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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr.

Sohail Zafar

Lectures 15
Valuation of Corporations continues

DDM (Dividend Discount Model) with constant growth assumption.

It is a probably the most frequently used model that attempts to estimate current value of common
shares of a corporation directly; and usually while applying this model a constant growth rate assumption
is used . Therefore it is called Dividend Discount Model with Constant Growth Assumption (Also called
Gordons Model). According to this model fair value of a share is:
Fair value now = DPS1/ (Kc g)
Please note this value is a theoretical value and it is compared with actual market price of the share. The
decision rule is simple: if actual market price is greater than this fair value estimate, then share is
overvalued. Please note the use of symbol Po instead of fair value does not mean that the model
estimates observed share price today in the stock market, rather it means that in view of this particular
analyst this should be the current share price in the market. Actually prevailing share price might be
different than the estimated fair value and due to this difference the analyst would pass judgment as to
share being over valued or undervalued at its prevailing market price.
This model can be used for non growing corporations as well, and in such cases it reduces to :
Po = DPS 0 / Kc
Since DPS1 = DPS0 (1 + g) but if growth rate (g) is zero then DPS0= DPS0 (1 + 0) = DPS0. That means next
year DPS would be same as last years DPS.
Therefore for the non growing companies fair value estimate is: DPS0 /Kc
Please also note that DPS1/ Kc is in fact PV of a perpetuity, where as DPS is perpetuity and discount rate
used to find PV of perpetual DPS is Kc, while Kc is risk adjusted required rate of return of shareholders.
because DPS 1 = DPSo (1 + g), DDM with constant growth assumption can be written as
Po = Fair value of share today = DPSo (1 + g)/(Kc g)
Usually the growth rate (g) used in this model is ROE (1 d). But you know that strictly speaking this
growth rate can be used only when you assume constancy of 5 major policies as discussed in previous
lectures. Major disagreement of stock analysts is about expected constant growth rate of a Co, and that
is why they arrive at different fair value estimates for the share of the same Co; and that is why at any
given time some analyst recommend BUY and the other recommend SELL for the same share.
This model has certain weaknesses: It is not usable for a company which does not cash pay dividends,
because with zero rupees dividend per share in the numerator, the fair value estimate would be zero
which is absurd for a share which has a market value and is being traded on that value. Also some very
famous companies such as Micro Soft did not pay cash dividends in the early decades of its life because its
growth was so fast that all the available profits were reinvested to expand its R&D, production, and


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

marketing capabilities. Share of Micro Soft experienced growth in price in the stock market during those
years of non-dividend payments, and investors earned their ROR in the form of capital gains yield only as
there was no dividend yield. So MicoSoft gave nothing in the form of cash to its shareholders for so
many years and its dividend yield was zero for those years, yet share market rewarded the shareholders
in the form of capital gains yield. DDM is not useful for valuing such non dividend-paying corporations.
DDM is also not usable for valuing portions of a co, such as a division of a corporation, or a product line,
or a plant of a Co, or operations of a company in a foreign country. But in real life we observe companies
selling their portions such as divisions, product lines, etc, to other companies. To estimate value of such
portions of a corporation DDM is not usable, rather free cash flows model is more appropriate and you
will learn about that model shortly.
DDM assumes that Co is expected to experience low constant growth rate every year for ever, because if
the growth rate is higher than Kc then the term (Kc - g) in the denominator of the above equation would
become a negative number resulting in a negative value for its shares; and negative value of a share is not
a meaningful idea.
Also the DDM assumes DPS per year till infinity and a constant percentage growth every year in the DPS.
That means DDM assumes policy constancy year after year, such as, constant dividend payout ratio (d =
DPS / EPS ratio), a constant capital Structure (TA / OE ratio), constant Net Profit Margin (NI / S ratio),
constant TA turnover (S/TA ratio), and fixed number of shares outstanding, which means no share issuing
and no share repurchases by the Co. With these assumptions about constancy of 5 corporate policies ,
the percentage growth rate in OE due to retention of NI translate into the same percentage growth rate in
TA, TL, Sales, NI, EPS, DPS, and finally growth in share price. But in real life companies are rarely managed
with such constant policies.
DDM also assumes that the Co must not be expected to merge with another Co, but should continue
forever as an independent Co.
Please note that Kc is rate of return expected to be earned by shareholders, but in finance returns without
risk considerations are not meaningful therefore a theory called CAPM is used which relates shareholders
expected rate of return with the relevant risk of that share as:
Risk adjusted required Kc = Rf + (Rm Rf) beta
And such Kc is termed risk adjusted required ROR by shareholders.
On the other hand expected rate of return from shares has 2 components, namely the dividend yield and
capital gains yield. Dividend yield is given by the Co by virtue of paying cash dividend to shareholders, but
capital gains yield is not given by the co to its shareholders rather it is solely decided in the stock market
as result of change in share price between the buying and selling times; and the co has no control on such
changes in its share price because such price changes in the market are result of actions of millions of
individuals involved in buying and selling that share. This formulation of expected Kc as sum of dividends
yield and capital gains yield is called expected rate of return for share holders; and it does not have in it
explicit considerations for the risk; it can be written as :
expected Kc =

DPS1/Po +

( P1 - Po) /Po


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

and since ( P1 - Po) /Po is percentage growth in share price in one year( or any other period), therefore it is
replaced by symbol g ; and thus formula for expected rate of return for shareholder becomes:
Expected Kc =

(DPS1/ Po ) + g

If 5 policies are kept constant then , as proven in previous sessions, this growth rate in share price ( called
capital gains yield) is also equal to ROE (1 d).
To understand the Value Drivers let us explode the DDM as follows:
Revision of variables in DDM:

1) DPS1= DPSo (1 + g)
2) g =ROE ( 1 - d)
3) ROE=NI/OE = NI/S * S/TA * TA/OE
4 ) d=

total cash Dividend /NI; or DPS/EPS

5) Kc = RF + (RM - RF)Beta (levered) .

