Fundamental Analysis of Automobile Industry VW BMW

Masaryk University
Faculty of Economics and Administration

Field of Study: Finance
THE FUNDAMENTAL ANALYSIS OF

AUTOMOBILE INDUSTRY WITH
REFERENCE TO THE SELECTED
COMPANIES
Master Thesis
Thesis supervisor: Author:

Ing. Dagmar, LINNERTOVÁ, Ph.D Vaibhav Verma
Brno, 2018
MASARYK UNIVERSITY
Faculty of Economics and Administration
MASTER’S THESIS DESCRIPTION

Academic year: 2017/2018
Student: Vaibhav Verma
Field of Study: Finance (eng.)
Title of the thesis/dissertation: The Fundamental Analysis of Automobile Industry with Reference to
the Selected Companies
Title of the thesis in English: The Fundamental Analysis of Automobile Industry with Reference to
the Selected Companies
Thesis objective, procedure and methods used: The aim of the thesis is to analyze and carry out the valuation of
automobile companies based on fundamental approach.
Process of work:
1. Introduction and analysis of a company
2. Literature review
3. Data collection, analysis of equity shares of companies using
valuation tools and techniques
4. Results, discussion
5. Conclusion
Methodology: analysis, comparison, valuation
Extent of graphics-related work: According to thesis supervisor’s instructions
Extent of thesis without supplements: 60 – 80 pages
Literature: DAMODARAN, Aswath. Damodaran on valuation : security analysis

for investment and corporate ﬁnance. New York: John Wiley & Sons,
1994. xi, 426. ISBN 0471304654.
Equity asset valuation. Edited by Jerald E. Pinto. 2nd ed. Hoboken,
N.J.: Wiley, 2010. xx, 441 p. ISBN 9780470571439.
WAHLEN, J M, S P BAGINSKI and M BRADSHAW. Financial Re-
porting, Financial Statement Analysis and Valuation. 8th ed. 2010.
ISBN 978-1-285-19090-7.
MADURA, Jeff. Financial markets and institutions. Abridget 9th
ed. Mason: South-Western Cengage Learning, 2011. xxix, 714.
ISBN 9780538482493.
DAMODARAN, A. Investment Valuation: Tools and Techniques for
Determining the Value of Any Asset. 3rd. 2012. ISBN 978-1-118-
01152-2.
Thesis supervisor: Ing. Dagmar Linnertová, Ph.D.
Thesis supervisor’s department: Department of Finance

Thesis assignment date: 2015/04/06
The deadline for the submission of Master’s thesis and uploading it into IS can be found in the academic year calendar.
In Brno, date: 2018/05/10

Name and surname of the author: Vaibhav Verma
Master’s thesis title: The Fundamental Analysis of Automobile Industry with

Reference to the Selected Companies
Department: Finance
Master’s thesis supervisor: Ing. Dagmar Linnertová, Ph.D.
Master’s thesis date: 2018
Abstract
The aim of the thesis is to perform the fundamental analysis of automobile industry with
reference to the selected companies. As a part of the analysis, world automotive market was
studied with a focus on European market and valuation using appropriate methods and models
was carried out for Volkswagen and BMW resulting in formulation of investment
recommendation.The first part of the thesis is focused on introduction of necessary theoretical
framework, the second part continues with analysis of automobile industry and finally in last part
valuation is performed and an investment recommendation is formulated.
Keywords
Fundamental Analysis, Analysis, Equity, Relative Valuation, Automobile Industry

Declaration
"I hereby declare that I worked on the Diploma Thesis “The Fundamental Analysis of
Automobile Industry with Reference to the Selected Companies”, under the supervision of Ing.
Dagmar Linnertová, Ph.D., and that I stated in it all the literary resources and other specialist
sources used according to legislation, internal regulations and internal management acts of
Masaryk University and the Faculty of Economics and Administration".
Brno, 11.05.2018 ……………………………

Author’s signature
Acknowledgement
I would like to take the opportunity to express my deepest gratitude and appreciation for all of
the people who helped me throughout the thesis.
First of all, I would like to thank my supervisor, Professor Dagmar Linnertová, who provided
me with continuous help, guidance, and cooperation. I am truly thankful for your patience and
understanding.
I also would like to thank my family and friends for their unconditional support during my
studies at Masaryk University.
Moreover, I would like to thank the ERASMUS MUNDUS coordinators, and especially the
EXPERTS4Asia program team and Ms. Jana Nesvadbová. This opportunity has been a life-
changing experience, a source of incredible life-long memories, and a strong influence on my
future.
Vaibhav Verma
Contents
INTRODUCTION ........................................................................................................................ 1
PART I: EQUITY STOCK INVESTMENT AND VALUATION ........................................... 2
1. The Investment Procedure ....................................................................................................... 2
1.1 Market Efficiency: Modern Portfolio Theory vs. Fundamental Analysis............................. 2
1.2 Conclusions ........................................................................................................................... 4
2. Fundamental Analysis .............................................................................................................. 6
2.1 Estimating the discount rate and other inputs to the model .................................................. 6
2.1.1 Risk-free rate .................................................................................................................. 6
2.1.2 Beta (𝛽𝛽)........................................................................................................................... 7
2.1.3 Equity Risk Premium (ERP) .......................................................................................... 9
2.1.4 Capital Asset Pricing Model (CAPM) .......................................................................... 12
2.1.5 Weighted Average Cost of Capital (WACC) ............................................................... 12
2.1.6 Growth rate (g) ............................................................................................................. 13
2.2 Dividend Discount Model (DDM) ...................................................................................... 14
2.3 Discounted Cash Flow Models (DCFM) ............................................................................ 15
2.3.1 Free Cash Flow to Firm (FCFF) ................................................................................... 16
2.3.2 Free Cash Flow to Equity (FCFE) ................................................................................ 18
2.4 Relative valuation................................................................................................................ 19
2.4.1 P / E .............................................................................................................................. 19
2.4.2 EV / EBITDA ............................................................................................................... 21
2.5 Intrinsic vs. Relative Value ................................................................................................. 23
PART II: AUTOMOTIVE INDUSTRY ................................................................................... 24
3. Global Automobile Industry: An Introduction .................................................................... 24
3.2 Global Automobile Sales .................................................................................................... 25
3.2.1 Sales by region ............................................................................................................. 25
3.2.2 Market share of auto companies ................................................................................... 26
3.3 Automobile Industry in Europe........................................................................................... 27
3.3.1 Car Registrations .......................................................................................................... 27
3.3.2 Marketshare of Car Brands ........................................................................................... 28
3.3.3 Age of the Car Fleet ..................................................................................................... 29
3.3.4 Passenger Car Fleet by Type of Fuel ............................................................................ 29
3.4 Saturation of automobile market ......................................................................................... 30
3.5 Factors affecting car sales ................................................................................................... 32
3.6 Current trends and events .................................................................................................... 35
3.6.1 Alternative Fuel ............................................................................................................ 35
3.6.2 Autonomous Vehciles .................................................................................................. 37
3.6.3 Dieselgate Scandal........................................................................................................ 39
PART III : VALUATION .......................................................................................................... 42
4. VALUATION OF VOLKSWAGEN and BMW .................................................................. 42
4.1 Valuation based on FCFF ................................................................................................... 42
4.1.1 Description of the applied valuation method based on FCFF ...................................... 42
4.1.2 Volkswagen .................................................................................................................. 47
4.1.3 Bayerische Motoren Werke (BMW) ............................................................................ 54
4.2 Relative Valuation of Volkswagen and BMW.................................................................... 61
4.2.1 Valuation using multiple P / E...................................................................................... 63
4.2.2 Valuation using EV / EBITDA multiple ...................................................................... 63
4.3 Comparison of Results and Investment Recommendation ................................................. 64
References .................................................................................................................................... 68
List of figures............................................................................................................................... 74
List of tables ................................................................................................................................ 75
List of abbreviations ................................................................................................................... 76
Appendix ...................................................................................................................................... 78
INTRODUCTION
The term “Automotive” is derived from Greek “autos” meaning self and Latin “motivus”meaning
of motion was coined by Elmer Sperry representing any form of self-powered vehicle. 1Europe
being the cradle of car industry, it is where the car was first invented around 130 years ago. The
automotive industry is one of the most important economic sectors for the European and world
economies. It is hugely crucial for contributing towards GDP creation and employment. At the
same time, the increasing availability of cars has greatly facilitated and improved the lives of
Europeans and people world over, whether for everyday work or active leisure. However, on the
other side the increase in the number of vehicles has accentuated some considerable problems,
namely, the increasing traffic density, parking problems in urban centers and degrading the
environmental condition. Additionally, the consumption of non-renewable resources, impaired
air quality and alteration of the landscape for construction of roads has further exacerbated the
pollution increasing the calls for finding sustainable alternatives. The transformative
developments in technology are making cars environmentally friendly, innovative mobility
platforms are altering the mode of usage of vehicles and pioneering advancement in artificial
intelligence is giving the car a brain.
The aim of the thesis is to execute the fundamental analysis of automobile industry with
reference to the selected companies. As a part of the analysis, world automotive market was
studied with a focus on European market, and valuation using appropriate methods and models
was carried out for Volkswagen & BMW resulting in formulation of investment
recommendation. The thesis is organized as follows:
Part I provides the theoretical definition of equity and fundamental analysis, which is necessary
for further investigation. In particular, the valuation models and procedures used are introduced,
including possible methods of estimating key input parameters.
Part II explores the development of global and European car sales, the share of individual
brands in the production of new cars, the saturation of individual markets and the factors
affecting car sales. The current trends and developments in the automotive sector, namely,
alternative fuels, autonomous vehicles and the Dieselgate scandal are discussed in detail.
Part III introduces the valuation of the Volkswagen and BMW based on the selected valuation
methods, compare the outputs from the individual models, and establishing the investment
recommendation.
The work is based on Bloomberg database, which is reliable source of information for financial
markets and publicly traded companies. In addition to the financial statements & annual reports
of the company’s research papers, books, studies and articles of renowned media houses, car
manufacturers' associations, research papers by policy institutes and consultancy companies are
used. To determine relevant parameters in valuation models, the database of Aswath
Damodaran, a leading expert in corporate finance and valuation, are used.
1
Automotive and automobile can be used interchangeably. Automotive means relating to road vehicles and
automobile pertains to cars.
1
PART I: EQUITY STOCK INVESTMENT AND VALUATION
“Happily, there is nothing in the law of value which remains

for the present or any future writer to clear up;
The theory of the subject is complete.”
John Stuart Mill, 1848
Contrary to John Stuart Mill’s opinion, stock valuation today is still a very subjective and
debatable matter. Financial professionals compare different ratios of a certain stock with
equivalent ratios of other or comparable stocks. Others use correlation coefficients to buy stocks
and calculate efficient frontiers but some use the fundamental principle of valuation. The
fundamental principle of valuation states that the cash flow generated by any financial asset
when discounted at the required rate of return gives the value of the financial asset. In this part
of the thesis, a short overview of investment procedure and common stock valuations
approaches are presented.
1. The Investment Procedure
The capitalist system is defined as ‘M-C-M’ by Karl Marx, in his book ‘Capital’. 2 To elongate,
the capitalists begins with Money (M), by investing transforms it into Capital(C) and ends up
with More Money (M) – this defines the investment procedure. Investing is the bedrock of
capitalist system that enables its functioning. Investors fund entrepreneurs that build businesses
to produce goods and services that are demanded by society. In lieu of providing capital, the
investor is rewarded with a share of the profits generated by the business.
An investment can be defined as the present commitment of money for a certain time period to
receive future payments rewarding the investor for (1) the time period of commitment of funds,
(2) the expected rate of inflation, and (3) risk or the uncertainty of future payments. 3
Two different approaches of investing are used in relation to common stocks, namely, modern
portfolio theory and fundamental analysis. A brief overview of fundamental analysis, modern
portfolio theory and valuation is described in the following text.
1.1 Market Efficiency: Modern Portfolio Theory vs. Fundamental Analysis

Investor’s belief about market efficiency shapes the decision, which stock investment process to
choose. The ambivalent conclusions derived from the academic literature whether the stock
market is efficient or not is long and endless. During the 1970s, efficient markets hypothesis
2 Marx, K. (1881). Capital. (F. Engels, Ed.) Moscow, USSR: Progress Publishers
3 Reilly, F. K., Brown, & Brown, K. C. (2003). Investment Analysis and Portfolio Management (7th ed.). Mason,
Ohio: South-Western.
2
gained accreditation due to one-sided evidence however, in recent year’s re-evaluation of theory
has led to diametrically opposite conclusions. 4The belief in the degree of market efficiency led
to emergence of two investment theories that bifurcates the financial community. On one side is
the modern portfolio theory (MPT) which believes the market is efficient and on the other is
fundamental analysis based on the idea that markets are inefficient.
Modern Portfolio Theory and Efficient Market Hypothesis
Modern portfolio theory (MPT) promulgates the efficient market hypothesis. The underlying
assumption of MPT is that all investors taking part in the stock market are intelligent, profit-
oriented and searching for stocks that are mispriced. The efficient market is created when these
informed market participants drive a stock price to its intrinsic value. This leads to detection of
mispriced securities immediately, the under – or overvaluation would vanish and no profit could
be garnered from any investment technique. MPT concludes that all equity stocks are priced
fairly and it is impossible to consistently outperform the market. Hence, the market participants
following this approach try to reduce risk by diversification and reducing costs by minimizing
transaction fees and taxes.
Three forms of market efficiency exist based on what information is reflected in prices: 5
• Weak form of market efficiency– assumes that stock prices fully reflect all historical
market information thus charts and technical analysis based on past prices will not be
useful in finding undervalued stocks.
• Semi-strong form of market efficiency– adds to the previous degree the ability of
market prices to respond very quickly to newly published information, the
implementation of fundamental analysis cannot, by theory, bring higher than market
yields
• Strong form of market efficiency– all public and private information is reflected in the
current prices and investors will not be able to beat the market.
Fundamental Analysis
In fundamental analysis approach, the existing economic information such as historical financial
statements and other available information about a company are used to make investment
decisions. The book ‘Security Analysis’ of Graham and Dodd was the first to outline the
principles of fundamental analysis. 6
Fundamental analysis states that the value of the firm can be deduced by its financial
characteristics such as risk profile, growth prospects and cash flows. The deviation of the stock
4
Palepu, K. G., Healy, P. M., & Peek, E. (2013). Business Analysis and Valuation: IFRS edition (3rd ed.). Andover,
United Kingdom: Cengage Learning. p. 384
5
Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance,
25(2), 383-417.
6 Graham, B., & Dodd, D. L. (1934). Security Analysis (1st ed.). New York: McGraw-Hill.
3
price from its true value points towards stock under- or overvaluation. It is a long-term
investment strategy, and the underlying assumptions are as follows: 7
• The interrelationship between value and the inherent financial factors is measurable
• The relationship is stable over time period.
• Deviations from the relationship are corrected in a reasonable time period.
Two approaches used in fundamental analysis are the top-down and bottom-up investing
approach. The top-down approach propounds to utilize all available information and
macroeconomic data to deduce an investment decision. Depending on the these factors investors
then identifies sectors with above-average growth potential and selects suitable stocks for
inclusion in the portfolio. In general, top-down approach users tend to have a short-term
investment horizon, while longer-term investors often prefer a bottom-up view. Applying the
"bottom-up" approach, the investor will focus primarily on looking for a particular company.
Key parameters include, for example, ratios indicating low valuation versus competition, growth
potential, or business management quality. When selecting a particular stock, the investor
believes in a positive development, regardless of the sector in which the company operates or the
macroeconomic situation in which it is currently located. 8
1.2 Conclusions
To conclude, sound investing directs an investor to not pay more for an asset than it is worth.
MPT and fundamental analysis are rooted on two fundamentally different understanding of the
relationship between price and intrinsic value. Supply and demand in balanced by price and thus
can be exactly determined whereas intrinsic value is more difficult to measure. A valuation
process requires forecasting the future parameters and is thus subjective. Different approaches
are used for valuation and the assumptions based on the views about future prospects of a
company make value individualistic.
Fundamental analysis assumes that the value and price can be different but in efficient markets
price should be equivalent to intrinsic value. In the author’s opinion, it is too simplistic to reach
a conclusion that markets are always efficient so that price adjust to intrinsic value. According to
Bhojraj & Lee (2001), price convergence towards intrinsic value is better characterized by a
process, which is accomplished through the interplay between information arbitrageurs and
noise traders. The change in the price occurs as investors buy and/or sell based on imperfect
informational signals. Conclusively, due to trial and error, the impact of a particular signal is
7 Damodaran, A. (2016). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset
(University edition ed.). Hoboken, New Jersey: John Wiley & Sons. p. 6
8 Leslie, K. (2018, January 8). Bottom-Up and Top-Down Investing Explained. Retrieved April 10, 2018, from
Investopedia: https://www.investopedia.com/articles/investing/092215/bottomup-and-topdown-investing-
explained.asp
4
reflected in the price upon completion of the information procession. Meanwhile by that time, a
new price adjustment process is initiated upon arrival of many new informational signals. 9
The previously mentioned view infers that price discovery of a stock is an on-going market
process and the current price should be considered as a noisy proxy for that stock’s intrinsic
value. Based on this context, the dynamics of price discovery should be understood while
conducting market-based research and a systematic valuation process should be followed to
derive an independent measure of the intrinsic value.
9
Bhojraj, S., & Lee, C. M. (2002, May). Who Is My Peer? A Valuation-Based Approach to the Selection of
Comparable Firms. Journal of Accounting Research, 40(2), 407-439.
5
2. Fundamental Analysis
The second chapter provides an overview of fundamental equity analysis methods with an
emphasis on applied methods in the practical part of this thesis. Firstly, the basic inputs fitted
into the models used to calculate the internal value will be presented, followed by methods of
valuation based on the method of discounting the cash flow and using relative valuation.
2.1 Estimating the discount rate and other inputs to the model
One of the most important input parameters of valuation models is the discount rate, which is
used to convert future cash flows to the present. The discounting process is based on the fact that
the amount of money received today is higher than the same amount earned in the future, due to
both inflation and a certain degree of uncertainty associated, for example, with the probability of
bankruptcy, the development of the competitive environment, political influences and other
unclear variables. It follows logically that with the increasing risk of the investment, the required
investor rate of return also increases. In calculating and determining the appropriate discount
rate, the analyst must always take into account the cash flows that he will discounted at that rate.
The following are the basic concepts of setting a suitable discount rate.
2.1.1 Risk-free rate
Most valuation models are reflected by the determination of the risk-free asset and the resulting
risk-free interest rates. An asset can be termed risk-free if the actual return is always equal to the
expected return. The issuer of such an asset must not carry a default risk, which narrows
potential candidates practically only to the government securities ruling out securities issued by
a private equity. At the same time, the investors should not be exposed to reinvestment risk in
the choice of such an asset, i.e. the uncertainty about the future coupons from bonds will not be
reinvested at the prevailing interest rate since the bond was initially purchased. Therefore, for
the determination of the risk-free interest rate, it is better to refer a zero bond of developed
country than a classic bond with ongoing coupon payments. In practice, long-term government
bond yields, most often with a 10-year maturity, are used in the valuation models predicting cash
flow over a very long future (or infinitely) to estimate risk-free interest rates. 10
Two examples as proxies for default risk-free assets are US government issued bonds and time
deposits insured by Federal Deposit Insurance Corporation, which are part of M2 money
aggregate. 11 However, in the case of a company valuation, the choice of a risk-free asset can be
based on a default-free security whose duration matches to the duration of the cash flows in the
analysis and can be used as the terminal growth rate 12.
10
Damodaran, A. (2016). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset
(University edition ed.). Hoboken, New Jersey: John Wiley & Sons. pp. 154-155
11
Vladimir, Y. (2014, December 19). In Search of a Risk-Free Asset . FEDS Working Paper No. 2014-108, 50.
Retrieved from https://www.federalreserve.gov/econresdata/feds/2014/files/2014108pap.pdf
12
Damodaran, A. (n.d.). Papers.Retrieved from Damodaran Online:
http://people.stern.nyu.edu/adamodar/pdfiles/papers/riskfree.pdf
6
2.1.2 Beta (𝜷𝜷)
An important element in the calculation of the discount rate is the beta coefficient, which reflects
the sensitivity of the stock’s return to the market’s overall return. A firm’s beta is a measure of
its systematic risk. It is typically measured with monthly or quarterly data over the last four
years or so. As the stock’s sensitivity to market conditions may change over a period of time due
to the changes in the firm’s operating characteristics, the beta of the stock may adjust with time
and in response, the stock’s value also adjusts. The beta measures the systematic risk by
determining how the value of the stock portfolio has been affected by market volatility. One of
the approaches to calculating the indicator is the regression analysis of the historical movements
of the traded title against the basket of shares representing the market portfolio. 13
A beta of one indicates that the security’s price is expected to move exactly with the market
movement while a greater than one value of beta indicates that the stock’s price is more volatile
than the market. A beta smaller than one signal the security’s price is expected to be less volatile
than the market. 14
The simplest estimation of bet is based, as noted above, on least squares regression analysis. The
result of such a procedure is the so-called untrained beta (raw beta or unadjusted beta). The
result is often termed as “raw” historical beta or an unadjusted beta. The values estimated of beta
are dependent upon the choice of the index representing a market portfolio. NYSE Composite
and the S&P 500 are used to represent US equities market. The value of estimated beta also
depends upon the frequency and the length of data period of observations. The most frequently
used is five-year period with monthly observations. The Bloomberg default values use a two-
year period with weekly observations. Generally speaking, a shorter period is more suitable for
fast growing The value of beta for a future period has been estimated to be on average closer to
the mean value of 1.0, the beta of an average-systematic-risk security, than to the value of raw
beta. Given the reason that valuation is forward looking, the raw beta should be adjusted so it
more accurately predicts a future beta. For the purposes of valuation, the coefficient is therefore
often corrected to the so-called adjusted beta according to the following relationship: 15
2 1
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = × 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 + × 1.0
3 3 [1]
The beta of a firm is not a mere abstract number generated as a result of a regression analysis
rather it is determined by these three underlying variable: 16
• Type of Business– A firm has a higher beta if it is involved in a business that is more
sensitive to market conditions. Thus, cyclical businesses can be expected to have higher
13Madura, J. (2010). Financial Markets and Institutions (9th ed.). Mason, Ohio, USA: South-Western. pp. 267-268
14Bloomberg Guide: Beta. (n.d.). Retrieved from BYU Library:
http://guides.lib.byu.edu/c.php?g=216390&p=1428678
15Pinto, J. E., Henry, E., Robinson, T. R., & Stowe, J. D. (2010). Equity Asset Valuation (2nd ed.). Hoboken, New
Jersey: John Wiley & Sons. pp. 58-59
16Damodaran, A. (2006). Security Analysis for Investment and Corporation Finance. Hoboken, New Jersey: John
Wiley & Sons. pp. 51-52
7
betas than non-cyclical businesses. Considering other remaining things equal, automobile
companies are sensitive to economic conditions and will have higher betas than food
processing and tobacco companies, which are relatively insensitive to business cycles.
• Degree of Operating Leverage–A firm with a high operating leverage (i.e., high fixed
costs relative to total costs) exhibit a more volatile operating income as compared to a
firm producing a similar product with low operating profit. The higher variance in
operating income results in higher beta for the forms with high operating leverage. In a
similar business, small firms have higher betas as compared to larger firms as they enjoy
fewer economies of scale.
• Degree of Financial Leverage– Generally, the increase in the financial leverage leads to
an increase in the beta coefficient. The fixed interest payments in favorable conditions
results in higher earnings per share and lowers in bad times. Higher leverage not only
increases the variance in earnings per share but also makes the firm riskier.
The capital structure affects the beta factor can be demonstrated using the following
relationship: 17
𝐷𝐷
𝛽𝛽𝐿𝐿 = 𝛽𝛽𝑢𝑢 × �1 + (1 − 𝑡𝑡) �
𝐸𝐸 [2]
β L = Levered beta for equity in the firm

