Business Valuation

VALUE?
Bosch
17,747.80
Motherson Sumi
298.80

Minda Ind
1,251.10

Gabriel India
136.70

2
Apple
• https://www.marketbeat.com/stocks/NASDAQ/AAPL/price-target/

• https://www.stock-analysis-on.net/NASDAQ/Company/Apple-Inc/
DCF/DDM
https://www.alphaspread.com/security/nasdaq/aapl/dcf-valua
tion

https://valueinvesting.io/AAPL/valuation/dcf-growth-exit-5y
What is Value and how to Value Business?

• The value of an asset is the present value of its expected returns Could be -
• You expect an asset to provide a stream of returns while you own it Equity, Bonds,
Property, Business
• To convert this stream of returns to a value for the asset, you must discount
etc.
this stream at your required rate of return (either the cash flows or the
discount rate adjusted to reflect the risk)
• This requires estimates of:
• The stream of expected returns, and
• The required rate of return on the investment

6
Essential Concepts
• Valuation is simple. We choose to make it complex
• A good valuation is more about the story than the numbers
• Three common problems with valuation (How to deal with them?):
• Bias
• Uncertainty
• Complexity / “Black box syndrome”
Approaches to Valuation
• 1. Discounted Cash Flow (DCF) Valuation
• 2. Relative Valuation
• 3. Contingent Claim Valuation (option-like characteristics)
DCF Valuation
• Present value of expected cash flows on the asset, discounted back at
a rate that reflects the riskiness of these cash flows
• + + + ... +
• where E(CFt) = Expected cash flow in period t
• r = discount rate reflecting riskiness of estimated cashflows
• n = life of the asset
Three ways to categorize DCF models
• Valuing a business as a going concern as opposed to a collection of
assets
• Valuing the equity in a business and valuing the business itself
• Value based on excess returns and the Adjusted Present Value (APV)
Going Concern vs. Asset Valuation
• Key difference between valuing a collection of assets and valuing a business – a business or a
company is an ongoing entity with assets it already owns and assets it expects to invest in, in the
future (special case of asset-based valuation is liquidation valuation)
• Look at the financial balance sheet as opposed to the accounting balance sheet

Assets Liabilities

Assets in Place Investments Already Debt Borrowed money

Existing investments Made
generate cash flows today

Growth Assets Investments Yet to Be

Equity Owner’s funds
Expected value that will be Made
created by future investments
Firm Valuation
• Cash flows before debt payments and after reinvestment needs are called free cash flows to the
firm (FCFF), and the discount rate that reflects the composite cost of financing from all sources of
capital is called the cost of capital
Assets Liabilities

Assets in Place Debt

Cash flows considered
are cash flows from Discount rate reflects the cost
assets prior to any debt of raising both debt and equity
payments but after firm financing, in proportion to their
has reinvested to create use
growth assets
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of all claims on
the firm
Equity Valuation
• Cash flows after debt payments and after reinvestment needs are called free cash flows to equity
(FCFE), and the discount rate that reflects just the cost of equity is called the cost of equity

Assets Liabilities

Assets in Place Debt

Cash flows considered
are cash flows from Discount rate reflects only the
assets, after debt cost of raising equity financing
payments and after firm
has reinvested to create
growth assets
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of all claims on
the firm
Equity Valuation versus Firm Valuation
• How do the two compare with each other?

