valuation basics - imarticus · including p/e, ev/ebit(da), p/book etc. •obtain market price data...

Valuation Basics

For internal use only

Agenda

In this session, you will learn about:• Basic approaches to valuation• Relative valuation• DCF and other intrinsic valuation• Trading comps and peer valuation• Transaction comps• DCF Valuation• Sensitivity analysis

Private and Confidential 3

Overview

Investors invest their funds in a financial instrument to earn

positive returns.

Prices of financial instruments, which are determined by market forces tend to move in

either direction.

In order to ensure that investors do not over pay or under sell a financial

instrument, it is important the

instruments are appropriately valued.

What is Valuation Required?

Key Valuation Terms (1/2)

PRICE Price of a financial instrument

NET WORTH =Total assets - Liability of a firm

BOOK VALUEThe value of an asset as shown in the books of accounts; same as net worth

MARKET VALUE The expected price at which an asset can be sold in the market

FAIR VALUEThe arms length price at which one knowledgeable investor would be expected sell to/buy from another knowledgeable investor

NET DEBT =Total debt - Cash and cash equivalents


MARKET CAPITALIZATION

The current market value of all the equity shares of a company

ENTERPRISE VALUE

Represents the value of a business; it is also viewed as the amount an acquirer will have to pay towards all the contributors of capital (including debt and equity)

=No. of shares issued * Price per share

COST OF CAPITALThe rate of return expected by contributors of capital expected which depends on opportunity cost and underlying risk.

= Market Capitalization + Gross Debt + Minority Interest + Preferred Shares outstanding – Cash and Investments

Approaches to Valuation

Valuation Approaches

Cost Based Approach

Selling Price Based

Approach

Income Based Approach

Contingent Claims

Approach

Cost Based Valuation


• Assets such as precious metals can be valued only using this approach

• If one ounce of gold cost 900 to produce and bring to market and if miners need a profit margin of 20%, then an ounce of gold can be valued at 1,080.

Values an asset, based on how much it would cost to create.


• Although the approach can be used to value most assets including equity and real estate, it is less common to use this approach

• When Tata Steel acquired Corus at c.12 bn., which analysts believe was an extremely high price, the management gave a rationale that it would cost them c.18 bn., to build similar level of production facility from scratch and hence the deal was not expensive.

Values an asset, based on how much it would cost to create.

Selling Price Based Valuation

Selling Price Based Valuation

• Real estate, for instance, is mostly valued by retail investors bycomparing price of other properties in the same vicinity

o However, it is key to note that real estate investors do not comparethe absolute price but compare price/sq. ft or price/sq. yd etc.

• Medium term equity investors prefer to use selling price basedapproach to valuation

o Value of different equity instruments can be compared usingvaluation ratios such price/EPS or EV/EBITDA etc.

o This method of valuation is also referred to as relative valuation

Values an asset based on the amount required to buy another similar asset.


PE RATIO

Ratio between price and EPS

EV/EBIT(DA

Ratio between enterprise value and EBIT or EBITDA

= Price/Earning per share = Market Cap/Net Profit

COST OF CAPITAL

Ratio between market price and book value of a share

= EV/EBIT(DA)

= Market Cap/Equity in balance sheet = (Price*No. of shares)/Net worth

PE ratio is applicable for all industries and companies as long as they are profitable

It is preferred when valuing from an acquisition stand point, as acquirers are interested in the value of entire firm and not just equity.

EV/SALES

Ratio between enterprise value and sales

The ratio is used when a company is currently loss making or when acquirer is looking at turn around stories

Trading vs Transaction Comparable

• Trading comparables tries to find out the valuation of peer group stocks based on the price at which they are currently traded at the market.

• Unless a company is considered as a potential acquisition target, trading multiple is what is generally preferred.

Relative valuation of a stock can be computed based on two approaches: Trading Comparables and Transaction Comparables

Trading vs Transaction Comparable

• Acquirers gain control of a company and hence would be willing to pay more (referred as control premium) for equity compared to other investors.

• Traded price of a share does not reflect such control premium and hence not ideal for valuing companies that are potential acquisition targets.

Transaction comparables tries to find out the valuation based on valuation of acquisition transaction carried out in the past.

