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NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-6

Session-11

Valuation of Equity Shares - I

Outline

Why Valuation? Valuation of Firm vs. Equity Measures of Valuation Asset-based Valuation Relative Valuation or Valuation based on Multiples

Why Valuation? The decision to buy or sell a security is driven by the valuation of such security. Depending upon under valuation or over valuation, the investor may take a buy or sell decision. Investors do look for securities that are mispriced so that they can gain from the same. Valuation of security as done by a suitable method is known as intrinsic value. There are several methods of valuation depending upon the type of security. For securities like bonds, debentures and preference shares the method of valuation is bit simple because of limited uncertainty about the future cash flows associated with such securities. However equity valuation is not as simple as other securities. There are numerous ways an equity share can be valued. Valuation is also fundamental to decisions by potential acquirers, lenders [when they lend against securities], inviting investors as partners etc. Valuation of Firm vs. Equity For valuing an equity share there are two broad types of techniques, viz. Direct and Indirect. As per direct approach, the equity shares are valued on their own. In case of indirect approach, the firm or the company is valued as a whole and subsequently value of equity is derived out of that essentially after deducting the claims of other financial stakeholders from the value of the firm. In case of firms where there is no other financial stakeholder except equity holders, the value of firm and value of equity are one and same. Classic Measures of Value: The valuation measures can be classified as below:

Asset based Measures Valuation Multiples or Relative Valuation Measures Discounted Cash Flow based Measures Venture Capital/ Private Equity Approach Valuation in case of Mergers and Acquisitions

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Asset based Valuation Measures: Balance sheet of a company as on a particular date reflects the assets and liabilities. The claims of all the stakeholders are reflected in the assets of the company. The total of the assets owned by the company can be considered as the value of the company. In case of asset based valuation methods, the fictitious assets [like debit balance of Profit & Loss Account, Miscellaneous Expenditure not written-off, etc.] and goodwill are not considered for valuation. Those are considered zero for the purpose of calculation. The different asset based valuation measures are discussed below. Book Value: The term ‘book’ means the accounting books. When one considers the value of assets as reflected in the balance sheet such value is known as book value. In total of assets except the fictitious assets is known as the value of the company or firm. Total book value of assets less book value of outsiders’ liabilities is taken as book value of equity.Book value of equity divided by number of equity shares gives book value per share. Since the balance sheet presents the audited figures, the value derived by this approach can be considered as authentic, unless one has doubt about the financial reporting system. Adjusted Book Value: One of the limitations of book value method is that the assets are recorded at historical cost and do not reflect the realizable value. Hence, as per adjusted book value method, the book value of assets are adjusted according to market value of assets then. Similarly the outsiders’ liabilities are also adjusted if necessary. Table 1 shows the valuation of equity share of a hypothetical company as per book value and adjusted book value method.

Table 1: Book Value and Adjusted Book Value of Equity

Particulars (figures are in Rs. Million) Book Value

Market Value

Net Fixed Assets 200 220

Investments 100 110

Inventory 30 32

Receivables 50 48

Cash and bank 40 40

Miscellaneous Expenses to the extent not written off 2 --

Outsiders’ liabilities 200 200

Number of equity shares (in million) 10 10

Value of Eligible Assets [Value of Company] 420 450

Value of Assets less value of liabilities 220 250

Value per share Rs.22 Rs.25

Asset-based valuation measures are suitable for such companies whose value is driven by the assets held by the companies. These measures do not consider other sources of value creation like brand, image, human resources etc. These are intangible assets and affect the revenue generation process of companies in almost all the sectors. Valuation Multiples orRelative Valuation: The relative valuation concept or comparable company approach suggests that a firm or company can be valued by comparing it to similar firms on the basis of