Inserting these values in above equation you get



This model says that share value increases if :
1. DPS increases; it makes sense because any asset which is expected to give high cash flows in future is
more valuable in your eyes today, and that is true for shares also
2. Beta decreases; it makes sense because beta is relevant risk of share, and low risk makes the share
3. interest rates in the economy decline thus causing both Rf and (Rm Rf ) to decline
4. net profit margin increases (NI /S ratio); it makes sense because higher profit margin on sales means
higher profitability
5. turnover of TA increases (S / TA ratio); it makes sense because higher asset productivity means that
more is produced and sold by using given resources called assets


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

6. financial leverage increases (TA / OE ratio); it is believed that higher leverage would result on one hand
in higher financial risk but at the same time it would also contributes toward in magnification of ROE , and
higher ROE would lead to higher growth rate, and higher growth is believed to lead to higher price. But it
is important to note at this stage that though higher ROE translates into higher growth rate, g, but it is not
always necessary that higher growth would translate into higher growth in share price or in other words
in value creation. Let us postpone that discussion for the time being.
7. dividend payout ratio decreases ( d); and that also makes sense because by retaining and reinvesting
a bigger percentage of NI the Cos management is sending a signal that it has promising investment
opportunities of high ROE, and such a signal is viewed positively by the market participants thereby
increasing the demand for such a share and pushing its price higher.
Please notice 4 of the 5 corporate policies (except number of shares outstanding) discussed above are
here as value drivers. These 7 value drivers are hidden in the DDM.
Interestingly by shuffling the terms of expected rate of return formula:
Expected Kc =

(DPS1/ Po ) + g

you can derive DDM with constant growth valuation formula for estimating fair value of a share , as
shown below:
Taking g on the left side you have
Kc - g = DPS1/ Po
and taking P0 on the left side you have
Po (Kc - g) = DPS1
And bringing (kc g) to the right side , you have Po = DPS1 / (Kc - g)
and this is DDM with constant growth valuation formula. Thus based upon the common sense that ROR
for shareholders by investing in shares of any corporation comes from 2 components , namely, expected
dividend yield (DPS1/Po )and expected capital gains yield (( P1 - Po) /Po ), the valuation formula can be


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

Free Cash Flows (FCF) Model:

This model is usable to value the entire company as well as a portion of a Co such as a division or product
line, or a plant, or operations of an MNC in a foreign country. It is usable if a company is planning to buy
another company, or division of another co, or a product line from another co, or a plant from another co,
or foreign operations of another co. It is usable for non-dividends paying companies as well. In that sense
it is a more versatile valuation model because it starts by estimating a fair value of assets, then subtracts
liabilities from this estimate to arrive at fair value of equity. Then divide the fair value of equity by number
of shares to arrive at an estimate of fair value of share. Then comparing this estimated fair value per
share with prevailing current market price of that share you can make a judgment as to share being over
or under valued at its current market price and accordingly you can decide to buy or not to buy that share.
FCF valuation Model is done in multiple steps as shown below:
1) Estimating annual free cash flows, FCF, for next few years , such as next 4 or 5 year ; and beyond that a
constant growth rate in FCF per year is assumed.
2) Annual FCF are discounted at the companys weighted average cost of capital (WACC) to estimate VALUE
OF OPERATIONS or in other words the fair value of its operating assets. Then the value of non-operating
assets is added to the value of operations to arrive at the value of TA, and this is also called value of firm.
From the value of TA the value of Debt capital is subtracted to arrive at the value of equity. But if that Co
has issued preferred shares as well then value of preferred shareholders capital is subtracted from the
value of equity to arrive at the value of common equity.
3) If debt is composed of bank loans only then BV of debt from balance sheet is used, but if market tradable
bonds issued by this Co are also part of its debt capital then based on prevailing market price of those
bonds the MV of debt is estimated.
4) For preferred share capital also the MV should be used if they are listed and traded, or conversion value
would be used if they are convertible in common shares, or call value is used if preferred shares are
callable; otherwise book value of preferred shareholders capital from the balance sheet is used as
estimate for value of preferred share capital. The value of debt capital and value of preferred
shareholders capital is subtracted from the value of TA to arrive at an estimate of the value of common
equity capital.
5) Then this estimated fair value of common equity is divided by number of common shares outstanding to
arrive at the estimated fair value of a common share.
6) But if a Co has no non-operating assets, then you can directly find value of total assets using the same
methodology of PV of FCFs; and subtract values of debt and preferred share capital to arrive at value of
common equity and finally fair value per common share.
Compared to direct share valuation under DDM, the FCF model estimates the share value by adopting a
longer step wise process.
The starting point is to estimate next four or five years income statements and balance sheets. Note:
You have already learned that skill in lectures on financial planning. From these projected income
statements and balance sheets you extract annual NOPAT (net operating profit after tax) as:


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

NOPAT per year = EBIT ( 1 - T)

Then free cash flows per year are estimated as:
Free Cash Flows per year (FCF) = NOPAT - Increase in total operating capital,
The concept of total operating capital invested in a Co has to be clear in your mind and is an important
learning objective. Please also note that total operating capital is also called operating assets. These
operating assets are called operating assets because these are necessary to operate a business on a day
to day basis. It is important to understand that total operating capital is financed by investors, that is,
owners equity and debt. This concept of operating assets implies that there are some assets in a Co
which are non-operating assets. Non operating Assets present in a Co include investment in marketable
securities, investments in shares of subsidiary companies, investment in land held for future use,
investment in long term securities held not for trading purposes as a parking of excess cash but held till
their maturity as long term investments; and these non-operating assets are added to the value of
operating assets estimated using FCF method to arrive at fair value of TA. For a well managed Co this fair
value of TA is likely to be much higher than the TA reported in the balance sheet at their book value (BV).


