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Valuation and Creating Sustainable Value
Valuation and Creating Sustainable Value
1. What is Value ?
What is Value, and what is valuation? This question puzzles a lot of us including researchers,
regulators, investment professionals and of course the common man. What is more intriguing
to us is the valuation of companies in Mergers and acquisitions or valuation of startups. Even
more useful application is for arriving at intrinsic value and to decide whether to buy sell or
hold stocks.
Simply put, valuation is the process of arriving at the “value” of an asset. An asset can be a
business, a division, a company, tangible assets such as land and building or intangible asset
such as patents, etc. The value of the asset is generally based on future returns that are generated
from present investments. Value of an asset or a company can be referred as the present value
of the future cash flows which the company is expected to generate during its life cycle.
Valuation is a very important activity in the field of finance. Valuation is required in varied
situations Valuation forms the basis of many business decisions like undergoing a merger &
acquisition deal, buying an asset, issuing new shares. So a company has to undergo valuation
exercise for a variety of reasons.
1
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
c. The selling company also needs to determine its fair value to estimate the sale value.
When companies are going for divestment, they need to value the business or the unit
proposed to be sold out.
d. Venture capitalists need to value the start-ups before investing in the new ventures.
e. Valuation is also required for identifying the main value drivers of the company
f. Valuation is a prior step in strategic decisions whether to continue the business, sell
the business, expand or merge the business.
3. Valuation Framework
2
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Book value can also be represented by a company’s net assets value that is Assets minus
Liabilities
adjustments may also be required where a company is having intangible assets as well and
those assets have not been properly valued in the balance sheet.
b) Adjusted book value
This method seeks to overcome the shortcomings of book value approach. This method seeks
to reflect the market value of the assets in place of their book value . So when the value of
the assets and the liabilities match their market value, the adjusted net book value is arrived
at.
The value of the company using adjusted book value method is $29,250 whereas its book
value is $20,500. So, the adjusted book value exceeds the book value by $8,750. Gross
5
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
adjusted book value is the value of the total assets which is $35,250 in the above case. After
deducting the liabilities, the net adjusted book value of the company is $29,250.
Liquidation value or Break-up value method
This method is used primarily when the company is going for liquidation, it is going to shut
down. The company is no more a going concern. The liquidation value is based on the
estimated realizable value of the assets.
The net worth of the company represents its book value while the liquidation value
determines the worth of tangible assets when the company goes for liquidation. Liquidation
value is arrived at by deducting the liquidation value of its assets minus the value of its
liabilities.
Liquidation value may slightly differ from the adjusted book value because when a company
goes to sell off its assets, it may receive lesser value than the market value. Liquidation is a
kind of forced sell situation. As the assets have to be sold within a limited time frame, the
assets may fetch a lower value than their fair market value. The company may also have to
incur certain liquidation expenses. These expenses have to be deducted from the adjusted
book value
This model of valuation is suitable only for such special cases where the company is going
for liquidation. However, this method is more realistic compared to the book value method of
valuation.
ii. Income Based Method
This valuation approach focuses on the cash earnings of the company and based on which the
value of the business is determined. The income based valuation method seeks to determine
the value of the company based on its expected future cash flows. The following are the
broadly used approaches under the income based method: -
a. The profit-earning capacity value method uses the past earnings of the business and
calculates the future maintainable earnings or profits of the business.
Future Maintainable Profits are the profits that are expected to be earned by the business in the
coming future under normal business condition and circumstances. For calculating the Future
Maintainable Profits of a concern, the analysis of the past profits earned by the company in the
few previous years say 2,3,4 or 5 years has to be conducted.. Its always better to take a short
and recent time period for calculation of Future Maintainable Profits or Adjusted Average Past
Profits as this helps in estimating the future profit which is likely to accrue in future.
If a business has been earning the same amount of profits over a few past years with almost
no fluctuations, we can take those past profits as Future Maintainable Profits. But if there are
6
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
considerable fluctuations in the earnings of the business, the Future Maintainable Profits are
calculated on the basis of Average Profits of the few past years. Average Profits can be
Average profits for a certain number of years do not always represent the normal profits
occurring to the business. There may be some unusual profits or losses that have occurred to
the business which do not occur in the normal course of the business. So adjustments have to
be done in order to get a true picture of the average profits of the business.
To get Adjusted Average Profits, following adjustments have to be made after calculating
Average Profits of the business.
1)Adjustment for extraordinary or abnormal loss or income. There are some losses or expenses
incurred by the business due to some abnormal circumstances eg. losses due to strike or theft,
fire, flood or some other natural calamity, expenses or damage due to a legal action against the
company, etc. These losses or expenses adversely affect the profits of that particular year. So
in order to obtain normal profit figure, these losses or expenses are added back to the past
profits.
These Profits or Losses should not be considered while calculating the average profits as they
are not a result of the business activity. Any such profits should be deducted and losses
should be added back to the past profits.
3)Adjustment for tax at current rates should be made in the past profits.
4) Any major changes in the business (expansion, discontinuation of a part etc) should be
considered while calculating past profits.
Adjustments:
1. There was an extra ordinary income in Year 1 on sale of land $1000 million
7
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
2. Year 2 witnessed an abnormal loss of $2000 million due to fire in the plant
3. Year 3 there was an interest income of $500 million on account of investments
So adjusted profits would be as under
1 2 3
Profit before tax 10000 20000 40000
Less: Extraordinary income on sale of
land -1000
Add: Abnormal loss due to fire 2000
Less Interest income on investments -500
9000 22000 39500
This method seeks to determine the value of a company based on its expected future cash
flows. The expected future cash flows are then discounted at the required rate of return or the
discount rate to calculate their present value. The cash flows are estimated after all operating
expenses, taxes, investment through capital expenditure and working capital have been met
from the operating income of the company. The expected future cash flows are then
discounted at the appropriate rate of return to calculate the present value.
The cash flow based method is the fundamental approach of valuation. The discounted cash
flow based method is widely used by analyst as this is the conceptually correct valuation
method. For the discounted cash flows we largely use the Dividend Discount Model and the
Free Cash flow method
iv. Relative Valuation
Relative valuation method compares a company's value to that of its competitors or others in
the industry to assess the firm's relative financial position or value. The assumption here is
that if similar companies are worth on a parameter (such as earnings), then the company that’s
being valued should also be worth based on the same parameter. In relative valuation method
one needs to identify comparable company and its market value. The values are then
standardised to obtain a multiple that will be applied to the company that is being valued.
Adjustments are made for any differences.
The value of the stock is present value of the expected future cash flows. So what is the
present value concept ? You guessed right ! It is the time value of money concept. The value
of money doesn’t remain same today vs tomorrow vs after one year !!. One dollar today is
valuable than a dollar tomorrow.
What $100 can buy today will be more than what $100 can buy after one year. Money can be
invested today to get some return in future. This shows that a dollar received today is worth
more than a dollar received in future or put it another way, the dollar will earn return and hence
we should be getting a higher amount in future. In an inflationary period a dollar today
represents a greater real purchasing power than a dollar a year hence. Thus, the decline in value
of money with the passage of time happens primarily due to inflation. Further, there is also a
risk element. Thus, inflation, risk factor and opportunity cost of money makes amount today
worth more than the same amount tomorrow.
9
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Let’s take an example: Suppose you have 100 dollars today. This, 100 dollars can be invested
at say 5% interest per annum. At the end of year one, you will receive $105 ($5 is the interest
earned at the end of the year on $100 invested today). So we can say $100 today is equal to
$105 after one year when the interest rate is 5%. This interest rate is also termed as the
discount rate or required rate of return.
This brings us to two important concepts ie. Future Value and Present Value. The process
of calculating the future value by applying compound rate is called as compounding and the
process of calculating the present value is called discounting
Future Value
Formula:
FVn = PV (1 + r)n
Present Value
Let us calculate the present value from the future value. This techniques is called as
discounting technique. This is the process through which we can compute the present value
of the cash flows to be received in future time period.
Present Value (PV) = FV/(1+r)n or
Where FV = the future value of the amount to be received in future
r = interest or discount rate
n = number of years
Let us say you want $1000 after 5 years and the current interest rate is 5% per annum. What
is the amount that you need to invest today so that you can get $1000 at the end of 5 years
from now?
Here FV = 1000 , n = 5 years r = 5%
Solving the equation: PV = 1000/(1 + 0.05) = $783.53
Modifying the above example, suppose the investment is $1000 today and it has a payoff of
$3000 in ten years. Here in this case we have the PV and the FV as well and the time period,
so we can solve for the interest rate.
So PV = 1000, FV = 3000 n = 10
Using the equation PV = FV/(1+r)n
1000 = 3000/(1 + r)10
11
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Annuity
An annuity is a series of payments or receipts which we can simply call as cash flows
(payments and receipts) over some period that are for the same amount and paid over the
same interval. That is they can be paid annually, semi-annually, quarterly or monthly.
When the cash flows occur at the end of each period, the annuity is called a regular annuity or
a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is
called an annuity due.
In general terms the future value of an annuity is given as
FVAn = A (1 + k)n - 1 + A (1 + k)n - 2 + .......+ A
(1 + K) n − 1
= A
k
13
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Example: What is the PV of a $4000 per year annuity that goes on forever, that is in
perpetuity if r = 10%?
