NISM SERIES – XV: RESEARCH ANALYST CERTIFICATION BY- CA NITIN GURU

Chapter 10: Valuation Principles

 Difference between Price and Value
Price and value are two different concepts in investing. While price is available from the stock market
and known to all, value is based on the evaluation and analysis of the value at a point in time.

 Why valuations are required

While purpose of carrying out valuation could vary from person to person, some of the reasons for
carrying out valuations on assets/businesses/liabilities are as follows:
 Buying a business as part of investment exercise
 Selling a business as part of investment exercise
 Mergers and Acquisitions
 General sense of value of business to owners
 Fair treatment to different set of stake holders in case of equity swap
 Accounting, taxation and other regulatory and legal requirements

 Sources of value in a business – Earnings and Assets

Warren Buffett stated “there are only two sources of value in a business- Earnings and Assets”. Business
are established for the same reason: to generate cash flows in the form of earnings and the potential to
realize cash flows from the sale of tangible and intangible assets if earnings are not sufficient.

 Approaches to valuation
Assets can broadly classified into three categories:
 Cost based valuation:
An asset is value based on the cost that needs to be incurred to create it.

 Cash flow based valuation (intrinsic valuation): Intrinsic valuation approach assigns value to an asset
based on what an investor would be willing to pay for the cash flow generated by the assets.
Intrinsic valuation can be divided into two categories:
 Risk neutral valuation: it is then discounted at risk free rate.
 Real world valuation: Discounting it at a rate of return that reflects the risk free rate plus a
suitable risk premium.

 Selling price based approach (relative valuation): Under this approach an asset is valued based on
the price of the other similar assets. Various valuation ratios such P/E, P/B, EV/EV/EBITDA can be
used as the valuation metrics.

Cost based valuation often involves technical assessment by engineers and is seldom employed by
financial investors.

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 Discounted Cash Flows Model for Business Valuation

Discounted Cash Flow (DLF) approach to valuation is the most appropriate approach for valuations when
three things are also known with certainty:

 Stream of future cash flows

 Timings of these cash flows, and
 Expected rate of return by the investors (called discount rate).

A rational way to find the value of a business may be to first find the inflows over outflows (called Free
Cash Flows-FCFs) at different points in time and then bringing them to today (find present value – PV) at
an appropriate rate of return (Discount Rate – DR). This is called Discounted Cash Flow (DCF) method to
value a project or a business/firm. Three different approaches to DCF models

 Dividend Discount Model (DMM):

The expected future dividends of a company are discounted based on the cost of capital. This
model is suitable for companies that pay regular and substantial dividend. Dividend payments
are not contractual in nature. DDM involves making certain estimates and assumptions.

 Gordon Growth Model:

Provides a way to value a dividend paying company where the dividend is expected to grow
perpetually at a constant rate. Cost of equity k, dividend that is expected to grow at a constant
rate g, the fair value of the shares (P)
P = D1
k-g

 Free cash flow to equity model (FCFE)

FCFE to equity is computed as follows:

Operating Cash Flow

(-) Capital Expenditure
(-) Interest Payments
(+/-) Net borrowings/ (repayments)
Free cash flow to equity

FCFE models are most likely to be useful for companies that are in “high growth” phase. Value
of Equity = Present value of FCFE during high growth phrase + Value of perpetual stream of FCFE
after high growth phrase (referred as terminal value). Analysts can then use the Gordon growth
model to value the perpetual stream of FCFE post maturity.

 Free cash flow to firm model (FCFF):

FCFF represents the free cash flow before taking into consideration any cash flows pertaining to
any source of capital.

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Operating Cash Flow

(-) Capital Expenditure
(-) Tax benefit on Interest Payments

Free cash flow to equity

Under the FCFF model, the value of the business (Enterprise value) is derived by discounting the
FCFF. Since FCFF is the cash flow available to all sources of capital, discount rate is taken as the
weighted average cost of capital (WACC)
Ke = Rf + β* (Rm – Rf)
Where:
Rf = Risk free rate,
(Rm – Rf) = Market risk premium (MRP), and
Β = Beta
WACC = [Ke* Equity/(Equity + Debt] + [Kd* (1-Tax)*Debt/(Equity + Debt)]
= [Ke * We] + [Kd * (1-Tx)*Wd]
Where Kd = Cost of Debt, Wd = Weight of Debt, Ke = Cost of Equity, We = Weight of Equity
The free cash flows are then discounted at the appropriate discount rate to arrive at the
Enterprise Value (EV) of the firm or the value of Equity.

 Relative Valuation
Valuation exercise is undertaken to compare the price with value to arrive at whether a business is
overpriced, under-priced or fairly priced by the market. This helps analysts make their recommendation
– buy, sell or hold.

 Earnings Based Valuation Matrices

 Dividend Yield – Price to Dividend Ratio:
Dividend yield = Dividend per share (DPS)/Current price of stock
If equity yields are in general higher than bond yields, clearly equity is available cheap. This is
typically true when markets are down. On the other hand, during bull markets, equity yields are
quite lower than the bond yields.