β u = Unlevered beta of the firm
t= Marginal tax rate for the firm
D/E= Debt/Equity ratio (in market value terms)
Damodaran suggests a methodology to estimate the beta factors corresponding for bottom-up
approach. A company is not only a single division and does not focus only on one activity, but
rather a holding or a company with a more complex structure of divisions, products and services.
In the bottom-up approach, the analyst first tries to identify the specific spheres of activity of the
firm. Most companies divide their revenue and profits among divisions into their annual report.
Every business division of a firm has a different risk, financial leverage composition and type of
business, which are also the factors affecting beta values, as discussed earlier. According to the
methodology by Damodaran, the business or businesses are identified in which the firm
operates. Next step is to find other publicly traded firms in each business and their regression
betas are obtained to calculate an average beta for the firms. The average unlevered beta for the
17
Damodaran, A. (2006). Security Analysis for Investment and Corporation Finance. Hoboken, New Jersey: John
Wiley & Sons. p. 52
8
business is calculated by unlevering the average (or median) beta for the firms by their average
(or median) debt-to-equity ratio. The following formula is used: 18
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏
𝐷𝐷
= 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ÷ �1 + (1 − 𝑡𝑡) � 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓�� [3]
𝐸𝐸
Further, to estimate an unlevered beta for the firm being analyzed, a weighted average of the
unlevered betas for the different business divisions it operates in is calculated using the
proportion of firm value derived from each business division as the weights. This weighted
average is termed as the bottom-up unlevered beta and is calculated as: 19
𝑗𝑗 =𝑘𝑘
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = �(𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑗𝑗 ∗ 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤ℎ𝑡𝑡 𝑗𝑗) [4]

𝑗𝑗 =1
j = business division of the firm

k= number of business divisions a firm is operating
Subsequently, the current market values of debt and equity of the firm are estimated and this
debt-to-equity ratio is used to calculate a levered beta.
In the valuation part of this thesis, the beta coefficient will be calculated by bottom-up approach.
The regression of the price development of a stock over a selected index often results in an
inaccurate result influenced by the chosen period and frequency of observation, as well as to a
certain extent by accidental movement of rates or temporary events within the company and
world markets. On the other hand, the calculation based on the average values of companies
appears in most cases to be more accurate and statistically more conclusive.
2.1.3 Equity Risk Premium (ERP)

The premium required by investors for holding equities and not a free asset is called equity risk
premium. It is calculated as the required return on equities minus a specified expected risk-free
rate of return. Equity risk premium is dependent on future expectations since the investor’s
return is dependent only on investment’s future cash flows. The equity risk premium can be
estimated using two approaches. First approach is based on historical average differences
between equity market returns and government debt returns and the second on current
exceptional data. 20
18
19
20
Pinto, J. E., Henry, E., Robinson, T. R., & Stowe, J. D. (2010). Equity Asset Valuation (2nd ed.). Hoboken, New
Jersey: John Wiley & Sons. p. 44
9
For a selected sample period, the mean value of the differences between a broad based equity
market index returns and a government debt returns is equivalent to historical equity risk
premium. Historical estimates are the preferred choice of estimation if reliable long-term records
of equity returns are available. Over a long term, average returns are an unbiased estimate of
investor expectation if the investors do not make systematic errors in forming expectation.
During the usage of historical estimate to represent the equity risk going forward, the parameters
describing return generating process are assumed to be constant over the past and into the future.
The parameters on which an analyst bases his proposition to develop a historical ERP estimate
are as follows: 21
I. Equity index to represent equity market returns– Analysts tries to choose an equity
index that precisely represents average returns earned by equity investors in the analyzed
market. Usually, broad-based market value-weighted indexes are selected.
II. Time period for computing the estimate–The precision in estimating the mean cannot
be achieved by dividing a data period of a given length into smaller sub periods. The
accuracy can be achieved only by extending the length of the data.
III. Type of mean calculated–It is calculated using an arithmetic mean or a geometric mean.
An arithmetic mean equity risk premium is equal to the sum of annual return differences
divides by the number of sample observation. A geometric mean equity risk premium
estimate is equivalent to the compound annual excess return of equities over the risk-free
return. CAPM model uses arithmetic for estimating required return, as both are model-
consistent choice with their focus on single period return.
IV. Proxy for the risk-free return– The choice for the risk-free rate area short-term
government debt instrument, such as a 30-day T-bill rate or a long-term government
bond yield to maturity (YTM). Highest rated corporate bonds are not preferred, as they
are not considered to have less or near zero default and equity market risk. Industry
practice has favored the use of a 10-year government bond yield even though short-term
rate points out that long-term government bonds are subject to risks, such as interest rate
risk complicating their interpretation.
The problem of estimating the market risk premium may be due to the so-called survivorship
bias. The fallacy occurs because of phasing out of poorly performing or defunct companies from
membership in a stock index, so that only relative successful companies remain. It inflates
historical estimates of the equity risk premium. To solve this issue, an equity returns series that
are free from survivorship bias must be used by the analyst. In many emerging markets, the
scant availability of historical data and volatility of existing data fails to yield a meaningful
estimate of the risk premium. The equity risk premium of a developing market can be viewed as
extra risk over a mature market. In such cases, the following formula can be used to calculate the
equity risk premium: 22
21
22
10
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 [5]
= 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑓𝑓𝑓𝑓𝑓𝑓 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
As a premium for a mature market, the US equity risk premium is assigned by default due to
sufficiently long series of available historical data. To determine a country risk premium, the
easiest way is by referring the rating of sovereign bonds of renowned agencies (Standard &
Poor’s and Moody's) and their comparison with the yield premium of the country's debt
securities relative to the US bond yield. Both bonds must be denominated in the same currency.
This way we can estimate the risk margins of the appropriate rating of the bonds of the leading
agencies. It is appropriate to adjust the premium calculated to the higher risk of equity
investments compared to the bond. The standard deviation of returns is considered to be a risk
measure; therefore, by comparing the standard deviation of daily earnings on the stock and bond
markets, the relative risk of the stock market can be estimated and incorporated into the
country's risk premium. The market risk premium is then calculated as the sum of the required
market risk premium (US) and the country risk premium (country risk premium). Estimation of
the required risk premium for specific regions or continents is then calculated as a weighted
average where weights are the values of the gross domestic product of each country: 23
The second approach used is the use of so-called implied market risk premiums. The analyst
does not need to rely on historical data or make adjustments for the risk premium of the country,
but it assumes that the stock market is correctly priced. The method consists in creating a
valuation model equivalent to present value of dividends growing at a constant rate. It as a
market-driven model, current and does not require any past data. Thus, it can be used to estimate
implied equity premiums in any market. The basic model looks as follows: 24
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

𝑉𝑉 = [6]
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔ℎ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
For the calculation of the market risk premium, the practical part of this thesis will be based on
Damodaran's methodology and its estimates of these values for the specific regions in which the
analyzed companies operate. As a benchmark for calculating stakeholder interests in specific
regions, the proportion of revenue generated by the companies in question in those parts of the
world will be taken into account.
23
24
11
2.1.4 Capital Asset Pricing Model (CAPM)
The previous introduction of the key determinants of the discount rate now allows us to estimate
the required yield for the shareholders, which is usually used in the CAPM model, the capital
asset pricing model.
The CAPM equation for required return must be valid in equilibrium (the condition when
demand equals supply) if the model’s assumptions are fulfilled. The assumptions of the model
states that the investors are risk averse and their investment decisions are based on the mean
return and variance of returns of their complete portfolio. The CAPM is based on the premise
that investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic
risk of their total portfolio (systematic risk that results from exposure to general stock market
movement). CAPM is widely used in valuation due to its relatively objective procedure for
required return estimation. It can be expressed as: 25
𝐸𝐸(𝑅𝑅𝑖𝑖 ) = 𝑅𝑅𝐹𝐹 + 𝛽𝛽𝑖𝑖 ∗ [𝐸𝐸(𝑅𝑅𝑀𝑀 ) − 𝑅𝑅𝐹𝐹 ] [7]
E(R i )= expected return of the security

R F = risk-free rate of return
β i = beta of the security
E(R M )= expected return on the market portfolio
2.1.5 Weighted Average Cost of Capital (WACC)
To value a company’s assets, the analyst must discount the cash flows available to equity and
debt holders. The discount rate used is called the weighted average cost of capital (WACC). The
interest rate on the debt is the cost of debt, which is used to calculate WACC, value debt capital
or calculate the present value of the tax shield on debt during the asset valuation. The current
interest rate will be a good proxy if the assumed capital structure in future periods is similar to
the historical structure. If the analyst assumes a change in capital structure, then it is pertinent to
estimate the expected interest rate given the new level of debt ratio. A possible way to approach
to this would be to estimate the expected credit rating at the new debt level of the company and
use the appropriate interest rates for that category. The formula for WACC is as follows: 26
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = (1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 +
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
× 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 [8]
The cost of debt will vary if there is an expectation of market interest rates to change. This may
arise if the investor expects a change in inflation over the forecasted period. The changes in
inflation will reflect in the cost of debt since it is a nominal rate and used to discount nominal
earnings or cash flows. This can be done by altering the cost of debt to increase or decrease over
time to reflect expected changes in interest rates each year. The yield curve shows the how the
25
Madura, J. (2010). Financial Markets and Institutions (9th ed.). Mason, Ohio, USA: South-Western. p. 267
26
Palepu, K. G., Healy, P. M., & Peek, E. (2013). Business Analysis and Valuation: IFRS edition (3rd ed.).
Andover, United Kingdom: Cengage Learning. p. 335
12
investors expect changes in the interests over a period of time can be used to scrutinize whether
the changing interest rate are important in the analysis. The cost of debt, in the WACC
calculation, must be expressed after tax because it net-of-tax cash flows that are being
discounted. Usually the interest rate in the market can be converted to after-tax basis by
multiplying it by one minus the corporate tax rate. The rate of equity and debt capital funding
may change over time, especially with relatively small growth companies. This is also related to
the change in the WACC indicator during the transformation of the company, so the analyst can
incorporate its estimate of the company's capital structure in the future into its model: 27
2.1.6 Growth rate (g)

An essential component of the vast majority of valuation models is the estimate of the rate of
future growth of the company's financial indicators. The analyst tries to predict the development
of sales, earnings, cash flows and other variables in order to place them in valuation models to
estimate the intrinsic value of the share.
The rate of growth can be determined using: 28
Based on retention ratio and the return on equity–Retention ratio is defined as the
percentage of earnings retained by the firm. The growth rate can be calculated using the
equation, g = b * ROE, where ROE is return on equity and “b” is the retention ratio. The
firm is not allowed to issue new shares, which would raise the equity and affect the
formula.
Based on historical growth–Estimation of the average growth rate can vary depending
upon whether it is arithmetic average or geometric average. If a firm has volatile
earnings, it gives two different estimates. When year-to-year growth has been erratic, the
geometric average gives a more precise account of historical growth rate. Choosing a
period beginning near the bottom or top of the market cycle can produce distorted data
regarding estimation of historical growth rate. Negative earnings also distort the
calculated value.
Based on analyst estimates of growth– The usual form of estimating growth rates is
reliance on the consensus of financial analysts presented by large news agencies (for
example, Bloomberg or Reuters). Analyst forecast of growth are better than using the
historical growth rate. Analyst incorporate the firm-specific information released
publically since the last earnings report into their valuation models. This news can lead
to major reevaluation of the expected cash flow of the firm. Macroeconomic information
such as GNP growth, interest rates and inflation affect the expected growth rate. Analyst
can update their estimated based on new information being released. They can also
condition their growth estimates for a firm based on the information revealed by
27
Palepu, K. G., Healy, P. M., & Peek, E. (2013). Business Analysis and Valuation: IFRS edition (3rd ed.).
Andover, United Kingdom: Cengage Learning. p. 335-336
28
13
competitors. For example, a negative earnings report by one mobile service provider firm
can lead to a reassessment of earnings of other mobile service providers. Analyst
sometimes have access to private information about the firm they follow, which could be
useful in forecasting future growth. To curtail information leakage, the Securities and
Exchange Commission (SEC) issued new guidelines preventing firms to reveal
information to selected analyst. However, outside US, firms convey sensitive
information to analyst tracking them.
In valuation models, the analyst has to make the choice of choosing the growth rate at the
terminal stage. The underlying limitation is that no company can grow faster than the growth
rate of the economy, rather there will be a tendency to choose a lower rate of growth. It is true
that over the long term, the nominal risk-free interest rate approaches the nominal rate of growth
of the economy (GDP). The simple rule for choosing the growth rate of a stable company is
therefore that it should not exceed the risk-free interest rate used in the model. However, growth
companies in the economy provide the extra growth, higher than the real interest rates. 29
2.2 Dividend Discount Model (DDM)
Dividend Discount Model is one of the first models for pricing stocks and was developed by
John B. Williams in 1931. It is still a widely applicable model and discounts the expected future
dividends by the required rate of return. The DDM model can account for uncertainty by
allowing D t and k to be updated when expectations of a firm’s cash flows and the required rate
of return respectively, are changed. The formula for DDM is as follows: 30
∞
𝐷𝐷𝑡𝑡
𝑉𝑉 = � [9]
(1 + 𝑘𝑘)𝑡𝑡
𝑡𝑡=1
V = Value per share of equity

t = period
D t = expected dividend per share in period t
k = discount rate
If the expected growth rate in dividends is constant, the above formula is called the Gordon
growth model: 31
𝐷𝐷𝑡𝑡
𝑉𝑉 =
(𝑘𝑘𝑒𝑒 − 𝑔𝑔) [10]
V = Value per share of equity in stable growth

D t = expected dividend per share in period t
k e = cost of equity
g = expected growth rate in perpetuity
29
Damodaran, A. (n.d.). Retrieved from Damodaran Online:
http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/dcfstabl.pdf
30
Madura, J. (2010). Financial Markets and Institutions (9th ed.). Mason, Ohio, USA: South-Western. P. 264
31
(University edition ed.). Hoboken, New Jersey: John Wiley & Sons. P. 585
14
The DDM may give an inaccurate valuation of a firm and has some major weaknesses pertaining
to its practical application. The paramount problem being of the observed dividends not directly
related to value creation within the company and therefore to future dividends. According to
Miller and Modigliani (1961) presently, observed dividends are not informative unless the
dividend payout policy is connected to the value generation within the company. 32Penman
(1992) describes this as the dividend conundrum: “price is based on future dividends but
observed dividends do not tell us anything about price”. The missing connection between value
creation and value distribution leads to the difficulty in forecasting dividends, as it is difficult to
forecast payout ratios. 33The practical application of DDMs in the present scenario, is further
complicated by share repurchases. Grullon and Michaley (2002) showed that since mid-1980,
large chunk of share repurchasing has been executed by many corporations. Share repurchases
transfer cash from firm to investors, which, in principal, is not different from dividends. These
reasons resulted in replacement of dividends as the relevant cash flow to investors since the
1980’s with free cash flows. 34
2.3 Discounted Cash Flow Models (DCFM)

