have 25,937 at the end of 10 years in order t

Question You have 75,000 in your bank account

You want to invest this in a deposit for 8 years. The deposit gives you a rate of 12% per year!

Tell me what is the expected value of your current bank balance in 8 years if you invest this in the said deposit.
 0 1 2 3 4
75,000 84,000 94,080 105,370 118,014

If you deposit 75,000 today, at the end of 8 years you would have

What will be the valueis 2750 years?

75000 1.12 ###

###

Question You have 90,000 rupees today!

You have two investment options!
Option A You can put it in a safe investment like government bonds, no default - very safe will give yo
Option B You can put it in a corporate bond, which will give you either 4% return over 15 years or 9%

You need to find out which is the better option for investing - where is your return higher?

Principal Multiplicative Value Exponential M ^F

Option A 90,000 1.06 15 2.40
Option B
Bad Scenario A 90,000 1.04 15 1.80
Good Scenario B 90,000 1.09 15 3.64

Therefore, which is the better option?

The better option is the option which gives us a net high return!
And which option is that?
Option B!

What is the risk of option A - the risk is losing return of 29,264 Rupees
Why? Because you went for a safer instrument!

What is the risk of Option B? Th risk is that you will lose 53,605 Rupees

THE END
erstand how to predict the future value of cash/ money that we have today!

valent of 10,000 rupees today.

ame things.

e have today, we make use of a rate!

5 6 7 8 9 10
16,105 17,716 19,487 21,436 23,579 25,937

at the end of 10 years in order to purchase the same things that I am purchasing today for 10,000

12% per year!

u invest this in the said deposit.

 5 6 7 8
132,176 148,037 165,801 185,697

185,697

no default - very safe will give you 6% return over the next 15 years.
r 4% return over 15 years or 9% return over 15 years. The probability of both is 50-50.

turn higher?

FV
215,690 215,690

162,085 215,690
327,823
244,954

a net high return!

Rupees!
Present Value of Money

Present value of money basically says, how much money you might get in the future is irrelevant!
How much that is worth today is what is most relevant!

Assume you will get 10,000 rupees today, you are trying to understand whether that is a good idea, or getting 1
How will you go about it?
Assume the current rate of interest in the market is 10%.

You have two options - Option A - get 10K today! And Option B - get 1L after 25 years.
Using the future value concept we saw, can we arrive at a decision?

Imagine, you invest 10K today, and you want to know how much it will be valued at after 25 years.
If that value is > 1L , then go with 10K today. Else. Choose 1L after 25 years.

Today, I am 25 years old and I can get 10K. And I can invest this 10K in the bank, and when I am 50, I will be able
Is that amount greater than, equal to or less than 1L?
If it greater than 1L, then go for 10K today!
If 1L is greater than that amount, choose 1L after 25 years.
If both are equal, you are indifferent. You don’t have an opinion, anything is OK!

We will try growing this 10K for 25 years by investing it in a bank - P * (1 + R) ^ T

if you get 1L after 25 years

Therefore, the first option is better, get 10K today!!!!

In this concept, what we did was, we took the 10K to a future period and compared with a future cash flow (1L)
The other option is to bring the future cash flow (1L] to today's preiod and compare it to what we will get today

A
2021
10K

A
2021
10K

FV = P * (1 + R ) ^T

1L = P * (1.1)^25

1L = P
1.1^25

FV = P
 (1 + R)^T

100000
1.1^25

9,230

10,000

10,000 today is better than 1L in 25 years!

Question Mr X wants to invest in a land that he will pay 10L to buy today, and he will get 1.5 CR in 25 years time! Alternati
annually!

Interest from savings accounts are tax exempt in the country where Mr X resides, but real estate gains (capital g

Find out which investment option is better - Option A: Land or Option B: Savings Account

Answer Option A What is the value of 1.5C in today's terms -> FV =

(1 + R) ^ T

Option B What is the value of 10 L today if you invest it in a 6% interest rate account>?

Option A is the better investment! Why? It has a better FV today even though

To make this more intuitive, you are growing 10L by greater than 6% under op

growing = compounding
bringing it back = discounting

Everytime your rate of compounding > discounting = PV go up!

If rate of compounding < discounting = PV will go down!
If rate of compounding = discounting = no change to PV!
THE END
e future is irrelevant!

ther that is a good idea, or getting 1L after 25 years is a good idea.

alued at after 25 years.

ank, and when I am 50, I will be able to withdraw this amount. How much is that amount?

P * (1 + R) ^ T = 108,347

= 100,000

mpared with a future cash flow (1L) and decided which is better!
ompare it to what we will get today!

B
2045
1L

B
2045
1L
get 1.5 CR in 25 years time! Alternatively, Mr X can deposit that money in a savings account and get 6% interest

sides, but real estate gains (capital gains) are taxable at 20%.

ings Account

15000000 MINUS Tax = 2,842,583 Rupees in today's terms!

1.06^25

Cost = 1,000,000

Profits = 1,842,583

Tax = I have topay a tax on the gains I enjoyed on this land

= 1.5C - 10L x 20 % tax
= 2,800,000

ate account>? = 10 (1 + R) ^ 25
(1 + R) ^ 25

Profits = 1,000,000

t has a better FV today even though there is taxation!

ng 10L by greater than 6% under option A, and bringing it back at 6%.

counting = PV go up!
will go down!
change to PV!
 Complexities in Time Value of Money.