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several relative ratios. Relative ratios compare the firm’s value (or equity value) to some aspect of the firm’s economic activity, such as cash flow, sales or EBITDA (earnings before interest, tax, depreciation and amortization), profit after tax, etc. Multiples are appropriate and easy to use when the comparison is made between two assets that are similar in nature. Multiples also vary over time. Market multiples that are generally drawn from stock prices for public companies are known as trading multiple and those drawn from completed transactions (e.g. a merger or acquisition) are known as transaction multiple. While selecting the comparable companies for a particular company [say target], one has to make a thorough analysis of its product space, product market performance, drivers of performance, suppliers, customers and competitors. This list is not exhaustive. It is also necessary to adjust the financial parameters to make those comparable to the comparable companies. Afterwards the average of the relative valuation measure for comparable companies is found out and applied to value the target company or its equity as the case may be. For the purpose of average, median is appropriate. Examples of Valuation Multiples for Equity: Valuation multiples of comparable companies can be found out by comparing the entire value of the equity with the absolute value of the performance parameter, say profit after tax, dividends or cash flow. This can also be done on per share basis.

Table 2: Select Valuation Multiples for Equity Valuation

Valuation Multiple or Ratio Aggregate basis Measure Per share basis Measure

Price Earning Multiple Market Capitalization / (Profit after tax less preference dividends)

Market price per share (MPS) / Earnings per Share (EPS)

Price to Dividend Multiple Market Capitalization / Equity Dividend

MPS / Dividend per share

Price to Book Value Multiple Market Capitalization / Net Worth

MPS / Book Value per shrae

Price to Cash Flow Multiple Market Capitalization / Cash flow

MPS / CF per share

Table 3: Valuation of a Sample Pharmaceutical Company

Company Name P/E* P/B*

Cipla Ltd. 21.99 3.93

Divi'S Laboratories Ltd. 14.66 4.89

Dr. Reddy'S Laboratories Ltd. 14.68 1.57

Glaxosmithkline Pharmaceuticals Ltd. 20.14 5.47

Glenmark Pharmaceuticals Ltd. 18.11 3.21

Lupin Ltd. 13.69 4.15

Piramal Healthcare Ltd. 14.75 3.41

Sterling Biotech Ltd. 21.43 1.89

Sun Pharmaceutical Inds. Ltd. 18.21 4.47

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Median 18.11 3.93

Target Company EPS and Book Value per share respectively (Rs.) Rs. 5.00 Rs. 25

Value per share (as per P/E and P/B multiple respectively)Rs.5.00x18.11

= Rs.90.55Rs.25.00x3.93

=Rs.98.25

* As found out in 2099-10

Examples of Valuation Multiples for the Firm [or Enterprise]: In this case the value of the entire firm or enterprise is derived by applying suitable multiples. Enterprise value is the sum of value of equity, preference share and interest bearing debt.

Valuation Multiple or Ratio Measure

EBIT Multiple Enterprise Value / Earnings before Interest and Tax

EBITDA Multiple Enterprise Value / Earnings before Interest, Tax, Depreciation and Amortization

Sales Multiple Enterprise Value / Sales

Total Assets Multiple Enterprise Value / Total Assets

Enterprise Value/EBITDA Multiple: This multiple is widely accepted as tool for valuation in case of mergers and acquisitions. EBIDTA neutralizes the effect of differences in financial leverage [affecting interest], depreciation policy and tax policy of the firms that are considered. That is why the firms become comparable. EBIDTA also reflects the core earnings of the firm. It also takes care of firms with negative earnings. There are two ways this multiple can be presented (Damodaran (2007)).

• The Classic Definition

onDepreciati and Taxes Interest, before Earnings

Debt of ValueMarket +Equity of ValueMarket

EBITDA

Value

• The No-Cash Version: When cash and marketable securities are netted out of value, none of the income from the cash and securities should be reflected in the denominator.

 

on Depreciati and Taxes Interest, before Earnings

Cash -Debt of ValueMarket +Equity of ValueMarket

EBITDA

Value Enterprise

Relative valuation techniques are certainly suitable for unlisted companies or companies the shares of which are thinly traded in the market. The relative valuation need not be limited to financial parameters. It can also be based on key operating parameters or characteristics of the firms in a particular sector, like, number of subscribers for an internet service provider, number of patents, number of employees, megawatt hour capacity etc. One of the limitations in relative valuation is the subjectivity involved. In the next session, the cash flow based valuation is discussed.