Firm value = equity + debt value

Firms are generally valued at higher than book value
only firms in distress are closer to book value or lesser.
Excess Return Valuation Framework
• We separate the cash flows into excess return cash flows and normal return cash
flows
• Earning the risk-adjusted required return (cost of capital or equity) is considered a
normal return cash flow, but any cash flows above or below this number are
categorized as excess returns (can be positive or negative)
• Value of business = Capital invested in firm today + Present value of excess return
cash flows from both existing and future projects
• If we assume that the accounting measure of capital invested (book value of
capital) is a good measure of capital invested in assets today, this approach implies
that firms that are expected to earn positive excess return cash flows will trade at
market values higher than their book values and that the reverse will be true for
firms that are expected to earn negative excess return cash flows
Adjusted Present Value (APV) approach
• We separate the effects on value of debt financing from the value of the
assets of a business
• In general, using debt to fund a firm’s operations creates tax benefits
(because interest expenses are tax-deductible) on the plus side and increases
the bankruptcy risk (an expected bankruptcy costs) on the minus side
• Value of business = Value of business with 100% equity financing + Present
value of expected tax benefits of debt – Expected bankruptcy costs
• In contrast to the conventional approach, where the effects of debt financing
are captured in the discount rate, the APV approach attempts to estimate the
expected dollar-value of debt benefits and costs separately from the value of
the operating assets
Inputs to DCF models
• Expected cash flow
• The timing of the cash flow
• Discount rate that is appropriate given the riskiness of these cash
flows
Discount rates
• Discount rates should reflect the riskiness of the cash flows
• Risk can be viewed as:
• Default Risk, or Fir will go bust
• Variation of actual returns around expected returns ---- volatile returns
• Cost of debt reflects the default risk for most firms
• Key concepts:
• Risk in an investment has to be perceived through the eyes of the marginal investor in that investment (assumed to be well
diversified)
• Therefore, the risk that should determine the discount rates is the non-diversifiable risk of that investment
• Expected return on the investment is obtained by starting with the expected return on a riskless investment, and adding to it a
premium to reflect the market risk in that investment (this expected return yields the cost of equity)
• Cost of capital can be obtained by averaging the cost of equity, the after-tax cost of borrowing (based on default
risk), and weighting by the proportions used of each
• Weights used should be based on MARKET values of debt and equity because, at fair value, we should be
indifferent between buying and selling an asset
As the company will be valued at the value of the firm in the market.
Expected Cash Flow
• In the strictest sense, the only cash flow an equity investor gets out of
a publicly traded firm is the dividend; models that use the dividends
as cash flows are called dividend discount models
• A broader definition of cash flows to equity would be the cash flows
left over after the cash flow claims of non-equity investors (bond
holders) and after reinvestment (FCFE)
• FCFF is obtained by taking the cash flows prior to debt and preferred
dividend payments and subtracting from the after-tax operating
income the net investment needed to sustain growth
Expected Growth
• Area of maximum uncertainty
• Three ways of estimating growth:
• Use historical growth rate ---- Easy to obtain, might not be actual
• Obtain estimates from informed sources ---- estimates may be more informed, bias is disadv
• Look at how much of the earnings is reinvested in the business and how well it is reinvested
---- as close to a fwd looking measure u can get, but all inv may not pay off so disadv
• Expected growth rate as a product of retention ratio (proportion of net income not
paid to stockholders) and return on equity of projects undertaken with that money
• This is internally consistent and companies that are assumed to have high growth
rate are required to pay for that growth with more reinvestment
• It lays the foundation for how firms can make themselves more valuable to investors
DCF: advantages and disadvantages
• + Requires in-depth understanding of the business
• + Warren Buffett: “We are not buying stocks, but the underlying
business”
• + Based on fundamentals – may be at variance with market
• - Can be manipulated
• - Need substantially greater amount of information and judgment
• - May find every stock to be overvalued in a strong up market
Relative Valuation
• We look at how the market prices similar assets
• Compare a stock to similar stocks (usually in its peer group)
• Basis for valuation: value of an asset is derived from the pricing of
comparable assets, standardized using a common variable
• We use multiples, where we divide the market value by earnings,
book value, or revenues to arrive at an estimate of standardized value
• We can then compare these numbers across companies
• But what is a similar asset? And which standardized multiple to use?
Variations on Relative Valuation
• Direct comparison
• Peer group average
• Peer group average adjusted for differences (e.g. Price Earnings /
Growth ratio where the traditional P/E ratio is divided by the expected
growth rates) or use statistical regressions
Applicability of multiples and limitations
• + Easy to use, quick to find
• + Useful for fund managers who are judged on relative performance
• - Definition of comparable is subjective, assumptions are not often
clearly stated
• - It builds in errors that the market may be making
• “Relative valuation” is just that – relative (not absolute)
Contingent Claim Valuation
• Option pricing models are used to value assets and businesses
• A contingent claim or option is an asset that pays off only under
certain contingencies
• A patent can be analysed as a call option on a product, with the
investment outlay needed to get the project going as the strike price
and the patent life being the life of the option
• Similarly, an undeveloped gold mine or oil reserve
• DCF models understate the value of assets with option characteristics
– why?
Option valuation: +/-
• + Some assets cannot be modelled using conventional methods – e.g. a biotech
firm with a single promising patent waiting for FDA approval, or equity in a
money-losing company with substantial debt (this like buying a deep out of the
money call)
• + Option pricing models yield more realistic estimates when there is benefit to
be gained from learning and flexibility
• + Recognizes risk. As volatility increases, some assets tend to increase in value
• - Used inappropriately, can result in overvaluation
• - Learning has benefits only if accompanied by some exclusivity
• - Options with longer lifetimes are difficult to value because variance and
dividend yields are hard to estimate over an extended period
Role of Valuation
• Portfolio Managers
• Fundamental analysts
• Activist investors
• Chartists
• Information traders
• Market timers
• Efficient marketers
• Acquisition analytics
• Corporate finance
• Legal and tax purposes
 Analyst Roles
Sell-Side Buy-Side
Analysts Analysts

Corporate Independent
Analysts Analysts