Trading Comparables: Overview

• Under this approach, the valuation of a stock is based on the average trading multiple of the peer group

o The approach assumes that all other stocks are fairly valued

• A premium or discount may be applied to the average peer group multiple to account for difference in growth or risk characteristics

o All else held constant, companies with higher growth potential should trade at a premium

o All else held constant, companies with higher risk profile should trade at a discount

• Trading multiple based on future earnings is more preferredthan past earnings

o Past earnings is an established fact and there is no scope for information superiority to help with stock picking

Steps in Valuation Using Trading Multiples (1/3)

Identify the peer group

Identify the appropriate

valuation multiple

Obtain market price data

Calculate market cap and enterprise

value

Capture profit metrics including

EPS, EBITDA, EBIT

Calculate the ratio for individual

companies and the averages

Ascertain the appropriate discount or

premium to be applied

Calculate the target multiple for

the company under

consideration

Multiply the multiple with the appropriate profit metric to arrive at

target value


• Identify the peer group

• Identify the appropriate valuation multiple to use

o In general, a trading comp will have various multiples including P/E, EV/EBIT(DA), P/Book etc.

• Obtain market price data

• Calculate market cap and enterprise value

• Capture profit metrics including EPS, EBITDA, EBIT etc.

o The profit metrics should be adjusted for non-recurring items as well as any difference in accounting policy of the companies being compared in order to ensure apple-to-apple comparison

• Calculate the ratio for individual companies and calculate the average

o The average can be simple average or weighted averages with weightages assigned to market cap or EV

• Ascertain the appropriate discount or premium to be applied

• Calculate the target multiple for the company under consideration

• Multiply the multiple with the appropriate profit metric to arrive at target value

o For example, if you use EV/EBITDA multiply target ratio with EBITDA; if you use PE multiple multiply target PE with EPS


Trading Multiples: Example

Price No. of

shares

Market Cap Minority

Interest

Net Debt EV

Current

year

Next

year

Current

year Next year

Current

year

Next

year

Current

year

Next

year

Wipro 541.0 247.0 133,649 - (24,257) 109,392 38.4 41.81 14,063.6 15,513.9 14.1 12.9 7.8 7.1

TCS 2,320.1 197.0 457,159 1,128 (36,840) 421,447 106.4 110.59 29,687.4 31,252.2 21.8 21.0 14.2 13.5

HCL 850.3 140.93 119,826 82 (18,328) 101,580 55.0 60.00 10,605.0 11,500.0 15.5 14.2 9.6 8.8

Tech Mahindra 453.9 96.68 43,883 160 (7,240) 36,803 24.0 27.00 4,107.6 4,250.0 18.9 16.8 9.0 8.7

Oracle fin. Serv 3,287.5 8.48 27,890 - (4,756) 23,134 122.9 135.00 1,739.2 1,860.0 26.7 24.4 13.3 12.4

Average 19.4 17.9 10.8 10.1

EPS EBITDA PE Ratio EV/EBITDA

Infosys

Ref. year PE EV/

EBITDA

Industry average Next 17.9 10.1

Premium/disc. 0% 8%

Target Multiple 17.9 10.9

EPS 125.0 n/ap

EBITDA n/ap 26,500

Target EV n/ap 288,872

(-) Net Debt/(cash) n/ap (42,367)

Target Mkt. cap n/ap 331,239

No. of shares n/ap 229.3

Target price 2,231.3 1,444.56

CMP 1,156.0 1,156.0

Potential upside 93.0% 25.0%

Discounted Cash Flow Valuation

DCF Valuation - Overview

• Based on the principles of time value of money

• Discount the relevant cash flows at an appropriate rate to arrive at the valuation

Cash flow Discount rate

Valaution of Debt Coupon / Interest received Yield to maturity

Valuation of equity Dividend (or)Free Cash Flow (Equity)

Cost of equity

Valuation of business Free Cash Flow (Firm) WACC

• Perpetual cash flows are valued using Gordon growth model

𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 ∗ 1 + 𝑔

𝑘 − 𝑔

DCF Valuation - Overview

• Based on the principles of time value of money

• Discount the relevant cash flows at an appropriate rate to arrive at the valuation

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Understanding Time Value (1/2)

• Same unit of currency received today will be more in future that the same unit of currency received in future

• If you have Rs.1,000 today, at 8% interest rate, it would become Rs.1,080 one year from now