PV = 4000/0.10 = $40000
14
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Lets begin with the simplest of models based on cash flow: Dividend Discount Model
One of the earlier cash flow based method is the Dividend Discount Model (DDM). DDM is
built on the assumption that company will pay dividend in the present and the future as well.
The model helps in determining the intrinsic value of the stock today based on its future stream
of dividends (cash flow to the investor). The model helps in calculating the intrinsic value or
fair price of the stock today. The value calculated can then be compared with the actual price
of the stock to determine whether the stock is overvalued or undervalued.
The dividend discount model values the stock based on the expected future dividend payments
by the company. The future dividend payments are discounted to their present value at the
required rate of return to arrive at the fair or the intrinsic value of the stock today.
The dividend discount model is useful particularly for companies who have been paying regular
dividends to their shareholders. There are companies which regularly pay dividends like
Walmart, McDonalds, Procter & Gamble, Coca-Cola etc. Dividend Discount Model can be
used to value these companies.
Since equity shares have no maturity period, they can be expected to generate cash flow
through dividends for an infinite period. Hence the value of the equity share could be
calculated as :
∞
𝐷1 𝐷2 𝐷3 𝐷∞ 𝐷𝑡
𝑃0 = + + + ⋯ + = ∑
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)∞ (1 + 𝑟)𝑡
𝑡=1
Example:
If the current dividend is $2 per share and the required rate of return is 10 percent, the value
of a share of stock is $20. Therefore, if you pay $20 per share and dividends remain constant
at $2 per share, you will earn a 10 percent return per year on your investment every year.
Example:
Let’s us assume that an investor intends to buy the share and will hold it for one year.
Suppose he expects the share to pay a dividend of $5 next year and would sell the share at the
expected price of $20 at the end of the year. If the investor’s required rate of return is 10% ,
what should be the value of the share today?
So the present value of the share today, P0 will be determined as the present value of the
expected dividend per share at the end of the first year D1 plus the PV of the expected price
of the share at the end of the first year, P1 .
𝐷1 + 𝑃1
𝑃0 =
1+𝑟
5 + 20
𝑃0 = = $22.73
1.10
So P0 gives the fair or reasonable price of the share since it reflects the present value of the
share. The investor would buy the share if its actual price is less than $22.73. So if the price
of the share is less than the share’s present value, the share would be treated as undervalued.
On the other hand, if the market price of the share is higher than its present value, the share
would be treated as overvalued.
Let us assume the dividends grow every year by a constant rate say g.
So the value of the share under this model would be
16
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
𝐷1 𝐷1 (1 + 𝑔) 𝐷𝑛 (1 + 𝑔)𝑛
𝑃0 = + + ⋯+ +⋯
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)𝑛+1
Applying the formula for the sum of geometric progression, the above expression simplifies
to
𝐷1
𝑃0 =
𝑟−𝑔
Let us take an example. ABC company paid a dividend of $5 last year. The dividends in the
future are expected to grow perpetually at the rate of 6%. What would be the share price
today if the required rate of return is 12%.
So the price of share would be
𝐷1
𝑃0 =
𝑟−𝑔
5(1.06)
𝑃0 = .12− .06 = $88.33
Estimating the future dividends of a company can be difficult. Analysts and investors may
make certain assumptions, or try to identify trends based on past dividend payment history to
estimate future dividends. Sometimes a fixed growth rate of dividends is assumed in
perpetuity. Sometimes the growth rates are based on past trends.
Another way to calculate the growth rate is based on the term called internal Growth rate,
which, represents the reinvestment made by the company calculated as follows:
We divide the retained earnings by net income, we would get the retention ratio or else, we
can also use (1 – Dividend Payout Ratio) to find out the retention ratio.
And ROE is the return on equity (net income/shareholders’ equity)
17
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Let us take an example. Company A’s ROE is 20% and the company has paid 60% of its net
income as dividend to its shareholders. Calculate the growth rate
From year 6, dividends grow at normal rate of 6% indefinitely. This a case of cash flows
growing at a constant rate. So present value of the dividends at the end of year 5 with growth
rate 6% would be
P5 = 4(1.10)5 (1.06) = $75.87
0.15 - .06
So the value of the share today can be found out by adding both the values
P0 = $ 17.54 + $37.72 = $55.26
Thus the value of the share is equal to the discounted value of the expected dividends for the
first 5 years growing at a high growth rate plus the discounted value of the dividends growing
at a stable rate forever beyond the high growth period. This can be expressed as follows:
Assuming growth rate for the first stage for n years is 𝑔1 and
The growth rate for the remaining phase of business is 𝑔2
𝐷0 = Current Dividend
Taking both the growth rates the price of the share would be calculated as under:
𝐷𝑛 (1+𝑔1 )𝑛 (1+𝑔2 )
𝐷0 (1+𝑔1) 𝐷1 (1+𝑔1 )2 𝐷𝑛 (1+𝑔1 )𝑛 (𝑟−𝑔2 )
𝑃0 = + (1+𝑟)2
+ ⋯+ (1+𝑟)𝑛
+
(1+𝑟) (1+𝑟)𝑛
19
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
The Discounting rate or the Expected rate of return (r ) used in cash flow based models is also
referred as the cost of capital. The required rate of return is what investors expect for a cash
flow stream generated by the company. How do we measure the expectations of the investors?
For investors in companies, the cost of capital is an opportunity cost or a the rate of return that
they would expect to make in other investments of equivalent risk. Of course one can’t go and
ask each investor his/her expectation. Many a manger in the organisation perceive that equity
is free of cost !! Particularly as they do not observe any outflow like in case of borrowings
A Company’s cost of capital is the weighted average of cost of various sources of finance used
in the business. When both the debt and equity components are used in the capital structure we
then calculate the weighted average cost of capital (WACC). The cost of capital consists of two
parts a) Cost of Equity b) the Cost of Debt. In this week we describe the cost of equity alone.
There are several methods available for calculating the cost of equity such as the Capital Asset
Pricing Model (CAPM), Fama Factor Model etc. The CAPM provides a grounded and
relatively objective method for required return estimation, therefore it has been widely used in
valuation. We will be using the widely used approach for calculating cost of equity, known as
the Capital Asset Pricing Model (CAPM).
The Capital asset pricing model (CAPM) was developed by economist William Sharpe.
CAPM model describes the relationship between an investor’s risk and the expected return.
𝑹𝒎
Risk premium
𝑹𝒇
0 Beta (𝜷)
𝐾𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑅𝑓 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝛽 = 𝑅𝑖𝑠𝑘 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘
𝑅𝑚 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛
Let us elaborate on each of the components of cost equity
Securities such as Government bonds are generally considered to be risk free securities as they
carry literally no default risk. They provide a minimum return to the investors and there is
almost no risk related to repayment obligations. Generally, the yield on long term Government
securities for that has a maturity between 10 to 20 years is taken as the risk free rate of return
but other yields could also be taken under different circumstances.
Market return –
Investors take risk and hence would expect a higher rate of return. The returns on the risk free
instruments is the minimum return. They would require something more for taking risk.
Stock market returns could be taken for this. The market portfolio of all assets financial and
real is taken in the CAPM model. Since it is difficult to measure such a portfolio, a proxy is
taken for the same. Generally a value weighted equity index is taken to calculate the market
return and the risk premium. Market return can be measured by taking market indices of
major markets. For example S&P 500 can be taken as a benchmark for estimating the market
return, The choice of the index used to represent the market portfolio. For a number of
markets there are traditional choices such as for US equities, the S&P 500 and NYSE
Composite have been taken. The difference between market return and the risk free rate is
called the market risk premium. Usually a long trend is used say 15 years or so.
21
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
Beta:
The expected return of a stock in the CAPM model is driven by its beta. Beta measures the
risk (or volatility) of individual security with respect to market risk.
This risk arises due to macro-economic factors that influence all the securities or the entire
securities market in a similar manner. This risk is beyond the control of the company or the
investors and arises due to external factors. Hence beta is also referred to as systematic risk.
Unsystematic risk: This risk is related to the company specific risk. This risk can be
controlled by a specific firm or industry by taking controlling actions. This risk can be
managed by investing in other securities which can compensate for the loss arising due to the
particular security. Hence they are called diversifiable risk.
Beta behaves in the same way as the market moves, the only difference lies in the degree of
volatility of the specific securities with respect to the market movement. There may be some
securities that move up more than in proportion to the market. Those securities are aggressive
(more volatile) and have a beta of more than 1 and the securities which move less than in
proportion to the market movement have a beta of less than 1. They are defensive securities.
This risk is called non-diversifiable risk.
Since beta is not directly observed, it needs to be calculated. The raw beta is measured with
the help of regression and later some adjustments are made to it.
The regression equation commonly used to estimate stock beta is as
Where Rit is the return on investment I in period t, RMt is the return on the market portfolio
in period t , βi beta is the slope of the linear regression relationship and the last is the error
term. To measure the systematic risk the slope of the regression needs to be calculated as
follows:
22
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 1 Handout
𝛽 = 0.80
𝑅𝑚 = 10%
𝑟𝑒 = 3% + 0.80(.10 − .03) = 8.60%
End of Note
23
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
Week 2 Handout
In the last week, we learned about various methods of valuation. Broadly we classified
them into
WE elaborated on the first 2 methods and started the cash flow based valuation model
using the dividends. This week we will focus on the discounted cash flow method using
Free Cash Flow.