The discounted cash flow model is the concept where the intrinsic value of the share is equal to
the present value of the expected cash flows generated by the company. In practice, two methods
are widely used: Free cash flow to firm (FCFF) and Free cash flow to equity (FCFE). The first is
a cash-flow approach available to all capital providers, both creditors and shareholders. The
second limits discounted cash flows only to the shareholders of the firm.
These models are particularly useful when the company under review does not pay any
dividends or dividends paid out is less than the company’s capacity to pay dividends. In
applying this approach, the analyst looks at the company from the point of view of the majority
owner, who may decide to increase the dividends paid up to the level of free cash flows, to the
maximum sustainable level. Application of FCFE or FCFF should, in theory, use the same
assumptions to determine inputs to the model to provide the same estimates of company internal
values. Generally, if the capital structure of the company is comparatively stable, the FCFE
model appears to be more straightforward and simpler than using FCFF. Conversely, using
FCFF is easier if the analyst values a levered company with negative FCFE, or a levered
company with a changing capital structure. If the past financial data are used to forecast free
cash flow growth rates, FCFF growth may reflect underlying fundamentals more clearly than
FCFE growth, which reflects changing amounts of net borrowing. In addition, the required
32
Miller, M. H., & Modigliani, F. (1961, October). Dividend Policy, Growth and the Valuation of Shares. The
Journal of Business, 34(4), 411-433. Retrieved April 15, 2018, from https://www2.bc.edu/thomas-
chemmanur/phdfincorp/MF891%20papers/MM%20dividend.pdf
33
Penman, S. H. (1992). Return to Fundamentals. Journal of Accounting, Auditing and Finance, 465-484.
34
Grullon, G., & Michaely, R. (2002). Dividends, Share Repurchases, and the Substitution Hypothesis. The Journal
of Finance, 57(4), 1649-1684. Retrieved April 15, 2018, from
http://forum.johnson.cornell.edu/faculty/michaely/final%20version.pdf
15
return on equity is more affected by the changes in financial leverage than that of WACC, which
makes the use of a constant discount rate is difficult to defend. 35
2.3.1 Free Cash Flow to Firm (FCFF)
Free cash flow to the firm is the cash available to all investors holding claims against firm’s
resources. Claimholders include common stockholders, preferred stockholders and lenders. The
cash flow is calculated prior to the determination of sources of financing and, as such, is not
affected by the firm’s capital structure. An enterprise-specific FCFF is usually not found in the
financial statements and must be calculated using the following formula: 36
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸(1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑎𝑎𝑎𝑎𝑎𝑎 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
[11]
− 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝛥𝛥 𝑁𝑁𝑁𝑁𝑁𝑁 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
The cash flow from operating and investment activities is included, but not from financing
activities. The tax rate is equivalent to marginal tax rate of the firm. Net working capital is the
current operating assets minus current operating liabilities. Current operating assets does not
include cash balances in excess of the amount required to meet normal operating expenses.
Depreciation and amortization are added to the operating income in calculating cash flow
because they are not actual cash expenses.
In the FCFF calculation, an appropriate tax rate must be selected. It can be either the firm’s
marginal rate (the rate paid on each additional dollar of income) or its effective tax rate (income
tax expense divided by pretax income). The marginal tax rate is generally more than the
effective tax rate because of depreciation charge to defer tax and use of tax credits to lower the
actual taxes paid. Post the exhaustion of ability to defer taxes and benefits of tax credits, the
effective rate can exceed the marginal tax rate in the future. In the early years of cash flow
projection, effective rates lower than the marginal rate may be used given the current
advantageous tax treatment is likely to continue. Eventually, the effective rate may climb till the
firm’s marginal tax rate. Thus, it is important to use the marginal tax rate in calculating after-tax
profits in perpetuity. 37
The simplest approach to valuing a FCFF-based company is a stable growth FCFF model. Two
conditions must be met to use this model. First, growth rate used in the model must be less than
or equal to the economic growth rate. Second, the assumptions of stable growth and the
characteristics of the firm have to be consistent. This method is used to evaluate stable firms
where no significant changes in the economy can be expected. The assumptions affect the
sensitivity made about capital expenditures relative to depreciation. If the return on capital is the
basis for estimation of the reinvestment rate, changes in the return on capital impacts the firm
value significantly. If expected growth is not a function of the reinvestment rate, the FCFF can
35
Jersey: John Wiley & Sons. Pp. 146-148
36
DePamphilis, D. M. (2014). Mergers, Acquisitions, and other Restructuting Activities (7th ed.). Kidlington,
Oxford, United Kingdom: Elsevier. p. 229
37
DePamphilis, D. M. (2014). Mergers, Acquisitions, and other Restructuting Activities (7th ed.). Kidlington,
Oxford, United Kingdom: Elsevier. pp. 229-230
16
be increased (decreased) by deflating (inflating) capital expenditures relative to depreciation.
The stable growth model is given by: 38
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1
𝑉𝑉 =
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔𝑛𝑛 [12]
V=Value of firm
FCFF 1 = Expected FCFF next year
WACC= Weighted average cost of capital
g n = Growth rate in the FCFF (forever)
Amore complex version of the stable growth formula is used when the firm reaches steady state
after n years and starts growing at a stable growth rate g n after that. It is as follows:
𝑡𝑡=𝑛𝑛
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 [𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝑛𝑛+1 ⁄(𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔𝑛𝑛 )]
𝑉𝑉 = � + [13]
(1 + 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊)𝑡𝑡 (1 + 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊)𝑛𝑛
𝑡𝑡=1
As mentioned already, this procedure will calculate the value of the company's operating assets.
However, equity investors are interested in the value of equity, which can be estimated by
adding assets that are not directly attributable to the operating activities of the enterprise and
deducting the company's non-equity claims on the company. Non-operating assets typically
include estimated value of minority interests in consolidated companies. Similarly, a firm may
have assets that are not used in operating activities, but which are of considerable value (e.g.
unused land, real estate, etc.). Items that should be deducted include liabilities to creditors
(interest-bearing debt). In addition, the present value of future lease payments (the equivalent of
debt) is often among the items deducted. If a company holds a majority stake in a subsidiary
(50% or more), it requires full consolidation of the subsidiaries’ assets and earnings in the parent
company. If these statements are the basis for the parent company's valuation, then the estimated
value of the minority interest must be deducted subsequently for an estimate of value of the
parent company. In addition, the value of liabilities arising under other potential claims against
the firm including unfunded pension plans, medical insurance obligations (they are not labeled
thus excluded from cost of capital calculations) should be deducted. If the company is embroiled
in litigations that may lead to large payouts, the expected liability from these lawsuits must be
calculated and subtracted to arrive at the equity value. If a company has issued preference
shares, it is necessary to reflect this fact in order to estimate the intrinsic value of ordinary shares
and deduct their market value from the quoted price of the operating assets. After these
adjustments, the analyst can estimate the internal equity value of the company attributable to
ordinary shareholders. 39
38
Wiley & Sons. Pp. 252-255
39
17
2.3.2 Free Cash Flow to Equity (FCFE)
The FCFE does not represent a radical departure from the traditional dividend discount model. A
free cash flow to equity is a model where rather than actual dividends potential dividends are
discounted. Using this model, discounting free cash flows to equity yields the value of equity in
business. The FCFE value can be calculated using FCFF as follows: 40
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
= 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 − 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 (1 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟) − 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑁𝑁𝑁𝑁𝑁𝑁 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
− 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 [14]
The model based on the free cash flows attributable to shareholders is a certain alternative to
dividend discount models for companies that do not pay a substantial portion of their dividend
profit. The difference between the values of the firm calculated using FCFE and DDM measures
the value of controlling dividend policy. Considering a case of a potential hostile takeover, the
bidder may control the firm and alter the dividend policy (to reflect FCFE), thus garnering the
higher FCFE value. The implicit assumption of the free cash flow to equity model pertains to
FCFE being paid to the stockholders and the remaining earnings are invested only in operating
assets. The FCFE model measures growth only in operating assets. The simplest way to
determine the intrinsic value of a firm growing at a stable growth rate can be expressed using the
formula: 41
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1
𝑉𝑉 =
(𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔𝑛𝑛 ) [15]
V = Value of firm
FCFF 1 = Expected FCFF next year
WACC = Weighted average cost of capital
g n = Growth rate in the FCFF forever
The caveats of using this formula is that the growth rate specified in the models has to be
smaller or equal to the economic growth rate (nominal growth, if the cost of capital is nominal
or real growth, if the cost of capital is real). In addition, the assumptions of stable growth should
be consistent with the characteristics of the firm. The above model is the simplest way to
determine the intrinsic value of a stable firm based on FCFE model. In comparison of a
simplistic model to value a firm with stable growth, a more complex version with a transition
growth phase is described formerly to the aforementioned formula. 42
40
41
42
(University edition ed.). Hoboken, New Jersey: John Wiley & Sons. pp. 383
18
2.4 Relative valuation
The most accurate and flexible method for valuing companies is the discounted cash flow
analysis. The accuracy of DCFM model is dependent upon the forecasts it relies on.
Misjudgments in estimation of key performance parameters of corporate value such as
company’s return on invested capital (ROIC), growth rate and WACC can lead to errors in
valuation. Relative valuation- comparing a company’s valuation multiples against the
comparable companies
Relative valuation is an approach used by analysts to value stocks, mainly due to its simplicity.
As the name suggests, companies are compared to each other based on valuation multiples of
certain parameters, such as profit, sales, book value, or cash flow. This is a fairly simple and
quick procedure in which the analyst compares the specific parameters of the firm being
evaluated relative to similar companies or industry averages. Importantly, companies with
different sizes can also be compared with relative valuation. With the help of financial data
providers (Bloomberg, Reuters, Morningstar, etc.), the investor are able to quickly assess
whether or not a given share price is understated or overestimated in comparison with its
competitors, thereby it is widely in investment community. However, there are reasons for
differences in valuation, which will be described in detail in the other section of this thesis. The
P / E and EV / EBITDA indicators are introduced in the following text.
2.4.1 P / E
In investment practice, the most pervasive valuation multiplier is the P / E ratio, the share price /
earnings per share ratio. It simply indicates the dollar amount an investor can expect to invest in
a company to receive that company’s earnings equivalent to one dollar. It can be calculated by
the following formula: 43
𝑃𝑃 Market value per share
=
𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎 [16]
The P / E mirrors the market expectation about a company’s growth prospect. Analyst must
reach a conclusion about the implied expectations by the market multiple, whether the market is
overvaluing or undervaluing the firm. Recall that, the constant-growth DDM formula, where
dividends represent the earnings that are not reinvested in the firm: D 1 = E 1 (1 – b), and growth
rates given by𝑔𝑔 = 𝑅𝑅𝑂𝑂𝐸𝐸×𝑏𝑏.These formulas are substituted in the constant-growth model to arrive
at more precise market expectations, as shown below: 44
𝑃𝑃𝑂𝑂 1 − 𝑏𝑏
=
𝐸𝐸1 𝑘𝑘 − (𝑅𝑅𝑅𝑅𝑅𝑅 × 𝑏𝑏) [17]
P O = current price of the stock
E 1 = next year earnings
43
Price-Earnings Ratio - P/E Ratio. (n.d.). Retrieved March 15, 2018, from Investopedia:
https://www.investopedia.com/terms/p/price-earningsratio.asp
44
Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th ed.). New York: McGraw-Hill Education.
pp. 609-610
19
ROE = return on equity
b = retention ratio
k = required rate of return
The above formula implies that the P / E ratio is directly proportional to ROE, P / E increases
with ROE. With high ROE, the company has solid prospects of future growth. The indicator also
increases with the increasing retention ratio, assuming that the ROE is higher than the required
rate of return. Therefore, if a company exploits good investment opportunities by plowing back
more earnings into those opportunities, the market will grant it with a higher P / E multiple.
However, if ROE is below the required rate of return, investors prefer receiving earnings as
dividends rather than investing into low-yield projects.
The P / E ratio the following alternative definitions: 45
Trailing P / E–It can be referred as current P / E and is calculated by ratio of current
market share and earnings per share for the last four quarters. For companies facing
dilution of shareholdings through the issue of new shares(executive stock options, equity
warrants and convertible bonds exercised to obtain common stock)it appears more
conservative to use diluted EPS per share instead of the basic earnings per share.
Earnings per share are also adjusted for nonrecurring items such as asset impairments,
discontinued operation and the disposal of a portion of a business segment and
extraordinary items, and so on, for analytical purposes, as the analyst focuses on profits
that can be consistently expected in the future. For these purposes, it is possible to use
cautiously the companies presenting adjusted earnings per share (adjusted EPS).
Forward P / E–It can also be called as leading P / E or prospective P / E. It is calculated
as the ratio of the stock’s current market price and the next years expected earnings. The
expected earnings per share are based on the analytical consensus, with variants based on
the expected EPS for the following four quarters, the next 12 months or the next fiscal
year.
Normalized P / E– Due to the business-cycle influences, net profit for the last four
quarter may not correspond to the average or long-term ability of an enterprise to
generate, especially for the cyclically sensitive sectors such as automotive and steel
manufacturers. The trailing EPS for such companies is often unusually high at the crest
of the cycle, and depressed or negative at the trough of a cycle. Thus, the analyst tries to
normalize the EPS by estimating the EPS that the business could be expected to sustain
corresponding to the middle of the economic cycle. This can be done by two methods—
the method of historical average EPS, in which the average EPS over the most recent
full economic cycle is calculated and the method of average return on equity, in which
the normalized EPS is calculated as the ROE from the latest full economic cycle
multiplied by latest book value per share.
45
20
The most common use of the P / E ratio is to estimate the current multiple of the company’s
stock and the multiples of comparable companies or the peer group. The average or median
value of the P / E for the company’s peer group is then compared to the company's valuation,
with the analyst taking into account the company specifics (as expected growth and risk),
including historical premium or historical discount compared to competing companies. 46
The comparisons of P / E multiple across time has its pitfalls. The usual practice of calling a
market to be over or undervalued based on comparison of recent to past P / E ratios will lead to
unscrupulous judgments when the interest rates are lower or higher than the historical norms.
The relative valuations have short lifespan as a stock may look cheap today relative to peer
companies today but a drastic shift in assessment can happen over the next few months 47. It is
well understood that companies in the same industry can have ghastly different expected growth
rates, capital structures and return on invested capital. This fact is overlooked by using the peer
group average. The P / E ratio commingles operating and non-operating items, thus can exhibit
flaws when comparing companies with identical prospects. In contrast, a well-formulated
forward-looking multiples analysis can provide insights about a firm and its competitors. 48
2.4.2 EV / EBITDA
The EV / EBITDA is the most used enterprise value multiple and is a firm value multiple.
EBITDA is a flow to both debt & equity and enterprise value (EV) is the total company’s value
(the market value of debt, equity and preference shares). Therefore, EV / EBITDA is a valuation
indicator for the overall company not limited only to its common stock. Enterprise Value (EV) is
the total value of the company and is taken as the theoretical price to which the eventual buyer
would have taken over the entire business. It can be expressed as: 4950
𝐸𝐸𝐸𝐸⁄𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
(𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 − 𝐶𝐶𝐶𝐶𝐶𝐶ℎ) [18
=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖, 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡, 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑, 𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑜𝑜𝑜𝑜 𝑡𝑡ℎ𝑒𝑒 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 ]
The EV / EBITDA is the most used enterprise value multiple. Therefore, the enterprise value is
calculated as the sum of the market value of the equity (market capitalization), market value of
preferred stock (if any) and the market value of the company's debt, deducing subsequently the
46
47
Damodaran, A. (2011). The Little Book of Valuation: How to Value a Company, Pick a Stock, and Profit.
Hoboken, New Jersey: John Wiley & Sons. p. 68
48
Koller, Tim; Goedhart, Marc; Wessels, David. (2005). Valution: Measuring and Managing the Value of
Companies (4th ed.). Hoboken, New Jersey: John Wiley & Sons. p. 361
49
50
21
value of the cash and investment. Analyst offer the following reason for using EV /
EBITDA 5152:
• Analyst argue in favor of EV / EBITDA against P / E for comparing companies with
different debt, because EBITDA is calculated pre-interest in contrast to EPS, which is
post interest.
• Depreciation and amortization are added back in EBITDA and thus controls for
differences in depreciation and amortization among businesses, contrary to net income,
which is after-depreciation and after-amortization. Thus, EV / EBITDA is used in the
valuation of capital-intensive businesses.
• When EPS is negative, EBITDA is frequently positive.
For all the above-mentioned reasons, this multiple is particularly favored for firms in sectors that
require large investments in infrastructure with large gestation periods. Companies operating in
telecom, airport or toll road construction are few examples.
Kim & Ritter (1998)used different multiples for the matching companies in the valuation of IPO
companies. The valuation multiples used in their study were P/ E, EV / EBITDA, price to sales,
market value to book value and enterprise value to sales. According to their study, they found
that at all of these multiples yield positively biased estimates but that the EBITDA multiple
results in the most precise valuation, especially for the more established IPO companies. They
also inferred that valuations are precise when forecasted earnings rather than historical earnings
are used and when the comparable companies or peer group are selected by a specialist research
firm rather than computer algorithm. 53
To analyze EV / EBITDA multiples, the free cash flow to the firm in terms of EBITDA can be
expressed as: 54
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 × (1 − 𝑡𝑡) + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷(𝑡𝑡) − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 [19]
− 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
Substituting this equation with inputs for the next year into the stable growth firm valuation
model:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸1 × (1 − 𝑡𝑡) + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷1 (𝑡𝑡) − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶1 − 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑊𝑊𝑊𝑊1
𝐸𝐸𝐸𝐸 =
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔 [20]
51
52
53
Kim, M., & Ritter, J. R. (1998). Valuing IPOs. Journal of Financial Economics, 53, 409-437. Retrieved from
https://www2.bc.edu/thomas-chemmanur/basfincorp/valuing%20IPOs.pdf
54
22
Dividing the equation by EBITDA yields the determinants of the multiple:
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
1 1 (𝑡𝑡)− 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 −𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑊𝑊𝑊𝑊
1
𝐸𝐸𝐸𝐸 (1 − 𝑡𝑡) + � �
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 [21]
=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸1 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔
For simplification and better clarity, we can consolidate the reinvestment terms as the sum of
capital expenditures and changes in working capital, from which we then subtract depreciation:
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 ×(1−𝑡𝑡)
𝐸𝐸𝐸𝐸 (1 − 𝑡𝑡) − −
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 1 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 [22]
=
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 − 𝑔𝑔
It shows that that companies with higher growth rates, lower cost of capital, higher return on
capital (which lowers reinvestment) will achieve higher EV / EBITDA multiples. Firms with
significant depreciation charges should trade at lower multiple of EBITDA rather than similar
firms (in terms of growth, reinvestment, and cost of capital) without this depreciation. At the
same time, the tax rate applied to the company's income is influenced by the earnings multiple,
with higher tax rates amounting to lower multiple of pre-tax earnings. Consequently, companies
incorporated and trading in higher-tax territories may trade at lower multiple of EBITDA than
companies in lower-tax territories. 55
2.5 Intrinsic vs. Relative Value

Generally, intrinsic and relative valuation will yield different estimates of the value of the same
firm in the same period. It is even possible for one approach to generate the result that the stock
is overvalued while the other shows that it is undervalued. In the early 2000, prior to dot-com
bubble burst, the discounted cash flow valuation of Amazon.com suggested that it was
significantly overvalued, whereas valuing the company relative to other internet companies at
the same time yielded the opposite conclusion. Even within relative valuation, the results can
differ depending upon which multiple is used and what firms the relative valuation is based. The
difference between the values calculated by FCFF and relative valuation appear due to different
views of market efficiency or inefficiency. When calculating the share price using FCFF, we
assume that markets make mistakes, that they correct these mistakes over time, and that these
mistakes can often occur across entire sectors or even the entire market. In relative valuation, we
assume that while markets make mistake on individual stocks, they are correct on average. Thus,
a stock may be overvalued on a discounted cash flow basis but undervalued on a relative basis,
if the firms used for comparison in the relative valuation are all overpriced by the market. The
reverse would occur if an entire sector or market were underpriced. 56
55
56
Damodaran, A. (2011). The Little Book of Valuation: How to Value a Company, Pick a Stock, and Profit.
Hoboken, New Jersey: John Wiley & Sons. pp. 77-78
23
PART II: AUTOMOTIVE INDUSTRY
“Automobiles are a passing phenomenon. I believe in horses.”
Kaiser Willhelm II, 1905
The words of the last German Emperor may sound ironic today, given the renaissance ushered
by automobiles in our life. Apart from the obvious benefits, use of automobiles has also created
environmental concerns and car companies have nefariously tried to go around them rather
strive to mitigate its negative effects . In the following, an analysis of the global automobile
industry is presented with a focus on the European automobile market. The current trends and
issues surrounding the automotive industry are discussed at the end of this part.
3. Global Automobile Industry: An Introduction
The global automobile industry is intrinsically an assembly industry where the suppliers of
components and different manufacturers are mutually dependent throughout the production
proces. 57 More accurately, the global automobile industry is an interlocked network of
specialised oligopolies where the marketplce is affected by the actions of individual
manufacturers. 58 It is a capital intensive industry having high fixed capital and labour costs
resulting in a relatively high capital-to-labour ratio where the global manufacturers compete on
price, product and technology. 59 This leads to a high concentration market resulting from high
entry barrier for new entrants. Mergers, alliances and other various collaborations among the
global automobile industry and it suppliers are leading to consolidation thereby globalizing the
competition and contributing to the inorganice growth. These consolidations resulted from
factors such as economies of scale, technological change and scope. 60
The automotive sector is one of the most industrial sectors. The arrival of the automobiles has
transformed lives across the globe and significantly contributes to productivity growth and
employment in global economies. The Forbes Global 2000 ranking includes eight companies in
top hundred rankings, further elaborates the importance of automobile industry. The rankings is
based on an equally weighted composite score of revenue, profits, assets and market value which
includes Toyota, Daimler, Volkswagen, General Motors, BMW Group, Ford Motor, Honda and
Nissan Motor in the top 100. 61
57
Dicken, P. (2011). Global Shift: Mapping the Changing Contours of the World Economy (6th ed.). New York:
The Guilford Press. p. 332
58
International Labour Organization. (2010). The Global Economic Crisis Sectoral Coverag- Automotive Industry:
Trends and Reflections. Geneva: International Labour Organization.
59
Haugh, David; Mourougane Annabelle; Chatal, Olivier. (2010). The Automobile Industry in and Beyond the
Crisis. OECD, Economics Department Working Papers. Paris: OECD Publishing
60
Weston, J. F., Mitchell, M. L., & Mulherin, J. H. (2003). Takeovers, Restructuring, and Corporate Governance.
New Jersey: Prentice Hall.
61
The World’s Biggest Public Companies. (2017). Retrieved from Forbes:
https://www.forbes.com/global2000/list/#tab:overall
24
3.2 Global Automobile Sales
The automobile companies have a global presence and are not only limited to their country of
origin. The following paragraph details the global car sales.
3.2.1 Sales by region

