VALUATION

SUMIT AMBEKAR
Why Value Value?

• Companies that grow and earn a return on capital that exceeds their cost of capital
create value; articulated as early as 1890 by Alfred Marshall.

• For value-minded executives, creating value cannot be limited to simply maximising

today’s share price.

• Rather, the evidence points to a better objective: maximising a company’s collective

value to its shareholders, now and in the future

• Markets do a great job with public information, but markets are not omniscient
Markets cannot price information they
don’t have
Companies with a long strategic horizon create
more value than those run with a short-term
mindset.
The pressure to show strong short-term results often
builds when businesses start to mature and see their
growth begin to moderate.
SOURCES OF COMPETITIVE ADVANTAGE
Lets start with basics
EMH
Efficient Market Hypothesis

• Efficient market hypothesis or EMH is an investment theory which suggests that the
prices of financial instruments reflect all available market information

• Hence, investors cannot have an edge over each other by analysing the stocks and
adopting different market timing strategies

• Investors can only earn high returns by taking more significant risks in the market
• Market participants who advocate this theory usually tend to invest in Index fund or
ETFs
Limitations

• Market crashes and speculative bubbles

• Behavioural Economics
• Investors have outperformed the market
• Market anomalies
Market anomalies refer to a situation where there is a difference between the trajectory
of a market price as established by the efficient market hypothesis and its behaviour in
reality. Market anomalies may arise anytime for no particular reason. This proves that
financial markets do not remain efficient at all times.
CAPM
Capital Asset Pricing Model
Security Market Line
SML

• Graphical representation of CAPM, which reflects the linear relationship between

security’s expected return and beta

• The premise of the security market line (SML) is that the expected return of a security
is a function of its systematic, or market risk

• The placement of the security relative to the security market line determines whether it
is undervalued, valued fairly, or overvalued.
Cost of Capital
WACC hai kya?
Weighted Average Cost of Capital

• Cost of Capital = COE + COD

• COE - CAPM model, APM, Fama French 3 factor Model, Fama French 5 factor
Model

• COD - Cost of Debt; other can we do is Rƒ + Spread (ICR)

Problems with calculating CoC

• Controversy regarding the dependence of CoC upon the method and level of financing
• Computation of Cost of Equity
• Computation of cost of retained earnings and depreciation funds
• FC v/s HC
• Problem with Weights
Revenue Growth
Drivers

• Portfolio Momentum
This is the organic revenue growth a company enjoys because of overall expansion in
the market segments represented in its portfolio

• Market Share Performance

This is the organic revenue growth (or reduction) a company earns by gaining or
losing share in any particular market

• Mergers and Acquisition

This represents the inorganic growth a company achieves when it buys or sells
revenues through acquisitions or divestments
Enterprise DCF
Especially useful when applied to multi business company
Economic Profit based valuation
What it is?

• The enterprise DCF model is a favorite of academics and practitioners because it relies
solely on how cash flows in and out of the company

• One shortfall of enterprise DCF, however, is that each year’s cash flow provides little
insight into the company’s competitive position and economic performance

• Economic Profit = NOPAT - (Invested Capital X WACC)

Adjusted PV model
APV Model

• Using a constant WACC, however, assumes the company manages its capital structure
to a target debt-to-value ratio

• The APV model separates the value of operations into two components: the value of
operations as if the company were all-equity financed and the value of
 The APV valuation model follows directly from the teachings of economists
Franco Modigliani and Merton Miller, who proposed that in a market with no
taxes (among other things), a company’s choice of financial structure will not
affect the value of its economic assets.
Capital CF Model
WHAT IT IS?

• When a company actively manages its capital structure to a target debt-to-value level,
both free cash flow (FCF) and the interest tax shield (ITS) should be discounted at the
unlevered cost of equity, k
u

• Richard Ruback of the Harvard Business School argued that there is no need to
separate free cash flow from tax shields when both flows are discounted by same cost
of capital
FREE CASH FLOW
FREE CASH FLOW
Replacement Cost Basis
RCB

• As part of the process of determining what asset is in need of replacement and what
the value of the asset is, companies use a process called net present value

• The cost to replace an asset can change, depending on variations in the market value of
components used to reconstruct or repurchase the asset and other costs needed to get
the asset ready for use.

• Companies look at the net present value and depreciation costs when deciding which
assets need to be replaced and whether the cost is worth the expense.