 Earning Yield- Price to Earnings Ratio:

Earning Yield = Earnings per share (EPS)/Current price of stock
Price to Earnings Ratio = Current Price of Stock / Earnings per Share (EPS)
The PE ratio indicates the amount of money an investor needs to invest to receive 1 unit of profit. A
stock with higher PE ratio compared to the peer group numbers and the market PE is considered to
be expensive stock. Investors access companies based on their future potential rather than past
performance.

 Growth Adjusted Price to Earnings Ratio (PEG Ratio):

The PEG Ratio is defined as :

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Growth Adjusted Price to Earnings Ratio = [Current price of stock/Earnings per share]/Growth rate.
PEG Ratio was the term coined by Peter Lynch as long as PEG Ratio is less than 1, business may be
treated as undervalued. For instance, a company (A Ltd) with earnings per share of Rs. 10 is trading at
a price of Rs.120. The PE Ratio of A Ltd work out to 12x. A Ltd is expected to grow at 10% p.a. The PEG
Ratio for A Ltd would be 1.2x (12x/10)

 Enterprise Value to EBIT(DA) Ratio

 Enterprise Value (EV) to Sales Ratio

 Assets based Valuation Matrices

 Price to Book Value Ratio
Price/Book Ratio = Market capitalization/Balance sheet value of Equity
Or
Price/book Ratio = Price per share/Book value per share

 Enterprise value (EV) to Capital employed Ratio

EV = Value of Equity + Value of Debt – Cash and cash equivalents
EV to capital employed ratio is defined as:
EV to capital Employed ratio = Enterprise value / Capital Employed (Total Equity + Total Debt)

 Net Assets Value Approach

Net asset value (NAV) of Equity is the market value of an entity’s assets minus the value of its
liabilities.

 Other metrics
 Price/Embedded value: This metric is especially used in the case of life insurance business.
Embedded value refers to the present value of the expected net future cash flow.

 Price/Adjusted book value: Adjusted book value (ABV) refers to the fair value of asset minus fair
value of its liabilities. This metric can be applied to value NBFCs.

 EV/Capacity: In this case of start-ups or companies that are currently undergoing special
situations. It may be appropriate to use operating metrics in a place of financial metrics. For
example, a large steel plant currently out of operation can be valued based on its production
capacity.

 Relative Valuations – Trading and Transaction Multiples

Relative valuation is basically intuitive. Best example of this is pricing real estate. This is highly useful
and quick estimate of value with limited computations and assumptions. It reflects current market
mood, which may be quite optimistic or pessimistic. Comparable may be coming from the stock market
(called Trading Multiples) or from the other similar transactions (called Transaction Multiples).

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 Sum-Of-The-Parts (SOTP) Valuation

Several businesses operate as a cluster/bundle of businesses rather than one business. Example, ITC,
L&T and other corporations have different business under one umbrella. Best way to value these
businesses is to value each business separately and then do the sum of those valuations. This method of
valuing a company by parts and then adding them up is known as Sum-Of-The Parts (SOP) valuation.

 Other Valuation Parameters in New Age Economy and Businesses

E-commerce companies or tech companies such as Whatsapp, Zomato, Linkedin, Facebook, etc. Honestly
speaking, it is difficult to put the numbers together to arrive at the valuations at which these
transactions are happening. Let us state that in new age economy, people use absolutely new
parameters/languages such as eyeballs, page reviews, footfall, ARPU, no. of users etc. to justify
exorbitant valuations.

 Capital Asset Pricing Model

Capital Asset Pricing Model has been discussed earlier in this chapter.

 Some important considerations in the Context of Business Valuation

 If earning power of business is high, book value (BV) of shares could be less important. But, if earning
power of business is low, BV becomes very important.
 As equity/share reflects pat ownership in a business, to value share, we need to value entire
business.
 EV and not the market capitalization is the true value of the firm for the private owner.
 PE for a leveraged firm may be deceptive- look at debt levels in the business.
 Look at the consolidate numbers and not just the standalone numbers.
 Focus on ROE and not EPS – EPS does not account for retained earnings.
 Leverage improves ROE but excessive leverage is risky
 Differentiate between ROCE and ROE - ROCE reflects the true return on capital. ROE could be
manipulated by higher leverage.
 ROCE and ROE should be closely knit. Any wide variation should trigger investigations.