The components involved in a time value of money analysis are below -

x Present Value
x Future Value
x Rate of Interest
x Time!

Rate of compounding or discounting - Basically depends on the following

1 Opportunity Cost
2 Rate of Interest In the Market
3 Inflation

Nominal Rate and Real Rate!

Nominal Rate = Real Rate + Inflation

Time - for compounding is basically the number of times you compound dueing the period you compound for!
In our examples, we assumed that we compounded only once a year!
But what if we compount monthly?
What if we compound daily?

Your FV in the future will also increase

But always remember - we need to have a link between T and R!

If T is being done weekly, the rate should be a weekly rate of interest.

The question might give you a yearly rate of interest, and ask you to compound weekly. You need to make sure
correct answer!
Both your measures should be in the same denomination!

Question Mr X is an American who wants to invest in India. He wants to determine the correct rate to be considered for m
he is being told that these investments can be made in multiple rates, that is there are different comparebles pr
which one he is more comfortable to use for his investing purposes.

Simple Interest Rate - 5%

Opportunity Cost - 7%
Inflation - 9%
Nominal Interest Rate - 14%

If you are given the nominal rate - always use the nominal rate in your answers.

So how is the nominal rate being arrived at? Simple Interest Rate + Inflation = 14%

Why don’t we use the opportunity cost? Because Mr X is American, the opportunity cost is the cost of investing
 Therefore, opportunity costs don’t matter!

Question Mr X understands that the formula for compounding changes when you compound multiple times in the same y
Mr X wants to compound weekly, what will T be for Mr X in his formula?
Assume his period of investment is one year!

T=nxt
small t = number of years.
n = number of times you are compounding

T = 54 x 1 = 54

Question Mr X has decided to go ahead with his investment in India, and invests 150,000 in a mutual fund that promises a
You need to find out how much will Mr X earn if he stays invested for 3 years.

P = 150K
R = 10% = 10/12 = 0.833333333333
T = n x t = 12 x 3 = 36 36

FV = P x (1 + R) ^ T
= 150K x (1 + 0.0083)^ 36
202,203

What if Mr X did not compound this monthly, but went for a yearly compounding, will the answer remain the sa

P = 150K
R = 10
T=3

FV = P x (1 + R) ^ T
= 150K x (1 + 1)^ 3
199,650

Because of monthly compounding, Mr X actually makes 2,553 more!

Therefore, if you are someone investing in the markets, the more you compound, the better it is for you!

Question Assume after 3 years, Mr X's prediction is accurate. He wants to understand, how much should he have invested
the question is how much more should he have invested to make this amount - assume same monthly compoun

FV = 300K
R = 10% = 10/12 = 0.833333333333
T = n x t = 12 x 3 = 36 36

FV = P x (1 + R) ^ T
 3L = P x (1 + 0.0083)^ 36
P = 300K/1.0083^36 222,787

THE END
e period you compound for!

eekly. You need to make sure to convert the yearly rate to the weekly rate so that you have the

ct rate to be considered for making his investments. When he approaches a professional,

are different comparebles present in the market. He is provided the below rates to decide

y cost is the cost of investing in his own country - which he doesn’t want to do anyway!
d multiple times in the same year!

a mutual fund that promises a return of 10% per year, compounded monthly.

will the answer remain the same?

the better it is for you!

much should he have invested in order to make 3L after 3 years. Right now, only only has 2L. So,
sume same monthly compounding and 3 year tenure and interest rates.
 Discounted Cash Flow

So when you try to make an investment and take a decision based on that, you have to understand how much t
So we need to see how much a particular investment will fetch us in today's terms.

The present value = which is what we need, because our investment will be repaid over multiple years. So you n

Let us look at an example - REL wants to purchase a machinery that will give it a benefit of 50K for 10 years.
Cost of the machinery is 3L.
Is it a good purchase or a bad purchase?

Advantages
Easy to understand
Easy to calculate
Will give you an approximation really quick.

Disadvantage

This method requires a lot of assumptions to be made!

Formula for discounted cashflows = All investments minus all benefits brought to the present.
It means you need to find out the present value for all the investments and benefits that are there out in the wo

If the present value of benefits > present vaue of investments -> go for the investment, it is good.
If the present value of benefits < present value of investment -> don’t go for the investment, it is bad!

Question You are asked to invest 3L in a machinery, which will give you a benefit of 50K per year for 10 years, determine
Discount rate - 10%

Some basics first!

1 Whenever we say we are making an investment today, assume it is today!!! So no discounting requir
2 Whenever we say there is a benefit that will accrue over ten years, assume the first payment of bene
today, since most cases, you will only get the benefit after making the investment -> so, unless specifi
0 1 2 3 4
Investment -300,000 - - - -
Benefits 50,000 50,000 50,000 50,000
Discounting 1 0.9091 0.8264 0.7513 0.6830
Discounted Numbers -300,000 45,455 41,322 37,566 34,151

Therefore, the net benefit of making this investment is 7,228 rupees!

Question You are asked to invest 6L in a machinery, which will give you a benefit of 50K for 20 years., determine if this is
Discount rate - 10%

0 1 2 3 4
Investment -600,000 - - - -
 Benefits 50,000 50,000 50,000 50,000
Discounting 1 0.9091 0.8264 0.7513 0.6830
Discounted Numbers -600,000 45,455 41,322 37,566 34,151

Why is my loss so big when I doubled investments, but at the same time, I doubled my benefits perio
The answer is simple - the more you invest in the beginning, the more you will have to get as benefit
But if you keep the benefit amount as the same, and only increase your duration of getting the benefi

What if I double my benefits, instead of increasing the duration?