Total Operating Capital = Operating NWC + Operating FA (net).
FA(net) = BV of FA minus accumulated depreciation of those FA.
Projected increase in total operating capital from one year to the next year can be calculated from
projected balance sheets in 2 different ways as shown below:
First Method
Increase in total operating capital =Total Operating Capital

(next year)

Total Operating Capital (last year )

Increase in total operating capital = (Operating NWC + Operating Net FA (next year) ) ( Operating NWC +
Operating Net FA (last year) )
Second Method
Increase in total operating capital=increase in operating NWC + increase in operating net FA
Increase in operating NWC = operating NWC (next year - Operating NWC (last year ).
Increase in operating net FA = Operating net FA (next year) - Operating FA (last year)
It is important to clearly understand how these items are calculated from balance sheet
The Concept of Operating NWC
Operating NWC = Operating WC Operating CL.
Operating WC are Operating CA. The Operating WC can be viewed as those CA which are used in normal
business operations to generate sales such as cash, account receivables from sales, and inventory; this


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

means investment in marketable securities, though a CA, do not qualify as operating CA because they
have no such role. Therefore:
Operating WC = Operating CA = CA non operating CA such as investment in marketable securities.
Operating CL= CL ST bank loans
Operating CL are those CL which are generated as part of normal business operations such as accounts
payable to suppliers of raw material inventory, accruals of various operating expenses which have been
recorded as expenses but not paid as yet. It means that short term bank loan is not an operating CL
because it is not created automatically (spontaneously) due to normal business operations , rather it is
created as a deliberate financing decision of management to take short term loan instead of long term
loan or instead of issuing shares or instead of issuing bonds; and therefore ST bank loan should be
counted as part of debt capital in this context along with long term interest bearing loans, long term
bonds payable and long term lease contracts.
Typically operating NWC is composed of only those CA which are financed by long term debt and OE. It
must be clear to you that all CA are not financed by investors ( i.e. shareholders and long term debt such
as long term bank loans) because some CA are financed by CL such as Accounts Payables and Accruals;
and only the remaining CA are financed by long term debt loan and owners equity. Therefore operating
NWC can be written as:
Operating NWC = (Cash + R/A + Inventory) (Acc P/A + Accruals related to operating expenses)
Operating NWC =(non interest or dividend earning CA) (non interest paying CL)
Operating NWC = (CA excluding investment in marketable securities) (CL excluding ST bank loans)
Operating NWC

= CA financed by investors.
The Concept of Operating net FA

Operating net FA = Net FA Non Operating FA . Non operating FA include those long term assets which
are not used in day to day business operations such as investment in land for future use, investment in
bonds and stocks for long term purposes, also investments in Subsidiary Cos shares.
Net FA = FA Accumulated Depreciation.
It is important for you to do a brief exercise at this stage. Following is the balance sheet given in
equation form
Cash + R/As + inventory + marketable securities + FA (net) + Govt Bonds and land = P/As + accruals + ST bank loan + LT Loan + OE

100 + 200 + 300

+ 100


+ 200


= 50 + 150 +

= 1,400

Op CA = cash + R/As + Inventory = 100 + 200 + 300 = 600

Op CL = P/As + accruals = 50 + 150 = 200



500 + 400

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

Op NWC = Op CA Op CL = 600 -200 = 400

Total Op capital (op assets) = Op NWC + FA (net) = 400 + 500 = 900.
Non op assets = investment in Govt bonds & in land + investment in marketable securities = 200+100
= 300
If you take non op assets on RHS of equation you have
Op NWC + FA (net) = ST Bank loan + LT loan + OE - non op assets
400 +


= 300

Op capital

= Debt


= 800


= 1200 - 300


= 900


+ 400 - 300
+ OE -

non op assets

+ 400 - 300

In this context Debt = ST bank loan + LT loan = 300 + 500 = 800.

The above analysis means operating capital (900) is always financed by investors (that is debt and equity
= 800 + 400); as available funds provided by financiers are 1,200 while investment of these funds in
operating assets is only 900 therefore the remaining 300 has been invested in non-operating assets.
In this Co management has forced investors (financiers) to do over investment in the form of financing
non operating assets as well by 300. Also note that in this case all the non operating assets of 300 were
financed by short term loan; which means ST bank loan could have been avoided if management had not
invested in non operating assets. Without over investment in non-operating assets the situation would
have been as follows:
Total operating capital = LT Debt + OE = 500 + 400 = 900
Total operating capital = NWC + operating FA (net) = 400 + 500 = 900
Meaning this Co can run its operations on a day to day basis with only 900 of investors capital invested in
it , therefore unnecessary investment of 300 additional capital in non- operating assets is something
about which investors (providers of debt and equity capital) should question the management of this co .
Please note in this context providers of equity as well as providers of short term and long term loans are
being termed as investors or capital providers or financiers of a corporation.
Another way of looking at FCF per year is through operating cash flows(OCF):
Operating CFs per year (OCFs) = NOPAT + Depreciation Expense
Gross investment in total capital = increase in Total Operating capital + Depreciation Expense
FCF = Operating CF Gross investment in Total Capital


