VALUATION

Dr. Kumar Bijoy

Financial Consultant
[email protected]
09810452266
Value… What is it?
 The buyers lens
 The sellers lens
 The investors / lenders lens
 The Consultant lens
Misconceptions about Valuation
 Myth 1: A valuation is an objective search for “true” value
 Truth 1.1: All valuations are biased. The only questions are how
much and in which direction.
 Truth 1.2: The direction and magnitude of the bias in your valuation
is directly proportional to who pays you and how much you are
paid.
 Myth 2.: A good valuation provides a precise estimate of value
 Truth 2.1: There are no precise valuations
 Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
 Myth 3: . The more quantitative a model, the better the valuation
 Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
 Truth 3.2: Simpler valuation models do much better than complex
ones.
 Approaches to Valuation
Valuation Models

Asset Based Discounted Cashflow Relative Valuation Contingent Claim

Valuation Models Models

Liquidation Equity Sector Option to Option to Option to

Value delay expand liquidate
Stable Current Firm
Market
Young Equity in
Replacement Two-stage firms troubled
Cost Normalized
firm
Three-s tage
or n-stage Earnings Book Revenues Sector Undeveloped
Value specific land

Equity Valuation Firm Valuation

Models Models
Patent Undeveloped
Dividends Res erves

Cost of capital APV Excess Return

Free Cashflow approach approach Models
to Firm
Basis for all valuation approaches

 The use of valuation models in investment decisions

(i.e., in decisions on which assets are under valued
and which are over valued) are based upon
 a perception that markets are inefficient and
make mistakes in assessing value
 an assumption about how and when these
inefficiencies will get corrected
 In an efficient market, the market price is the best
estimate of value. The purpose of any valuation
model is then the justification of this value.
FIRM VALUATION

 Equity Valuation Models

- Balance Sheet Valuation Models
• Book Value: the net worth of a company as shown on the
balance sheet.

• Liquidation Value: the value that would be derived if the firm’s

assets were liquidated.

• Replacement Cost: the replacement cost of its assets less

its liabilities.
FIRM VALUATION ….

 Dividend Discount Models

D1 D2 D3
V0    .......
1k (1k) (1k)
2 3

Where Vo = value of the firm

Di = dividend in year I
k = discount rate
FIRM VALUATION ……

 The Constant Growth DDM

D 0 (1  g ) D 0 (1  g ) 2
V0    ......
1 k (1  k ) 2

And this equation can be simplified to:

D0 (1  g ) D1
V0  
kg kg

where g = growth rate of dividends.

FIRM VALUATION……

 Price-Earnings Ratio
P0 1  PVGO 
 1
E1 k  E / k 

where PVGO = Present Value of Growth Opportunity

P0 E1 (1  b )

E1 k  ROExb

Implying P/E ratio

P0 1 b

E1 k  ROExb
where ROE = Return On Equity
FIRM VALUATION …..

 Cash Flow Valuation Models

- The Entity DCF Model : The entity DCF model values the value of a company as
the value of a company’s operations less the value of debt and other investor claims,
such as preferred stock, that are superior to common equity
. Value of Operations: The value of operations equals the discounted value of expected
future free cash flow.

Net Operating Profit - Adjusted Taxes

Continuing Value =
WACC

. Value of Debt

. Value of Equity
FIRM VALUATION ….

 What Drives Cash Flow and Value?

- Fundamentally to increase its value a company must
do one or more of the following:
. Increase the level of profits it earns on its existing
capital in place (earn a higher return on invested
capital).
. Increase the return on new capital investment.
. Increase its growth rate but only as long as the return
on new capital exceeds WACC.
. Reduce its cost of capital.
FIRM VALUATION …..

 The Economic Profit Model: The value of a

company equals the amount of capital invested plus a
premium equal to the present value of the value created each
year going forward.
Economic Profit  Invested Capital x (ROIC WACC)
where ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital

Economic Pr ofit  NOPLAT  ( Invested Capital x WACC )

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

Choosing among different approaches

 If earnings are negative because of

transient phenomenon or some other
one time loss there is a need to
normalize earnings
 Average earnings over prior periods can be
used
 The average profitability measures like
return on equity or capital, margins can be
used
Choosing between different approaches-2

 If the earnings are negative due to long-

term operational problems at the
specific firm being valued, rather than
being sector-wide, adjusting margins
over time towards sustainable levels, in
conjunction with revenue growth seems
to be a much better solution.
Choosing between different approaches-3

 If earnings are negative due to

structural problems, option pricing
model must be used to ascertain firm’s
additional value.
Relative Valuation: Choosing the Right Model
Which approach should you use? Depends
upon the asset being valued..