Original
0 1 2 3 4
Investment -300,000 - - - -
Benefits 50,000 50,000 50,000 50,000
Discounting 1 0.9091 0.8264 0.7513 0.6830
Discounted Numbers -300,000 45,455 41,322 37,566 34,151

If I double Duration and investment, but benefits are the same

0 1 2 3 4
Investment -600,000 - - - -
Benefits 50,000 50,000 50,000 50,000
Discounting 1 0.9091 0.8264 0.7513 0.6830
Discounted Numbers -600,000 45,455 41,322 37,566 34,151

If I double investment and benefits, but keep duration the same

0 1 2 3 4
Investment -600,000 - - - -
Benefits 100,000 100,000 100,000 100,000
Discounting 1 0.9091 0.8264 0.7513 0.6830
Discounted Numbers -600,000 90,909 82,645 75,131 68,301

My profit is doubling!

Original Profit 7,228

My 2x Investment, 2x profit 14,457
2.00

This means that if the duration of your investment is the same, and you only double the investment a
The key here is to keep your duration to only 10 years!

THE END
o understand how much this investment will be valued at or will be worth in today's terms.

er multiple years. So you need to pull all your future benefits to todays date.

fit of 50K for 10 years.

at are there out in the world

, it is good.
tment, it is bad!

r for 10 years, determine if this is a good investment or not!

So no discounting required to bring it to present value, because it is already at present value!

the first payment of benefit starts from 1 year down the line - never assume first payment is done
tment -> so, unless specified in a Q, never assume the first benefit payment will be received today!
5 6 7 8 9 10
- - - - - -
50,000 50,000 50,000 50,000 50,000 50,000
0.6209 0.5645 0.5132 0.4665 0.4241 0.3855
31,046 28,224 25,658 23,325 21,205 19,277 7,228

ears., determine if this is a good investment or not!

5 6 7 8 9 10 11 12 13 14
- - - - - - - - - -
 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 0.3505 0.3186 0.2897 0.2633
31,046 28,224 25,658 23,325 21,205 19,277 17,525 15,932 14,483 13,167

doubled my benefits period?

will have to get as benefit within the same period of the initial investment.
ation of getting the benefit, it is riskier.

5 6 7 8 9 10
- - - - - -
50,000 50,000 50,000 50,000 50,000 50,000
0.6209 0.5645 0.5132 0.4665 0.4241 0.3855
31,046 28,224 25,658 23,325 21,205 19,277 7,228

5 6 7 8 9 10 11 12 13 14
- - - - - - - - - -
50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 0.3505 0.3186 0.2897 0.2633
31,046 28,224 25,658 23,325 21,205 19,277 17,525 15,932 14,483 13,167

5 6 7 8 9 10
- - - - - -
100,000 100,000 100,000 100,000 100,000 100,000
0.6209 0.5645 0.5132 0.4665 0.4241 0.3855
62,092 56,447 51,316 46,651 42,410 38,554 14,457

y double the investment amount and benefits you will get from it, your profits today are also double!
15 16 17 18 19 20
- - - - - -
50,000 50,000 50,000 50,000 50,000 50,000
0.2394 0.2176 0.1978 0.1799 0.1635 0.1486
11,970 10,881 9,892 8,993 8,175 7,432 -174,322

15 16 17 18 19 20
- - - - - -
50,000 50,000 50,000 50,000 50,000 50,000
0.2394 0.2176 0.1978 0.1799 0.1635 0.1486
11,970 10,881 9,892 8,993 8,175 7,432
Question A firm gets the below cash flows over the next 10 years. Analyse and understand where the firm is profitable or

Investment Today (2021) 2,500,000

Benefits 2022 500,000
Benefits 2023 500,000
Benefits 2024 500,000
Benefits 2025 500,000
Investment 2026 350,000
Benefits 2027 200,000
Benefits 2028 200,000
Benefits 2029 200,000
Benefits 2030 200,000

Assume a cost of capital of 8%, and analyse whether the firm is profitable or not.

Answer 1 Today (2021) -2,500,000

2 2022 500,000
3 2023 500,000
4 2024 500,000
5 2025 500,000
6 2026 -350,000
7 2027 200,000
8 2028 200,000
9 2029 200,000
10 2030 200,000

Since the total value for the firm is in negatives, the firm is actually losi

This or That Decisions

Basically, this or that decisions involve analyzing the discounted cash flows for a particular company, between t
Based on which option has the better discounted cash flow, we will go ahead and choose that option! This will e

So for example, Mr Ambani can choose to open a hotel in two places - either in Chennai, which is more of a tem
Based on that, you need to analyze which option is the better option, and which one he needs to go with

So let us look at the cost - benefit analysis for the two options!
Chennai Mumbai
Investment 6,000,000 9,000,000
Benefits for the next 25 years 500,000 750,000
Maintenance costs for the hotel/ yr 125,000 200,000
Salary Costs/ yr 90,000 100,000
Rent cost 65,000 75,000