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References:

Damodaran, Aswath (2007), Corporate Finance – Theory and Practice, 2e, Wiley India Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage) Learning, New Delhi Bodieet al (2009), Investments, 8e, Tata McGraw Hill, New Delhi Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New Delhi

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Questions and Answers

Q.1: List different methods or techniques of valuing equity share.

Ans.: The different methods of valuing an equity share are as below:

Asset based Measures • Book value of Assets less book value of liabilities (based on values as presented

in the latest balance sheet of the company) • Adjusted book value (valuation of assets and liabilities done on the basis of

market value) • Liquidation value (with the assumption that the firm will be liquidated, hence the

valuation is done more on piece meal basis) Valuation Multiples or Relative Valuation Measures

• Price/ Earnings Multiple • Price/ Book value Multiple • Price/ Cash flow Multiple • Price/ Sales Multiple

Discounted Cash Flow based Measures • Dividend discount model • Free cash flow to equity model

Valuation in case of Mergers and Acquisitions: based on similar types of companies that went through merger/ acquisition.

Q.2.With the help of the following balance sheet of MNOP Limited find the value of equity share as per book value and adjusted book value basis as on 31 March 2010. Figures are in Rs. Crore.

SOURCES OF FUNDS 2009-10 2008-09 APPLICATION OF FUNDS 2009-10 2008-09

Share Capital (Face Value: Rs.10)

151.25 151.25 Gross Block 1,936.02 1,928.02

Reserves Total 1,094.82 1,032.13 Less: Accumulated Depreciation 1209.66 1121.96

Total Shareholders Funds 1,246.07 1,183.38 Net Block 726.36 806.06

Secured Loans 1,044.07 790.2 Capital Work in Progress 1,615.43 1,143.87

Unsecured Loans 20.00 50.00 Investments 27.10 62.21

Total Debt 1,064.07 840.2 Current Assets, Loans & Advances

Less: Current Liabilities and Provisions

Inventories 103.55 89.69

Current Liabilities 273.06 240.33 Sundry Debtors 137.26 179.06

Provisions 77.12 68.5 Cash and Bank 1.56 3.43

Total Current Liabilities 350.18 308.83 Loans and Advances 49.06 48.09

Total Current Assets 291.43 320.27

2,660.32 2,332.41 2,660.32 2,332.41

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Ans. Book value of equity as on 31st March 2010 (in Rs. Crore) =

Total Assets – Total Debt – Total Current Liabilities = 2,660.32 –1,064.07 – 350.18 = 1236.07

Number of equity shares = 15.125 crore

Value per share = Rs.1236.07 Crore / 15.125 crore = Rs.81.72

Q.3: Refer the question # 2 above. If the comparable companies’ average Market to Book Value of equity is 1.3, what is the expected market value per share of MNOP?

Ans.: Expected value per share = Book value per share x M/B ratio = Rs.81.72 * 1.3 = Rs.106.24

Q.4: The shares of Ship limited trades at Rs.85. The average P/E multiple and Price/ Sales per share multiple of companies in the same sector are 14 and 1.3 respectively. With the help of the following information suggest if the shares of Ship Limited are under or over valued.

Particulars Amount (Rs. Crore)

Sales 670Operating Expenses 520Profit before interest and tax (PBIT)

150

Interest 20Profit before tax 130Tax @ 40% 52Profit after tax 78Equity Share Capital 120Reserves and Surplus 350

Ans.: Sales per share = Rs.670 crore / 12 crore = Rs.55.83

Price / Sales per share = 85/55.83 = 1.52 times (>1.3)

Earnings per share = Rs.78 crore / 12 crore = Rs.6.50

P/E ratio = 85/6.50 = 13.08 times (<14)

As per price/sales per share criteria, the share is overvalued whereas according to P/E multiple, the share is undervalued.