Case Studies
 Case Study - I
You have been given financial summary of two companies which includes one year of historical data and
one year of estimates. Using the data in the table, answer subsequent questions.
(Rs. In lakhs) Company A Company B
2XX8 2XX9 E 2XX8 2XX9 E

Income Statement Summary

Operating Revenue 8,642.0 9,100.0 6,427.0 7,524.0
EBITDA 4,611.8 4,754.6 3,375.2 3,938.8
Net Profit 2,376.5 2,763.1 1,607.8 1,962.8
EPS 17.0 19.5 26.8 32.2

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PE ratio 17.7 15.4 21.9 18.2

Balance Sheet Summary

Cash, Cash equivalents and 165.0 169.0 54.0 57.0
investments
Other assets 4,402.5 4,518.0 3,685.8 4,010.0
Total Assets 4,567.5 4,687.0 3,739.8 4,067.0
Debt 1,598.6 1,640.5 1,540.0 1,626.8
Equity 2,968.9 3,046.6 2,199.8 2,440.2
Total debt and equity 4,567.5 4,687.0 3,739.8 4,067.0

(i) PE Ratio for the Company B is higher than that of Company A. Which of the following are
plausible reasons to justify such higher PE ratio of the Company B?
(a) EPS growth rate for Company B is higher than EPS Growth rate for the Company A and higher
growth justifies higher PE ratio.
(b) Company B is relative smaller company, and the smaller base justifies higher PE ratio
(c) Company B has high financial leverage which justifies higher PE ratio
(d) None of the above statements are true

(ii) Which of the two companies appear cheaper based on PEG ratio? Use the expected growth rate
for the 2XX9 for the calculation.
(a) Company A is cheaper as its PEG ratio is 1.05x compared to 0.91x for Company B
(b) Company B is cheaper as its PEG ratio is 0.91x compared to 1.05x for Company A
(c) Company A is cheaper as its PEG ratio is 2.91x compared to 1.07x for Company B
(d) Company B is cheaper as its PEG ratio is 1.07x compared to 2.91x for Company A

(iii) Which of the following is the closest to market value of Equity (Market Capitalization) of Company
A?
(a) Rs. 3,046 lakhs
(b) Rs. 30,000 lakhs
(c) Rs. 42,600 lakhs
(d) None of the above

(iv) The market cap of Company B based on its last traded price is Rs. 36,000 Crores. Which of the
following is the closest to its EV/EBITDA based on forecast for 2XX7?
(a) 8.17x
(b) 8.74x
(c) 9.14x
(d) 9.54x

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(v) The average PE ratio of peers in the industry is 16x based on 2XX9 earnings. The analyst believes
that Company B deserves to trade at 20% premium compared to its peers because of its low risk
and high growth potential. Which of the following is closest to the fair price of its share?
(a) Rs. 428.7
(b) Rs. 514.8
(c) Rs. 617.8
(d) Rs. 643.6

(vi) The analyst estimates the fair EV/EBITDA multiple for Company A is 8.5x. Which of the following
is closest to the fair value of the Company’s Equity?
(a) Rs. 38,944 lakhs
(b) Rs.40,415 lakhs
(c) Rs. 41,886 lakhs
(d) Rs. 42,224 lakhs

 Case Study - II
You have been given financial statement for the last reported year for a company. Answer subsequent
questions based on that.
(Rs. In lakhs) 2XX8

Income Statement Summary

Operating Revenue 8,642.0
EBITDA 4,611.8
Finance Cost 175.8
Net Profit 2,376.5
EPS 17.0
Payout ratio 80.0%

PE ratio 17.7
Tax Rate 30%

Balance Sheet Summary

Cash, Cash equivalents and 165.0
investments
Other assets 4,402.5
Total Assets 4,567.5
Debt 1,598.6
Equity 2,968.9
Total debt and equity 4,567.5

Cash flow summary

Operating Cash flow 4,200.0

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Capital expenditure -2,400.0

Other investing cash flows 1,200.0
Financing Cash flows 240.0

(i) The AGM of the company approved dividend for the recently concluded year and it was just paid. If
the dividend is expected to grow at a constant rate of 5%, which of the following is closest to the fair
price of the share, assuming cost of equity of 12%?
(a) Rs 113
(b) Rs 142
(c) Rs 194
(d) Rs 204
(ii) Which of the following is the closest to the free cash flow to firm for 2XX8?
(a) Rs. 1,624 lakhs
(b) Rs. 1,677 lakhs
(c) Rs. 1,747 lakhs
(d) Rs. 1,800 lakhs

(iii) Based on the following information, calculate the cost of equity of the company?
Risk percent rate: 6%
Expected return from the market: 10%
Beta of the company: 1.2
(a) 7.20%
(b) 10.8%
(c) 12.0%
(d) 18.0%

(iv) The fair value of total assets of the company is expected to be Rs. 12,000 lakhs while the
liabilities are worth the same as shown in the balance sheet. If the cost of equity is 12% and cost
of debt (net of tax) is 8%, which of the following is closest to the weighted average cost of
capital?
(a) 8.0%
(b) 10.0%
(c) 11.0%
(d) 11.5%

(v) The FCFF of the company for the next year is estimated at 2,000 lakhs. It is expected to grow at
10% in the year after that and is expected to grow at 5% perpetually post that. If the weighted
average capital is 11.0%, which of the following is closest to the fair value of the firm (Enterprise
Value)?
(a) Rs. 33,333 lakhs
(b) Rs. 34,835 lakhs
(c) Rs. 42,087 lakhs
(d) Rs. 42,700 lakhs