Discounted cash flow (DCF) method of valuation is the most popular cash flow based
method of valuation used by analysts and investment professionals for valuation
purposes. It is based on the fundamental principle of valuation that the value of an asset
is equal to the present value of its future cash flows. The general premise is
The value of a business or a company is equal to the present value of the cash flows that
the business generates in the future. The DCF method requires estimating the free cash
flows of the company in the future. Estimating future cash flows requires a careful
analysis of the industry, company growth, product segments, market competition,
economic growth. DCF method is conceptually the most appropriate method of
valuation as this is based on key parameters and value drivers.
Applying the basic rule, the value of any asset can be arrived at by calculating the
present value of the estimated future cash flows of the firm.
t = Estimated period during which the asset would generate cash flows
The discount rate or the required rate of return depends on the risk involved in
generating the cash flows. Higher the risk, higher will be the discount rate or expected
rate of return.
The Discounted Cash Flow (DCF) Method can be used in two ways. The method can
be used to:
If you were to measure the value of a firm, the formula would be modified as follows;
𝑪𝑭 𝒕𝒐 𝒇𝒊𝒓𝒎𝒕
Value of the firm = 𝑽 = ∑𝒕=𝒏
𝒏=𝟏 (𝟏+𝑾𝑨𝑪𝑪)𝒕
Here, CF to firm = Expected future cash flows of the firm in the time period t
The first input is free cash flow. How to calculate the free cash flows?
Free Cashflow:
2
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Week 2 Handout
Free cash flow denotes the cash a company generates after meeting all the expenses
(outflows) related to the operations and the outflow related to company’s capital assets
and the changes in the working capital. In an accounting sense, we use the cash flow
from operations and subtract the purchase of operating assets. The FCFF to the firm
can also be arrived at using the Earnings before interest and tax represented as follows:
Free cash flow to Firm (FCFF) = Earnings Before Interest and Tax (EBIT) –
Taxes + Depreciation and Amortization – Capital Expenditures – Increase in
non-cash working capital.
The free cash flows to the firm represent the ‘Unlevered Free Cash Flow’, that is the
cash flow available to both the debt and equity holders. FCFF calculates tthe overall
firm value (ignoring the fact as to financing pattern)
The explicit forecast period is often a period of 5 to 10 years, during which the firm is
expected to grow at a high rate. So a great deal of effort and analysis is required about
the industry situation, business growth, risk factor, product demand, macro-economic
factors. A careful analysis of each of these factors is required to be factored in
estimating the free cash flows during the forecast period.
Step 1 Elaborated
For projecting the financial statements we need to:
i. Estimate the revenue growth and costs
Forecasting sales or revenue is the first step in the preparation of an income statement
. There are two ways to do this; the top-down approach and the bottom-up approach.
The top-down approach begins with analyzing the economic factors, industry pattern,
company growth, product segment behavior. The bottom-up approach is the reverse of
the top-down approach. It begins by analyzing the demand for the product.
Irrespective of the approach followed, sales forecasting over a long horizon is an
inherently uncertain and challenging exercise. Hence we have to re-evaluate the sales
forecasts periodically.
4
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Week 2 Handout
Based on the sales forecast, estimate the revenue and expense trend during the forecast
period. We can use the following three steps for this:
i) Determine the economic driver of line items: Most line items like employee cost, cost
of goods sold, selling, and distribution cost can be linked to sales. Other items like
administrative costs are annual costs and may be estimated on the basis of the past trend;
interest cost can be linked to debt shown in the balance sheet.
ii) Estimating the forecast ratio: For each item in the income statement, we can
calculate the cost to sales ratio like the raw material cost to sales, cost of goods sold to
sales ratio, etc.
iii) Multiplying the forecast ratio by an estimate of its economic driver: As all the cost
ratios can be calculated as a percentage of sales, each line item can be estimated by
multiplying the ratio by the estimated sales.
We can present all these items and their ratio with sales in the following tabular way:
Line Item Forecast Driver Forecast ratio
1. Estimate the cost pattern, future trend in expenses, capital expenditure and
borrowings
2. Preparing the forecasted income statement detailing the pattern of expenses and
computing the net income
3. Preparing the forecasted balance sheet stating the assets and liabilities position.
4. Calculating the free cash flows (FCFs) during the forecast period
5
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Prof. Padmini Srinivasan
Week 2 Handout
Income
Similarly, the balance sheet items can be forecasted based on the relation of each
balance sheet item with its relevant driver. For example, property, plant & equipment
(PP&E) is used to drive revenue, hence PP&E can be estimated as a percentage of
revenue.
6
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
The relation between the line items and forecast driver can be as follows:
Line Item Driver Forecast ratios
Net fixed assets Sales Net fixed assets/Sales
Investments None Growth in investments
Inventories COGS Inventories/COGS
Receivables Sales Receivables/Sales
Loans and Growth in loans and
Advances None advances
Accounts Payable COGS Account Payable/COGS
7
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
Actual Projected
Balance Sheet as at 31st
Dec 2017 2018 2019 2020 2021
ASSETS
Non-current assets
Property, plant and
3,24,600
equipment 235000 2,57,100 2,84,100 2,99,600
Other intangible assets 40000 38,000 36,000 34,000 32,000
Total non-current assets 275,000 295,100 320,100 333,600 3,56,600
Current assets
Inventories 30000 80,000 1,15,000 1,40,000 1,55,000
Trade receivables 40000 50,000 80,000 90,000 95,000
Cash and cash equivalents 64900 1,14,790 1,47,010 2,66,960 3,17,720
Other current assets 10000 12,000 15,000 12,000 14,000
Total current assets 144,900 256,790 357,010 508,960 5,81,720
Total assets 419,900 551,890 677,110 842,560 9,38,320
Equity and Liabilities
Equity
Share capital 200000 2,00,000 2,00,000 2,00,000 2,00,000
Retained earnings 58940 1,41,890 2,43,110 3,57,560 4,81,320
Total equity 258,940 341,890 443,110 557,560 6,81,320
Liabilities
Non-current liabilities
Long-term borrowings 98000 1,15,000 1,34,000 1,65,000 1,32,000
Total non-current
1,32,000
liabilities 98,000 115,000 134,000 1,65,000
Current liabilities
Short-term borrowings 20000 30,000 20,000 25,000 20,000
Trade payables 42960 65,000 80,000 95,000 1,05,000
Total current liabilities 62,960 95,000 100,000 120,000 1,25,000
Total liabilities and equity 419,900 551,890 677,110 842,560 9,38,320
8
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Prof. Padmini Srinivasan
Week 2 Handout
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Prof. Padmini Srinivasan
Week 2 Handout
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Week 2 Handout
𝑊𝐴𝐶𝐶 = 𝑟𝑒 ∗ ( 𝐸 ⁄𝑉 ) + 𝑟𝑑 ∗ (1 − 𝑡)(𝐷 ⁄𝑉 )
Where
𝑟𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
D = Market value of debt
𝑉 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
𝑟𝑑 = 𝑃𝑟𝑒 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
t = Tax rate
In the above equation, WACC has been calculated using market value as weights.
WACC can also be calculated using book value as weights. In that case, the book value
of equity and debt will be taken for the purpose of determining the respective weights
of equity and debt.
Cost of each component in the capital structure-
The cost of debt is relatively simple to calculate. Since debt carries interest costs, the
interest rate can be used to determine the cost of debt
The cost of debt is = interest rate * (1-tax rate)
11
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
Cost of equity
There are several methods available for calculating the cost of equity, such as the
Capital Asset Pricing Model (CAPM), Fama Factor Model, etc. The CAPM provides a
grounded and relatively objective method for required return estimation, therefore it has
been widely used in valuation. We will be using the widely used approach for
calculating cost of equity, known as the Capital Asset Pricing Model (CAPM).
The Capital asset pricing model (CAPM) was developed by economist William
Sharpe. CAPM model describes the relationship between an investor’s risk and the
expected return.
Expected return
Security market line (SML)
𝑹𝒎
Risk premium
𝑹𝒇
0 Beta (𝜷)
12
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
Market return –
Investors take a risk and hence would expect a higher rate of return. The returns on the
risk free instruments are the minimum return. They would require something more for
taking risk. Stock market returns could be taken for this. The market portfolio of all
assets financial and real is taken in the CAPM model. Since it is difficult to measure
such a portfolio, a proxy is taken for the same. Generally a value-weighted equity index
is taken to calculate the market return and the risk premium. Market return can be
measured by taking broad-based indices of major markets. For example S&P 500 can
be taken as a benchmark for estimating the market return. There are traditional choices
such as for US equities, the S&P 500 and NYSE Composite have been taken for
computing the market return. The difference between market return and the risk-free
rate is called the market risk premium. Usually a long trend is used, say 15 years.
13
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Prof. Padmini Srinivasan
Week 2 Handout
Beta:
The expected return of a stock in the CAPM model is driven by its beta. Beta measures
the risk (or volatility) of individual security with respect to market risk.
This risk arises due to macro-economic factors that influence all the securities or the
entire securities market in a similar manner. This risk is beyond the control of the
company or the investors and arises due to external factors. Hence beta is also referred
to as systematic risk.
Unsystematic risk: This risk is related to the company-specific risk. This risk can be
controlled by a specific firm or industry by taking controlling actions. This risk can be
managed by investing in other securities, which can compensate for the loss arising
due to the particular security. Hence they are called diversifiable risk.