• The same amount of money received in future is worth less than the same amount of money received today

Cash available at a point in time grows higher on account of interest income that one can earn

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Amount in hand today

Interest earned @ 10%

Amount at end of year 1

Today Year 1

Receive today

Receive later

10,000 1,000 11,000

0 0 10,000

Delayed payment would be acceptable only if your friend offers 11,000 one year from now instead of 10,000; in other words, 10,000 today equals 11,000 one year from now

Understanding Time Value (2/2)

Key Points to Note

Time value of money depends on opportunity cost i.e. what is the return you can expect from elsewhere

• Thus, if interest rates in the market go down, the future cash flows would become more valuable today than it was during high interest regime

Opportunity cost depends on the amount of risk involved

• One would expect a much higher rate of return compared to a safer bank deposit, if the borrower is not well known and has low credit quality

How Money Grows?

Compounding @ 10% p.a.

Year 1 Year 2 Year 3

10,000

11,000

12,100

Future Value and Present Value

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FUTURE VALUE=𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒∗(1+𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛)^(𝑛𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑡𝑜 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤)

PRESENT VALUE =𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒

1 + 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑛𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑡𝑜 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

Applying Time Value Concepts

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Fair value of the bond

• The GOI bond with three year to maturity is expected to give Rs.6every year as interest.

• Further, at the end of three years, the bond would also pay backRs.100 towards the principal amount.

• Currently GOI bonds offer 7.5% interest rate.• Calculate the fair price of the bond in question.

Bond Valuation using DCF

Required rate of return 7.50%

Year Cash flow Present value

1 6 5.58

2 6 5.19

3 106 85.33

Total 96.10

Challenges in Applying DCF for Equity

What cash flows to discount?Equity holders receive dividend.

However, several profitable companies do not pay dividends. Are

their equity worthless?

What is the required rate of return?Unlike a bond market where reference rate

of return expected on other comparable securities are know, it is not possible to

know the same for equities.

How long to forecast?A company, in theory, has perpetual

existence. Further, unlike bond, equity is not redeemed in future.

Which Cash Flow to Discount?

Rather than focusing on dividends, we can focus on the maximum

amount that a company can pay as dividends i.e. the free cash

flows.

Other Industries Matured Industries

Companies in matured industries pay regular dividend and hence

we can take divided as therelevant cash flow for such

industries

Which Cash Flow to Discount?

Free cash flow

Free cash flow to equity

Free cash flow to firm

What is the amount of dividend that can be

paid to the equity holders of the company given the current capital

structure.

What is the amount of dividend that can be

paid to the equity holders assuming that the entire capital was

funded through equity i.e. no debt

Free Cash Flow

Free Cash flow

Free cash flow (Equity)

Operation Cash flow(-) Capex(-) Loans repaid(+) Loans borrowed

Free cash flow (firm)

Alternative 1Operating Cash flow(-) Tax benefit on int.(-) Capex

Alternative 2EBIT*(1-T)(+) D&A(+/-) Changes in working capital(-) Capex

What Return Should Equity Holder Expect?

• Rf is the risk free rate; normally the YTM on 10 Yr treasury security

• Rp is the market risk preium; it is assumed number based on house views

• Developed markets: 5%; Emerging markets:10%; Frontier markets:15%

𝛃 is either measured using a formula

• Alternative 𝛃 is also derived using house views on account of calculation issues

𝛃 =𝐶𝑜𝑣𝑎𝑟 𝑆𝑡𝑜𝑐𝑘,𝑀𝑎𝑟𝑘𝑒𝑡

𝑉𝑎𝑟 𝑀𝑎𝑟𝑘𝑒𝑡

Cost of equity is most commonly measured using CAPM

𝐾𝑒 = 𝑅𝑓 + 𝑅𝑝 ∗ 𝛽

What Return Should A Firm Expect?

The rate of return that a firm needs to generate should be weighted average cost of capital (WACC) expected by the two providers of capital

where Ke represents cost of equity and Kd represents cost of debt

WACC 𝐾𝑒 ∗𝐸𝑞𝑢𝑖𝑡𝑦

𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡+ 𝐾𝑑 ∗

𝐷𝑒𝑏𝑡

𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐷𝑒𝑏𝑡

The capital contributors to a firm include both equity holders and debt holders.