The following chart shows the sales of motor vehicles in different countries across the world.
The data is only available till 2016 in OICA statistics.
Figure 1: Worldwide motor vehicle sales of passenger car(2005-2016)
100
Million
90
80
70
60
50
40
30
20
10
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
CHINA AFRICA ASIA/OCEANIA/MIDDLE EAST (without China) NAFTA EU 28 countries + EFTA
Source: Author’s calculation from OICA statistics. http://www.oica.net/category/sales-statistics/
In the 2005-2016 period, world auto vehicle sales have grown at 42.4% from 65.9 million to
93.85 million. China is the biggest market with sales of 28.9 million vehicles in the year 2017
and has shown an astronomical growth of 401.5% since 2005 62. The second biggest market is
US with sales of 17.9 million in 2016. In 2009, China overtook America as the biggest country
for auto sales and in 2010 became the largest automotive market leaving behind NAFTA
countries namely US, Canada and Mexico. EU-28 countries and EFTA members are the third
biggest market with sales of 17.6 million registering a slight decline of -3.4% during the period
2005 to 2016. Japan, India and South Korea are the other big markets in the
Asia/Oceania/Middle East markets. India and Indonesia with respective growth rates of 154.7%
62
CAAM. (2018, January 1). The automobiles witnessed stable growth. Retrieved Februrary 15,
2018,
from China Association of Automobile Manufacturers (CAAM):
http://www.caam.org.cn/AutomotivesStatistics/20180115/1305214919.html
25
and 96.3% since 2006, with atleast a million cars in 2016, highlighting their importance. Central
and South America have sales of 4.05 million and the least in Africa amounting to 1.31 million.
3.2.2 Market share of auto companies

The following pie chart compares car companies according to the number of cars sold
worldwide. The data incorporated is till 2016. The absence of latest data is mainly due to the
inconsistency of the fiscal reporting period of the individual companies and a lag between the
end of the accounting period and the release of the financial results.
Figure 2: Market share of auto companies (2016)
Other
manufacturers Volkswagen
17.02% 11.07%
Daimler GM
2.34% 10.62%
BMW
2.52%
Dongfeng
2.96%
[NÁZEV
Suzuki
KATEGORIE]
3.09%
Changan [PROCENTO]
3.26%
PSA
3.35% Ford
7.09%
Honda
3.95% SAIC Motor
Fiat Chrysler
5.01% Hyundai-Kia Renault-Nisan 6.91%
5.24% 6.16%
Source: Author’s calculation based on Bloomberg
According to the number of cars sold in 2016, Volkswagen is the leading automobile company
with 10.39 million uniits sold and having a market-share of 11.07%. General Motors comes next
with a market share of 10.62% with 9.97 million units sold. The third largest company by sales
is Toyota with 8.8 million cars sold. The Chinese manufacturer, namely SAIC Motor, Changan
& Dongfeng capture fifth, eleventh and thirteenth spot backed by the exponential growth of car
sales in China since the last decade. The German manufacturers namely, BMW and Daimler,
have a marginal share of 2.52% and 2.34% respectively, because of their premium category car
offerings.
26
3.3 Automobile Industry in Europe
The automotive industry is a key sector contributing to the growth & productivty of economic
activity in EU. According to the statistics of the European Automobile Manufacturers
Association(ACEA) the turnover of the automotive industry is 6.8% of EU GDP and employs
12.6 million people or 5.7% of the total EU workforce. The 3.3 million jobs pertaining to
automotive manufacturing tantamount to almost 11% of EU manufacturing jobs. Automobile
manufacuring is one of the most important industry in the EU where the total number of cars,
vans, trucks and buses manufactured amount to 19.2 million. This industry brings in a 90 billion
euro trade surplus and tax contributions amounts to almost €396 billion in 15 EU countries. 63
3.3.1 Car Registrations

The graph below describes the long-term development of passenger car registrations in the EU
and EFTA countries. The data has been selected since 2004, when the 10 countries joined the
EU, to maintan the consistency and eliminate variability arising due to varied composition of the
EU.
Figure 3: New registrations in EU and EFTA for the period 2004-2017 (in thousands)
17,000
16,000
15,000
14,000
13,000
12,000
11,000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: ACEA. http://www.acea.be/statistics/tag/category/by-country-registrations
During the period under consideration, peak sales of passenger car is achieved in 2007 when
more than 16 million cars are registered. Since 2008, there is a slide in the registration which is
attributed to the 2008 financial crisis lasting till 2013 and thereafter, recovered following the
recovery in the EU.
63
ACEA. (n.d.). Facts about the Automobile Industry. Retrieved April 10, 2018, from ACEA: Facts about the
Automobile Industry
27
3.3.2 Marketshare of Car Brands
In total, more than 15.6 million passenger cars were registered in 2017 in the European Union
and EFTA countries (Iceland, Norway, Liechtenstein and Switzerland). The percentage of the
eighteen best-selling brands in the monitored region is described in the chart.
Figure 4: Market share of companies in EU-28 countries + EFTA (2017)
Volvo Others VW
Seat
1.93% 8.84% 10.89%
2.56%
Dacia Renault
2.95% 7.32%
Kia
2.98%
Hyundai Fiat
3.31% 6.70%
Nissan
3.60%
Citroen BMW
3.66% 6.67%
Toyota
4.37% Ford
6.67%
Skoda
4.50% Opel
Audi Mercedes Peugeot 6.03%
5.28% 5.82% 5.92%
Source: Authors calculation based on ACEA statistics
The European passenger car market is dominated by Volkswagen having 10.89% marketshare,
which represents more than 1.7 million cars delivered. Its well-known brands include Porsche,
Audi, Skoda and Seat has managed to help the VW Group with a total of almost 3.7 million
European registrations, resulting in a 23.23% share. The second in terms of car sales is the
French group PSA producing car brands Peugeot, Citroen and a premium sub-brand DS. In
March 2017, it acquired Opel from General Motors. In total, the PSA holds 15.61% of the
market with 2.48 million registered vehicles. The French car manufacturer Renault and its
subsidiary Dacia making affordable cars are third in the top selling brand. Together, both brands
in this group occupy 10.27% of the market share, with more than 1.6 million cars sold in 2017.
The German premium car manufacturers BMW and Daimler accounted for 6.67% and 5.82%
market share respectively. Daimler with its premium Mercedes brand sold 0.9 million units and
BMW sold 1.04 million units. The Italian manufacturer Fiat sold 1.04 million units and has a
market share of 6.70%. Volvo, the Swedish based manufacturer has a paltry share of 1.93% on
sales of 0.3 million cars.
Ford has a strong presence in the European market. Ford reached a solid 6.68% share and sold
1.04 million cars. Solid growth in sales has been recorded in the last decade by the South Korean
car maker Kia and Hyundai. While in 2006 their registrations together accounted for 3.6% of the
28
European-wide number, in 2017, their representation increased to 6.31%. Japanese cars aren’t a
dominating force in the European car market. The largest representation of them on the market is
Toyota with a 4.38% share followed by Nissan, with 3.61% of total registrations.
As can be seen from the structure of European registrations described, the continental market is
rather diversified and there is no unilateral dominance of specific brands. However, it should be
noted that many of them have their roots in Germany or France.
3.3.3 Age of the Car Fleet

According to the statistics available till 2015, the average age of the EU car fleet has marginaly
increased consistently. The trend shows that there is not a need felt by consumers to renew their
vehicles indicating a saturated market.
Figure 5: Average age of the EU car fleet (2015)
Number of years
12.0
10.0 10.7
10.3 10.5
8.0 8.9 9.1 9.3
8.4 8.5 8.6
6.0
4.0
2.0
0.0
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: ACEA. http://www.acea.be/statistics/tag/category/average-vehicle-age
3.3.4 Passenger Car Fleet by Type of Fuel

The fuel options available in passenger cars in EU includes petrol, diesel & natural gas among
the non-renewable sources. The electric vehicles include hybrid, plug-in hybrid and battery
electric or fuel cell. Flex-fuel running vehicles which is made by combining ethanol and
gasoline is available in France and Sweden. The following figure shows the passenger cars
running on the different fuel types.
29
Figure 6: Passenger car fleet by fuel type (2016)
80
70
60
50
40
30
20
10
0
Diesel Battery/Plugin/Hybrid Natural gas Petrol
Source: Author‘s calculation based on The International Council on Clean Transportation. (2017). European
Vehicle Market Statistics: Pocketbook 2017/18
The EU-28 average for diesel and petrol cars is 49% and 47% respectively. Ireland has the
highest dependence on diesel cars amounting to 70% whereas Netherlands has the lowest as
19%. Netherlands has also one of the highest electric cars amounting to 8.8% and petrol run cars
as 71.8%. Cars running on natural gas have only few takers and has negligible to no presence
among the listed countries except in Italy having 7.8% of cars.In Norway the share of electric
vehicles is 40.3% which is among the highest in the world. Sweden has 7.2% cars as eletric
vehicles. Electric vehicles have a miniscule marketshare as compared to diesel and petrol cars
but as the technology progresses it sure to dent the market leadership of the non renewable fuel
car industry. In the further part, this would be discussed in detail. Also the relationship between
tax policy affecting sale of a specific type of fuel carwill be in the section titles- Factors
affecting car sale.
3.4 Saturation of automobile market

The car sales in the developed market is experiencing saturation. The sales growth in the US
have stagnated since 2005 which was discussed in the previous section. The sales of cars in
European Union and NAFTA countries have declined during the same period.
The total number of motor vehicles around the world in the year 2015 was 1.282 billion with the
motorization rate of 182 vehicles per 1000 inhabitants (data is available till 2015). The graph
below depicts the saturation in selected automobile markets in 2015, including passenger and
commercial vehicles.
30
Figure 7: Motorization rate of selected countries, includes passenger and commercial vehicles
(2015)
India
China
EU + EFTA
UK
Germany
France
Japan
Italy
USA
0 100 200 300 400 500 600 700 800 900
Source: OICA statistics. http://www.oica.net/world-vehicles-in-use-all-vehicles-2/
The highest level of motorization exists in US with 821 vehicles per 1000 inhabitants. Italy has
706 cars per 1000 inhabitants which is second only to US among the G7 economies. Japan
exhibits the aforementioned statistics as 609 which exceeds its European counterparts, where
France and Germany exhibit 598 and 593 cars per 1000 inhabitants. UK trails by 587 cars per
inhabitants but above the EU and EFTA countries average of 581.
A promising future lies ahead for the automotive market of China. Despite increasing the tax on
smaller cars with engine capacity of 1.6 or less from 5% in 2016 to 7.5% in 2017 and car
manufacturers facing the least sales growth since the last two decades, the motorization rate of
118 cars per inhabitant together with the rising living standards of the middle class and the
ongoing urbanization process, provides a legroom for growth. The tax rate is expected to be
increased to 10% in 2018 and this may adversely affect the buying propensity of the Chinese
consumers. 64
The annual passenger vehicle sales in China is expected to reach 22 millions by 2020, according
to a study by McKinsey, mainly due to continued urbanization and economic growth in the
country. The Chinese consumers are exploring alternatives instead of purchasing new cars such
as leasing or renting, buying a used car, and relying on e-hailing and car-sharing services which
may hamper sales growth. 65
64
Spring, Jake; Cheng, Fang. (2017, January 12). China vehicle sales to grow 5 percent in 2017 as tax cut reduced.
Beijing, China: Reuters.
65
Wang, Arthur; Liao, Wenkan; Hein, Arnt-Phillip. (2012). Bigger, Better, Broader: A perspective on China’s Auto
Market in 2020. McKinsey & Company.
31
India registered a growth of 15.8% in FY2017 of passenger vehicles with sales reaching 3.05
million as compared to sales figures of FY2012. 66 The 22 cars per 1000 inhabitants is bound to
increase resulting from the burgeoning economic growth. Owing to the world’s largest youngest
population and low motorization rate, makes it one of the most attractive automobile market in.
According to Ernst & Young study, the personal vehicles per 1000 inhabitants is expected to
reach 48 by 2020. 67
3.5 Factors affecting car sales
The automotive sector is a cyclical sector. The consumers may postpone the purchase of a new
car during the crisis years until they are better off in economic terms. The key determinant of
sales of passenger cars is unemployment, and the mutual development of the two quantities
since 2006 in the EU-28 countries is illustrated by the graph below. While sales are shown in a
blue column with a relevant left axis, the unemployment rate is plotted with a line graph in
percent with the right-hand axis.
Figure 8: EU car sales and unemployment rate (2006-2017)
18 12%
Million
16
10%
14
12 8%
10
6%
8
6 4%
4
2%
2
- 0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
New registrations in EU Uemployment
Source: Author’s calculation based on ACEA and Eurostat
The graph shows an inverse relationship between sales of cars and the unemployment rate.
Improving economic activity is associated with an increase in both employment and the related
strengthening of the financial condition of households, whose willingness to renew and purchase
a new car is seen rising. A drop in passenger car sales of almost 8% was recorded during the
financial crisis in 2008, with the downward trend continuing for the next 5 years, after which
only 11.87 million were registered cars in 2013. Apart from the lowest number of car sales since
2006, unemployment peaked in 2013 reaching 10.9%. The downward trend of car sales and
increasing unemployment both were reversed from the 2014. Since 2014 car registrations
66
Society of Indian Automobile Manufacturers. (2017). Domestics Sales Trends. Retrieved February 17, 2018, from
Society of Indian Automobile Manufacturers: http://www.siamindia.com/statistics.aspx?mpgid=8&pgidtrail=14
67
Ernst & Young. (2016). Making India a World Class Automotive Manufacturing Hub.
32
numbers have been increasing reaching a 15.11 million in 2017 which is still less than the 15.57
million high of 2007.
The economic condition of households is linked to the consumer confidence indicator, which
can be used to estimate future developments in economic activity and GDP. When calculating
this indicator, households are asked about their current financial situation and planned purchases
of long-term consumption goods in the near future. The graph below illustrates the weighting of
this indicator in points through a bar chart weighted along the left-hand scale and the sales of
passenger cars depicted as a line of units with the right-hand axis.
Figure 9: Passenger car sales and consumer confidence in EU-28 countries (2006-2017)
0 18
Million
16
-5
14
-10 12
10
-15
8
-20 6
4
-25
2
-30 -
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Consumer confidence New registrations in EU
Source: Author’s calculation based on ACEA and Eurostat
Again, an inverse relationship between the two variables is evident. However, it is clear that if
households are in poor financial condition and their short-term outlook is negative, the
purchases of passenger cars (which are a typical example of durable goods) do not go too far.
Other key determinants of sales include the availability of bank loans to acquire vehicles, or the
possibility of financing leasing purchases. Individual carmakers have their own financial
divisions to offer clients the opportunity to finance the purchase of a new vehicle. Thanks to
these possibilities, the consumer can make purchase conveniently.
The proportion of cars sold through external financing varies considerably across Europe.
According to the Bankenfachverbrand (German Association of Credit Banks), which represents
the interests of credit banks in Germany, 35% of the new passenger cars sold in 2014 were
financed compared to 42% in 2016. 68In France, the percentage of cars sold by auto financing is
estimated to be 60% in 2015. The 40% of the cars are financed directly on-site dealerships. In
the United Kingdom, the percentage of such sales is 86.5% in 2017 up from 82.7% in
68
GfK Financial Market Research. (2017). Market Study 2017 - Consumer and Vehicle Financing in Germany.
German Association of Credit Banks.
33
2016. 69Within US, financing of new vehicle purchases is more popular as compared to Europe,
with purchases in some form of credit accounting for 85.5% of total sales in 2017. The average
new car loan on the local market amounts to $ 31,099 in 2017 and is burdened with an annual
interest rate of 5.2% up from 4.9% an year ago. 70A positive trend, in popularity of external
financing is comforting for the consumer as well as the auto companies. The growing economy
as displayed by the indicators previously discussed have boosted the sales of cars which were
facilitated by the availablity of external finance. The divergence of popularity of consumers
finance across the globe is a factor of consumer prefernces, economic prosperity, among others.
The propensity to buy new vehicles is affected by the costs associated with ownership. The price
of oil is a major cost of running , whose decline from over $ 100/barrel in the mid-2014 to under
$ 50/barrel untill mid 2017 is a welcome boost for the automotive industry. The oil price has
begun to increase since mid 2017 and is hovering at a mark of around $ 60/barrel. Consumers
not only make more use of their vehicles, they are more often forced to invest in their
maintenance and replacement, but also when shopping for a new car they tend to use higher-
class cars, which in addition to higher fuel consumption also have higher profit margins for
automakers.
Taxes are another factor which the consumers consider before making a decision to purchase
any product, let alone car. The Government policy of tax on automobiles can encourage or
discourage the consumer to purchase or otherwise.
Taxes are levied on motor vehicles in three different forms in the EU member states namely,
taxes on acquisition, taxes on ownership and taxes on motoring. Taxes on acquisition are
imposed during the purchase of the new vehicles in the form of a VAT levy and registration tax.
All 28 EU member states levy this tax but only 19 member states include tax based on CO 2
emissions. Registration tax is based upon cylinder capacity, selling price, weight, fuel type,
vehicle type and registration chargé varying upon country specific tax levy mechanism.
Denmark has the highest tax on acquisition based on traffic safety equipment and evaluation
which may amount to 105% upto DKK 106,600 plus 150% on the remainder. Taxes on
ownership are based similar to registration tax.Taxes on motoring are levied as excise duties on
fuels in € per 1,000 litres. It is different for unleaded petrol and diesel. The EU minimum rates
for unleaded petrol & diesel is € 359 and € 330 respectively. The highest tax for unleaded petrol
exists in Netherlands amounting to € 772 and for diesel is € 680 in United Kingdom. The lowest
rates being in Bulgaria amounting to € 363 for unleaded petrol and € 330 for diesel.In
Netherland, the electric vehicles are exempt from the registration tax and since 1 January, 2017,
a special tax rate is applied for new plug-in hybrid vechicles. Cars with zero CO 2 emissions are
completely exempt from motor vehicle tax up to 2020 and are also eligible for a discounted 4%
income tax is levied. Germany grants a bonus of € 4,000 for pure electric car and fuel cell
vehicles and € 3,000 for hybrid vehicles. It also provides an exemption from the annual
circulation tax for ten years from the date of registration. Sweden grants a premium for the
69
Reuters Staff. (2017, May 12). More UK Cars Bought on Credit - Data. London: Reuters. Retrieved February 20,
2018, from https://uk.reuters.com/article/uk-britain-economy-autos-finance/more-uk-cars-bought-on-credit-data-
idUKKBN1882AX
70
Experian. (2017). State of the Automotive Finance Market: A look at loans and leases in Q1 2017. Experian.
34
purchase of a new electric or hybrid vehicle. It grants SEK 20,000 for hybrids with CO 2
emissions between 1 and 50g/km and SEK 40,000 for electric vehicleswith zero CO 2 emissions.
According to the Norwegian EVs policy, the electric vehicles have to pay zero annual road tax,
free municipal parking depending on cities decision making body and access in bus lanes in
Oslo which has resulted in the lion’s share of eletric vehicles. 71727374
From Figure 6, we have seen that electric cars are most popular in Norway, Sweden,
Netherlands. The high number of electric vehicle adoption is due to the available electric vehicle
tax benefits which includes motor vehicle tax exemption up to 2020. It can be said that the
decision of consumers to purchase an electric car, a buyer friendly tax policy is important.
3.6 Current trends and events
3.6.1 Alternative Fuel