Beta behaves in the same way as the market moves. The only difference lies in the
degree of volatility of the specific securities with respect to the market movement. There
may be some securities that move up more than in proportion to the market. Those
securities are aggressive (more volatile) and have a beta of more than 1, and the
securities which move less than in proportion to the market movement have a beta of
less than 1. They are defensive securities. This risk is called non-diversifiable risk.
Since beta is not directly observed, it needs to be calculated. The raw beta is
measured with the help of regression and later, some adjustments are made to it.
The regression equation commonly used to estimate stock beta is as
Rit = αi + βi RMt + εit
Where Rit is the return on investment I in period t, RMt is the return on the market
portfolio in period t , βi beta is the slope of the linear regression relationship, and the
last is the error term. To measure the systematic risk, the slope of the regression needs
to be calculated as follows:
14
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
𝛽 = 0.80
𝑅𝑚 = 10%
𝑟𝑒 = 3% + 0.80(.10 − .03) = 8.60%
Cost of debt
Interest rate = 10% Tax rate is 30%
Cost of debt net of tax = 10%*(1-0.3) = 7%
𝑊𝐴𝐶𝐶 = 𝑟𝑒 ∗ ( 𝐸 ⁄𝑉 ) + 𝑟𝑑 ∗ (1 − 𝑇)(𝐷 ⁄𝑉 )
Assume Market value of equity = 400,000 & Market value of debt = 100,000
WACC = 8.6% *(4/5) + 7%*(1/5) = 6.88% + 1.4% = 8.28%
𝐹𝐹𝐶𝐹𝑡 ∗ (1 + 𝑔)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑊𝐴𝐶𝐶 − 𝑔
15
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Prof. Padmini Srinivasan
Week 2 Handout
Where
𝐹𝐹𝐶𝐹𝑡+1 𝑖𝑠 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟
𝑎𝑓𝑡𝑒𝑟 𝑡ℎ𝑒 𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
𝑔 𝑖𝑠 𝑡ℎ𝑒 expected growth rate for free cash flows forever
WACC is the weighted average cost of capital
The value of the firm is:
The present value of the Free Cash Flow for explicit forecast period + Present value of
the terminal cash flows. Assume the stable growth rate for the company is 2% forever.
The value of the firm is the present value of the future cash flows, which is calculated
as $1,091,766.
From the above analysis, we can conclude, the key variables for calculating the value
of the firm are:
1. Free cash flows
2. WACC
3. Growth rate
4. Forecast period also to some extent
The firm value is sensitive to the above variables. So lastly, a sensitivity analysis has
to be performed to examine the impact of change in input variables to the output
derived.
16
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
The firm value represents the present value of cash flows available to both the debt
holders and equity holders. So how should we calculate the value of the cash flows
available to equity holders? Like free cash flow to the firm for valuation, we need to
calculate free cash flow to equity for equity valuation.
Free Cash Flow to Equity (FCFE) can be calculated by reducing the debt related
obligations from Free Cash Flow to Firm (FCFF).
𝑭𝑪𝑭𝑬𝒕
Equity Value = ∑𝒏𝒕=𝟏
(𝟏+𝒓𝒆 )𝒕
Cost of equity = Risk-free rate + Beta *(Market return – Risk fee rate)
𝑟𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )
Where,
𝑟𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑅𝑓 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 of return
𝛽 = 𝑅𝑖𝑠𝑘 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑡ℎ𝑒 𝑜𝑣𝑒𝑟𝑎𝑙𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑚𝑜𝑣𝑒𝑚𝑒𝑛𝑡
17
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Week 2 Handout
𝑅𝑚 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛
Continuing with the same example of ABC Co., let us calculate the free cash flow to
equity
Value
Terminal of the
Calculation of FCFE 2019 2020 2021 value firm
Forecast year 1 2 3
Free Cash Flow to firm 20600 98500 91000
Less: Interest (1 - tax) 9380 11550 9240
-
Net borrowings 19,000 31,000 33,000
753564
Free cash flow to equity (FCFE) 30,220 1,17,950 48,760
588343
Present value of FCFE 27827 100009 38069
Equity value 754248
• Works best when the free cash flows can be estimated with a high degree of
reliability.
• DCF method needs constant modification as the underlying factors change.
End of note
19
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Valuation and Creating Sustainable
Prof. Padmini Srinivasan
WEEK 3 – HANDOUT
Last week, we discussed the discounted cash flow (DCF) method of valuation. Discounted
cash flow method is the fundamental approach of valuation.
This week we will learn a popular approach to valuation called the multiples based valuation.
This valuation method is also referred as the comparable approach or the relative valuation
method.
The multiples approach is based on the fundamental assumption that an asset is valued on the
basis of how similar assets are priced in the market. This approach is also regarded as market-
based approach, since market price of the stock or the market value of the company is the key
component used while valuing the target company. Thus, in a market where all technological
stocks see their prices move up, relative valuation is likely to yield higher values for these
stocks than discounted cash flow valuations.
In fact, relative valuations generally yield values that are closer to the market price than
discounted cash flow valuations. That is why this approach is also referred as the Market
approach to valuation.
Relative valuation seeks to value a company based on the value of a similar company. This
method of valuation is the most widely used method used by analysts performing valuation
exercise. Most valuation reports are based on multiples approach. Substantial portion of all
acquisition valuations are based on some or the other multiple.
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Valuation and Creating Sustainable
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• Lastly, relative valuation reflects the market sentiments, since it uses the market value
form valuing the company and not the intrinsic value.
The basic underlying principle of relative valuation is that similar assets should sell for
similar prices. Unlike the discounted cash flow valuation, where the company is valued on
the basis of future free cash flows, in relative valuation, company is valued based upon how
similar companies are valued.
Analyse the company for which you want to do the valuation. The analysis should be as
detailed as possible. It should include identifying the key drivers, business model of the
company, features specific to the company, analysing the competitive and financial position
of the company, identifying and analysing the comparable companies.
• Nature of business
• Product segments and market segments in which the company operates
• Technological and production expertise
• Market strength and distribution network
• Managerial competence
• Financial parameters such as revenue, growth, margins, return on investment
After a detailed analysis of the company based on the different key drivers, our next step is to
select a company that is comparable. Comparable in terms of the lines of business, nature of
market served, scale of operations, product ssegment, market geography in which they
operate and so on. Comparable in term of financial characteristics such as revenue, EBITDA,
net income etc. However, practically it is very difficult to find a company that is exactly
similar to the company concerned. So, a good deal of subjective judgement is also involved
in this process. We must carefully select at least 3 to 4 companies which represent as close
as possible, the business structure of the subject company.
The third step is to analyze and select the valuation multiple. There are a number of multiples
that are used in valuation. What is a multiple? A multiple is a ratio between two financial
variables.
The numerator is either the company’s market price (in the case of price multiples) or its
enterprise value (in the case of enterprise value multiples) and in the denominator, we have
the fundamental variables such as revenue, earnings, book value, EBIT, EBITDA, Free cash
flow or other such specific variables
Price multiples and Enterprise value multiples are the most widely used valuation multiples
used by analysts and investment professionals to value the subject company. Many
acquisition valuations are based upon a multiple approach such as a price to earnings multiple
or the enterprise value to EBITDA multiple to determine the relative value of the companies.
• Price-to-sales multiple
Price multiples involve examining ratios between a company’s share price and an element of
the underlying company’s performance, such as earnings, sales, book value or such other
fundamental variable. The most commonly used price multiple is price to earnings multiple.
The formula:
The price-to-earnings ratio (P/E ratio) measures market price of each share of the company
relative to its earnings per share (EPS). It represents the dollar amount the investors are
willing to pay for every dollar of earnings per share of the company.
Price is usually the current price of the share. The EPS can be the EPS for the previous
financial year or the EPS for the trailing 12 months (Trailing P/E ) or expected EPS for the
current year or the expected EPS for the following year (Forward PE). In its most common
version, it is measured as the expected EPS for the current year.
Analysts use P/E ratios of similar companies to estimate the offer price of the share if a
company is going for IPO.
The market price of Company X’s stock is $100 and the company’s EPS for the last twelve
months is $10. Calculate the P/E multiple
This reflects that the investors are willing to pay $10 for $1 earnings of Co. X. The higher the
P/E multiple, the higher the investor confidence on the future earnings and profitability of the
company. So In essence, the price-to-earnings ratio indicates the dollar amount an investor
can expect to invest in a company in order to receive one dollar of that company’s earnings.
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Valuation and Creating Sustainable
Prof. Padmini Srinivasan
Learners please recall the dividend discount model, we had spoken about the Gordon growth
model. In case of stable growth , the value of the stock could be determined as
𝐷1
Value of Equity = 𝑃0 =
𝑟−𝑔
Where 𝐷1 is the expected dividend per share in the next year, r is the required rate of return
or the cost of equity and g is the expected growth rate.
Dividing both sides by the earnings, you obtain the following equation specifying the PE
ratio for a stable growth firm.
𝑃 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
Price earnings ratio = =
𝐸 𝑟−𝑔
So we can say the PE ratio is an increasing function of the payout ratio and the growth
rate and a decreasing function of the riskiness of the firm.
Example: A company’s ROE is 15% and its cost of equity or the required rate of return is
12%. The dividend payout ratio is 40%. Calculate the P/E multiple of the company.