COST OF DEBT (kd) = effective interest rate * (1-T)

Note: The weightage for equity and debt should be based on their fair value.

Market value is taken as proxy for fair value of equity and book value is taken as a proxy for fair value of debt

How Long Should You Forecast?

• The later a cash flow occurs, the lower will be its present value; as time approaches infinity present value approaches zero

• Based on this premise, if a cash flow is expected to grow a fixed rate, present value of all future cash flow can be valued using Gordon growth model

Valuation of perpetual cash flow

Current year dividend 10.0

Cost of equity 12.0%

Expected growth rate 4.0%

Value of equity 130.0

PERPETUAL VALUE =(𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 ∗(1+𝑔))/(𝑘−𝑔)

Problems with Gordon’s Growth Model

The degree of error increases as perpetual growth rate increases

• As g approaches k, valuation approaches infinity

• If g is greater than k, valuation turns negative and that is logically incorrect

It is difficult to determine the growth rate at which an industry can be expected to grow forever into future

• This problem is tackled by looking long term growth rate of the GDP of geographies in which the company operates

• The premise is that eventually a company cannot grow faster than overall economy

Gordon’s growth model is an approximation and thus has a degree of error.

DCF Valuation – Multistage Models

Perpetual growth models do not work when growth rate is high.

Valuation

Periods of high (or very low) growth

Explicit forecast period (where we have visibility)

Out-years (where we do not have perfect visibility)

Perpetual value

Out-year cash flows are projected using prior-year trends or other quantitative approaches as analysts do not have visibility about the same

DCF Demystified

What is Discounted Cash Flow?

Foundation for all Valuation

Approaches.

Basis

Function

Derives the intrinsic value of any

asset based on what cash flows it is

expected to generate.

DCF Demystified

Based on Present Value Rule /Time Value of Money

Value of any asset is the summation of the present value of all the expected future cash flows it can generate

Where

• n – Life of the asset

• CF (t) – Cash flow in period t

• r – discount rate reflecting the riskiness of the estimated cash flow

What is Discounted Cash Flow?

The DCF Valuation Model – Enterprise Value Calculation

Year >>>> (n) 0 1 2 3 4 5

What it stands for >>> Valuation

Date

First Fiscal

Year End

Second Fiscal

Year End

Third Fiscal

Year End

Fourth Fiscal

Year End

Fifth Fiscal

Year End

Free Cash Flow to Firm /

Unlevered Free Cash Flow

- 100 200 300 400 500

Terminal Value 7,500

Total Cash Flows (A) - 100 200 300 400 8,000

WACC 10%

Discounting Factor (1 / (1 +

WACC)^n) (B) 1.00 0.91 0.83 0.75 0.68 0.62

Discounted Cash Flows (A * B) - 91 165 225 273 4,967

Enterprise Value 5,722

Less: Net Debt 1,000

Equity Value 4,722

i. FCFF is projected and calculated using the formula in earlier slides [EBIT / PAT / PBT / EBITDA based approach]

ii. WACC is discounting factor when calculating Enterprise Value

iii. Terminal Value is calculated on year 6 cash flows and not year 5

The DCF Valuation Model – Equity Value Calculation

i. FCFE is projected and calculated using the formula in earlier slides [FCFF – Financing Changes / Costs]

ii. Cost of Equity is discounting factor when calculating Equity Value

iii. Terminal Value is calculated on year 6 cash flows and not year 5

Year >>>> (n) 0 1 2 3 4 5

What it stands for >>> Valuation

Date

First Fiscal

Year End

Second Fiscal

Year End

Third Fiscal

Year End

Fourth Fiscal

Year End

Fifth Fiscal

Year End

Free Cash Flow to Equity /

Levered Free Cash Flow

- 100 200 300 400 500

Terminal Value 7,500

Total Cash Flows (A) - 100 200 300 400 8,000

Cost of Equity 14.58%

Discounting Factor (1 / (1 +

Cost of Equity)^n) (B) 1.00 0.87 0.76 0.66 0.58 0.51

Discounted Cash Flows (A * B) - 87 152 199 232 4,051

Equity Value 4,722

Add: Net Debt 1,000

Enterprise Value 5,722

valuation basics - imarticus · including p/e, ev/ebit(da), p/book etc. •obtain market price data...

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