The automobile indutry has been dominated by conventional combustion engines and have been
investing in increasing their capabilities, efficiency and effectiveness. The environmental
concerns have sparked a shift towards seeking sustainable alternatives for transportation needs.
Alternative technolgies like electric vehicles are being developed by the auto manufacturers but
due to their high cost of acquisition their sales remain low. Apart from these concerns the
limited travelling range and a small number of reachrging stations also discourages the
prospective customers.
Currently there are three types of alternative vehicles, namely, hybrid electric vehicles (HEVs),
plug-in hybrid electric vechiles (PHEVs) and all-electric vehicles (EVs). HEVs combine the
capabilities and are powered by an internal combustion engine or other source that run on
alternative or conventional fuel along with an electric motor running on energy stored in a
battery. They combine the benefits of high fuel mileage and low emissions with the range and
power of normal vehicles. The electric motor provides extra power and allows for substituting a
powerful engine by a smaller engine for the same output The battery also provides auxiliary
systems consuming power like headlights and results in reducing engine idling when stopped
contributing to a beeter fuel economy. The battery is charged by the internal combustion engine
and regenerative braking. HEVs are expensive than similar conventional cars. PHEVs work
similar to HEVs the only difference being that they can be additionally charged from external
power source. They generally have a larger battery pack as compared to HEVs making it
possible to drive moderate distances of 10 to 50-plus miles using just electricity. EVs are
vehicles powered by a battery pack that stores the electricla energy for the motor. EVs are
sometimes called as battery electric vehicles (BEVs) and are charged by plugging into an
electric power source. Fuel cell electric vehicle (FCEVs) are vehicles powered by an electronic
71
ACEA. (2017). ACEA Tax Guide. Brussels: ACEA.
72
ACEA. (2017). CO2 Based Motor Vehicle Taxes in the EU. Brussels: ACEA.
73
ACEA. (2017). Overview on Tax Incentives for Electric Vehicles in the EU. Brussels: ACEA.
74
Norwegian EVs policy. (2018)
35
motor but derives energy from a fuel-cell. In a fuell cell hydrogen is converted into elektricity
and water. The limitation being costly hydrogen production and storage, the advantage being
fast refuelling. 75
According to the The International Council on Clean Transportation, the EU-28 average for
alternative vehicles in 2.9%. The adoption is low due to the high cost of these vehicles and
varying tax benefits available accross Europe. The adoption is high among the countries where
the government regulation has helped reduce price by subsidy and tax exemptions. 76
The global electric car stock which was 1 million in 2015 crossed the 2 million units mark in
2016. The global electric car stock have been consistently decreasing since 2011 despite a
continuous increase in the electric stock. BEVs account for 60% of the electric car stock. The
global electric car stock accounts only for 0.2% of the total passenger car circulation worldwide.
Despite the low adoption of alternative fuel-powered vehicles, the pressure of regulators to
reduce emissions and the higher environmental performance of manufactured vehicles contribute
significantly to the implementation of new concepts.The International Energy Agency came up
with the forecasts of deployment of electric cars until 2030 on the basis of three scenarios based
on the GHG emissions reductions target set in the Paris Agreement: 77
• Reference Technology Scenario (RTS) – Projections based the polices announced or
under consideration pertaining to energy efficiency, energy diversification, air quality
and decarbonisation.- 56 million eletric cars by 2030
• Two degree scenario (2DS) – 1170 GtCO 2 of cumulative emission reductions during
2015-2100 period providing 50% probability of limiting average future temperatures
increases to 2o C- 160 million cars by 2030
• Beyond two degree scenario (B2DS) – 750 GtCO 2 of cumulative emissions during
2015-2100 period along with a 50% probability if limiting average future temparatures
increases to 1.75o C- 25 million by 2020 and exceed 200 million by 2030.
Major investments in the development of alternative propulsion units will play a key role in the
revenues for carmakers over the coming years. Governments are implementing policies to reap
the benefits of EVs The technological advancement being researched has confirmed the cost
declines for mass production and these trends will continue to improve performance and reduce
the cost competitveness gap between electric and ICE (internal combustion engine) vehicles.
The pressure from regulators and imposition of limits reducing green house gas emissions can
be met with adoption of cars using alternative drives. However, the shift towards renewable
energy production is of paramount importance to derive the complete environment benefit of
running electric vehicles and to reduce the dependence of world on fossil fuels. Lastly, the
75
EERE. (n.d.). Alternative Fuels Data Center. Retrieved March 10, 2018, from Office of Energy Efficiency &
Renewable Energy
76
The International Council on Clean Transportation (ICCT)). (2017). European Vehicle Market Statistics:
Pocketbook 2017/18. Berlin: The International Council on Clean Transportation.
77
IEA. (2017). Global EV Outlook 2017: Two Million and Counting. International Energy Agency , Energy
Technology Policy. Paris: IEA Publications. pp. 21-23
36
evolution of ICE with reduced emissions and higher emissions are likely to dominate in the
passenger car segment.
3.6.2 Autonomous Vehciles
Digitial disruption has pioneered services empowering customers and is driving the revolution
in the automobile industry. The economic value of this industry is being altered across its
stakeholders. The companies are devising strategies and business models not only considering
their direct consumers but all users affected by the transportation issues. The arrival of high-
speed mobile internet and smartphones has created a thriving ecosystem of services and opened
up new business avenues in the form of virtual platforms. The advancement in the field of
artificial intelligence has opened plethora of opportunities and applications in the transportation
industry.
According to a PricewaterhouseCoopers study, the car of the future will be electrified,
autonomous, shared, connected and yearly updated. The progress in the the field of machine
learning, artificial intelligence and deep neural networks would concur the possibility of
autonomous vehicles which requires no human actions in complex traffic situation. The concept
of connected car means Car2Car and Car2X communication, which means the communication
of the car with other cars and with the transport infrastructure respectively. It also means the
networking of car riders with the oustide world as they will be able to access internet, use
multimédia services, work and communicate while travelling in the car. Keeping these factors
the report estimates that by 2030, 40% of the mileage in Europe could be done by autonomous
vehicles Autonomous vehicles are divided in the following category: 78
1. Level 0 – Driver has full longitudinal and lateral control of the vehicle. It informs the
driver and area of application is in all traffic situations
2. Level 1 – Driver has either logitudinal ot lateral control as the vehicle controls the other
function. It supports the driver and is applicable on the highway.
3. Level 2 – The longitudinal and lateral control in certain situations is handled by the
vehicle and the traffic monitoring is the responsibility of the driver. It is useful as
highway pilot on highway.
4. Level 3 – The longitudinal and lateral control in many situations is done by the vehicle
with the driver taking over with a lead time.
5. Level 4 – The longitudinal and lateral control in approved situations is managed by the
vehicle making the vehicle driverless in certain situations. It is a fully automatic mode in
urban settings.
6. Level 5 – The pedals and steering wheel are optional as the vehicles has full control over
all the tasks. It can be used in all settings and meking the vehicles on demand.
According to the report by PricewaterhouseCoopers, there will be around 470 million connected
cars in the EU, the US and China by 2025 and around 80 million level 4 & level 5 autonomous
cars by 2030. The following table shows the forecasted vehicle base in EU, US and China. The
forecasting is based on the assumptions that due to technology and policy breakthroughs
78
Kuhnert, F., Stuermer, C., & Koster, A. (2018). Five Trends Transforming the Automotive
Industry.PricewaterhouseCoopers GmbH Wirtschaftsprüfungsgesellschaft. p. 20
37
consumers will move to shared/autonomous vehicles; overal driven distance & relative share of
vehicle based mobility will grow; sharing and pooling will lead to higher vehicle utilization &
turnover; vehicle base will decline due to sharing & pooling and lastly, new car sales will
increase temporarily. 79
Table 1: Vehicle base (in millions)
2017 2020 2025 2030

AN EVs CD AN EVs CD AN EVs CD AN EVs CD
US - 0.5 31.3 - 2.2 67.3 2.1 11.3 116.3 20.8 45 146
EU - 0.8 32.6 - 1.5 71.3 2.7 9.5 123.5 27.1 45.4 147.7
China - 1.2 27.8 - 4 99.2 2.4 20.5 230.9 33.1 73.7 299
Total - 2.5 91.7 - 7.6 237.7 7.3 41.2 470.7 81 164 592.7
Source: PricewaterhouseCoopers. (2017). Legend: AN- Autonomous, EVs- Electric Vehicle, CD- Connected. Note:
Total may not equal due to rounding off
In the EU, electric vehicles account to 1.5 million lagging behind 2.2 million & 4 million in US
and China respectively for the year 2020. This trend is continued in the EVs market till 2025 but
in 2030 EU has 45.4 million cars which is slightly more number of cars as compared to 45
million in US. China is the biggest EVs market in 2030 with 73.7 million cars on the road. In the
year 2017, the connected car in US and EU have 31.3 million and 32.6 million respectively. The
upward trend continues and in 2030 the connected cars amount to 146 million in US and 147.7
million in EU. Here again, China leads the pack while it was trailing in 2017 with 27.8 million
cars and and becoming the biggest connected car market in 2020 with 99.2 million cars and 299
million by the end of 2030. The technology and policy initiatives will curtail the possibilities of
autonomous vehicles till 2020. In 2025, EU leads the way with 2.7 million autonomous vehicles
higher than China & US with 2.4 million & 2.1 million on the road respectively. In 2030, China
overtakes the EU with 33.1 million and EU trailing with 27.1 million. The US comes last with
20.8 million autonomous vehicles.
The Figure:10 illustrates an estimated industry distribution of household mobilty spend in
shared autonomous scenario as estimated by PwC analysts based on the assumption that 35% of
total person-km is conducted in shared mobiulity.The household mobility spend is expected to
increase in Mobility-as-a-Service (MaaS) which includes ride-sharing and car-sharing services.
It offers the travelers mobility solutions based on the travel needs. The increase in MaaS spend
will put pressure on the profits of traditional car makers. The customers can be seen shifting
from cars running on fossil fuels and would substitue them with ride sharing services
therebydecreasing the ownership of cars. The overall market are likely to be reduced in favor of
shared mobility services, software vendors and digital solutions.80
79
PricewaterhouseCoopers. (2017). The 2017 Strategy& Digital Auto Report. Fast and Furious: Why Making
Money in the "Roboconomy" is Getting Harder. p. 9
80
PricewaterhouseCoopers. (2017). The 2017 Strategy& Digital Auto Report. Fast and Furious: Why Making
Money in the "Roboconomy" is Getting Harder. p. 26
38
Figure 10:Distribution of household mobility spend in shared autonomous scenario. (in $)
270
1110 1470
2490
1000
3960 2360
3860
2830
1790
4260 2930
Industry value added-2017 Industry value added-2030
5
90 170
220
100
340 170
170 310
70
260 180
Profit-2017 Profit-2030
Other (used vechicles, public transport) Gas Lease,finance,insurance,maintenance OEM Suppliers MaaS
Source: Authors calculation based on PwC report
3.6.3 Dieselgate Scandal

Automobile companies have invested heavily in the development of diesel engines with
percentage of diesel cars sold in EU-15 and EFTA increasing from 13.8% in 1990 to 44.4% in
2017. 81 The diesel engines emissions have become cleaner over the years but as compared to
petrol engines it produces higher amouns of particulates, microscopic elements of soot left as the
end product of the combustion process. Diesel engines also emit notrogen oxides or No x whose
longterm exposure oncrease the risk of respirátory conditions. To limit the harmful effects, the
EU imposes European emissions standard such as Euro 6 to which all the cars sold adhere since
September 2015. 82
The Dieselgate scandal came to light in September 18, 2015, when United States Environmental
Protection Agency (EPA) publicly announced in a “Notice of Violation” and red flagged
Volkswagen Group. The discrepancies pertain to the measured NO x emissions of Euro 3-6
diesel cars in test conditions and in real driving conditions, which substantially exceeds the
limit. The responsible authorities in Brussels and of the Member States knew about it since
2004-2005, but due to the political priorities emanating from the aftermath of 2007 financial
81
ACEA. (2018). Share of Diesel in New Passenger Cars.
82
Leggett, T. (2018, January 21). Air pollution: Are diesel cars always the biggest health hazard?
39
crisis, concerns regarding exceeding limit were sidelined. 83 Due to these unchecked diesel
emissions exceeding limits about 10,000 people die prematurely across Europe in a year 84.
Around 11 million cars were affected worldwide by the Dieselgate scandal. The share price of
Volkswagen dropped 43% after the news surfaced and within few days, the CEO of
Volkswagen Martin Winterkorn resigned and was replaced by Matthias Mueller who was the
head of Porsche. The US authorities have garnered $25 billion from Volkswagen for the 580,000
affected diesel vehicles it sold in US whereas there has been no fine levied in Europe where it
sold 8 million tainted diesel vehicles. 85 Oliver Schmidt, former general manager for VW’s
Engineering and Environmental Office in Michigan was indicted and sentenced to seven years in
prison and fines $400,000 for his role in the scandal. 86
As define by US law, the so-called “defeat device” which circumvents the allowed emission
limits, was proved to exist in VW cars. In addition, the NO X limits are stricter US than Either
US law allows class-action lawsuits wherein a one of the parties is a group of people who are
represented collectively by a member of that group. These lawsuits are not allowed under
German law but are possible in other territories where Volkswagen is present. They result in
huge payouts for the plaintiffs. The total amount awarded in penalties and provisions made by
Volkswagen have amounted to €25.8 billion The contingent liabilities pertain to the various
ongoing court cases, including in Switzerland, Germany, and South Korea and in various
countries where VW operate, have already been included in €25.8 billion. The management
believes significant court and governmental proceedings in US by concluding settlement
agreements. Still investigations by various government authorities and US regulatory are
ongoing, including in area relating to securities, financing and tax. Given the currently unknown
legal risks related to the diesel issue, provisions of approximately €2 billion exist as of
December 31, 2017. 878889
A similar lawsuit in the US is being faced by Fiat Chrysler where the EPA alleges that nearly
104,000 light duty diesel vehicleshaving 3.0 liter EcoDiesel engines were installed with
defective software devices. 90Fiat Chrysler is also under investigation by the French DGCCRF
consumer watchdog. The authorities have accussed Fiat Chrysler’s Fiat 500X and Jeep Cherokee
of emitting 11 times the legal limit of NO X . Volkswagen, Renault and PSA Group are also under
83
Gieseke, J., & Gerbrandy, G.-J. (2017). Report: On the Inquiry into Emission Measurements in the Automotive
Sector. European Parliament, Committee of Inquiry into Emission Measurements in the Automotive Sector.
European Parliament. pp.3-5
84
Valentino, S. (2017, September 18). Thousands of Deaths Due to Diesel Cars. Retrieved March 21, 2018, from
European Data Journalism Network: https://www.europeandatajournalism.eu/eng/News/Data-news/Thousands-of-
deaths-due-to-diesel-cars
85
Parloff, R. (2018, February 6). How VW Paid $25 Billion for 'Dieselgate' — and Got Off Easy. Retrieved March
23, 2018, from Fortune: http://fortune.com/2018/02/06/volkswagen-vw-emissions-scandal-penalties/
86
DW. (2017, December 2017). VW Executive Oliver Schmidt Sentenced to Seven Years in Jail over Dieselgate.
87
Volkswagen. (2017). Annual Report. pp. 91-93
88
Volkswagen. (2017). Annual Report.pp. 178-186
89
Neuerer, D., & Votsmeier, V. (2017, August 8). Politicians Squabble Over Class-Action Suits. Retrieved March
30, 2018, from https://global.handelsblatt.com/politics/politicians-squabble-over-class-action-suits-808845
90
EPA. (2017, May 5). United States Files Complaint Against Fiat Chrysler Automobiles for Alleged Clean Air Act
Violation. Retrieved April 4, 2018, from United States Environmental Protection Agency
40
scrutiny by French authorities. 91Due to the stringent regulations by the authorities to reduce CO 2
emissions automakers have have been pushed to massively promote and streamline diesel
engines that deliver lower fuel consumtion and reduce CO 2 emissions. The emissions targets as
per CO 2 per kilometre set by the EU for 2015 was 130g and was significantly below in 2016 for
the new cars being only 118.1g. The 2021 target to be achieved by all new car sis set at 95
grams of CO 2 per kilometre which means a fuel consumption of around 3.6 litre/100 km of
diesel or 4.1 litre/100 km of petrol. 92However, according to many engineers, much of the
reduction in emissions of newly sold cars is due to a significant increase in the proportion of
diesel engines and further improvements will require leaner materials, increased sales of electric
cars and hybrids, or a low fuel consumption. In particular, alternative propulsion vehicles are
one way to achieve further significant reductions in greenhouse gas emissions. 93
The Dieselgate scandal has caused a rethinking among the EU officials, pointing out the need to
update the emission testing methodology. The New European Driving Cycle (NEDC) was the
old lab test and due to its shortcomings is being phased out and replaced by Worldwide
Harmonised Light Vehicle Test Procedure (WLTP) since September 2017. The new test
requires stricter vehicle set-up and measurement conditions than NEDC and includes higher
speeds, dynamic accelerations and decelerations. Apart from WLTP, Real Driving Emissions
(RDE) test have been introduced to emulate the road emissions scenario. It takes place on real
roads under driving conditions which are practical and realistic apart from the other mentioned
test. It is a one of a kind test with Europe being the only continent with an on-road test. 94
Even though major settlement has been reached with US authorities but it does not cease the risk
of possible penalties emanating from impending court cases. Further, litigations in other
territories may result in fines too. The total cost of the VW scandal has been estimated to be
around €25 billion to €30 billion.95
As mentioned in citation 87, € 2 billion provisions exists for possible future fines, as of 31
December 2017. On the basis of the above facts, the author has assumed the cost of the scandal
to be in the middle range and amounting to €27.3 billion. This results in expected litigation costs
to be €1.5 billion, as the rest amount has already been settled. This amount is incorporated as
expected litigations in the FCFF model of VW.
91
Sigal, P. (2017, November 27). Fiat Chrysler could face big diesel-cheat fines in France, paper reports. Retrieved
April 8, 2018, from Automotive News Agency.
92
European Commission. (2017, November). Reducing CO2 Emissions from Passenger Cars. Retrieved April 10,
2018, from European Commission: https://ec.europa.eu/clima/policies/transport/vehicles/cars_en#tab-0-0
93
Management Today. (2017, March 13). Counting the Real Cost of Dieselgate.
94
ACEA. (2018). Laboratory Test.
95
Dee, S. (2015, September 24). Dieselgate Scandal Could Cost Volkswagen Up To $35 Billion.
41
PART III : VALUATION
“Price is what you pay, value is what you get.”
Warren Buffett, 2008
One of Warren Buffett’s favorite old admonitions reveals that price and value are not always the
same. While the intrinsic value of a business is admittedly a somewhat imprecise estimate that
depends on assumptions, it nevertheless stays within a much narrower range than the common
stock price investors are asked to pay on any given day. This final part of the thesis brings
everything written before together.
4. VALUATION OF VOLKSWAGEN and BMW

In this practical part of the work, the valuation of BMW & Volkswagen will be carried out. On
the basis of the theoretical portion, the best applicable methods are the free cash flow for the
firm (FCFF) valuation method, relative valuation based on Price to Earnings ratio (P/E) and
Enterprise Value to Earnings Before Interest, Taxes, and Depreciation& Amortization
(EV/EBITDA) ratio. The underlying assumptions of the valuations models are based on the part
two of thesis.
4.1 Valuation based on FCFF
In the theoretical part of this thesis, the valuation procedure has been described in terms that are
more general. In this part, focus will now be centric to the practical approach, which is based on
specific choice of input parameters and assumptions that are crucial for the model. All valuation
models are sensitive to the correct estimations and thus it is of paramount importance to pay
attention while formulating those numbers.
4.1.1 Description of the applied valuation method based on FCFF
The valuation approach is based on the analysis and statistics of Damodaran, a leading expert
and renowned expert on corporate finance and company valuation. His statistics and analysis are
used by analysts in the capital markets to estimate input parameters. Damodaran January 2018
statistics were used for the analysis The valuation models are made using the Microsoft Excel
spreadsheet and are included in the electronic supplement. For all both the companies, similar
valuation procedure is used with specific variations pertaining to each company respectively.
The first step towards valuing the companies is to determine the required risk-free interest rate.
The 10-year German government bond yield is being considered as the risk-free interest rate as
it is considered a safe investment destination among the investors in Europe. The risk of non-
payment of 10-year German government bond is at a minimal level. The 10-year German
government bond yield as of 30 March 2018 is 0.498%. The next step is to calculate beta for
each company, which measures the company’s relative risk to the market. It can be done by
regressing stock returns against the market returns wherein the slope of the regression is the beta
and measures the riskiness of the company. According to Damodaran, this beta has three
problems. It has high standard error, it does not reflect the firm’s current business mix but the
42
business mix during the regression period and it does not show the firm’s current leverage rather
it shows the firm’s financial leverage over the period regression period. 96
Subsequently, a beta is calculated for each company, which measures the company's relative risk
to the market. The conventional approach is to perform a regression against a broad index that
represents the market as a whole. For example, this value can be easily detected using the
Bloomberg Terminal. However, this method is greatly influenced by the choice of the period
during which we will observe the mutual performance of both assets, as well as the specific
events that have affected the movements in the share price of the monitored company or the
selected index. For these reasons, the regression method provides, in the author's opinion, a
distorted view of the true relative riskiness of the company. In this work, an estimate of the beta
coefficient was made on the basis of the so-called bottom-up approach. In its application, it is
necessary to divide the monitored companies into the individual segments in which they operate.
It is typical for carmakers that, besides the production of vehicles themselves, they also provide
financing through their leasing companies, or even focus on production spare parts. The division
of companies into individual parts was made proportionally on the basis of their revenue
sources. Subsequently, the value of the unlevered typical of the sectors in the monitored region
of Western Europe is taken from the statistics made available by Damodaran and are mentioned
in the table below.
Table 2: Sector-wise unlevered beta for European companies
Segment unlevered beta
Passenger Vehicles 0.9
Commercial Vehicles 0.9
Power Engineering 1.15
Financial services 0.18
Source: Damodaran, http://people.stern.nyu.edu/adamodar/New_Home_Page/datacurrent.html
The calculation of levered beta from the unlevered beta of the firm is described in the theoretical
part of the thesis and is calculated by using the marginal tax rate and the debt-to-equity ratio.
The levered beta calculation is required for the valuation of the companies. In order to determine
the required rate of return, it is also necessary to identify the market risk premium that the
investor will require when investing in the company's securities. The common practice is to look
at the historical return on the stock market of the country in which the company has its
registered office and its subsequent adjustment to the risk-free interest rate, thereby establishing
the required market risk premium. However, the registered office of the company reflects its risk
only partially, according to the author is a much more important factor the actual place of
business of the company, or in which parts of the world the company actually products are sold.
For this reason, the equity risk premium is calculated based on the breakdown of sales by
country and region from which these yields originate. In order to determine the required equity
96
Damodaran, A. (n.d.). Teaching. Retrieved from Damodaran Online:
http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/discrate2.pdf
43
risk premium used for calculating beta, Damodaran’s yearly updated estimates are being used.
The following data is used for the calculation.
Table 3: Country-wise Equity Risk Premium