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

FCF=(NOPAT + Depreciation expense) ( increase in Total Operating Capital + Depreciation expense)

FCF = NOPAT Increase in Total Operating Capital
FCF = [EBIT(1 - T)] - (Increase in Total Operating Capital)
So, if you are given OCFs per year and gross investments per year you can find FCF per year.
After estimating FCF per year as explained above and after estimating WACC as you already are familiar
with, the value of operations (that is fair value of operating assets of that Co, or operating assets of a
division of a Co) is estimated as:
Value of operations = PV of FCFs of all future years
But in practice only next 4 or 5 years income statement and balance sheets are projected; and FCFs
from these statements are extracted; but beyond these 4 to 5 years a constant growth rate of FCFs is
assumed. Therefore
Value of operations =FCF1/(1+WACC)

+ FCF2/(1+WACC) + + (FCF5 + Terminal value in year 5) /(1 +

Terminal value at the end of year 5 is PV of all FCFs beyond year 5 till infinity, and it is estimated
assuming a constant growth rate of FCFs after year 5.
Terminal value in year 5 = FCF5(1 + g) / (WACC g).
Please Note that FCF 5 (1 + g) means FCF 6 and dividing it by the term (WACC g) estimates at the end of
year 5 the PV of all FCFs from year 6 onwards till infinity. Also note that since terminal value is estimated
at the end of year 5 so from the viewpoint of time zero,( i.e. now ) it is still a future value and has to be
discounted for 5 years to find its PV therefore the whole term

FCF5(1 + g) / (WACC g) has to be divided by (1 + WACC) . Similarly the original FCFs of year 5 also
have to be discounted by this term (1 + WACC) . Therefore in the above formula both the FCF of year 5
as well as the terminal value of cash flows at the end of year 5 are jointly shown as being discounted by
the factor (1 + WACC) . The following data is from your text book.


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

From the above tables showing projected income statements and balance sheets , we have shown below
the estimation for FCF. Note the Year 2009 is the latest year and its data is actual, years 2010 to 2013 are
projected data.



Operating NWC = (Cash

+ R/A +

Inventory ) (P/A +


Operating NWC = (CA excluding investment in marketable securities) (CL excluding ST bank loans)
Operating NWC =(17+85+170) (17+43),


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

Operating NWC =212

Total Operating Capital = Operating NWC + Operating net FA


2010 Estimated
Operating NWC =(Cash

+ R/A +

Inventory ) (P/A +

=(20 + 100 +200)


+ 50)


Total Operating Capital = Operating NWC + Operating net FA

= 250

+ 310

Increase in Total Operating Capital2010 = Total Operating Capital 2010 - Total Operating Capital 2009



= 69
NOPAT 2010 = EBIT( 1 - T)
= 85 ( 1 0.4)
= 51 million Rs
Free Cash Flows (FCF) 2010 = NOPAT Increase in Total Operating Capital


= - 18 m Rs.
Similarly in the table above the FCFs are estimated for the next 4 years till 2013. Using the data given in
table, and WACC estimate of 10.84% for this Co, and beyond year 4 (year 2013) the FCF constant growth
rate estimate of 5% per year for ever, the following is an estimate of its Value of operations. Note next
year 2010 is year 1; 2011 is year 2 from today that is end of year 2009.

Value of operations =FCF2010 /(1 + WACC) + FCF2011/(1 + WACC) + FCF2012/(1 + WACC) +

(FCF2013 + Terminal value end of year 2013 )/(1 + WACC)

Note that Terminal Value at the end of year 4 (that is end of in 2013) of all the FCF beyond 2013 is


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

=FCF 2013 ( 1 + g) / ( WACC - g), and it works out

= 49(1 + 0.05) / ( 0.1084 - 0.05)
= 881

Value of operations =FCF2010 /(1+WACC) + FCF2011/(1+WACC) + FCF2012/(1+WACC) +

( FCF2013 + Terminal value of year 2013 )/(1+WACC)

Value of operations = -18 / ( 1 + 0.1084) + -23 / ( 1 + 0.1084) + 46 . 4 / (1 + 0.1084) +

(49 + 881) / ( 1 + 0.1084)

= 615 million Rs
Value of TA ( Value of Firm) = Value of Operations + Value of non operating assets
= 615

+ 63

= 678
Note : the only non operating assets in this co now (that is end of 2009) are marketable securities of Rs
Value of Equity = Value of TA - Debt
= 678

- 247

= 431 million Rs
Note: operating CL (accounts payables and accruals) are not included in debt, because those were already
used in estimating FCF. The remaining liabilities are short term bank loan of 123 and LT Bonds payable of
Rs 124 , adding up these interest paying Debts you get 123 + 124 = 247 million Rs.
Value of Common Equity = Value of Equity - Preferred equity capital
= 431

- 62

= 369 million Rs
(preferred share capital was taken from balance sheet of 2009)

Fair Price per share = Value of common equity / number of shares outstanding
= 369 / 100 million
= 3.69 Rs per share
This is the maximum price you are willing to pay per share based on your forecast and analysis; usually it
is termed fair value or intrinsic value, or justified value , or theoretical value of share.