For both the options, Mr Ambani has to take a loan from Citibank @ 11% rate of interest. Find out which option
Answer Chennai Mumbai
Investment -6,000,000 -9,000,000
Benefits for the next 25 years 500,000 750,000
Maintenance costs for the hotel/ yr 125,000 200,000
Salary Costs/ yr 90,000 100,000
Rent cost 65,000 75,000
220,000 375,000
Chennai Mumbai
1 220,000 800,000
2 220,000 960,000
3 220,000 1,152,000
4 220,000 1,382,400
5 220,000 1,658,880
6 220,000 1,990,656
7 220,000 2,388,787
8 220,000 2,866,545
9 220,000 3,439,854
10 220,000 4,127,824
11 220,000 4,953,389
12 220,000 5,944,067
13 220,000 7,132,880
14 220,000 8,559,456
15 220,000 10,271,348
16 220,000 12,325,617
17 220,000 14,790,741
18 220,000 17,748,889
19 220,000 21,298,667
20 220,000 25,558,400
21 220,000 30,670,080
22 220,000 36,804,096
23 220,000 44,164,915
24 220,000 52,997,898
25 220,000 63,597,478

Investment

Both projects are not profitable, but if you have to choose one of these

Analysis

1 Why is our project for Mumbai profitable without discounting, but not
2 At what discount rate will Mumbai break even?
3 Is there an issue with our assumptions or our calculations? Are we doin
Let us assume 10% inflation
 As long as our inflation< discount rate - we will be making losses. If infl

THE END
 lyse and understand where the firm is profitable or not.

m is profitable or not.
Discount at Cost of Capital
1 -2,500,000
0.925925925925926 462,963
0.857338820301783 428,669
0.79383224102017 396,916
0.735029852796453 367,515
0.680583197033753 -238,204
0.630169626883105 126,034
0.583490395262134 116,698
0.540268884501976 108,054
0.500248967131459 100,050
-631,305

e for the firm is in negatives, the firm is actually losing money! Therefore, this is not a good investment!

ted cash flows for a particular company, between two options.

we will go ahead and choose that option! This will ensure that you derive the best possible value for an investment!

wo places - either in Chennai, which is more of a temple tourism city, or in Mumbai, which is more of a business tourism city!
er option, and which one he needs to go with

bank @ 11% rate of interest. Find out which option is more profitable, and analyze whyyyy this option is preferred!
 Chennai Mumbai
198,198 720,721 90.090%
178,557 779,158 81.162%
160,862 842,332 73.119%
144,921 910,630 65.873%
130,559 984,465 59.345%
117,621 1,064,286 53.464%
105,965 1,150,579 48.166%
95,464 1,243,870 43.393%
86,003 1,344,724 39.092%
77,481 1,453,756 35.218%
69,802 1,571,628 31.728%
62,885 1,699,057 28.584%
56,653 1,836,818 25.751%
51,039 1,985,750 23.199%
45,981 2,146,756 20.900%
41,424 2,320,818 18.829%
37,319 2,508,992 16.963%
33,621 2,712,424 15.282%
30,289 2,932,350 13.768%
27,287 3,170,108 12.403%
24,583 3,427,144 11.174%
22,147 3,705,021 10.067%
19,952 4,005,428 9.069%
17,975 4,330,192 8.170%
16,194 4,681,289 7.361%
1,852,784 53,528,293
-6,000,000 -9,000,000
-4,147,216 44,528,293

ot profitable, but if you have to choose one of these projects, choose the one with the least loss - Chennai!

or Mumbai profitable without discounting, but not profitable after discounting?

te will Mumbai break even?
th our assumptions or our calculations? Are we doing something wrong?
tion< discount rate - we will be making losses. If inflation > discount rate, we will make profits.
an investment!

business tourism city!

n is preferred!
 CAPM, FF and WACC

Capital Asset Pricing Model! - this is majoly used for equities

It gives you a relationship between the expected price of the equity we have, the risk free rate, BETA! And Mark

Expected Price of the equity is a function of risk free rate, beta and risk premium.

Expected Price E = RF + B(RP)

We are going to find out what E is.

RF = given in the question, this will be the minimum rate fixed by the Central Bank of the country.
B = sensitivity of the security to the market
If the security moves by 1 Re for every 1 Re move of the general market (index), then we say B = 1. If security m
Market = the general stock market. A good substitute / indicator is an index in the market.
RP = MRP or Market Risk Primuum or RP = M Return minus RF Return

The stock that we are analyzing is INFY.

Now, INFY has a price in the market of 350 Rs/ stock.
We need to calculate INFY's real price based on CAPM and decide if INFY is a BUY or SELL.

RFR = 6%
SENSEX = 9%
For very 1% move in SENSEX, INFY moves by 1.5%
What is INFY's BETA? 1.5/1 = 1.5

ER = RFR + B (RP)
ER = 6 + 1.5(9-6)
ER = 6 + 1.5*3
ER = 6 + 4.5
ER = 10.5%

It means if you buy INFY today, you should be expecting a return of 10.5% annualized.

But…. Will this always be the case?

There is a chance INFY gives less return, gives more return etc.

If INFY adheres to CAPM - understand what its price one year down the line could be - 350 + 10.5%
386.75

Question Assume you are now valuing BOB - and you have to find out the expected return for this stock.
Same Risk Free Rate and Sensex performance as the last question. But BOB falls by 1% for every 1% increase in

RFR 6%
RP 3%
Beta -1 It has something called as a perferct negative correlation with the market
 Which means everytime the market moves in a particular direction, the stock will move in

Is there any benefit of owning a stock which is always negatively correlated. That is , what
market goes up?

it moves in the opposite direction of the market! Therefore, if you expect a stock to move
market will go down!