Country Equity Risk Premium
Africa & Mid East 0.081097357
Australia, NZ & Canada 0.050821324
Latin America & Caribbean 0.087504941
Japan 0.05891221
US 0.0508
Europe 0.06005813
Emerging Markets 0.07141001
Small Asia (No India, China & Japan) 0.069263798
India 0.0905
China 0.05891221
Global 0.062080009
Asia Pacific 0.069397055
Germany 0.0508
Rest of Americas 0.069163132
Rest of Asia 0.072892003
Source: Damodaran http://people.stern.nyu.edu/adamodar/New_Home_Page/datacurrent.html
After this step, we calculate the shareholder risk by using the commonly used CAPM model,
once again introduced in the theoretical part of the thesis.
The next step is to estimate the cost of debt capital, which is done through a risk-free interest
rate, effective tax rate and default spread. This spread reflects investors' demand for additional
returns that they require to undertake the risk associated with an investment in a given corporate
bond or other form of credit as opposed to an investment in a risk-free asset. The default spread
is estimated based on the Damodaran’s statistics, which assigns a default spread to individual
companies on the basis of the ratings calculated by Moody's and Standard & Poor's.
Since interest costs are tax deductible for companies, it is appropriate to take this tax advantage
into the cost of debt capital. To estimate the actual cost, the calculated cost is corrected by the
effective tax rate, i.e. the so-called tax shield is used.
We can now proceed to determine the required discount rate for future cash flows that is
calculated using the WACC method as the cost of total capital. This widely used process has
been described in more detail in the theoretical part of the text.
44
Table 4: Estimation of default spreads for large industrial companies on a rating basis
Rating Spread
D2/D 0,186
C2/C 0,1395
Ca2/CC 0,1063
Caa/CCC 0,0864
B3/B- 0,0437
B2/B 0,0357
B1/B+ 0,0298
Ba2/BB 0,0238
Ba1/BB+ 0,0198
Baa2/BBB 0,0127
A3/A- 0,0113
A2/A 0,0099
A1/A+ 0,009
Aa2/AA 0,0072
Aaa/AAA 0,0054
Source: Damodaran, http://pages.stern.nyu.edu/~adamodar/
A very important parameter, with which the cost of capital is compared, is the ROIC, the return
on invested capital. The indicator expresses how effectively the company manages the invested
capital, while by comparing with the cost of capital it is possible to determine whether an
enterprise generates an economic value for the shareholder reduces the shareholder's assets. The
ROIC values for each year is calculated using the formula mentioned below with values
corresponding to the respective year unless stated otherwise. The ROIC terminal year values
chosen for the individual companies for are discussed individually in the companies’ respective
valuation write-up.
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 × (1 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)
=
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒) + 𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 − 𝐶𝐶𝐶𝐶𝐶𝐶ℎ & 𝑜𝑜𝑜𝑜ℎ𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
[23]
To determine the growth rate of sales, analysts' consensus estimates are used for the next three
years provided by Bloomberg. From the year 2021, revenue growth rates are adjusted linearly.
According to Damodaran, if the economy consists of stable and high growth companies, the
growth rate of the stable companies will be lower than the economy’s growth rate. As discussed
in the theoretical part, a proxy for growth rate can be assumed as the risk free rate. The terminal
growth rate for VW & BMW is taken as 0.498%, which is 10-year Germany government bond
as of 29 March 2018. The rationale behind this being that the automobile industry is a stable
growth industry whose growth cannot exceed or reach the GDP growth rate till perpetuity.
45
Subsequently, the tax rate is changing during the forecasted period, and in the base year is equal
to the effective tax rate and in the following year is equal to the average effective tax rate of the
past 10 years. Tax rate in the following years is increasing towards the stipulated tax rate, which
is also set as the terminal year tax rate. It is assumed that companies will not endlessly benefit
from temporary tax relief in the form of a deferred tax liability or use losses from previous years
to reduce the taxable amount basis. The rationale behind this has also been discussed in the
theoretical part.
For the FCFF calculation, the net operating profit after tax (NOPAT) deducts the need for
reinvestment needed for company growth. The amount of capital expenditure required in excess
of the maintenance investment is estimated on the basis of the ratio of sales and invested capital
ratio. Higher value exhibits that the company manages its capital more effectively and does not
need to invest more in its capital assets in the growth of sales.
To determine the value of the company's operating assets from which the value of equity will be
derived for the ordinary shares, the FCFF has to be discounted according to the discounting
factor of the corresponding year. The terminal value is determined by using the Gordon Growth
model, whose output is again converted to the current value using the respective discount rate of
the base year. The present value of the corresponding FCFF is calculated by the multiplication
of respective discounting factor. The sum of the present value of FCFF is added to the present
value of the terminal value to calculate the value of the operating assets. Henceforth, the
following formula is used to calculate equity value.
Table 5: Procedure for calculating Equity Value from Operating Asset
Value of operating assets of the firm (Free cash flow to the firm is discounted at the cost of
capital)
(+) Cash and Marketable Securities
(-) debt
(-) other long-term liabilities
(-) value of minority interests in consolidated companies
(+) value of minority holdings in other companies
(-) value of preference shares
(-) expected litigation costs
= Value of equity
Source: Author’s calculation based on Damodaran, A. (2006). Security Analysis for Investment and Corporation
Finance. Hoboken, New Jersey: John Wiley & Sons. p. 198.
Cash and marketable securities are not a source of operating profit nor do they contribute to free
cash flow, but they are the property of ordinary shareholders and must be added to the value of
operating assets. Debt and other long - term payables must be deducted because it is a liability
towards creditors or other entities, which are settled in the future. If the company owns a
minority interests in the subsidiary and consolidated operating income and cash flow is used for
valuation of the parent company the estimated value of the called minority interest is deducted to
clear this discrepancy. On the contrary, the operating income from minority holdings in other
firms is not part of the FCFF and in the operating income. Thus, we have value these minority
46
holdings and their value is added to the operating assets. The value of the preference shares is
subtracted from the value of operating assets . The valuation of preference shares is carried out
at market value on 29 March2018. In the case of ongoing litigation or expected customer
compensation, as is the case with Volkswagen for Dieselgate, it is standard practice to deduct
the expert estimate of these costs. After these adjustments the value of equity for ordinary
shareholders is reached.
Finally, the value of equity is divided by the number of common shares to arrive at the
calculated share price, which is then compared with the closing price of 29 March 2018 (last
trading day in March 2018). All estimates of input values for FCFF models are made as of 29
March 2018, on which the resulting company valuations are based upon.
4.1.2 Volkswagen
The Volkswagen Group is the largest German automobile company and is headquartered in
Wolfsburg, Germany. The business divisions of Volkswagen constitutes of two divisions
namely, automotive and financial services division. The automotive division comprises of
passenger vehicles, commercial vehicles and power engineering business area. In addition to the
passenger car brands such as Volkswagen, Škoda, Audi, Porsche and Seat, the group also owns
marquee luxury and sports car brands such as Bentley, Bugatti and Lamborghini. As for
commercial vehicles, the company boasts of Scania and MAN brands in addition to the
Volkswagen. It also owns Ducati, a motorcycle manufacturer. The power engineering business
division is titled as MAN Power Engineering. As of 31 December 2017, the Volkswagen group
had 117,400 employees. 97
Figure 11: Stock price movement of Volkswagen stock from 1 April 2013 to 29 March 2018
Source: Yahoo finance
Figure 11 shows the price movement of Volkswagen's current stock. The black vertical line
marks September 18, 2015, when information came about that the company deliberately
installed a defeat device to alter the emission results during the tests for its diesel cars. The stock
was trading at € 153.90 on 1 April, 2013 and increased 60.2% by 1 April 2015, when it reached
97
Volkswagen. (2017). Annual Report. pp. U3,21
47
its € 246.60. Subsequently, the price began to fall and after the news of scandal emerged, the
stock had a significant fall and reached a low of € 92.36 on 2 October 2015. Since then, the
course has picked up the growth trajectory as the situation around Dieselgate has cleared up
making the stock to trade in the range of € 150 to 190 since 1 January 2018 till 39 March 2018.
Looking at the total sales of Volkswagen vehicles, the growth trend is noticeable. In 2015, there
was a slight decline, due to the negative impact of the issue scandal.
Table 6: Sales of Volkswagen Group Cars from 2013 to 2017 (in thousands)
2013 2014 2015 2016 2017

Volkswagen 9,728 10,217 10,010 10,391 10,777
Source: Volkswagen Annual Report 2017. p. 326,
Looking at the financial performance of the company, there is a gradual increase in both sales
and operating profit over the period under review, with both indicators expected to be similar in
the coming years. In 2015, a margin of € 16.2 billion was earmarked for the emission scandal,
and therefore net profit turned negative. In 2016, the amount earmarked for Dieselgate scandal
was € 6.8 billion and in 2017 was € 2.8 billion. The revenue growth rate dipped in 2016 due to
the aftermath of Dieselgate scandal but rose back in 2017 as VW had settled the case with US
authorities. The revenue, revenue growth and net profit forecast for subsequent years are based
on the estimates of Bloomberg analyst’s survey.
Table 7: Revenue, EBIT and Net Profit in 2013-2017, including estimates up to 2020 (in €
million)
2013 2014 2015 2016 2017 2018E 2019E 2020E

Revenue 197007 202458 213292 217267 230682 240186 248665 254061
Revenue - 2.76% 5.35% 1.86% 6.17% 4.12% 3.53% 2.17%
growth
rate
EBIT 11935 13045 13829 15928 15535 16703 17840 18786
Net 9145 11068 -1361 5379 11638 7,906.35 8,413.31 8,432.2
Profit
Source: Bloomberg
The company was severely affected by the scandal regarding breaching the emissions allowed
by law in its diesel cars, the so-called Dieselgate issue, of September 2015. This has negatively
impacted the sales figures and in particular on the expected cost of settling the whole case.
From a valuation point of view, the breakdown of sales into individual segments is essential,
from which the relative risk reflected in the beta coefficient is based. According to data available
from VW Annual Report 2017, the company’s share of revenues is divided into passenger
vehicles with 69% and commercial vehicles totaling to 15%, which amounts to total of 84% of
revenues from the automotive business. The financial services division brings in 15 % of
48
revenue and power engineering garners a miniscule 1% of revenue. 98 In the case of Volkswagen,
this ratio is 1.75, so the company uses more foreign capital than its own. The debt to equity ratio
of VW is 1.499, which implies that the company uses more foreign capital than its own. The
share of revenues according to the different divisions was necessary to calculate the levered
beta. The levered betas for different divisions have been calculated using the unlevered beta
statistics taken from Damodaran’s statistics, as has been discussed earlier. The unlevered beta
for passenger and commercial vehicles division was taken as 0.9, equivalent to auto and truck
companies. The power engineering division’s and financial services unlevered beta was taken as
the unlevered beta for the electrical equipment industry and financial services beta (non-bank &
insurance), as suggested by the thesis supervisor. The debt to equity ratio has been calculated
using the financial statements of VW. The following table details the levered beta of each
segment.
Table 8: Percentage share, unlevered beta, levered beta of different divisions of VW
Segment % share unlevered beta D/E ratio levered beta
Passenger Vehicles 69.00% 0.9 1.499 2.028
Commercial Vehicles 15.00% 0.9 1.499 2.028
Power Engineering 1.00% 1.15 1.499 2.592
Financial services 15% 0.18 1.499 0.406
Source: Authors calculation based on Damodaran’s statistics, Annual report of VW 2017
The beta of VW is calculated by taking the sum of the product of the percentage share of each
segment with their respective levered beta. The distribution of VW’s revenue have been shown
in the following figure.
Figure 12: Distribution of worldwide sales of VW
South America
4% Europe
Asia-Pacific
(excluding
17%
Germany)
43%
North America
17%
Germany
19%
Source: VW Annual Report 2017, p. 116
98
Volkswagen. (2017). Annual Report. p. 116
49
To calculate the required rate of return using CAPM model, equity risk premium (ERP) is to be
calculated by taking the sum of the products of the distribution of revenues according to the
region and ERP of the respective region. The ERP of different regions have been taken from
Damodaran’s ERP statistics, which have been mentioned in the previous part. The risk free rate
is taken as the 10-year German government bond yield as of 30March, 2018.
The beta calculated previously along with ERP and risk free rate is used to arrive at the CAPM
rate of return. The following table shows the respective values.
Table 9: Calculation of CAPM for VW

Risk free rate 0.498%
Beta 1.7905
ERP 5.94%
required CAPM rate of return 11.14%
Source: Author’s calculation
The VW’s rating according to the Standard & Poor’s is BBB+ and Moody’s is A3. 99 The
average of corresponding debt rating’s values of the spread is taken from Damodaran’s cost of
debt for large manufacturing firms, apart from effective tax rate and risk free rate, to calculate
the cost of debt capital, which is equal to 1.42%. The values of equity and debt is taken from the
balance sheet for the year 2017 and the ratios of debt to total capital and equity to total capital
are calculated. The WACC is thus calculated by taking the sum of the product of the cost of debt
with debt to total capital and required CAPM rate of return with equity to total capital. The
following table elucidates the WACC calculation.
Table 10: Calculation of WACC

Equity € 109,077 million
Debt € 163,472 million
Total capital € 272,549 million
Debt to Total Capital 0.599789396
Equity to Total Capital 0.400210604
WACC 5.31%
The FCFF model for VW’s common stock valuation has underlying assumptions. The expected
tax rate for 2018 has been set at the average of the effective tax rate of past 10 years, whose
value is 19.66% and is based on the following table as shown below.
99
Volkswagen. (2018). Ratings. Retrieved April 20, 2018, from Volkswagen:
https://www.volkswagenag.com/en/InvestorRelations/fixed-income/ratings.html
50
Table 11: Effective tax rate of VW (in %)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Effective 29.06 27.70 19.65 16.52 14.15 26.42 25.19 -4.61 26.23 16.35
tax rate
Source: Author’s calculation based on the financial data of VW on Bloomberg data.
The year 2015 shows a negative value for the effective tax rate due to the loss declared to make
provisions for emissions scandals to the tune of €16.2 billion. The tax rate is assumed to increase
by 0.5% for subsequent years after 2018. The terminal value of the tax rate is set at 29.79%,
equivalent to the corporate tax rate in Germany, it is assumed the tax rate will converge towards
the benchmark and the VW will not be able to take benefit of tax hacks in the long run. The
shared autonomous scenario, as discussed in the previous chapter, would result in lower
household spending on diesel cars and ownership patterns will change thus leading to receding
revenue growth rate. The average age of the fleet in Europe has been increasing and given the
VW’s majority of sales originate from Europe will also affect the revenue growth rate
negatively. The revenue growth rate from the year 2021 is assumed to taper off by 0.05% in
subsequent years. The author has based this assumption also on the fact that a significant portion
of VW sales are of passenger cars which are economically priced as compared to BMW, whose
sales are going to be affected by ride sharing economy. The EBIT margin will increase by 0.22%
from 2018 as VW expands into MaaS and automated vehicles, as analyzed in the previous
chapter. The terminal value of EBIT margin is taken as the expected EBIT margin of 2027. The
sales to invested capital ratio and WACC is assumed to be constant and their 2017 value is taken
as terminal year value as well.
The following is a representation of the FCFF model for the VW's common stock valuation. The
Volkswagen Group also issued preference shares in addition to ordinary shares, which are
valued at market value within the model. The total number of preferred shares were 206.205
million and value of a preference share was € 161.70 on 29 March 2018. 100 Since the valuation
method is based on FCFF, it is also necessary to deduct the estimated costs of the emissions
scandal from the calculated value of the operating assets. Although the company has previously
reserved significant reserves for its business, it has had no impact on the amount of operating
earnings from which it is based on the valuation below. The cost of the scandal is estimated by
the author at the middle limit of the expert estimated margin of € 25-30 billion referred to in the
chapter devoted to the Dieselgate case. The author has assumed the value to be € 27.3 billion out
of which VW has made provisions of € 25.8 billion from 2015 till 2017. The value deducted for
expected Dieselgate scandal is € 1.5 billion in the FCFF model, which is the difference between
author’s estimate and provisions already made by VW. The internal value of the ordinary share
is calculated at € 165.15, which is higher than the closing market rate on the valuation date.
100
Valentino, S. (2017, September 18). Thousands of Deaths Due to Diesel Cars. Retrieved March 21, 2018, from
European Data Journalism Network: https://www.europeandatajournalism.eu/eng/News/Data-news/Thousands-of-
deaths-due-to-diesel-cars
51
Figure 13: FCFF of VW
2017 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Terminal
Figures in millions (base year) 1 2 3 4 5 6 7 8 9 10 year
Revenue growth rate 4.12% 3.53% 2.17% 2.12% 2.07% 2.02% 1.97% 1.92% 1.92% 1.92% 0.498%
Revenue 230 682.00 240 186.10 248 664.67 254 060.69 259 446.78 264 817.32 270 166.63 275 488.92 280 778.30 286 169.25 291 663.70 293 116.18
EBIT 15 535.00 16 703.45 17 840.15 18 786.21 19 755.26 20 746.79 21 760.24 22 795.00 23 850.37 24 937.87 26 058.34 26 188.11
EBIT margin 6.73% 6.9544% 7.1744% 7.3944% 7.6144% 7.8344% 8.0544% 8.2744% 8.4944% 8.7144% 8.9344% 8.9344%
Tax rate 16.35% 19.66% 20.16% 20.66% 21.16% 21.66% 22.16% 22.66% 23.16% 23.66% 24.16% 29.79%
EBIT*(1-Tax) 12 994.78 13 418.85 14 242.82 14 904.19 15 574.22 16 252.17 16 937.26 17 628.69 18 325.63 19 036.53 19 761.55 18 386.67
Sales to invested capital ratio 0.77 0.77 0.77 0.77 0.77 0.77 0.77 0.77 0.77 0.77 0.77 0.77
Reinvestment (-) 12 364.08 11 029.95 7 019.79 7 006.87 6 986.66 6 959.03 6 923.87 6 881.07 7 013.19 7 147.84 1 889.57
FCFF 1 054.77 3 212.88 7 884.40 8 567.35 9 265.51 9 978.23 10 704.83 11 444.55 12 023.34 12 613.71 16 497.10
cost of capital (WACC) 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31% 5.31%
discount factor 1 0.95 0.90 0.86 0.81 0.77 0.73 0.70 0.66 0.63 0.60
PV of FCFF 1 001.60 2 897.13 6 751.16 6 966.16 7 154.07 7 316.01 7 453.10 7 566.46 7 548.41 7 519.87
Invested capital 300 099.00 312 463.08 323 493.03 330 512.82 337 519.69 344 506.35 351 465.38 358 389.25 365 270.32 372 283.51 379 431.36 381 320.92
ROIC 4.33% 4.29% 4.40% 4.51% 4.61% 4.72% 4.82% 4.92% 5.02% 5.11% 5.21% 4.82%
Terminal value 342 942.18