𝑃 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
=
𝐸 𝑟−𝑔
𝑃 0.4
= = 13.33
𝐸 0.12−0.09
● The price earning multiple is used by investors to compare stock valuation across
companies in the industry
● Earnings is a major driver of investment and hence EPS is an important input for
valuation
● Empirical research suggests that low P/E tend to outperform the market.
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Prof. Padmini Srinivasan
• When EPS is negative, P/E multiple does not make any sense
• Earnings are a mix of recurring and non-recurring earnings, the task of projecting the
EPS at times becomes difficult
• Earnings are prone to manipulation also. Such manipulations can vitiate the
comparability across companies
Like P/E multiple, the P/B multiple is also been a popular valuation multiple used by
analysts.
In the P/E multiple, the denominator is an income statement item, whereas in P/B multiple,
the denominator (book value per share) is a balance sheet derived item
The formula:
Price to book value = Market value (market cap) ÷ book value or
Price to book ratio analysis (PBV ratio or P/B ratio) expresses the relationship between the
stock price and the book value of each share. In general, the lower the PBV ratio, the better
the value is. It represents what the investors are willing to pay for every dollar of it book
value. However, the value of the ratio varies across industries. A better benchmark is to
compare with industry average.
Note that in the numerator of this multiple, we have deducted preference capital because we
are focusing here on finding the book value per equity share
Example
Company X’s price per share is $100 and its book value per share is $20. Calculate the Price
to book multiple.
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Prof. Padmini Srinivasan
This implies the company’s stock is trading at 5 times its book value. Investors are paying $5
for every dollar of book value per share of the company.
Fundamental approach
We have arrived at Price to Book ratio as Price per share /Book value per share
Dividing both sides by the book value of equity, you can estimate the price/book value
ratio for a stable growth firm as under.
𝑃 𝑅𝑂𝐸( 1 + 𝑔)(1 − 𝑏)
=
𝐵𝑉 𝑟−𝑔
Where ROE = Return on equity , BV = Book Value = Net Income/ROE, g = growth rate, r =
required rate of return.
Explanation:
We know
g = (1 - Payout ratio) * ROE
P0 = D1/r - g
=ROE(1+g)(1-b)
r-g
Example
A company’s ROE is 15% and the required rate of return is 12%. The dividend payout ratio is
0.4 and g is 10%. Compute the P/B multiple.
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Prof. Padmini Srinivasan
𝑃 𝑅𝑂𝐸 (1 − 𝑏)(1 + 𝑔)
=
𝐵 𝑟−𝑔
𝑃 0.15 (1−0.6)(1+0.10)
=
𝐵 0.12−0.10
= 3.30
Another variant of price multiple is the price to sales multiple. The price to sales ratio
compares the price of the company’s stock to its revenue during the previous 12 months. It
indicates the value placed on company’s stock for each dollar of company’s revenue.
It can be calculated as company’s market capitalization divided by its revenue during the year
or on per share basis dividing its market price per share by its revenue per share.
Dividing by the Sales per share, the price/sales ratio for a stable growth firm can be estimated
as a function of its profit margin, payout ratio, risk and expected growth.
Fundamentally, P/Sales =
𝑃 𝑁𝑃𝑀 (1 + 𝑔)(1 − 𝑏)
=
𝑆 𝑟−𝑔
Coal Ltd. Has a NPM of 10% and the growth rate of 8%. The dividend payout is 30% and its
r is 16%, The P/S multiple would be
= 0.95
A lower P/S ratio is preferable. The lower the P/S ratio, the more attractive the investment.
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Prof. Padmini Srinivasan
● Where the company has incurred loss or is having negative equity, the price to sales
ratio can be used in place of price to earnings ratio. Revenue remains positive even
when EPS is negative.
● Therefore, P/S ratio can be used even when EPS is negative, whereas P/E based on a
negative EPS is not meaningful.
● Because revenue generally remains more stable than EPS, P/S is generally more
stable than P/E. P/S ay be more meaningful than P/E when EPS is abnormally high or
low.
Some drawbacks:
● A business may show high growth in revenue, although it may not be operating
profitably as judged by earnings and cash flow from operations. A business must
ultimately generate earnings and cash to have true value.
● The P/S ratio does not reflect differences in cost structures across companies.
The last and the most important step in valuing the company is to apply the selected multiples
and value the subject company adjusting for any differences between the subject company
and the comparable.
Let us take an example and illustrate all the steps for relative valuation
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The next important variant which analysts use is the Price to earnings growth multiple.
Often companies have huge growth potential. The company has high future growth prospects.
It would be improper if we do not consider this growth rate while valuing companies. To
overcome this drawback, another variant of price multiple called the Price to earning growth
(PEG) multiple is used. It factors in the growth component as well into the P/E multiple.
P/E multiple aren't always useful all by themselves, as they don't take a company's growth
rate into account. For this reason, one more ratio got introduced which inbuilds growth factor
also to arrive at the valuation multiple.
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The price-to-earnings to growth ratio, or PEG ratio, adjusts the P/E ratio of a company with
its expected earnings growth in order to better estimate the valuation of growing companies.
The PEG ratio can be calculated by dividing the P/E ratio of the company by its expected
growth rate in earnings per share.
The formula:
PEG Ratio = Price to earnings multiple/Expected growth rate
The numerator is calculated by dividing the market price per share by the earnings per share
which give the price earnings ratio and the denominator is the expected growth rate of its
earnings per share
The denominator, on the other hand, isn’t as straight forward. Investors can use either the
historical growth rate or an expected future growth rate to calculate the EPS growth. This can
give somewhat deviating result if the expected future growth rate is different than the
historical rate. Different investors could get two completely different answers depending on
what inputs they used in their equation.
Example:
ABC Co. currently has a P/E multiple of 12 and the expected annual EPS growth rate is 15
percent over the next five years. Calculate their PEG ratio:
A PEG ratio of less than 1 indicates the stock is undervalued and a PEG ratio of more than 1
implies the stock is overvalued. However, the PEG ratio is only one piece of the valuation
puzzle, and different industries have different average PEG ratios based on the nature of
industry and the growth prospects.
As you can see, ABC Co. has a PEG of 0.80 indicating that the stock is undervalued when the
expected earnings of the company are taken into account. ABC Co. would be a good
investment; although, it’s important for investors to compare ABC CO’s metric with other
companies’ metrics because there might be an even better deal out there.
The Price earnings growth ratio or the PEG is an improved version of PE ratio as it considers
the earnings growth rate also when evaluating its valuation. This would represent a better
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Prof. Padmini Srinivasan
However, the first company is projected to grow its earnings at 10% per year while the
second ‘s projected earnings growth rate is at 18% per year .
Using this information, we can calculate the PEG ratio for both the companies :
Company A PEG ratio = 15/10 = 1.5
And, company B PEG ratio is:
PEG ratio = 20/18 = 1.11
So we find that even though the second company has the higher P/E valuation, it is actually
the cheaper of the two when growth is taken into account.
For this reason, the price-to-earnings-growth ratio, or PEG ratio is a better ratio for valuation
of growing companies.
Since companies’ earnings and growth potential vary greatly among industries, there isn’t a
standard number that indicates a good or bad investment. It varies greatly between industries,
but the general rule of thumb is that any PEG less than 1 is considered a good buy because
the stock price is undervalued.
Let us move to the other major multiple used for valuation, the Enterprise Value Multiples.
Enterprise value multiple, by contrast, relates the total market value of all providers of capital
to a measure of fundamental value for the entire company.
Enterprise value = Market value of debt + MV of equity – Cash and other non-operating
assets
Let us take an example: We have the following information for ABC Inc.
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Enterprise value multiple measures the value of the company taking enterprise value as the
numerator and EBITDA (earnings before interest tax depreciation and amortization) as the
denominator.
𝐸𝑉
EV /EBITDA multiple =
𝐸𝑞𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥𝑒,𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛
Enterprise value multiple measures the enterprise value (EV) relative to its earnings before
interest, taxes, depreciation and amortization (EBITDA). A company with a low enterprise
value to EBITDA multiple is considered to be an attractive investment as it reflects a low
price as compared to the gross cash earnings of the company.
Let us take an example, the enterprise value as we computed above is $20,500 and lets
assume its EBITDA is $2,000.
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This means the enterprise value is 10.25times its EBITDA. The higher the multiple, the
higher the valuation.
Let us recall free cash flow to firm valuation. Specifically, we estimated the value of the
operating assets (or enterprise value) of a firm.
We can write the free cash flow to the firm in terms of the EBITDA
The tax rates would have an impact on the EV to EBITDA multiple. Other things remaining
equal, firms with lower tax rates should command higher enterprise value to EBITDA
multiples than otherwise similar firms with higher tax rates.
Again, depreciation & amortization would too influence the multiple. Firms that derive a
greater portion of their EBITDA from depreciation and amortization would have lower
multiples of EBITDA than otherwise similar firms
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Lastly, the greater the portion of the EBITDA that needs to be reinvested to generate
expected growth, the lower will be the enterprise value to EBITDA. Similarly low cost of
capital and high growth rate would allow the firm to have a high multiple. Enterprise value
multiple is a better measure than the P/E ratio because it is not affected by the changes in the
capital structure.
For example, if a company raises equity finance and uses these funds to repay the loans. How
will that affect the enterprise value?
This will result in lower earnings per share (EPS) and therefore a higher P/E ratio.