ER 3 3%

Now in the next year, the stock is still in our portfolio, but this time, the market has crashed by 10%

RP -16

ER 22 22%

The expected return from stocks is basically how much a shareholder will expect from the equity from the comp
There is an obligation from the company to deliver this to the shareholder (this is according to the shareholder,

This 'delivering of return' to the shareholder is done in two ways

1 Better performance by the company -> better share prices -> happy shareholders.
2 Better performance by the company -> dividends

Technically, this CAPM ER that we calculated is a cost to the company - and is called the cost of raising equity!

If the company makes 8%, the company has failed!

If the company makes 12%, the company has succeeded, but the first 10% is taken away by the equity sharehol

THE END
 free rate, BETA! And Market Risk Premium!

the country.

we say B = 1. If security moves by less than 1Re = B <1.

- 350 + 10.5%

% for every 1% increase in the SENSEX. Calculate its ER.

tion, the stock will move in the complete opposite direction!

y correlated. That is , what is the advantage of owning something that goes down when the

ou expect a stock to move in the opposite direction, buy that stock when you think the

ashed by 10%

m the equity from the company issuing the stock!

ording to the shareholder, there is no written contract/ law saying you have to deliver)

ppy shareholders.

he cost of raising equity!

way by the equity shareholder since its his ER. The company has technically made only 2%
CAPM has a fancy terminology asociated in it called the Beta!

Beta is nothing but the sensitivity of the stock, to the index.

Beta can be any value - +INF to - INF

Positive Beta - means the stock is rising when the market rises, and the stock is falling when the market falls.
Negative Beta - means that the stock is going in the opposite direction to the market.
Zero Beta? It means that the stock never moves irrespective of what happens in the market.

How is Beta Calculated = Covariance between the stock and the market
Variance of the Market

MARKET = A representation of the market - index, SENSEX, NIFTY, NASDAQ, NIKKEI, DAX, FTSE etc.

A concept - Beta!

Beta is basically a concept of risk.

There are two types of risk for every stock! The general risks of the market, and the specific stock related risks.

You want to invest in a company called IOCL.

They buy crude oil, refine it and sell in the market as petroleum.

General Risks - crude oil prices, tension in the Middle East, electric vehicles, natural resource depletion, etc.
Specific Risks - key person risks, financial statemtn risks, reputation risks. Etc

General risks - systematic risks.

Specific risks - non systematic risks

Now, as an investor, it is your duty to get rid of all systematic risks.

How do you get rid of systematic risks?

By diversification.

If you buy 1 share in IOCL - also buy the below shares -

1 share in TESLA
1 share in BP
1 share in Exxon

By following the above portfolio - you have gotten rid of all systematic risks.
It is the duty of all investors to get rid of all systematic risks in their portfolio!
Higher the risk, higher the return!

Higher the unsystematic risk, higher the return! You will not get any reward for holding on to systematic risks, o
The only risk you will be exposed to is unsystematic risk!
And it is only basis this unsystematic risk that we will actually find out expected return.
 Therefore, Beta is also called the unsystematic risk of a company!

Imagine you are doing your CFA Level 1.

You know there are 10 chapters/ subjects you need to study!
There will be questions from all 10 subjects.
If you leave out one subject, and study remaining 9 you are exposing yourself to systemaic risk.
But if you leave out on sub division in a chapter and study the rest properly, you are exposing yourself to unsyst

Leverage!

Leverage is the amount of debt you have in your company!

Two or more companies will have different amounts of debt and therefore will have different leverage.

Beta = Asset Beta

Debt beta

Equity Beta = Asset Beta

Debt beta

Equity Beta - is what we use in the CAPM calculations.

You might not have the equity beta for your company!
So you might have to use a comparible equity beta number for your analysis

When we say comparible - we are referring only to our assets.

The assets are comparable!
But is debt comparable? NO!

In order to get your company's equity beta from a comparible equity beta,
1 Unlever the comparible equity beta, so you are left with the asset beta for the compari
2 We know that the asset beta for the comparible = asset beta for our company
3 Re-level the asset beta using our debt numbers
4 so now you have the equity beta for our company!

Suppose I am trying to find out the Eq Beta for INFY. There is no Eq Beta for INFY available in the market. But I k
the Eq B for INFY from WIPRO's Eq B.

1 Unlever Wipro's EQ B, so you are left with the A Beta for Wipro.
2 Now you have WIPRO A Beta = INFY A Beta
3 Re lever INFY's A Beta , so now you have INFY's DEBT Component added
4 INFY's Eq B

You can next use this Eq B from INFY into our INFY's CAPM calculation.

THE END
is falling when the market falls.

in the market.

IKKEI, DAX, FTSE etc.

nd the specific stock related risks.

natural resource depletion, etc.

or holding on to systematic risks, only get dandruff and losses!

 to systemaic risk.
ou are exposing yourself to unsystematic risk!

ll have different leverage.

with the asset beta for the comparible.

set beta for our company

NFY available in the market. But I know that WIPRO is a comparible asset beta. Now how do you arrive at

for Wipro.

Component added
 What is the the WACC or Weighted Avg Cost of Capital?

A cost is nothing but the amount you pay to get something…

The cost o fwashing machine - is how much you pay to get the washing machine
The cost of a TV - is how much you pay to get the TV, so on and so forth.