PV terminal value 204 450.51
Sum of PV of FCFF 62 173.95
Value of operating assets 266 624.46
cash (+) 43 549.00
debt (-) 163 472.00
other LT liabilities (-) 71 099.00
minority interest (-) 229.00
investment in affiliates (+) 8 205.00
Preference shares (-) 33 343.35
expected Dieselgate costs (-) 1 500.00
Value of common equity 48 735.11

number of common shares 295.09
Calculated Share price € 165.15

Market Price (29 March 2018) € 161.38
Figure 14: Sensitivity Analysis of VW
Terminal value TV Growth

342,942.18 € 0.300% 0.50% 0.80% 1.30% 1.80% 2.30% 2.80% 3.30% 3.80%
4.00% 445,867.68 471,076.65 515,534.51 611,003.86 749,868.37 970,417.90 1,374,758.69 2,356,729.17 8,248,552.11
4.40% 402,368.40 422,785.86 458,252.90 532,164.65 634,504.01 785,576.39 1,031,069.01 1,499,736.75 2,749,517.37
4.80% 366,602.32 383,475.23 412,427.61 471,345.83 549,903.47 659,884.17 824,855.21 1,099,806.95 1,649,710.42
5.20%
Cost of capital
336,675.60 350,852.92 374,934.19 423,002.67 485,208.95 568,865.66 687,379.34 868,268.64 1,178,364.59

5.31% 329,384.61 342,942.18 365,914.21 411,556.93 470,208.96 548,356.69 657,658.05 821,379.83 1,093,637.16
5.60% 311,266.12 323,345.83 343,689.67 383,653.59 434,134.32 499,912.25 589,182.29 717,265.40 916,505.79
6.00% 289,422.88 299,838.32 317,252.00 351,002.22 392,788.20 445,867.68 515,534.51 611,003.86 749,868.37
6.40% 270,444.33 279,517.18 294,591.15 323,472.63 358,632.70 402,368.40 458,252.90 532,164.65 634,504.01
6.80% 253,801.60 261,775.69 274,951.74 299,947.35 329,942.08 366,602.32 412,427.61 471,345.83 549,903.47
7.20% 239,088.47 246,151.96 257,767.25 279,611.94 305,501.93 336,675.60 374,934.19 423,002.67 485,208.95
7.60% 225,987.73 232,288.15 242,604.47 261,858.80 284,432.83 311,266.12 343,689.67 383,653.59 434,134.32
Calculated share price TV Growth

165.15 € 0.300% 0.50% 0.80% 1.30% 1.80% 2.30% 2.80% 3.30% 3.80%
4.00% 373.09 424.02 513.84 706.71 987.26 1,432.83 2,249.72 4,233.58 16,136.74
4.40% 285.21 326.46 398.11 547.44 754.19 1,059.40 1,555.37 2,502.21 5,027.12
4.80% 212.95 247.04 305.53 424.57 583.27 805.47 1,138.76 1,694.24 2,805.20
5.20%
Cost of Capital
152.49 181.14 229.79 326.90 452.57 621.58 861.01 1,226.46 1,852.95

5.31% 137.76 165.15 211.56 303.77 422.27 580.15 800.97 1,131.73 1,681.77
5.60% 101.16 125.56 166.66 247.40 349.39 482.28 662.63 921.39 1,323.92
6.00% 57.03 78.07 113.25 181.44 265.86 373.09 513.84 706.71 987.26
6.40% 18.69 37.02 67.47 125.82 196.85 285.21 398.11 547.44 754.19
6.80% (14.94) 1.17 27.79 78.29 138.89 212.95 305.53 424.57 583.27
7.20% (44.66) (30.39) (6.92) 37.21 89.51 152.49 229.79 326.90 452.57
7.60% (71.13) (58.40) (37.56) 1.34 46.95 101.16 166.66 247.40 349.39
53
4.1.3 Bayerische Motoren Werke (BMW)
BMW is a leading German manufacturer of premium passenger cars headquartered in Munich,

Germany. The business divisions of BMW includes automotive, motorcycles, financial services
and other entities. Holding and group financing companies constitutes the other entities segment.
The automotive segment includes passenger car division, which is the most important part of the
business having premium brands like MINI, BMW and Rolls-Royce, and the motorcycle
segment includes BMW branded motorcycles. The company operates globally and has
worldwide presence in more than 150 countries, employing nearly 129,932 employees by the
end of 2017. 101
Looking at price developments during the observation period, the stock was trading in the price
range of € 64 to € 74 till May 2013 and reached a low of € 64.36 in mid-June 2013 from where it
started an upward trend till early September 2014. Due to the volatility, the stock traded in the
price bracket of € 79 to € 95 from early September to early October 2015. The upward trend
began from November 2014 till March 2015 when the trend reversed and stock price fell till late
September 2015. The BMW stock suffered a 19% loss in January 2016 due to concerns of
global auto sales cycle peaking and uncertainty due to Chinese economic situation. 102 The news
of Volkswagen emission’s scandal in September 2015 did not have direct short term impact on
the stock, but created a case for automobile industry companies. Currently, the price has been
consolidated around the level of € 88.
Figure 15: Stock price movement of BMW stock from 1 April 2013 to 29 March 2018
Source: Yahoo finance
The following table shows the past 5 year sales of BMW group.
101
BMW. (2018). Annual Report 2017. BMW. Retrieved April 2, 2018, from
https://www.bmwgroup.com/en/investor-relations/financial-reports.html. p. 4
102
Rosevear, John. (2016, February 1). Why BMW Shares Fell 19% in January. Retrieved April
21, 2018, from The Motley Fool:
https://www.fool.com/investing/general/2016/02/01/why-bmw-shares-fell-19-in-january.aspx
54
Table 12: Sales of BMW in 2013-2017
2013 2014 2015 2016 2017

BMW 1,665,138 1,811,719 1,905,234 2,003,359 2,088,283
MINI 305,030 302,183 338,466 360,233 371,881
Rolls-Royce 3,630 4,063 3,785 4,011 3,362
Motorcycles 115,215 123,465 136,963 145,032 164,153
Source: BMW Annual Report, p. 4
The BMW car sales have grown steadily for the past 5 years and registered 4.2% growth in
2017. The sales of MINI have decreased only in 2014 and maintained a steady growth rate
thereafter. Both brands have maintained a positive trend despite the VW emissions scandals
erupted in 2015. The ultra-luxury Rolls-Royce has witnessed rather volatile sales and
experienced a -16.2% decline in sales as compared to previous year due to unfavorable market
conditions in the US &the political uncertainties in the Middle East. 103The motorcycles sales
have been steady and were up 13.2% since last year.
As far as financial performance is concerned, in recent years, the company has managed to
steadily increase both revenue and operating and net profit. In the coming years, the Bloomberg
analytical consensus predicts continued revenue growth and operating profit, with net gains in
2017 and 2018 expected to decline slightly over the past year levels.
million)
2013 2014 2015 2016 2017 2018E 2019E 2020E

Revenue 76,059 80,401 92,175 94,163 98,678 100,720 104,580 107,120
Revenue - 5.71% 14.64% 2.16% 4.79% 2% 4% 2%
growth
rate
EBIT 7,954 9,121 9,480 9,304 9,785 9,992.52 10,380.71 10,638.18
Net 9145 11068 -1361 5379 11638 6,720.61 7,005.96 7,151.04
Profit
Source: Author’s calculation based on Bloomberg
From a valuation point of view, the breakdown of sales into individual segments is the key
factor, depending on the relative risk projected in the beta coefficient. According to Bloomberg
statistics, the company’s revenue share for automotive segment is 71.49%, motorcycle’s is
2.302%, financial services amount to 26.2% and other entities have a miniscule 0.003% revenue
share. The debt to equity ratio of BMW is 1.715, which implies that the company uses more
foreign capital than its own. The revenue share of each division is used to calculate levered beta
103
55
and the latter is based on the unlevered beta based on Damodaran’s statistics. The unlevered
beta for automotive and motorcycle division was taken as 0.9, equivalent to auto and truck
companies. The financial services unlevered beta was taken as the unlevered beta for the
financial services beta (non-bank & insurance), as suggested by the thesis supervisor. As
mentioned earlier, other entities constitutes holding and group financing companies, thus its
unlevered beta is taken equivalent to financial services beta (non-bank & insurance). The debt to
equity ratio has been calculated using the financial statements of BMW. The following table
details the levered beta of each segment.
Table 14: Percentage share, unlevered beta, levered beta of different divisions of BMW
Segment % share unlevered beta D/E ratio levered beta

Automotive 71.491% 0.9 1.715 2.161
Motorcycles 2.302% 0.9 1.715 2.161
Financial Services 26.203% 0.18 1.715 0.432
Other Entities 0.003% 0.18 1.715 0.432
Source: Authors calculation based on Damodaran’s statistics and Bloomberg
Henceforth, the beta of BMW is calculated by taking the sum of the product of the percentage
share of each segment with their respective levered beta. The geographic distribution of BMW’s
revenue is depicted in the following figure.
Figure 16: Distribution of worldwide sales of BMW (2017)
Rest of Other regions
Americas 3% Europe
Rest of Asia (excluding
12% 4%
Germany)
32%
Germany
14%
US China
17% 18%
Source: BMW Annual Report 2017, p. 187
ERP is calculated using the distribution of revenues according to different region and the
respective ERP taken from Damodaran’s statistics. Thereafter, CAPM model is used to calculate
required rate of return using beta and risk free rate. The following table shows the values.
56
Table 15: Calculation of CAPM for BMW
Risk free rate 0.498%

Beta 1.71
ERP 5.89%
Required CAPM rate of return 10.55%
Standard & Poor’s and Moody’s rate BMW A+ and A1 respectively(Debt & Ratings, 2018).
The cost of debt capital is calculated by taking the average values of corresponding debt ratings
from Damodaran’s statistics and also the effective tax rate and risk free rate are used. The cost of
debt is calculated as 1.14%. Knowledge of the funding structure is subsequently used in the
calculation of the total capital cost by the WACC method.
Table 16: Calculation of WACC of BMW

Equity € 54,548 million
Debt € 93,558 million
Total capital € 148,106 million
Debt to Total Capital 0.631696218
Equity to Total Capital 0.368303782
WACC 4.61%
The expected tax rate for 2018 is assumed to be the average of the effective tax rate of past 10
years in the FCFF model equivalent to 29.95%.
Table 17: Effective tax rate of BMW (in %)

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Effective 5.98 49.15 33.18 33.54 34.50 32.48 33.19 30.66 28.50 18.29
tax rate
Source: Author’s calculation based on the financial data of BMW on Bloomberg.
BMW had an effective tax rate in certain years more than the stipulated corporate tax rate in
Germany. The expected tax rate is assumed to increase by a factor of 0.5% till 2027 but the
terminal tax rate is set as the corporate tax rate in Germany as in the long run, the BMW’s tax is
expected to be in line with the stipulated tax. The revenue growth rate from the year 2021 is
assumed to reduce by 0.05% in subsequent years as repercussions of shared autonomous
scenario and aging fleet of cars, change in ownership patterns as discussed in details in previous
chapter. The EBIT margin is assumed to increase by 0.005% from 2018 given that BMW has a
higher EBIT margin and the increased research & development costs for alternative mobility
57
will put pressure on it. The terminal value of EBIT margin is taken as the expected EBIT margin
of 2027. The 2017 values of sales to invested capital ratio and WACC is assumed to be constant
throughout.
In addition to ordinary shares, BMW also issued preference shares that are valued at market
value. The value of preference share according to the closing price of € 76.15 on valuation date
and 55.605 million preference share is calculated to be € 4,234.321 million 104. The detailed
valuation procedure has been described in the previous chapter, and in the case of the BMW
model, there are no deviations from the standard outline. The calculated value of the share is
€90.60, which is slightly higher than the closing market price on the valuation date. The
following is a representation of the FCFF model for the Company's common stock valuation.
104
58
Figure 17: FCFF of BMW
2017 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Terminal
Figures in millions (base year) 1 2 3 4 5 6 7 8 9 10 year
Revenue growth rate 2.00% 4.00% 2.00% 1.95% 1.90% 1.85% 1.80% 1.75% 1.70% 1.65% 0.498%
Revenue 98 678.00 100 720.00 104 580.00 107 120.00 109 208.84 111 283.81 113 342.56 115 382.72 117 401.92 119 397.75 121 367.82 121 972.23
EBIT 9 785.00 9 992.52 10 380.71 10 638.18 10 851.09 11 062.82 11 273.15 11 481.84 11 688.64 11 893.32 12 095.63 12 155.86
EBIT margin 9.92% 9.9211% 9.9261% 9.9311% 9.9361% 9.9411% 9.9461% 9.9511% 9.9561% 9.9611% 9.9661% 9.9661%
Tax rate 18.29% 29.95% 30.45% 30.95% 31.45% 31.95% 32.45% 32.95% 33.45% 33.95% 34.45% 29.79%
EBIT*(1-Tax) 7 995.14 6 999.97 7 220.00 7 345.89 7 438.65 7 528.48 7 615.25 7 698.81 7 779.04 7 855.79 7 928.94 8 534.63
Sales to invested
capital ratio 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67 0.67
Reinvestment (-) 3 065.94 5 795.55 3 813.66 3 136.27 3 115.44 3 091.09 3 063.18 3 031.70 2 996.62 2 957.93 0 907.49
FCFF 3 934.03 1 424.44 3 532.23 4 302.38 4 413.05 4 524.16 4 635.63 4 747.33 4 859.17 4 971.01 7 627.14
cost of capital
(WACC) 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61% 4.61%
discount factor 0.96 0.91 0.87 0.84 0.80 0.76 0.73 0.70 0.67 0.64
PV of FCFF 3 760.71 1 301.70 3 085.65 3 592.84 3 522.89 3 452.48 3 381.69 3 310.61 3 239.30 3 167.87
Invested capital 148 159.00 151 224.94 157 020.49 160 834.15 163 970.41 167 085.85 170 176.94 173 240.13 176 271.83 179 268.45 182 226.38 183 133.87
ROIC 5.40% 4.63% 4.60% 4.57% 4.54% 4.51% 4.47% 4.44% 4.41% 4.38% 4.35% 5.48%
Terminal value 185 544.03 WACC=0.632*1.14%+0.368*12.93%=5.48%

PV terminal value 118 241.32
Sum of PV of FCFF 31 815.75
Value of operating assets 150 057.07 Cost of debt: Required return of equity:
= (0.498% +0.9%)*(1-0.183) CAPM = 0.498%+1.71*5.887%
cash (+) 17 004.00
= 1.14% CAPM = 10.55%
debt (-) 93 558.00
other LT liabilities (-) 17 057.00
minority interest (-) 436.00 Equity risk premium:
investment in affiliates (+) 2 767.00 Risk free rate: = 5.887%
Preference shares (-) 4 234.32 =0.498%
(10Y German govt. bond yield) Segment % share unlevered beta D/E ratio levered beta
Automotive 71.491% 0.9 1.715 2.161
Value of common equity 54 542.75 Motorcycles 2.302% 0.9 1.715 2.161
number of common shares 601.99 Financial Services 26.203% 0.18 1.715 0.432
Other Entities 0.003% 0.18 1.715 0.432
Calculated share price € 90.60 Rating:
Market price (29 March 2018) € 88.15 Moody's A+
S&P A1 effective tax rate = 18.29%
Spread 0.9% marginal tax rate = 29.79%
59 beta = 1.71
Figure 18:Sensitivity Analysis of BMW
Terminal value TV Growth

185,544.03 € 0.300% 0.498% 0.80% 1.30% 1.80% 2.30% 2.80% 3.30% 3.80%
4.00% 206,139.03 217,793.95 238,348.25 282,486.82 346,688.37 448,655.53 635,595.34 1,089,592.01 3,813,572.04
4.40% 186,027.90 195,467.56 211,865.11 246,036.91 293,351.70 363,197.34 476,696.51 693,376.73 1,271,190.68
4.61% 177,017.61 185,544.03 200,256.25 230,518.39 271,555.00 330,366.43 421,693.87 582,806.56 943,145.49
4.80%
Cost of capital
169,492.09 177,292.98 190,678.60 217,918.40 254,238.14 305,085.76 381,357.20 508,476.27 762,714.41

5.20% 155,656.00 162,210.64 173,344.18 195,567.80 224,327.77 263,004.97 317,797.67 401,428.64 544,796.01
5.60% 143,908.38 149,493.22 158,898.84 177,375.44 200,714.32 231,125.58 272,398.00 331,614.96 423,730.23
6.00% 133,809.55 138,624.94 146,675.85 162,279.66 181,598.67 206,139.03 238,348.25 282,486.82 346,688.37
6.40% 125,035.15 129,229.82 136,199.00 149,551.84 165,807.48 186,027.90 211,865.11 246,036.91 293,351.70
6.80% 117,340.68 121,027.36 127,119.07 138,675.35 152,542.88 169,492.09 190,678.60 217,918.40 254,238.14
7.20% 110,538.32 113,804.00 119,174.13 129,273.63 141,243.41 155,656.00 173,344.18 195,567.80 224,327.77
7.60% 104,481.43 107,394.31 112,163.88 121,065.78 131,502.48 143,908.38 158,898.84 177,375.44 200,714.32
Calculated share price TV Growth

90.60 € 0.300% 0.498% 0.80% 1.30% 1.80% 2.30% 2.80% 3.30% 3.80%
4.00% 112.41 124.74 146.50 193.23 261.19 369.13 567.03 1,047.63 3,931.24
4.40% 91.12 101.11 118.47 154.64 204.73 278.67 398.82 628.20 1,239.87
4.61% 81.58 90.60 106.18 138.21 181.66 243.91 340.59 511.15 892.60
4.80%
Cost of capital
73.61 81.87 96.04 124.88 163.32 217.15 297.89 432.46 701.60

5.20% 58.96 65.90 77.69 101.22 131.66 172.60 230.61 319.14 470.91
5.60% 46.53 52.44 62.40 81.96 106.66 138.86 182.55 245.24 342.75
6.00% 35.84 40.94 49.46 65.98 86.43 112.41 146.50 193.23 261.19
6.40% 26.55 30.99 38.37 52.50 69.71 91.12 118.47 154.64 204.73
6.80% 18.40 22.31 28.76 40.99 55.67 73.61 96.04 124.88 163.32
7.20% 11.20 14.66 20.34 31.04 43.71 58.96 77.69 101.22 131.66
7.60% 4.79 7.87 12.92 22.35 33.40 46.53 62.40 81.96 106.66
60
4.2 Relative Valuation of Volkswagen and BMW
The second method of evaluating BMW and VW incorporated in this thesis is called relative
valuation, a procedure based on the use of ratios. The method is easier to implement compared
to a discounted cash-flow model, and is therefore widely used by financial analysts to evaluate
the company. The two most frequently used multiples are, namely the P / E ratio and the EV /
EBITDA ratio. Modeling is based on consensus analytical estimates of these ratios for the end of
fiscal years 2018 and 2019 of individual companies by Bloomberg, these values being compared
to predicted net profit or EBITDA respectively for the same periods. The valuation is done, in
the previous case, till 29 March 2018.
The peer group is chosen of selected companies from the same sector, similar in size, risk, and
life cycle phases. The chosen peer group for BMW & VW a Daimler includes Renault, Fiat
Chrysler, Daimler, Peugeot, General Motors, Nissan, Toyota, Ford and Honda. In case of
automobile companies, it makes no sense to include Tesla because it is in a diametrically
different phase of the life cycle and offerings are significantly different. In addition to the
European hegemony in the auto industry, major automakers based in the US and Japan are
included in the peer group. The following table shows the list of ratios to be measured, including
average values.
Table 18: P / E and EV / EBITDA for the peer group