But the Enterprise value multiple will not be affected by this change in capital structure.
● Another benefit of Enterprise value multiple is that it makes possible fair comparison
of companies with different capital structures.
● Enterprise multiples are compared to other companies within the same industry and
not across industries in order to obtain an insightful assessment.
● Enterprise multiple can be used to compare the value of one company to the value of
another company within the same industry. A lower enterprise multiple can be
indicative of undervaluation of a company.
● First, they are directly affected by capital structure. Companies financed entirely by
equity can artificially increase its P/E ratio by taking the benefit of leverage.
● Second, the P/E ratio is based on earnings, which include many nonoperating items,
such as restructuring charges, sale of assets/division or unit of a business and write-
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offs. Since these are often one-time events, multiples based on P/Es can be
misleading. P/E ratio would not be meaningful for companies having negative
earnings
One alternative to the P/E ratio is the ratio of enterprise value to EBITDA.
Limitation
Enterprise value multiple is not usually appropriate for comparison of companies in different
industries. Capital requirements of other industries are different. Therefore, Enterprise value
multiple may not give reliable conclusions when comparing different industries.
Let us assume the enterprise value to be $20,500. The depreciation and amortization amounts
to $500 . Its EBITDA is $2000.
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Example
A company has a tax rate of 30% and a reinvestment rate of 70%. The WACC is 12% and
growth rate is 9%. Compute the EV to EBIT multiple
𝐸𝑉 (1 − 0.3)(1 − 0.70)
=
𝐸𝐵𝐼𝑇 0.12 − 0.09
= 7
Enterprise value-to-sales is an extension of the price to sales (P/S) ratio, which uses market
capitalization instead of enterprise value. It is perceived to be more accurate than P/S,
however, because market cap does not take a company's debt into account when valuing the
company. Generally, a lower EV-to-sales indicates the company is relatively undervalued and
is a good bet for investment.
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Example
A firm’s after tax operating margin is 15% and growth rate is 10%. Its reinvestment rate is
70% and its WACC is 13%. Compute its EV to sales ratio
= 1.50
Firms with higher operating margins, lower reinvestment rates (for any given growth rate)
and lower costs of capital will trade at higher value to sales multiples.
Enterprise Value to Free Cash flow to firm Multiple (EV to FCFF Multiple)
It denotes the value of the company per dollar of its Free cash flow to firm (FCFF). enerally,
lower the ratio the better it is. This suggests the company is rich on cash and shows a good
sign for the future prospects and expansion of the company. A high EV/FCF on the other hand
means the company is potentially overvalued
Formula:
Enterprise Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)/
EBIT (1-t) - (Cap Ex - Depreciation) - Changes in Working Capital
Value of Firm =
𝐹𝐶𝐹𝐹
𝐸𝑉 =
𝑊𝐴𝐶𝐶−𝑔
Dividing both sides by the expected free cash flow to the firm yields the Value/FCFF
multiple for a stable growth firm.
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𝐸𝑉 1
=
𝐹𝐶𝐹𝐹 𝑊𝐴𝐶𝐶−𝑔
Example :
A company’s WACC is 15% and its g is 10%. Compute it EV to FCFF multiple
EV/FCFF = 1/ WACC - g
= 1/(15% - 10%) = 20
𝐸𝑉 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒
This multiple is calculated as 𝐵𝑉 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠
We have calculated the different multiples. The last and the most important step in valuing
the company is to apply the selected multiples and value the subject company. The important
question is which multiple to choose from
5. Choice of multiples
There are different views on the selection of a multiple
A popular view is that multiple can be chosen that serves a preconceived notion. If you want
to sell a business that is, you are the seller, you will choose the multiple that gives the higher
value. If you are the buyer, you will possibly choose the multiple that gives the lowest
valuation. While this may appear like selection based on results, it seems to be a fairly common
practice. Practically valuation has a lot of biases and ultimately it is all about negotiations.
The most common problem in multiples valuation is that the range of multiples can be very
wide. To avoid this, you can calculate a simple average of the various values arrived at by the
different multiples. The advantage of this approach is its simplicity. You can also calculate a
weighted average – the weight assigned to each value reflecting its relative precision.
Conclusion
Although DCF valuation is considered as the most sound and robust method of valuation but
in practice most companies are valued using relative valuation.
Equity research reports are generally based on multiples like enterprise value to EBITDA
multiple, price-earnings multiple, price to book multiple and price to sales multiple. Even when
DCF valuation is done, they are often cross checked or justified on the basis of some multiples.
DCF valuation requires projection about ROIC, growth and free cash flows. Since projecting
the future is relatively difficult, analyst find it convenient to use multiples . If the expected
ROIC, growth and risk are similar for a given set of companies, they should command similar
multiples.
In spite of its popularity, relative valuation suffers from certain drawback. As the underlying
assumptions of relative valuation are not explicitly defined, it provides the scope for
manipulation. The analyst can justify his valuation based on choosing an appropriate multiple
or comparable firm. The multiples used in relative valuation approach reflect the valuation
errors (over valuation or under valuation) of the market. Thus, for example, if infrastructure
companies in general are undervalued, applying the average price earnings multiples of listed
infrastructure companies to determine the valuation of unlisted company may lead to
undervaluation. In contrast DCF valuation is based on firm specific cash flows and growth
rates and hence is likely to be less affected by market valuation errors.
Remember, Multiples have to be used judiciously to prevent misleading results and we need
to define all the variables used in a consistent manner. The comparable companies must also
similar in terms of risks and growth prospects
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
WEEK 4 HANDOUT
INTRODUCTION TO VALUE DRIVERS
STRATEGY, MARKETING AND COST MANAGEMENT
The first 3 weeks we learnt the method of valuing a business. While valuing techniques are useful,
we need to understand what drives the value. Focusing on creating sustainable value involves
generating return on invested capital that is greater than WACC. We calculated the Value by
discounting the future cash flow to arrive at the present value.
Focusing on return on invested capital and future cash flows over the long term is a tough has lot of
challenges and therefore we need to understand the key drivers of valuation and the driver for
sustainable value creation.
To Recap
ROIC focuses on the true operating performance of the firm. ROIC is a better measure in the sense it
reflects the rate of operating profit earned on the invested capital.
Pre-tax ROIC can be broken down as:
The first term, operating margin measures the operating efficiency of the firm – how effectively the
firm is converting its revenue into profits and the second term, the capital turnover reflects how
effectively the company is employing its invested capital.
If a company improves its operating margin and capital turnover rate, its ROIC will improve.
If profit growth is unsatisfactory, we need to identify the reasons of the poor performance and take
corrective action. The above equation can be further broken down to reach the root cause of the
decreasing profitability see Figure 1.
Figure 1: ROIC Analysis into components
Breaking down the ratio into its least possible component items helps identify the root cause of the poor
performance and corrective action can be taken to correct the specific area and improve its performance.
Strategy and
Marketing
for revenue
growth
Managing Operational
human excellence for
capital cost
Sustainable management
Value
Strategic
Corporate Allocation
Governance and Financing
decisions
These are
The attractiveness (long-term profitability) of any industry is determined by the interaction of these five
competitive forces (Porter’s five forces).
1. Organic Growth
2. Inorganic Growth (Mergers and acquisitions)
Organic revenue growth is the true revenue growth which reflects the company’s core competency. The
company achieves this growth solely on its own capabilities and efficiency.
One of the major reasons for going for M&A is expansion of the business thereby achieving increase
in revenue, income and build strong competitive advantage
What needs of customers are you fulfilling? If you look at markets there is a huge competition
and to be successful you need a strategy. Is it budgets ? Is it our vision ? Is it sustainable ?
Strategy is the planning phase where the company sets its plan of action, formulates its policy
framework to achieve the goals and objectives of the organization. Strategy specifies how a company
utilizes its resources to the opportunities in the market and achieve its objectives. A good strategy is
aimed at utilizing the company’s resources as well as adjusting itself perfectly to the external
environmental changes.
Companies develop strategies to build their revenue, expand their operations by enhancing their own
capabilities as well as by acquiring other companies and businesses
Broadly companies employ 2 or 3 strategies today.
There are three generic strategies a company may employ in order to compete and generate profits:
1. Cost leadership: Being the lowest-cost producer of the good.
2. Product differentiation: Addition of product features or services that increase the attractiveness of
the firm’s product so that it will command a premium price in the market.
3. Focus: Employing one of the previous strategies within a particular segment of the industry in order
to gain a competitive advantage or some times a mix of both.
Some of the Key strategies that will help generate competitive advantages are :
Innovation; Innovation can be a leading source of competitive position. Innovation should be
considered in broad terms and not simply limited to product performance. In addition to product
innovation, firms such as Dell have differentiated themselves by radically changing the customer
fulfillment and supply chain processes to redefine the business model within an industry.
Customer Satisfaction; Customer satisfaction plays a vital role in revenue growth in three ways.
First, customer satisfaction will always be a key factor in retaining existing customers. Second,
customers that are satisfied with a supplier's performance are likely to offer additional
opportunities to that supplier. Third, a strong reputation for customer satisfaction and un derlying
performance may also lead to opportunities with new customers.
Customer Service Many companies compete by providing outstanding service beyond the
traditional customer satisfaction areas such as delivery and quality performance. Working
with customers to solve their problems and participating in joint development programs are both
examples of investments that build long-term customer loyalty.