Now…. What is the cost of an IPO?

That, I am not asking you what expenses are incurred by raising money in the share market.
Are there any dividends promised for equity shares? NO!
Do you promise results, you give them an expectation of results, but you never promise returns, you never prom

How do you calculate/ quantify the cost of equity?

We need to think about how much the sharehold expects to receive from the market!

Where have we seen shareholder expectations before? CAPM!

So using the CAPM formula, we can arrive at a shareholder expectation, which the company should try to meet
Therefore, the ER in CAPM is our cost of equity!

What are the other forms of capital? We just saw equity, can you think of how else capital can be raised?

What do you mean by capital, it is nothing but the raising of money (either with a promise of payment or with n
promise of participation.
Participation
Yes No
Promised Yes Prefence Share Debt
Return No Equities unsecured creditor

We saw how equities are classified and valued!

We use a method called CAPM!

Debt
Debt is basically everything that involves a fixed repayment and no participation!
1 Bonds
2 Debentures
3 Loans

These are all having an inherent cost - what is the cost? The cost of interest payment!

So you have to pay interest for this debt! That is the cost for the company!
But there is a small benefit that the company gets because of this debt!
What is this benefit? Tax benefits!

Tax - is generally calculated on your net profits after deducting all expenses …. More the expenses, less the net
Interest expenses are included within the scope of expenses for reducing your tax burder.
Therefore, the actual cost of debt =/= I
Actual Cost of Debt = I (1 - T)

Lets assume you have a loan of 1L, with interest payments at 10% (10k/ year). The company has a profit before
 Calculate the interest that you will pay, the net profit, the net tax liability and the cost of debt.

Interest - 1L x 10% = 10K

Net Profit = 15K minus Interest = 15K - 10K = 5K
Net tax liability - assume tax in calculated at 20% of net profits = 5K x 20% =
Cost of Debt = i x (1 - T)
0.08
8% is my actual cost of Debt

The actual interest we paid 10%

How much tax did we save by making this interest payment?

Without Interest = 15K x 0.2 = 3,000

With Interest = 1,000
My Tax Saving 2,000

Actual cost of Debt = Interest payment minus any tax saving

Loan amount O/s

8%

Preference Share Capital

They get a fixed rate of Income - the only difference between a bondholder and a preference shareholder is tha
Bondholders get interest, which is tax deductible.
Preference shareholders get dividends, which are not tax deductible.

Cost of Capital for PS = D

THE END
share market.

r promise returns, you never promise capital appreciation.

the company should try to meet!

else capital can be raised?

h a promise of payment or with no promise payment), either with promise of participation, or with no

More the expenses, less the net profits and less the tax amount!
tax burder.

The company has a profit before interest of 15,000.

he cost of debt.

1,000

d a preference shareholder is that…..

 Application of the cost of capital!

WACC will tell you how much cost the capital has - and this will determine how much return you must get at a m
Because -
It is the capital you raised that is basically being deployed in a lot of projects!

Return from the project you are using the capital for > cost of the capital

Suppose I take a loan for 5% and use it to start a business. My minimum return from the business must be 5%.

WACC = Prop. Of Eq x Cost of Eq + Prop of Debt x Cost of Debt + Prop of Pref x Cost of Pref
Amount Cost Weights WACC
Example Equity 100,000 9% 0.33 3.00%
Pref 100,000 5% 0.33 1.67%
Debt 100,000 6% 0.33 2.00%
Total Cap 300,000 6.67%

What does this mean?

It means the bare minimum return that I need to get out of all of my investment that I make with the 3L is 6.67%
Anything less than that, return the 3L, close shop!
Anything more than that, profits!

Question ABC Industries need to raise 10L of capital in order to invest in a project that will give them a return of 8%.
ABC raises 5L via equities, through a follow-on public offer, assume ABS has a sensitivity of 1.25 to the market, a
ABC raises 3L via debt, promising to pay 6% interest. Assume tax rate for ABC is 20%.
ABS raises 2L via preference shares paying the same 6%.
Find out the WACC for ABC, and if the project is a good proposal or not!
Cost Amounts Weights
Answer Cost of Eq = RFR + B x (MR - RFR) = 9 500,000 0.50
Cost of Debt = D x (1 - T) = 4.8 300,000 0.30
Cost of PS = Dividends Rate = 6 200,000 0.20
1,000,000
WACC 7.14

We need to compare WACC to return on the project, and then determine if profitable or not!

Project 8
WACC 7.14

From the outlook, this seems very profitable!

The most important point!

You remember? We spoke about a discount rate for discounted cash flows?
The best discount rate you can use for your DCF calc is the WACC!
 But be selective when you use the WACC - if the company is using only equities to fund a project, do not use the

You should be compare like for like!

For example, in our previous question, assume the company wanted only 5L for the project and they use only th
Same return 8%
WACC 7.14

It is wrong!
Because the debt and PS were not used to fund the project…. You have to use only the comp

WACC 9

We will say that the project is not profitable!

Assume the project is only giving a return of 7%, and only needs 5L for funding it. The company decides to fund
Determine if the project is profitable or not!

Return on the project that we expect 7%

WACC
A 7.14 Total WACC - No! Therefore, this is wrong!
B 9 CoE - Are you using only equity? NO!
C 2.64 Weights under the old WACC x Cost - because you are using old we
D New weights have to be ascertained

The answer is 5.28%

Is this higher or lower than what we have?
This is lower.
Cost < Return!
Therefore, the project is a good proposition! We should go ahead with funding the project!