P/E P/E P/E EV/EBITDA EV/EBITDA EV/EBITDA
(Nor.) FY1 FY2 (TTM) FY1 FY2
VW 6.43 6.44 6.14 5.24 1.82 1.76
BMW 8.17 8.19 7.83 2.63 6.65 6.33
Renault 5.91 5.91 5.75 6.41 3.68 3.48
Fiat Chrysler 5.88 5.88 5.61 2.65 2.3 2.24
Daimler 6.87 6.87 6.85 7.17 2.54 2.34
Peugeot 8.03 8.03 7.24 1.28 2.1 1.97
General Motors 6.24 6.24 6.22 5.47 2.83 2.83
Nissan 6.2 6.2 7.67 6.52 4 3.7
Toyota 8.7 8.7 9.81 8.94 12.02 12.12
Ford 7.35 7.36 7.57 2.64 2.99 2.97
Honda 7.02 7.02 9.29 6.65 8.62 8.17
Peer group average 6.98 6.99 7.27 5.05 4.50 4.36
Source: Author’s calculation based on Bloomberg data.
For valuation, the current multiples of the monitored indicators are not valid, instead their
estimates for two subsequent fiscal periods are used. This reflects market expectations about the
future profitability of companies and provides a salient picture of the potential price. On the next
page, the two valuation models are depicted, and their comments can be found in the chapters
below. All data is taken from the Bloomberg terminal.
61
Figure 19:Valuation models based on P/E and EV/EBITDA
P / E Multiple
Target prices without adjustments Premium Adjusted (5Y) vs. Peer Group
Company FY1 Est EPS FY2 Est EPS Est Price FY1 Est Price FY2 5Y hist premium vs. Peer group ADJ Est Price FY1 ADJ Est Price FY2 Calculated Price Actual price Price difference
VOLKSWAGEN AG 26.59 27.88 185.72 202.74 -15.0% 157.86 172.33 165.10 161.38 2.303%
BMW 11.10 11.60 77.55 84.37 8.0% 83.76 91.12 87.44 88.15 -0.807%
EV / EBITDA multiple
Company FY1 Est EBITDA FY2 Est EBITDA Est EV FY1 Est EV FY2 EV 5Y premium ADJ EV FY1 ADJ EV FY2 Current market EV
VOLKSWAGEN AG 37,244.00 38,705.00 167,767.29 168,577.87 -60.0% 67,106.92 67,431.15 68,518.61
BMW 14,681.00 15,428.00 66,131.23 67,195.95 42.0% 93,906.35 95,418.25 95,854.00
Company Equity according to market Equity by model Preference Shares Common Equity Number of shares Calculated price Actual price Price difference
VOLKSWAGEN AG 80,964.97 79,715.39 33,343.35 46,372.05 295.09 152.06 161.38 -5.77%
BMW 57,299.74 56,108.04 4,234.32 51,873.72 601.99 86.17 88.15 -2.25%
62
4.2.1 Valuation using multiple P / E
The simpler of the two presented relative valuation models is the one that uses the P / E ratios.
In this framework, the estimated annual earnings per share for the years 2018 and 2019 are
multiplied by the average of normalized P / E indicator, which is predicted for the selected peer
group of eleven companies in the corresponding years. Henceforth, gross estimates of individual
share prices are calculated for 2018 and 2019. However, the P / E indicator encapsulates the
overvaluation or under-valuation due to underlying fundamentals. This can arise due to
difference in estimated EBIT margin or return on equity or the tax rate in the coming years, as
well as the general risk profile of a company's business.
Due to this reason, gross price estimates for 2018 and 2019 are adjusted by 5 year historical
premium against the peers of the company under consideration. This greatly eliminates the
fundamental differences of the individual companies resulting in a more accurate price is
derived. For determining the internal value, the adjusted end-of-year estimates of 2018 and 2019
are each given 50% weightage. Subsequently, the individual internal values are compared to the
market closing price on the valuation day and the price difference of the shares is calculated.
4.2.2 Valuation using EV / EBITDA multiple
The EV / EBITDA multiple model is a more complex option of the two relative valuation
methods. First, it is necessary to get Enterprise Value (EV) estimates at the end of 2018 and
2019, which is essentially the value of the company's operating assets. These estimates are
calculated by multiplying the expected annual EBITDA for years 2018 and 2019, whose value is
based on Bloomberg estimates, with predicted average multiples of the EV / EBITDA for the
peer group in the corresponding years. It is then necessary to adjust the achieved gross value of
EV for individual companies by the 5 year historical EV premium compared to the peer group,
thus ensuring a higher level of accuracy for the model. Different valuations can be
fundamentally based on the different expected growth rate of a company, different capital costs,
profitability, tax burden, or the need for capital expenditures.
The next step is to determine the market value of the EV value that was made again using the
Bloomberg terminal. The equity according to market of each company at the valuation date was
calculated by multiplying the price of share and number of equity shares and then adding to the
value of the preference shares. The following table illustrates the preference share valuation for
BMW & VW.
63
Table 19: Calculation of preference share value for BMW & VW (on 29 March, 2018)
Preference shares (in millions) Price Value
VW 206.205 161.70 33,343.349
BMW 55.605 76.15 4,234.321
Source: Author’s calculation based on Bloomberg, page 17 Annual Report BMW and
https://www.volkswagenag.com/en/InvestorRelations/shares/fact-sheet.html
The weighted average of adjusted EV estimates for the end of 2018 and 2019, with weights
being set at 50% for each year is taken. The difference of current market EV and equity
according to the market is again subtracted from the weighted average calculated previously to
arrive at the equity by model. Equity by model is an estimate of market capitalization of
individual companies after adjustment. Equity by model is subtracted from the market value of
the preference shares. The model now displays the estimated equity value of ordinary
shareholders, which is divided by the number of ordinary shares to determine the intrinsic value.
In the case of Volkswagen, the calculated internal value includes, in addition, an adjustment of
the estimated cost of the Dieselgate affair, which is set at € 1.5 billion.
4.3 Comparison of Results and Investment Recommendation
Based on the FCFF model, P / E and EV / EBITDA multiples, target prices can now be
determined and investment recommendations are made for the BMW & VW. For calculating the
annual target prices for individual shares valid at the end of 1Q 2018, the weighted average of
the outputs of each model is used. Long-term forecasts are difficult to determine due to a large
number of critical variables and uncertainties about future developments at the macroeconomic
and sectoral level and are therefore subject inaccuracies.
As discussed in the chapter 2.5 Intrinsic vs. Relative Value, the FCFF model assumes market
makes mistakes and relative valuation models assumes that market makes mistake on individual
stocks, but are right on average. Using this rationale, the weighted averages taken to include the
different market views of the valuation techniques. The author regards FCFF as the most
important and robust model based on FCFF, thus the weight assigned is 50%. The P/E and
EV/EBITDA are each assigned 25% weight.
Table 20: Determination of target prices of monitored companies on the basis of valuation
carried out as of 29 March 2018
Company FCFF P/E EV/EBITDA Calculated Price on 29 March, Potential to
Price 2018 Market Price
VW 165.15 165.10 152.06 161.87 161.38 0.302%
BMW 90.60 87.44 86.17 88.70 88.15 0.629%
Volkswagen's stock price was calculated as € 161.87, slightly exceeding the closing market price
on the valuation date. The investment recommendation is "hold".
64
BMW’s stock price was calculated as at € 88.70, slightly above the market price. The
investment recommendation is "hold".
In case of VW, the FCFF and P / E yield almost the same result. It means that the market is
valuing the stock fairly but EV / EBITDA shows the stock is overvalued. In the EV / EBITDA
calculation, the historical five year premium vs. peer companies for estimated price is -15% and
estimated EV are -60%. We can see that the historical five year premium is negative because
after the Dieselgate scandal, the VW stock suffered a significant decline in stock price due to
which the historical five year premium against its peers are negative or at a discount as the peer
group companies didn’t suffer this loss. The EV / EBITDA historical premium is much lower
than P / E historical premium because the enterprise value reduced due to the Dieselgate crisis.
In addition, the author has deducted €1.5 billion from final EV, due to the expected litigation
costs, which further reduces the price. In the case of BMW, the stock price calculated by three
different models are within an acceptable range and differ due to different valuation
methodologies and market conditions.
65
CONCLUSION
The aim of the thesis is to execute the fundamental analysis of automobile industry with
reference to the selected companies. As a part of the analysis, world automobile industry was
studied with a focus on European market, and valuation using appropriate methods and models
was carried out for Volkswagen & BMW resulting in formulation of investment
recommendation.
From the analysis of European and worldwide sales of motor vehicles, it is clear that the
automotive sector is among the sectors most sensitive to economic developments and a major
source of wealth & job creation in Europe. The environment of low interest rates, robust
economic recovery in many countries, and lower oil prices have driven world-wide sales of
motor vehicles to historic highs. Growth has been driven mainly by developing economies, led
by China, which has been the world's largest car market for several years. Last year, 28.9 million
cars were in China, showing an increase in supplies to almost four times over the last ten years.
Within the countries of EU & EFTA and North America, current sales have reached
approximately pre-2007 crisis levels, with no significant growth expected in the coming years.
This is due to the high saturation of these markets, in which the purchase of a car in most cases
is due to fleet renewal rather than its expansion. Specifically, there are 821 vehicles in the
United States per 1,000 inhabitants, while 581 is the EU & EFTA average. On the contrary,
China& India still has a huge growth potential in this respect with 118 and 22 vehicles per
inhabitants respectively.
A significant impact on the entire sector was the Volkswagen emissions scandal from September
2015 and resulted in a significant decline in Volkswagen stock price The impact of the scandal
had severely impacted the Volkswagen stock price in . The profound effect of the scandal has
also impacted the valuation presented in this thesis for Volkswagen. Like a domino effect,
similar lawsuits cropped up involving Fiat Chrysler, apart from Renault and PSA, who also
came under scanner. The aftermath of this scandal lead to a rethinking among EU officials and
lead to formulation of new emissions tests.
The innovation and technological advancement in the field of alternative fuel is pushing the
automotive industry to seek sustainable technologies to solve our mobility needs. However, the
high cost of acquisition has kept the customers away. A favorable tax regime in the countries for
the alternative fuel powered vehicle has certainly helped to reduce the acquisition cost for the
customers and therefore, is required in future for the adoption of these cars by prospective
customers. The EV’s are expected to increase in number in the coming years as with time the
technology develops and economies of scale help to reduce the cost making their adoption
cheaper for potential customers
Autonomous vehicles is ushering a new era in the automotive industry. This is the future of
mobility and would change the way of transportation. The autonomous vehicles are expected to
be available from 2025. The car sharing platforms would impact the ownership model and
create new business opportunities for the automobile companies. It has the capability to change
the business model for automobile companies. In addition, would have a negative effect on car
66
sales as the younger generation prefers to seek mobility solutions on sharing plat forms, like
Uber, without owning a car. It would create new business avenues for the companies and it
remains to be seen if they are able to capitalize on them.
The fundamental analysis of VW and BMW was carried out using discounted cash flow model
and relative valuation models. FCFF was used as a part of DCFM while, P / E and EV /
EBITDA was used for relative valuation.
The first valuation of VW & BMW was based on the FCFF method, i.e., discounting the
predicted future free cash flows available to creditors and shareholders by the cost of total
capital. Thus, the value of the operating assets of the companies was subsequently transformed
into assets belonging to ordinary share holders through appropriate adjustments. In order to
increase the credibility of the investment recommendation, the author has decided to apply the
second valuation approach on the basis of ratios using two most commonly used multiples in
practice: P / E and EV / EBITDA. Since the analysis aims to form an investment
recommendation based on the calculated price, estimated multiples for the fiscal years 2018 and
2019 were used. The model also took into account the typical five-year historical premium, or
discount, for individual companies compared to a peer group. The peer group includes Renault,
Fiat Chrysler, Daimler, Peugeot, General Motors, Nissan, Toyota, Ford, and Honda The target
price for VW & BMW, was calculated by allotting 50% weighting of the share price calculated
using FCFF model and 25% for each of the two relative valuation models.
Bases on the analysis, the author has given investment recommendation of “hold” for VW &
BMW. The automobile sector is a capital intensive business with high competition. Automobile
companies must constantly innovate their products and regularly launch new models to meet the
ever-increasing demands of customers on the quality and safety standards. There is constant
pressure from the regulators for the ever-decreasing standard consumption and emissions of
vehicles that pushed Volkswagen to involve in illegal practices. Automobile companies are in a
situation where, in addition to complying with increasingly stringent emission standards and the
standard need for conventional engine development, the market is pushing for research into
alternative fuels and autonomous cars. The opening up of new business verticals in car sharing is
a challenge for the companies to maintain sales volume.
This thesis does not contain the analysis and forecasting based on the financial statement
analysis. It would be interesting to compare the results achieved in this thesis with the financial
statement based analysis.
67
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73
List of figures
Figure 1: Worldwide motor vehicle sales of passenger car(2005-2016) ..................................... 25

Figure 2: Market share of auto companies (2016) ....................................................................... 26
Figure 3: New registrations in EU and EFTA for the period 2004-2017 (in thousands) ............. 27
Figure 4: Market share of companies in EU-28 countries + EFTA (2017) ................................. 28
Figure 5: Average age of the EU car fleet (2015) ........................................................................ 29
Figure 6: Passenger car fleet by fuel type (2016) ........................................................................ 30
Figure 7: Motorization rate of selected countries, includes passenger and commercial vehicles
(2015) ............................................................................................................................................ 31
Figure 8: EU car sales and unemployment rate (2006-2017) ...................................................... 32
Figure 9: Passenger car sales and consumer confidence in EU-28 countries (2006-2017) ......... 33
Figure 10: Distribution of household mobility spend in shared autonomous scenario. (in $) ..... 39
Figure 11: Stock price movement of Volkswagen stock from 1 April 2013 to 29 March 2018 .. 47
Figure 12: Distribution of worldwide sales of VW..................................................................... 49
Figure 13: FCFF of VW ............................................................................................................... 52
Figure 14: Sensitivity Analysis of VW ........................................................................................ 53
Figure 15: Stock price movement of BMW stock from 1 April 2013 to 29 March 2018 ............ 54
Figure 16: Distribution of worldwide sales of BMW (2017)....................................................... 56
Figure 17: FCFF of BMW............................................................................................................ 59
Figure 18: Sensitivity Analysis of BMW ..................................................................................... 60
Figure 19:Valuation models based on P/E and EV/EBITDA ...................................................... 62
74
List of tables
Table 1: Vehicle base (in million) ................................................................................................. 38

Table 2: Sector-wise unlevered beta for European companies...................................................... 43
Table 3: Country-wise Equity Risk Premium ............................................................................... 44
Table 4: Estimation of default spreads for large industrial companies on a rating basis .............. 45
Table 5: Procedure for calculating Equity Value from Operating Asset ....................................... 46
Table 6: Sales of Volkswagen Group Cars from 2013 to 2017 (in thousands) ............................. 48
million)........................................................................................................................................... 48
Table 8: Percentage share, unlevered beta, levered beta of different divisions of VW................. 49
Table 9: Calculation of CAPM for VW......................................................................................... 50
Table 10: Calculation of WACC ................................................................................................... 50
Table 11: Effective tax rate of VW (in %) .................................................................................... 51
Table 12: Sales of BMW in 2013-2017 ......................................................................................... 55
million)........................................................................................................................................... 55
Table 14: Percentage share, unlevered beta, levered beta of different divisions of BMW ........... 56
Table 15: Calculation of CAPM for BMW ................................................................................... 57
Table 16: Calculation of WACC of BMW .................................................................................... 57
Table 17: Effective tax rate of BMW (in %) ................................................................................. 57
Table 18: P / E and EV / EBITDA for the peer group................................................................... 61
Table 19: Calculation of preference share value for BMW & VW (on 29 March, 2018) ............. 64
Table 20: Determination of target prices of monitored companies on the basis of valuation
carried out as of 29 March 2018 .................................................................................................... 64
75
List of abbreviations
ACEA European Automobile Manufacturers Association

BEVs Battery electric vehicle
BMW Bayerische Motoren Werke
CAPM Capital asset pricing model
CO 2 Carbon dioxide
DCFM Discounted cash flow model
DDM Dividend discount model
DGCCRF Directorate-General for Competition, Consumer Affairs and
Fraud Control
DKK Danish Crown
EBITDA Earnings before interest tax depreciation and amortization
EFTA European Free Trade Association
EPA Environment Protection Agency
EPS Earnings per share
ERP Equity risk premium
EU European Union
EU-15 European Union 15 countries
EU-28 European Union 28 countries
EV Enterprise value
EV/ EBITDA Enterprise value by earnings before interest tax depreciation and
amortization
EVs Electric vehicles
FCEVs Fuel cell electric vehicle
FCFE Free cash flow to equity
FCFF Free cash flow to firm
FY Financial year
G7 Group of seven countries
GDP Gross domestic product
GNP Gross national product
HEVs Hybrid electric vehicles
ICE Internal combustion engine
IPO Initial public offer
MaaS Mobility-as-a-Service
MPT Market Portfolio Theory
NAFTA North American Free Trade Agreement
NEDC New European Driving Cycle
NO X Nitrogen oxide
NYSE New York Stock Exchange
76
OICA International Organization of Motor Vehicle Manufacturers
P/E Price to equity
PHEVs Plug-in hybrid electric vechiles
PSA Peugeot Citroën
PwC PricewaterhouseCoopers
RDE Real driving emissions
ROE Return on equity
ROIC Return on invested capital
RTS Reference technology scenario
SEC Securities Exchange Commission
SEK Swedish crown
UK United Kingdom
US United States of America
VAT Value added tax
VW Volkswagen
WACC Weighted average cost of capital
WLTP Worldwide harmonised light vehicle test procedure
YTM Yield to maturity
77
Appendix
Two FCFF models of BMW & VW and one relative valuation are available in the Information
System. The results from BMW & VW FCFF excel sheets are inputs in the relative valuation
excel sheet. Please store the 3 excel files in the same folder retaining their original file title.
78

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Masaryk University

Faculty of Economics and Administration

THE FUNDAMENTAL ANALYSIS OF

Thesis supervisor: Author:

MASTER’S THESIS DESCRIPTION

Student: Vaibhav Verma

Field of Study: Finance (eng.)

Methodology: analysis, comparison, valuation

Extent of graphics-related work: According to thesis supervisor’s instructions

Extent of thesis without supplements: 60 – 80 pages

Literature: DAMODARAN, Aswath. Damodaran on valuation : security analysis

Thesis supervisor: Ing. Dagmar Linnertová, Ph.D.

Thesis supervisor’s department: Department of Finance

In Brno, date: 2018/05/10

Master’s thesis title: The Fundamental Analysis of Automobile Industry with

Master’s thesis supervisor: Ing. Dagmar Linnertová, Ph.D.

Master’s thesis date: 2018

Fundamental Analysis, Analysis, Equity, Relative Valuation, Automobile Industry

Brno, 11.05.2018 ……………………………

“Happily, there is nothing in the law of value which remains

1. The Investment Procedure

1.1 Market Efficiency: Modern Portfolio Theory vs. Fundamental Analysis

β L = Levered beta for equity in the firm

j = business division of the firm

2.1.3 Equity Risk Premium (ERP)

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

E(R i )= expected return of the security

2.1.6 Growth rate (g)

V = Value per share of equity

V = Value per share of equity in stable growth

2.3 Discounted Cash Flow Models (DCFM)

2.5 Intrinsic vs. Relative Value

3. Global Automobile Industry: An Introduction

3.2.1 Sales by region

Figure 1: Worldwide motor vehicle sales of passenger car(2005-2016)

CHINA AFRICA ASIA/OCEANIA/MIDDLE EAST (without China) NAFTA EU 28 countries + EFTA

Source: Author’s calculation from OICA statistics. http://www.oica.net/category/sales-statistics/

3.2.2 Market share of auto companies

3.3.1 Car Registrations

Source: ACEA. http://www.acea.be/statistics/tag/category/by-country-registrations

3.3.3 Age of the Car Fleet

Source: ACEA. http://www.acea.be/statistics/tag/category/average-vehicle-age

3.3.4 Passenger Car Fleet by Type of Fuel

Diesel Battery/Plugin/Hybrid Natural gas Petrol

3.4 Saturation of automobile market

0 100 200 300 400 500 600 700 800 900

Source: OICA statistics. http://www.oica.net/world-vehicles-in-use-all-vehicles-2/

New registrations in EU Uemployment

Source: Author’s calculation based on ACEA and Eurostat

Consumer confidence New registrations in EU

Source: Author’s calculation based on ACEA and Eurostat

3.6 Current trends and events

3.6.1 Alternative Fuel

2017 2020 2025 2030

US - 0.5 31.3 - 2.2 67.3 2.1 11.3 116.3 20.8 45 146

Industry value added-2017 Industry value added-2030

Source: Authors calculation based on PwC report

3.6.3 Dieselgate Scandal

4. VALUATION OF VOLKSWAGEN and BMW

Table 3: Country-wise Equity Risk Premium

Source: Yahoo finance

2013 2014 2015 2016 2017

2013 2014 2015 2016 2017 2018E 2019E 2020E

Table 9: Calculation of CAPM for VW

Terminal value 185 544.03 WACC=0.6321.14%+0.36812.93%=5.48%