Cost or Pricing Advantages Price is nearly always a key factor in a customer's procurement
decision. The price of a product or service will be driven by the cost of the product, profit targets,
and market forces.
The cost of a product or service includes direct and indirect costs. Prices are often set by
marking up or adding a profit margin to the cost to achieve a targeted level of profitability or
return on invested capital (ROIC). The actual price will have to be set in the context of
market forces, including price-performance comparisons to competitor products.
Suppliers can attain a cost advantage in a number of ways, including achieving economies of
scale, process efficiencies, or improvements in quality. Most sophisticated customers look at the
total life cycle cost of a procurement decision, of which the product selling price is one
component. Other elements of life cycle cost may include installation and training, service,
maintenance, and operating and disposal costs. Suppliers that can demonstrate a lower life cycle
cost can achieve an advantage over competitors, even if the product price component is more
expensive.
All strategies have to be implemented. And marketing plays an important role in selling goods
and services.
Marketing is the core of any business. Why does a business exist? A business exists only because there
is somebody who wants your output which is your product or service. And therefore, if the customer
does not exist you have no business to be around. And therefore, how do you get the customer marketing
is the only way to get the customer.
Peter Drucker quoted as , "the business has only two functions marketing and innovation all others
are costs ". I go one step further, I say the business has only one function marketing
because innovation is required in all functions; whether you are in finance, whether you are in HR,
with you in whatever function you need .
First, how do we create value and if we are agreed that without a customer, we have no reason to
exist. If that is a fair statement, I believe that first of all every function in an organisation is in some
ways or the other a marketing function. So marketing is the process by which companies create value
for customers and build strong customer relationships in order to capture value from customers in
return.
Marketing deals with many aspects of business and traditionally they were represented by 4 P’s and
later 6 P’s
The Product which has certain features, functions and other capabilities that can be used or exchanged.
Products includes both goods and services.
The next aspect is the Price that a customer is willing to pay for the goods and services. Many firms
compete by lowering their prices but a good pricing strategy ensures that you remain competitive
without diminishing the perceived value .
Marketing also includes Place or how the goods are distributed or carried to the customers.
Promotion includes strategies that will influence the customer to purchase the goods or services. A
good promotion is one that understands the target customers.
People are also important as they include people who came up with the idea of the product or services
and it includes people or employees in the organisation who are champions of the brand. Lastly the
unique selling proposition of the product is also important. That brings repeat customers.
The second driver we are focusing on is the operating efficiency. When firms focus on cost
leadership strategy they have to focus on costs and efficiency in operations. It is not always
possible for firms to charge a price of whatever they want. This is rarely a sustainable situation
over the long term. Additionally, profitability does not directly reflect the asset levels required to
support a business Return on invested capital (ROIC) and return on equity (ROE) are considered
better overall measures of management effectiveness, since they reflect both profitability and asset
effectiveness measures. Substantial portion of the cost gets fixed and frozen at the development
stage itself and hence the new product development becomes important. The effectiveness of this
new product development process will impact costs in each of these functional areas. Mistakes
made early in the process, in product conceptualization and design, will often have a significant
impact on subsequent steps in the process.
Operations management is responsible for producing goods and providing services. It is the core
function of any organisation and has to be managed well. It is the department responsible for
converting organisation’s strategy into action. It plans and coordinates the use of organisation’s
resources to convert inputs into output.
To cite a few names regarding operational excellence, Apple’s strategy is based on its innovative skill
with providing its users always a new technology, new look to its products. Walmart’s success
depends on its ability to keep prices low and the task of shopping convenient. Toyota being one of the
world’s largest auto maker – its success lies in its lean model of manufacturing and its core principles
To conclude, Organisation with a robust operating model gives them a competitive advantage over its
competitors.
Key areas of Operations Management
Four areas where operations management has to focus are:
1. Productivity
2. Quality
3. Costs
4. Matching supply with demand
Productivity: A company has to focus on its processes, and should aim at maximising productivity
with the given resources and reduced waste. Each process should be studied, should identify where
extra time is getting spent on a process, how to reduce the process time and improve the efficiency.
To achieve higher productivity, the company should focus on its process efficiency. A process can be
said to be a set of correlated activities through which an input is transformed into an output. Process
can be depicted in the form of a flow diagram where the flow units or the inputs flow through the
process and leaving the process as output.
The time it takes a flow unit to get through the process is called the flow time or the throughput time.
It is the average processing time taken to convert the input to output.
Flow time is an important performance metric in a business especially in a service business where the
customers may be lost to competitors due to increased flow time. Finally, the rate at which the
process is delivering output is called as the flow rate or throughput rate. Its calculated as flow
units/unit of time eg. Units per day, patients attended per day.
Operations management focus on the flow rate, flow time to match supply with demand. If there is
excessive demand, the flow time or the throughput time has to be reduced or faster processing time to
meet the excess demand. It would directly result an increase in revenue. Shorter flow times also result
in additional unit sales and or higher prices. Lower inventory results in low working capital
requirements as well as enhanced focus on quality of the product.
Inventory Management
Inventory management plays an important role in efficient operations and supply chain. Inventory
management is a core operations activity. Effective inventory management enables smooth operations,
improves productivity , reduces costs and enhances customer satisfaction. Some organisations have
excellent inventory management and many have satisfactory inventory management. Toyota for
example is known for its JIT inventory management which has played a prominent role in reducing cost
and improving productivity . One widely used measure of performance is ROI (net profit/average
assets). Because inventories may represent a significant portion of total assets, a reduction in inventory
can result in significant increase in ROI. Effective inventory management is needed for to meet
anticipated customer demands, for smooth production, operations, to protect against stockouts, to hedge
against price increases. Inadequate control over inventory may result in both under and overstocking of
items. Understocking results in missed deliveries, lost sales, dissatisfied customers and production
bottlenecks; overstocking results in excessive supply, forcing to reduce prices and offer discounts
Quality
Quality is consistent performance to customers’ expectations. Operations regard quality as a
particularly important objective as it is the most visible part of what an operation does. It is the
promise of performance ie. of what it is supposed to do like the dial tone reliability.
Because of this, it is clearly a major influence on customer satisfaction or dissatisfaction.
A customer perception of high-quality products and services means customer satisfaction and
therefore the probability that the customer will come back. Quality reduces cost and the less time
will be needed to correct the mistakes. Quality increases dependability
From late 1980s, companies started having customer satisfaction as specific goals. In this light a
concept called Total Quality Management evolved. It is a principle that involves everyone in an
organisation in a constant effort to improve quality and achieve customer satisfaction. It can be said to
be a quest or desire for an organisation to deliver quality products beyond customer expectations.
The three elements surrounding TQM are : Continuous improvement – never ending push to improve;
Involvement of everyone in the organisation; Customer satisfaction which means meeting or
exceeding customer expectations.
TQM works as under:
1. Find out what customer wants
2. Design a product or service that will meet his/her demand
3. Design processes that facilitate doing the job right the first time. Strive to make the process
mistake proof.
4. Keep track of results and use them to guide improvement in the system.
5. Extend these concept to suppliers and distributors.
Successful TQM program implementation needs dedication form management and each and every
employee within the organisation.
Speed
Speed means the elapsed time between customers requesting products or services and them
receiving them. When goods and services are delivered on time, customers will be satisfied and pay
for it. Further, the speed also reduces inventories in a sense of both the raw materials and finished
goods.
Flexibility
Flexibility means being able to change the operation in a way that matches a) demand quantity as
well as customisation. Specifically, customers will need the operation to change so that it can:
• product/service flexibility – the operation’s ability to introduce new or modified products
and services;
• mix flexibility – the operation’s ability to produce a wide range or mix of products
• volume flexibility – the operation’s ability to change its level of output or activity to produce
different quantities when required
Cost
A company which compete directly on price, cost will clearly be their major operations
objective. The lower the cost of producing their goods and services, the lower can be the price to their
customers. Even those companies which do not compete on price will be interested in keeping costs
low. Thus low cost is always attractive to business. The ways in which operations management can
influence cost will depend largely on where the operation costs are incurred.
Lets examine some cost concepts
Cost Object: anything for which you need to find the cost
Cost Driver: what drives the total cost of the cost object
Direct cost : Costs that are directly to a product, activity, or department are direct costs. Examples of
direct costs are comsumable supplies, direct material, sales commissions, freight.
Indirect cost : Indirect costs are those that either cannot be directly traced to a product, activity, or
department or are not worth tracing. Further indirect costs are used by multiple activities and which can
not therefore assign to specific cost objects. Examples of indirect costs are Accounting and legal
expenses, Administrative Salaries, Office expenses, Rent, Telephone expenses etc. Also called as
overheads.
Fixed Cost: Cost that remain constant when there are changes in the level of business activity are fixed
costs. Depreciation and rent are costs that typically do not change with changes in business activity.
Variable cost: Costs that increase or decrease in proportion to increases or decreases in the level of
business activity are variable costs. Material and direct labour are variable costs because they fluctuate
with changes in production/ business activity.
Contribution Margin: Contribution margin is defined as revenue minus variable expenses. It tells how
much of the revenue will be available for the fixed expenses and net income. For example
80,000 units is manufactured and sold during the recent year. The selling price is $10 per unit and
variable expenses were $4 per unit. The company’s fixed expenses are $390,000 hence contribution
margin is $480,000 and contribution per unit is $6 and contribution margin ratio is 60% (contribution
margin of $ 480,000 divided by revenues of $ 800,000).
