Corporate Valuation

Session 3

Shobhit Aggarwal
9 July 2021
IIM Udaipur
 Real World Investing Biases
• You value a company and you come up with a
ridiculously low number
– Market must know something I do not
 Valuation Vs Pricing
• What is the difference between valuation and
pricing?
– Price is what you pay
– Value is what you get
• Should you attempt to get your valuation
closer to the market price?
 Why value companies?
• To find out the right price to be paid/received
in any transaction
• To find not just the value of an asset but also
the source of that value
• Every asset has a value
– Techniques may differ; People may disagree about
the right inputs or the right value of inputs to use;
But the basic principles of valuation remain the
same
 Disagreements in Valuation
• What is the fair value of an asset (due to
disagreements about inputs values)
• How long will the market take to correct
itself?
 Methods of valuation

• DCF/Intrinsic Value
• Relative Valuation
• Real Options
 Value estimate depends on how you define a company

• Uber (Cab services Vs Transportation Services,

Local Vs Global Networking Benefits,
Comparative Advantages)
• Amazon (e-Retail company Vs Technology
company)
 Concept Checker
• Value of an asset depends on the demand and
supply in the market
• Value is determined by investor perceptions
about the asset
• Value of an asset depends on the
methodology or the model used
• Value of an asset will depend upon the
assumptions used in a model
 Do analysts have bias?
Do professional research analysts have biases?
• Of course. The bias depends heavily on
– How does the analyst make money?
– What is the purpose of valuation?
• E.g. valuing own business for sale, VC valuing a
company, sell-side equity research analyst,
buy-side equity research analyst, M&A analyst
Approaches to Valuation
 Valuation Exercise
• Your valuation should not become a black-box.
You should always know where the value is
coming from?
• It should be you valuing the company, not the
model
 Valuation Exercise
Assumptions behind any valuation exercise
• The market is inefficiently valuing the
company you are valuing
• We can find that inefficiency and find a ‘true’
valuation
• The market will correct its inefficiency in
future in a reasonable time frame
 Discounted Cash Flow(DCF)

• The value of an asset is the present value of

the expected future cash flows from the asset
• Inputs needed
– Life of the asset
– Cash flows during the life of the asset
– Discount Rate to be applied to the cash flows
• You need long time horizons for the markets
to really come to true value
 DCF Advantages

• Since, it depends on fundamentals, if it is done

correctly, it is less exposed to vagaries of the
market
• It forces you to think about the fundamentals
of the company
• If good investors buy businesses rather than
stocks, DCF is the way to achieve it
 DCF- Disadvantages
• Too many explicit inputs required
• There is room for manipulation of inputs due
to analyst discretion
• DCF might tell you that the entire market is
over-valued and hence you have nowhere to
invest
– Especially problematic if you are a sell-side analyst
or a mutual fund manager
 When does DCF work best?
• When an asset has cash flows
– What assets don’t have cash flows?
• Paintings, coins, any collectors’ items, bitcoin, gold etc.
• Investors who have a long time horizon
• Investors who are not affected by short-term market
movements
• Investors who have the ability to push the market towards
‘value’

“Be Fearful When Others Are Greedy and Greedy When Others
Are Fearful” – Warren Buffet
 Relative Valuation

• The value of an asset is whatever the market is willing

to pay for it
• The value can be estimated by looking at how ‘similar’
assets are priced
• Inputs required
– An identical asset or a large number of similar assets
– A comparable measure of value (e.g. P/E multiple)
• Assumptions
– Markets are correctly pricing other assets on average
except the company you are valuing
– The error you find will correct itself soon
 Relative Valuation - Advantages

• If you are correct, results are normally quick

• You can capture market perceptions and
moods with this which you cannot with
intrinsic valuation
• Does require fewer inputs
• You will always find under-valued and over-
valued securities. This works for portfolio
managers since they are judged relative to
other managers/market
 Relative Valuation - Disadvantages

• If the entire market is under-valued

(recession) or over-valued (asset bubble),
relative valuation will often lead you into risky
territory
• It requires less information
– All assumptions are built into the black-box called
‘Multiple’ and you have no idea about what those
assumptions about cash-flows or risk are
 Who should use Relative Valuation

• Investors who have a short time horizon

• Investors who are evaluated based on relative
performance
• Investors who have the ability to take actions
which can exploit relative mispricing (e.g.
short selling shares)
 Contingent Claim (Option) Valuation

• Features
– The value depends on an event occurring
– They have a finite life
• Examples where this can be used
– Sick firms
– Natural reserves
– Patent valuation
 Option Valuation Advantages

• Allows us to value assets that are otherwise

difficult to value
• Helps us understand new sources of value e.g.
the driver of value can be option like
characteristics or high risk
 Option Valuation Disadvantages

• The inputs required are difficult to estimate

• There is a risk of double counting assets e.g.
an analyst may be valuing a newly acquired oil
reserve as an option while at the same time
giving higher sales to the company due to the
new reserve
 Intrinsic Valuation
• DCF valuation is a tool for estimating intrinsic
value where the expected value of an asset is
the present value of expected future cash
flows with either the cash flow or the
discounting rate adjusted for risk
 Generic DCF Valuation
• Cash Flows
• Expected Growth
• Discount Rate
 DCF Valuation
Input Required Dividend Discount FCFE Model FCFF Model
Model
Cash Flow Dividends and Potential dividend = FCFF = Cash flows
Share Repurchases FCFE = Cash flows after tax and
after tax, reinvestment needs
reinvestment and but before debt
debt issues issues
Expected Growth In dividends In FCFE In FCFF
Discount Rate Cost of Equity Cost of Equity Cost of capital
Steady State When dividends When FCFE grows When FCFF grows
grow at a constant at a constant rate at a constant rate
rate