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

MVA (Market Value Added)

MVA is a life-covering concept and it is different from EVA which is per year concept.
Market value added ( MVA) = Present Value of owners wealth - original investment by owners
= Value of common equity

- BV of common equity

= 369
= 124 m Rs

- 245

(BV of OE is from balance sheet of 2009, and it is common share capital + RE)
This increase in wealth of shareholders has occurred over the whole life of the company , not in one year.

Relationship of Market Value Added (MVA) With Value of TA

Value of TA as you estimated includes MVA as shown below.
Value of TA = Debt

+ BV of preferred stock + BV of common Equity + MVA









678 554 = MVA



Note: There are various ways to decompose value of TA that you have just estimated, some of these
decompositions are shown below:
Value of TA = Debt + BV of preferred stock + MV of common equity

= 247 +



Value of TA = Value of Operations + Value of non operating assets


Value of TA =



+ BV of preferred equity + BV of common Equity + MVA





+ 124

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

EVA (Economic Value Added)

Economic Value Added per year (EVA) 2010 in Rs = EBIT (1 - T) - [ Total Operating capital * WACC)

85 ( 1 0.4)

51 -

- [560 * 10.84%]
60 .7

= -9.7
In 2010 EVA was negative, so shareholders wealth was lost in that year, no value creation took place in
that year. EVA of -9.7 is also called Residual Income, that is the income left over after paying the providers
of capital their respective required RORs, which means shareholders get their expected Kc, and Debt
holders get their respective Kd from EBIT, Government gets its tax, after that the left over is called
residual income and it belongs to shareholders. Positive residual income or EVA is likely to reflect itself in
higher share price in the stock market.

EVA concept is usable in compensating the divisional managers : if their respective divisions show
positive EVA they are rewarded. EVA is being increasingly used to reward or punish top management
teams of corporations. Note the relationship of EVA with MVA is not mathematical , that is, the sum of all
past years EVAs do not add up to MVA but a conceptual one, that is, a co would have positive MVA if it
had positive EVAs in the past years of its life.


it is found by dividing the EVA in rupees by total operating capital. You can divide both sides of EVA
equation by total operating capital to get EVA % = ROIC WACC , as shown below for 2010:
EVA / Total operating Capital = [EBIT (1 - T) / Total operating Capital ] [(total operating capital *
WACC) / total operating capital]
-9.7/ 560

= 51 /560


= 9.1%


= - 1.73%

- 60.7/560
- 10.84%

Note: ROIC refers to return on invested operating capital and it is EBIT (1 T) / total operating capital.
From the data given in tables above we found the following EVA estimates. Note EBIT ( 1 - T) is also
called NOPAT; and WACC in this example is 10.84%.

- (WACC * Total operating Capital)

EVA2009 =43.8

- (0.1084 *491) =- 9.4 million Rs

EVA2010= 51

- (0.1084*560) = -9.7 m


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

EVA 2011=33

- (0.1084*616) = -33.7 m

EVA 2012=77.4 - (0.1084*647) =7.3 m

EVA 2013=81

- (0.1084*679) =7.4 m

It shows that for the next 2 years ( 2010 and 2011) EVA is going to be negative based upon projected
income statements and balance sheets. Thereafter this Co can hope not to see value creation in next 2
years (2010 and 2011) but can hope to see value creation in year 2012 and year 2013 as estimated EVA is
positive for those years. It implies that share price is likely to fall in next 2 years (2010 and 2011), but in
the following 2 years (2012 and 2013) you expect as analyst that share price would increase.
Please note the logic of value creation by attaining positive EVA is based upon the idea that once the
providers of debt capital and equity capital have their expected rupee of returns = (WACC * total
operating capital) from NOPAT and still some NOPAT is left over then that left-over NOPAT belongs to
shareholders. Thus EVA in rupees is a type of surprise profits, over and above the expected profits, for
shareholders. If this surprise is positive then shareholders are happy and demand for such shares
increases thus causing the share price to go up. But if this surprise is negative (negative EVA) then
shareholders are disappointed and demonstrate their disappointment by getting rid of this share that
causes increase in supply of share due to the disgruntled and disappointed shareholders off loading the
share, resulting in fall in share price. EVA is also termed as residual income, meaning after paying all the
claimant their due share, whatever is left over as residual profits that goes to shareholders.

Relationship of EVA with MVA

Generally a company whose EVA is positive year after year would experience increase in MVA over the
years. But this is not a mathematical relationship, i.e., you cannot add EVAs of all the past years of a
company to arrive at it MVA.

Equity Cash Flows Method:

This is a share valuation method which calculates the value of shares directly but not by using the brief
formula of DDM with constant growth because that formula, as we discussed earlier, has number of
restrictive assumptions build into it. It requires preparing projected income statements and balance
sheets for next 4 or 5 years , and then beyond year 5 assuming a constant growth rate of equity cash
Value of Equity = PV of Equity CFs,
and equity cash flows of future years are discounted at Kc of that company. Equity cash flows are the
amounts of annual cash which shareholders can expects to extract from a co after some of its NI has been


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

used to reinvest in the business to make-up for the regular wear and tear in its operating capital and also
used to expand its operating capital.
Equity CFs each year = ( NI + Depreciation Expense) Retention.
The retention shows up as annual increase in RE of the co. Such reinvestment of NI in a co is deemed
necessary because such investment is required to replace assets that have depreciated, and to finance
growth of its operating capital ,i.e. , growth in its operating NWC + Operating FA.
Both free cash flows method and equity cash flows method require forecast of next 4 to 5 years Income
Statements and Balance Sheets. Beyond that it is customary for analysts to assume a constant g of cash

flows till infinity to find Terminal Value at the end of 5 year.