Contribution margin is a key component in computing a company’s break-even point.
Break-even Point: The break-even point is the number of units that must be sold for a company to
break even-to neither earn a profit nor incur a loss.
In the above example we can find out break-even point in sales dollars by dividing company’s total
fixed expenses(i.e $390,000) by the company’s contribution margin ratio (i.e 60% ). Hence at $ 650,000
of net sales the company will at break-even point, which is the point where sales will be equal to all the
company’s expenses.
Required
Solution:
Tipon Ltd sells various equipment and tools for different segments. Although the company had been
profitable for several years, management has seen a significant decline in garden supplies over the
years and this year it has turned negative. Much of the decline has been due to influx of cheap
substitutes.
The following are the product line income statement for the year ended Dec 31
T1 T2 T3 Total
Total
Tipton wants to drop T3 based on the changing market conditions and accompanying losses. Give
your comments
Hint: Fixed costs are sunk cost. Once incurred they cannot be reversed and cannot be avoided. Only
costs which are direct to the product or service can be avoided had the production for the particular
product has stopped.
Traditional Costing
Under this approach, the overhead costs are allocated uniformly to the departments or products based
on number of labor hours or number of machine hours consumed. This costing system is a volume
based approach.
Overheads can be allocated using single plant wide overhead rate or department wise overhead
allocation. Overhead cost are those cost that cannot be conveniently traced to a product or a service .
Hence they are allocated using some suitable allocation base. For example, rent can be apportioned to
the different departments based on area occupied.
Single plant wide rate attempts to allocate overhead across the products on the basis of single
overhead rate. For example, overhead incurred is $500,000 and the number of labor ours is 50,000.
Single plant wide overhead rate equals $10 per hour.
Departmental overhead rate approach allocates overheads department wise.
Let us discuss in detail how the overhead expenses are allocated among the production and
service departments
Allocation of Overhead
Overheads are indirect expenses that cannot be charged directly to cost objects. Thus, the overhead
cost needs to be allocated to the cost units or cost objects using some appropriate allocation basis.
For efficient working, better management and control, the factory is divided into several sub-
divisions known as departments. Each department in a factory is engaged in a particular activity. The
department in a factory can be broadly classified as:
Overhead costs arising solely from the existence of a particular department (production and service
departments) can be charged or allocated to that department. For example, the salary of the
departmental head, cost of the indirect materials issued to a particular department are assigned to
that department.
Certain other types of overhead expenses are expected for the entire factory, such as factory rent,
insurance, lighting, electricity, the salary of the factory manager, etc. These overhead expenses are
required to be allocated to the different departments based on some suitable parameters or basis.
As regards the basis to be used for apportioning the overhead costs, there is no single basis for
assigning the overhead costs. Some of the common bases for apportionment of overhead may be
highlighted as follows –
i. Floor area or Floor space – The expenses like rent of the factory can be apportioned
between the different departments based on the floor space occupied by each department
ii. Direct wages – Under this basis, the items of overhead costs are apportioned in proportion
to the direct wages of the departments. This is used for items related to direct wages
example, contribution to provident fund, contribution to employees’ state insurance
scheme, etc.
iii. Number of workers – Under this basis, overhead costs are apportioned based on direct
labour hours worked in various departments.
iv. Number of machine-hours – This basis is used for the apportionment of overheads to the
different departments based on the number of machine-hours used by the different
departments.
v. Value of assets – Expenses related to capital assets, the values of assets can be used to
apportion expenses like insurance, depreciation of plant and machinery.
vi. Kilowatt hours – The cost of electricity can be apportioned based on kilowatt hours
consumed by each department.
Illustration - 1
The following information is extracted from the records of ABC Co. for April 2021.
$
Production Department P1 3800
P2 4800
P3 800
Service Department S1 6000
S2 1600
Indirect Wages
Production Department P1 5400
P2 6600
P3 1800
Service Department S1 4000
S2 2600
Solution –
Statement of allocation of overhead
Production Service
Department Department
Basis of
Items allocation Total P1 P2 P3 S1 S2
As per
Indirect materials details given 17000 3800 4800 800 6000 1600
As per
Indirect wages details given 20400 5400 6600 1800 4000 2600
Kilowatt
Power and fuel hours 30000 10000 11000 4000 3750 1250
Rent and rates Floor area 11200 3200 3200 2400 1600 800
Value of
Insurance assets 6000 1500 1800 1200 900 600
Value of
Depreciation assets 2000 500 600 400 300 200
Number of
Canteen charges employees 15000 4500 6000 1500 2000 1000
Total
departmental
overhead 101600 28900 34000 12100 18550 8050
After the apportionment of the overhead costs to the production and service departments, the next
step is to allocate the expenses of various service department to production departments. Since the
service departments are indirectly linked to production activities, it becomes necessary to apportion
the costs of the service departments to production departments to arrive at the production cost.
This process of re-apportionment of service department costs to production department is also
known as Secondary Distribution.
Some of the suggested measures of allocating the service department costs can be enumerated as
below –
Let us understand how the service department costs can be allocated to production departments.
Methods of Reapportionment:
There are two methods in use for the apportionment of service department costs:
1. Apportionment of service department costs only to production departments.
2. Apportionment of the service department costs to the production as well as other
service departments.
Apportionment to Production Departments only:
Under the first method, service department costs are directly apportioned to the production
departments. This method can be explained with the help of the following example:
Illustration - 2
ABC Co. Ltd. has three Production Departments and two Service Departments. The
Departmental expenses as per Primary Distribution Summary for the month of January 2020
are as follows:
Departments Rs.
Production Department 14,700
'X' Production Department 17,300
'Y' Production Department 6,000
'Z' Maintenance Department 9,600
'A'
Stores Department 'B' 5,000
Departments X Y Z
Direct labour hours 1,500 1,400 1100
Number of Requisitions 90 60 50
Production Service
Basis of
Items Total departments departments
Apportionment
X Y Z A B
Rs. Rs. Rs. Rs. Rs. Rs.
Total Departmental
52,600 14,700 17,300 6,000 9,600 5,000
overhead
Expenses of Service Direct labour
- 3,600 3,360 2,640 (-)9,600 -
Dept. 'A' hours
Expenses of Dept. Number of
- 2,250 1,500 1,250 - (-)5,000
'B' Requisitions
Total Overhead 52,600 20,550 22,160 9,890 - -
Illustration 3
ABC Co. has two production departments P1 and P2 and three service departments S1 , S2
and S3.
The expenses assigned to each department are as below -
Production Department
P1 65000
P2 6000
Service Department
S1 20000
S2 30000
S3 14000
Prepare Overhead distribution summary (using Step ladder method) . The cost of service
department to be apportioned as follows –
P1 P2 S1 S2 S3
S1 40% 50% 10%
S2 40% 40% 10% 10%
S3 60% 40%
Total
97780 37220 0 0 0
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Illustration — 4
A factory has two production departments and two service departments. The overhead
departmental distribution summary is as follows:
A B C D
Overhead 7,000 4,000 1,800 2,500
allocated
The expenses of the service departments are to be charged out on a percentage basis as
follows
Solution :
Apportionment of service department costs under the Repeated Distribution Method
is as follows :—
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Illustration — 5
Continuing Illustration 4 show the apportionment of service department expenses by
Simultaneous Equation Method.
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Solution :
Let x = Total expenses of Service Dept. 'C' to be apportioned ; and
y = Total expenses of Service Dept. 'D' to be apportioned.
3
𝑥 = 1800 + 𝑦 (i) (since 30 % of y will be apportioned to Dept. C ) and
10
1
𝑦 = 2500 + 𝑥 (ii) (10% of x will be apportioned to Dept. D)
10
Based on the above explanation, you have understood there are different methods through
which overheads can be apportioned to production departments.
Under this technique, the overhead costs of the organisation are identified with each activity . These
activities are the cost driver i.e. the cause for incurrence of overhead cost. Such cost drivers may be
number of set -ups, number of purchase orders issued, quality inspections, number od designs, etc.
Costs are assigned on the basis of cost driver rate per activity and allocated to the product based on
the quantity of activity consumed by the product or service.
Categorisation of Activities
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
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Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
1. ABC co produces three products A, B and C . Until now the company has been following
the traditional costing to allocate overheads to its products. The company is now
considering to switch to activity based costing for better planning, control and
profitability . The details are as under
A B C
Production and sales (units) 2,000 1,000 500
The raw material cost per kg is $20. The direct labor cost is $10 per hour. The overhead cost detail is
as follows:
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
Total 215,000
1. Traditional costing
1. Traditional costing
A B C
Production and sales (units) 2,000 1,000 500
The raw material cost per kg is $20. The direct labor cost is $10 per hour. The overhead cost
Total overhead incurred = $215,000
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
A B C
Production and sales (units) 2,000 1,000 500
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Valuation and Creating Sustainable Value
Prof. Padmini Srinivasan
The above exercise illustrates how overheads can be more precisely allocated to the different products
based on the resources they consume. Thus activity based costing is a more scientific method of
ascertaining the cost of a product based on the activities required to produce the product.
End of note
© All Rights Reserved. This document has been authored by Prof. Padmini Srinivasan and is permitted for use only within the course "Valuation
and Creating Sustainable Value” delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.