THE END
much return you must get at a minimum for whatever you spent on raising capital!

from the business must be 5%.

ost of Pref

t that I make with the 3L is 6.67%

l give them a return of 8%.

ensitivity of 1.25 to the market, and the market moves by 8% when the risk free rate is 4%.

WACC New Weights

4.50
1.44 0.60 2.88
1.20 0.40 2.40
7.14 5.28

fitable or not!
 to fund a project, do not use the WACC! Use only cost of equity.

the project and they use only the equity component to fund the project.

…. You have to use only the components that were used for funding the project! ONLY EQ!

t. The company decides to fund the project using the debt and PS component.

t - because you are using old weights! WRONG!

ahead with funding the project!

 Fama French Model

Two blokes - Fama and French discovered this model, and this is basically and asset pricing model. We saw anot

An extention of the CAPM, or the capital asset pricing model!

CAPM = RFR + B x (MR - RFR)

FF = RFR + B1 x (MR - RFR) + B2 x (SC - LC) + B3 x (VS - GS) + E

Three factor fama french model!

RFR = Risk Free Rate (Same as CAPM)

B1 = Sensitivity to Market (Same as CAPM)
B2 = Sensitivity to SC stocks
SC = Index of SC stocks
LC = Index of LC stocks
B3 = Sensitivity to value Stocks
VS = Index of Value Stocks
GS = Index of growth stocks

If the red portion of your formula is +, it means Market is doing better than RFR, and we have +ve correlation to
OR
It means the market is doing badly, that is MR < RFR, and we have negative correlation to the market.

If the green portion of your formula is +, it means small cap stocks are doing better than large cap stocks, and yo
OR
it means SC stocks are doing worse than LC stocks, SC<LC, but you have a negative correlation to small cap stock

If the brown portion of your formula is +, it means value stocks are doing better than growth stocks, and you ha
OR
It means value stocks are doing worse than growth stocks, VS< GS and you have a negative correlation to value

Application of the Fama French Model in Real Life

Market Move Long (Buy) Short (Sell) Beta

Increase in RFR RFR MR Negative
Increase in Market Returns MR RFR Positive
Increase in small cap returns SC LC Positive
Crash in small cap returns SC Negative
Crash in Large cap returns SC LC Positive
Increase in large cap returns LC Negative
Increase in value stocks VS Positive
Crash in value stocks VS Negative
Crash in growth stock GS Positive
Increase in growth stocks GS Negative
Question XR is a long only investor who wants to position a trade in the NIFTY based on NIFTY returns. XR expects NIFTY t
using a FF model.

What will you do?

Answer XR is long only - so no chance of shorting.

If NIFTY crashes, the value in the bracket will be negative - therefore yo need to have a negative B1 to counter i
How do you have a negative B1?
Buy stocks that are negatively correlated to the NIFTY, stocks which will go down if NIFTY goes up!

Question ABC Incorporated are looking to invest in the stock market, and are particularly focussed only small cap stocks.
Even though they expect the index to go up vs the NIFTY 50, which is the large cap index, they want a position i
What would you advise?

Answer Inside the bracket, the index is moving up vs the large cap index, which means there is a +ve effect. Therefore, i
If you need a positive beta, you should be heavily correlated to the small cap stocks.

THE END
et pricing model. We saw another asset pricing model - remmebr?

and we have +ve correlation to the market.

lation to the market.

er than large cap stocks, and you have a +ve correlation to small cap stocks.

e correlation to small cap stocks.

han growth stocks, and you have a +ve correlation to value stocks,

a negative correlation to value stocks.

FF = RFR + B1 x (MR - RFR) + B2 x (SC - LC) + B3 x (VS - GS) + E

FTY returns. XR expects NIFTY to crash in the next few months, and he wants to position his trade accordingly

ave a negative B1 to counter it and make our returns positive.

if NIFTY goes up!

ocussed only small cap stocks. Their index which is their benchmark is the NIFTY N50,
p index, they want a position in individual small cap stocks to make returns!

ere is a +ve effect. Therefore, it makes sense to have a positive Beta!

 Dividend Discount Model

This model basically arrives at the value of equity by using the discounted cash flow model.

Discounted cash flow - basically said - the value of anything that you own today, is the present value of future c

So, the present value of the cash flows that you get from a particular stock is called the intrinsic value!

If the MV > Intrinsic Value, don’t buy, sell!

If the MV< Intrinsic Value, buy!

Using the dividend discount model - we will arrive at the instrinsic value, and then decide whether to buy or sel

Under the discounted cash flow model - the main cash flow for equities -> dividend!

We discount the dividends to the present value to arrive at the Intrinsic value!

This method is also called the Gordon Growth model!

Value Today = Future Dividends

Rate of Discounting - Growth

Ideally, what you should be having as denominator should be the discount rate for the period!

Dividend 1 = X
1.1^1
Dividend 2 = X
1.1^2

etc. etc. etc.

The main assumption under the Gordon Growth Model is called as perpetuity - meaning, we will hold on to the

Perpetuity = Cash Flow

Rate

This is a simple idea, or a simple expression, but what if the rate increases over time?
It means your present value should also be higher!

So, you will reduce the growth from the rate of discounting.