Value of Equity today = Equity CF1 / (1+Kc) + Equity CF2 / (1+Kc) +


. + (Equity CF5 + Terminal Value at the end of year 5) / (1+Kc)

Terminal Value of equity CFs at the end of year 5 = Equity CF5 (1 + g) / (Kc g )
Fair value for share of a Co Today = Value of Equity of Co / number of shares outstanding
And it is an estimate of fair value of shares of Co today in the eyes of analysts, though in real life all
analysts sitting in different brokerage houses and investment banks may not make the same estimate for
annual equity cash flows or for constant growth rate or for required rate of return of shareholders (Kc),
and therefore may not recommend the same fair value of share of a co, but their estimate of fair value is
usually very close to each other; and for an outsider an average of these estimated fair values estimates
of various analysts is a good working number. The following table gives projected income statements for
the next 5 years along with equity cash flows estimated for each of the next 5 years for a target Co being
evaluated by analysts as a potential target for take-over. Please note that projected next 5 years balance
sheets must also have been made by this analyst but those have been omitted here.
Why making projected balance sheets is also necessary? Is it not sufficient to make projected income
statements? The answer is No! without having some idea of projected assets in balance sheets, you
cannot project annual depreciation expense in income statements; nor without loan amounts in balance
sheets, you can project interest expense in the income statements.

Please note that depreciation

expenses as well as interest expense are increasing in the projected income statements in this example, it
implies that in the projected balance sheets FA were increasing, and long term debt was also increasing
because these 2 expense items in income statement depend on the 2 items of balance sheet.


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

Projected Income Statements for the next 5 years and extraction of Equity Cash Flows







Net sales












Selling &
Admin Exp
































Add back:


Cash Flow =
NI +








Equity cash






Please note that after doing 5 years forecasting in detail it is customary to assume that the co would
continue as a going concern (a living co) for ever therefore equity cash flows generated by this co after 5
years (after 2015) are also relevant to value its shares today. It is done by finding terminal value of equity
cash flows at the end of 2015. Terminal value of equity cash flows at the end of year 2015 is sum of PVs
of all future equity cash flows growing at constant growth rate of 10% per year for ever. Formula for the


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

PV of growing perpetuity is used to estimate terminal value of equity cash flows at the end of 2015 as
shown below.

Note all equity cash flows , including cash flows separately estimated for each of the next 5 years as well
as cash flows beyond 5 years estimated as terminal value of equity cash flows, are discounted at the Cos
cost of equity ( Kc) to estimate fair value of the Cos equity, and this value of equity is divided by the
number of shares of the Co outstanding to estimate the fair value of its share. Constant growth rate of
cash flows after 2015 is estimated as 10% per year for ever, and Kc (risk adjusted required rate of return
demanded by shareholders) is estimated as 18.2% in this case. Please remember CAPM is one model
which can be used to estimate Kc.
Terminal value of equity cash flows at the end of year 5 (2015) = equity cash flows 2015 ( 1 + g) / ( Kc g),
= 11.2 ( 1 + 0.1) / (0.182 - 0.1),
= 150 .2 million Rs

Fair value of equity now (end of 2010) = equity Cash flows 2011 / (1 + Kc )
+ equity cash flows 2013/ (1 + Kc)

+ equity cash flows 2012 / (1 + Kc)

+ equity cash flows 2014 / (1 + Kc) +

(equity cash flows 2015 + Terminal value of equity cash flows at the end of 2015) / (1 + Kc)

Entering the above data in this equation


Value of Equity now ( end of 2010) = 6.4 / (1 + 0.182) + 8.8 / (1 + 0.182)

+ 10.2 / (1 + 0.182)

+ (11.2 + 150.2) / ( 1 + 0.182)

+ 9.8 / ( 1 + 0.182)

= 92.8277 million Rs
You can use FC-100 calculator to get the same answer as follows:
CASH mode; data editor; enter cash flows as :
-0 exe; 6.4 exe ; 8.8 exe ; 9.8 exe ; 10.2 exe ; 161.4 exe ; esc ; i 18.2 exe ; solve NPV ; and you
get 92.8277 as answer.
Since 10 million shares of this co are outstanding so


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

Fair value of share = Value of equity / number of shares

= 92.8277 / 10 = 9.28 Rs per share
There are many other valuation methods in use to estimate a fair value for shares of a Co, some of these
methods are elaborate and others are based upon the idea of improvising due to lack of relevant data.

Price to Book Value Ratio Model of Valuation

PB ratio = P0 / BV per share. Book value per share is OE / number of shares outstanding. PB ratio is also
called market value to book value ratio or BV multiple.
PB ratio = P0 / BV per share, therefore taking BV on the left side you get:
PB ratio * BV per share = P0

This is another model of valuation of shares that is useful for valuing unlisted and untraded companies
such as private limited companies. Since current share price ( P0 ) is not observable for such companies
and so their PB ratio cannot be calculated, therefore average PB ratio of comparable companies is used as
a proxy:
P0 of a Pvt Ltd Co = Average PB ratio of comparable companies * book value per share of this Pvt Ltd co
This model of valuation can be used for companies which do not pay cash dividends, and also for
companies that are not listed and their shares are not trade thus their share price is not observable. PE
ratio assumes a positive EPS to arrive at a positive PE ratio and therefore can not be used for companies
reporting negative EPS, but PB model can be used for companies whose EPS is negative
Use of PE ratio and PB ratio for valuation purpose can be brought together as analyzed below:
PB ratio = P /BV
PB ratio * BV = P (1)
And we know that ROE = NI /OE , you can write it on per share basis as
ROE = (NI /shares) / (OE / shares)
Inserting this formulation of BV in equation (1) above we get
PB ratio * (EPS / ROE) = P
P = PB ratio * EPS * 1 / ROE ..(2)
We also know that