Asset Marketa bility and Valuati on Approaches

Mature businesses Gro wth businesse s

Separable & marketable assets Linked and non-marketable assets

Liquidation & Other valuation models

Replace ment cost
valuation
Cash Fl ows and Valuation Ap proa ches

Cashflows currently or Cashflows if a contingency Assets that will never

expected in ne ar future occurs generate cashflows

Discounte d cashflow Optio n pricing models Relative valuation models

or relative valuation
models
Uniquene ss of Asset and Val uation Approaches

Large number of similar

Unique asset or business assets that are priced

Discounte d cashflow Relative valuation models

or option pricing
models
 And the analyst doing the valuation….
Inve stor Time Horizon and Valuati on Approaches

Very short time horizon

Long Time Horizon

Liquidation value Relative valuation Optio n pricing Discounte d Cashflow value

models

Vi ews on market and Valuation Approaches

Markets are co rrect on Asset markets and financial Markets make mistakes but
average but make mistakes markets may diverge correct them over time
on individual assets

Relative valuation Liquidation value Discounte d Cashflow value

Optio n pricing models

STEPS IN VALUATION

 Analyzing Historical Performance

NOPLAT
Return on Investment Capital =
Invested Capital

Economic Profit = NOPLAT – (Invested Capital x WACC)

FCF = Gross Cash Flow – Gross Investments

STEPS IN VALUATION-2
 Forecast Performance
- Evaluate the company’s strategic position, company’s
competitive advantages and disadvantages in the
industry. This will help to understand the growth
potential and ability to earn returns over WACC.
- Develop performance scenarios for the company and
the industry and critical events that are likely to
impact the performance.
- Forecast income statement and balance sheet line
items based on the scenarios.
- Check the forecast for reasonableness.
STEPS IN VALUATION-3
 Estimating The Cost Of Capital

B P S
WACC  kb(1-Tc )  kp  ks
V V V
where
kb = the pretax market expected yield to maturity on non-callable, non convertible debt
Tc = the marginal taxe rate for the entity being valued
B = the market value of interest-bearing debt
kp = the after-tax cost of capital for preferred stock
P = market value of the preferred stock
ks = the market determined opportunity cost of equity capital
S = the market value of equity

- Develop Target Market Value Weights

- Estimate The Cost of Non-equity Financing
- Estimate The Cost Of Equity Financing
STEPS IN VALUATION-4
 Estimating The Cost Of Equity Financing
- CAPM

ks  rf  E(rm)  rf  

where rf = the risk-free rate of return

E(rm) = the expected rate of return on the overall market portfolio
E(rm)- rf = market risk premium
В = the systematic risk of equity

. Determining the Risk-free Rate (10-year bond rate)

. Determining The Market Risk premium 5 to 6 percent rate is used for the US
companies
. Estimating The Beta
STEPS IN VALUATION-5
 The Arbitrage Pricing Model (APM)

ks  rf  E(F1) rf  1  E(F2) rf  2 ....

where E(Fk ) = the expected rate of return on a portfolio that mimics the kth factor and is
independent of all others.
Beta k = the sentivity of the stock return to the kth factor.
STEPS IN VALUATION-6
 Estimating The Continuing Value
- Selecting an Appropriate Technique
. Long explicit forecast approach
. Growing free cash flow perpetuity formula
. Economic profit technique
Economic Profit T+1 (NOPLATT+1 )( g / ROIC )( ROIC  WACC )
CV = +
WACC WACC (WACC  g )
where
Economic Profit T+1 = the normalized economic profit in the first year after the explicit
forecast period.
NOPLAT T+1 = the normalized NOPLAT in the first year after the explicit forecast period.
g = the expected growth rate of return in NOPLAT in perpetuity
ROIC = the expected rate of return on net new investment.
WACC = weighted average cost of capital
STEPS IN VALUATION-7
 Calculating and Interpreting Results
- Calculating And Testing The Results
- Interpreting The Results Within The
Decision Context
The dark side of valuation
Firms with
 No earnings
 No history
 No comparables