Example We own stocks of INFY - and expect to get 1000/- per year for the rest of our life. Our expectation (cost of equit

Value Today = Future Dividends

Rate of Discounting - Growth
 = 1000
0.1

= 10,000

Assume you think the value will increase by 2% every year!

= 1000
.1-.02

= 12,500

Major assumptions -
1 Growth rate can never be more than discount rate!

Assume that your dividend is growing at 15%

Value Today = Future Dividends

Rate of Discounting - Growth

= 1000
10% - 15%

= -20,000

Question You have shares of REL currently trading at 15000/ share. You expect REL to give out a dividend of 1450/ perpet
The cost of equity for REL is determined to be 13%.
Find out the instrinsic value of REL shares, and if REL is a buy/ sell according to Gordon Growth Model!

Answer Value Today = Future Dividends

Rate of Discounting - Growth

= 1450
13% - 3%

= 14500

The intrinsic value of one share in REL is 14,500 while the MV is 15,000! What does this mean? This means the s

The other types of calculation under the Gordon Growth Model -

1 One Period Model
2 Multiperiod Model
 Till now, we saw perpetual model…. Dividends will be paid forever.

1 One Period Model tells you, you will receive dividends for one period alone and then you will sell the

V =PV of D + PV of Selling Price

Example XYZ Corp is currently paying a dividend of 2000/ share.

Mr A has 1 share and expects to sell this in one years after receiving the dividend
Expected selling price - 4500 Rs. Assume 10% discount rate!

V = 2000 + 4500
1.1^1 1.1^1

= 1818.182 + 4090.909

= 5,909

Assume the share is selling in the market for 5000 - will you buy or not? BUY!

2 Multiperiod model - these are genetally more complicated to calculate, since they will hav
But realistically, multi period models are the most practical way of doing DD calculation.

THE END
resent value of future cash flows!

ntrinsic value!

e whether to buy or sell the stock!

, we will hold on to the stock forever!

xpectation (cost of equity) - CAPM is 10%

ividend of 1450/ perpetually and this amount will be growing at 3%.

Growth Model!

mean? This means the shares in the market are overvalued! Do not buy!!
nd then you will sell the stock!

not? BUY!

ulate, since they will have different growth rate, dividends, etc for different periods.
doing DD calculation.
Relative Valuation Models

The models we saw till now - CAPM, FAMA FRENCH and Dividend Discount are all standalone models!
When we say these are standalone models, what we mean is that these models only look at the fundamentals o

CAPM - Beta!
Fama French, 3 Betas!
Dividend Discount - Dividends, and the discount rates!

All of the above pertain ONLY to the stock that we are valuing!

But that changes, when we see something called as Relative Value Models!

Single Valuation Models - fundamentals of the stocks vs the price of the stock!
Relative Value Models - fundamentals of the stocks vs other stocks in our portfolio!
When I say other stocks in the portfolio, I mean other stocks in the industry, the industry avg, etc.

There are broadly two types of valuation multiples!

1 Equity Multiple!
2 Enterprise Multiples, or Enterprise Value Multiples!

Equity Multiples!

These are basically used by retail investors!

Who is a retail investor? Anybody investing for a few shares, or anybody investing for a minority interest!

Minority Interest - if you own less than a particular % of shares, you don’t really control the company!
When you don’t control the company, you must value the shares as if you want to sell them at any time.

Types of Equity Multiples -

1 P/E Ratio
2 Price/ Book Ratio
3 Dividend Yield
4 Price/ Sales Ratio

P/E Ratio = Price Price = Market Price

Earnings!
EPS = Total Earnings/ Total No. of Shares
Earnings also called as EPS.

Through the PE ratio, we are trying to understand what the Price of the Share is, for every rupee of e

If every rupee of earning is a rupee of price it should technically be 1.

But that is not generally the case!

A PE of 10 means the Market is 10x the earnings of the company!

 If EPS is 5, MP = 50
If EPS is 7, MP = 70

Ideally, for a PE ratio, we compare the Market Price of the equity and earnings, with the competitors and indust

Small exercise…
PE Industry Avg is EPS MP
INFY 31.28 43.65 1,365
WIPRO 22.54 33.3 18.53 418
32.14 14 450
That means, on an average, all tech stocks have a PE of 33.3.
If you use relative valuation, your INFY is correctly valued, while WIPRO is undervalued

If PE < Sector avg, it means your market price can increase till it hits the sector avg.

WIPRO can go up to 600 without becoming overvalued. In other words, if I have to reword this, WIPR

For any relative valuation, there are two components - numerator and the denominator

We assumed that the denominator would be the same over time. Is this the case?
Technically, the denominator is OLD!
BE VERY VERY VERY CAREFUL, your analysis can go for a toss if denominator changes.

P/B Ratio Price/ Book Value

Numerator is the same as PE ratio, but denominator is different.

Book Value = Fair Value of Assets - Liab

No. of shares.
Quarterly Daily
PB Industry Avg is Book Value MP
INFY 8.84 154.59 1,367
WIPRO 4.13 6.5 101.23 418

It means, INFY is overvalued, and WIPRO is undervalued!

SELL INFY
BUY WIPRO

THE END
andalone models!
y look at the fundamentals of the equity that we are trying to value!

ustry avg, etc.

or a minority interest!

trol the company!

ell them at any time.

/ Total No. of Shares

hare is, for every rupee of earnings.

the competitors and industry!

undervalued

I have to reword this, WIPRO can have a price target of 600 based on relative valuation.