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

PE ratio = P / EPS, and therefore

P / PE ratio = EPS, inserting this form of EPS in equation (2) above gives:
P = PB ratio * P / PE ratio * 1 /ROE
Since P = PE ratio * EPS, so inserting this expression of P we get
P = PB ratio * (PE ratio * EPS) / PE ratio * 1 / ROE
P = PB ratio * PE ratio * EPS * 1 / PE ratio * 1 / ROE .. (3)
Please note that PE ratio = P/ EPS
And therefore P = PE ratio * EPS,
But about EPS we know that analytically it can be written as:
EPS = NI/S * S/TA * TA/OE* OE /shares, and that can also be written as
Inserting this expression of EPS in
P = PE ratio * EPS, we get
P = PE ratio * ROE * BV (4)
Since we know that P = PB ratio * BV, then entering this on the left side of equation (4) we get
PB ratio * BV = PE ratio * ROE * BV
Cancelling BV from both sides give us
PB ratio = PE ratio * ROE
and so we have an expression for ROE as:
ROE = PB ratio / PE ratio .. (5)
The foregoing analyses showed that there are various ways to combine ROE, EPS, BV, PB ratio, and PE
ratio. You can use this understanding to select which formulation is suitable for use depending upon the
data availability.
Please notice from above analyses that:
PE ratio is inversely related with ROE. But in the DDM with constant growth model as discussed above we
P0 = DPS1 / (Kc - g)
Dividing by EPS0
P0 / EPS0 = {DPS0 (1 + g) / EPS0} / (Kc - g)
PE ratio = d (1 + g) / (Kc g).
Entering : g = ROE (1 - d) in this model we get
PE ratio = d (1 + ROE (1 - d)) / (Kc ROE (1 - d))
Which shows that PE ratio is directly related to ROE.
Now which one is correct?


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

High ROE causes high PE ratio as suggested by

PE ratio = d (1 + ROE (1 - d)) / (Kc ROE (1 - d));
or high ROE cause low PE ratio as suggested by ROE = PB ratio / PE ratio
Both cannot be true simultaneously, therefore caution must be used in applying PE ratio for analytical and
valuation purposes. Though it must be stated that among the practicing analysts the use of PE ratio is
widespread compared to any other valuation technique, probably without the knowledge of underlying
contradictions inherent in PE ratio.
For example higher PE ratio is taken as indicator of for higher growth, but low PE ratio is taken as shares
being undervalued. If that is correct and we look at the following data in comparison to Pakistan:


Average PE Ratio











Then as a believer in PE ratio, one must conclude that Pakistani market is undervalued, and therefore
international investors should move in herds to invest in Pakistani share market. But objective reality is
exactly the otherwise, not only international investors are not flocking in Pakistani market but also local
Pakistani investors are leaving Pakistani market. Similarly if US market is overvalued compared to
Pakistani market, then why Pakistan investors are buying over valued shares in USA?
Moreover it is not clear whether low PE ratio indicates undervaluation or poor growth prospects?
Similarly whether high PE ratio indicates overvaluation or high growth prospects?

Let us take the case of high PE ratio first. If high PE ratio means share is already over valued relative to its
EPS, then how can we expect its share price to grow more in value in future, that is, how can we expect
growth in price of a share that is already viewed as over valued at its current price. Common sense tells
us that price of overvalued assets fall in future, rather than experiencing an increase in future. So the
growth in their value should be negative.
Let us now take the case of low PE ratio. If low PE means share is already undervalued relative to its EPS
and common sense tells us that undervalued assets are expected to grow in value in future then how can
low PE can be viewed as a signal of low growth prospects for its value in future.

Is It EPS or ROE that Creates Value

You must have observed excessive concern among the analysts community about the announcement of
quarterly EPS by the companies. Consequently executives performance is judged also with the short term


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

perspective, and is based upon EPS reported under their supervision. Though this practice is unfortunate,
and is partially responsible for excessive focus on short term performance probably at the expense of
ignoring the long term survival and growth prospects of a company, yet a relevant question arises as to
which variable is more important for value creation? EPS or ROE?

The following is an analytical

breakdown of EPS that shows that higher EPS leads to higher ROE , which ultimately leads to higher value
per share, though not always.
ROE = NI /S * S/TA * TA/OE
Multiplying both sides with OE/shares
ROE * OE/shares = NI /S * S/TA * TA/OE * OE / shares
NI/OE * OE /shares = NI /S * S/TA * TA/OE * OE / shares
As OE/shares is called book value per share or just BV
And as RHS reduces to NI/shares that is EPS
ROE * BV = NI /shares
This shows that higher EPS is likely to result in higher ROE if BV per share remains constant. Usually BV
per share gets diluted due to issuance of bonus shares, but dilution of EPS due to the same reason also
takes place; so the relationship of high EPS and high ROE remains unchanged. But if co issues new shares,
raises new equity capital , invests in new projects, but investment turns out not that profitable, and thus
EPS does not increase as much, in this case BV increases but EPS does not increases as much and net
result is low or no increase in ROE, and that is still in line with EPS and ROE being related. Thus from value
creation perspective:
Higher EPS leads to higher ROE, which in turn leads to higher share price; and therefore focus on EPS as
value driver is not misplaced; and media reporting EPS as indicator of managerial performance and
investors using EPS as a guide about value creation is not altogether wrong because of direct relationship
of EPS with ROE. But a more important issue is whether high ROE always leads to value creation? The
following paragraphs attempt to analyze that contention.

Does High ROE Always Create Value for Shareholders?

Generally it is understood that higher ROE always leads to higher share price, and in most cases that is
true. The accounting valuation model you studied earlier also quantifies that relationship in a precise
manner with the condition that high ROE creates value only as long as ROE is greater than shareholders
risk adjusted required rate of return (Kc). DDM with constant growth assumption also shows a direct
relationship between ROE and value of share. Bifurcation of PE into tangible PE and Franchise PE showed


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

that franchise PE is positive only if franchise factor is positive and franchise factor can be positive only if
ROE is greater than Kc.
But it is important to realize that value creation due to high ROE is subject to certain other conditions as
well. From your corporate finance course you know that for non financial companies:
The derivation of this ROE model and its implications for value of share would be discussed in detail in
the later lectures about financing decisions.
ROIC = EBIT (1 - T) / capital invested in a business
capital invested = NWC + FA = LTL + OE
EBIT = S CGS Operating Expenses.
Ki = Kd (1 - T)
Kd = weighted average cost of debt , that is, interest expense / debt capital employed by a company.
EBIT is operating profits of a business, and ROIC shows operating performance of a business regardless of
its financial policy and dividend policy. In other words it does not matter for generating ROIC whether
NWC + FA were financed all by OE or by some combination of LTL + OE. What matters for earning ROIC is
the fact that how much assets are available, and once these assets (NWC + FA) have been put in place
then how productively and efficiently they are managed. So for earning ROIC investing decision or capital
budgeting decision matter; and financing or capital structure decisions are irrelevant.

But for earning

ROE that is not the case, for ROE depends both on operating performance and financial leverage, that is
on both investing decisions as well as financing decisions, or in other words both on capital budgeting
decisions and capital structure decisions. And that can be seen by the presence of both ROIC and debt to
equity ratio and after tax cost of debt in the above stated formulation of ROE.
So a co can choose to attain higher ROE through better operating performance (higher ROIC); or through
employing higher financial leverage (high Debt to equity ratio). Both paths of attaining higher ROE are
available to the top management of a company. But employing high debt to equity ratio entails higher
financial risk. Since perceived higher risk has a dampening effect on the value, therefore higher ROE
achieved by using higher debt to equity ratio may not translate in higher share price because market
recognizes the fact that the method used to attain higher ROE was risky. The analytical logic of this
common sense is as follows:
If D/OE ratio is high, it leads to higher Beta of shares because, according to Hamda equation,
BL = B BU (1 + ( 1 - T) D/OE
And higher BL results in higher Kc as per CAPM
Kc = Rf + (Rm Rf)BL
And higher Kc results in lower share price as per DDM :
P0 = DPS0 (1 + g) / (Kc - g)


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

And though higher ROE should result in higher g because * g = ROE (1 d)], and ultimately higher share
price should result as pricing model given above shows, but that effect of higher growth rate is likely to be
more than neutralized due to higher Kc , and it is possible share price falls though co has shown higher
ROE and resulting higher growth rate. Such situation is termed as growth without value creation,
though such a co is growing but shareholders are not getting wealthier by experiencing increase in share
price. In fact shareholders of such a co may be losing wealth due to fall in share price. In plain words, the
number of factories in a co may be increasing one to two factories, and two to four; but its shareholders
wealth may be shrinking due to persistent fall in share price.

On the other hand higher ROE achieved through higher ROIC has no such negative fallout, and this is the
sure route to value creation. Therefore confused thinking should be avoided, myopic view that higher
ROE must be attained at any cost should be shelved, and more analytical approach of charting the right
course of attaining higher ROE through earning higher ROIC should be adopted for definite value creation.
In summary it is the better operating performance through higher ROIC that is the sure way of value
creation. It is useful to look deeper into operating performance. Better operating performance is
attained either by:

higher EBIT (1 T)


lower capital invested (NWC + FA = LTL + OE).

Higher EBIT is result of higher sales revenues, lower CGS, and lower operating expenses. Note CGS +
Operating expenses are termed operating costs. That means improving the Marketing performance
(sales); and cutting production costs (CGS) and cutting the overhead costs ( the operating expenses)
generates value. Higher ROIC also means avoiding overinvestment in the assets of a business so that
capital invested is a smaller number , and since it is in denominator of ROIC, therefore a smaller
denominator means higher ROIC.
ROIC = EBIT (1 T) / capital invested. It can be bifurcated as:
RIOC = EBIT (1 - T) / Sales * Sales / capital invested
ROIC = after tax operating profit margin * turnover of capital invested
After tax operating margin on sales depicts ability of a co to extract after tab operating profits from a
rupee of sale; and turnover of total capital shows productivity of 1 rupee of capital employed to generate
sales. For example if after tax operating margin is 20% or 0.2 and turnover of capital is 2, then ROIC = 0.2
* 2= 0.4 or 40%.

Please note that better operating performance can be neutralized if after tax cost of debt ( Ki) is too high.
For value creation through higher ROE, it is imperative that ROIC must be greater than Ki, otherwise ROE


Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar

would be lower than ROIC, growth rate would be low and value would be destroyed. It must be
understood that in most cases after tax cost of debt is too high if a big portion of total capital is raised as
debt capital , therefore companies with too high a debt to equity ratio are more likely to have an
excessively high Ki. In simple language, do not borrow at very high interest rate (kd), because that may
cancel out good effect of high ROIC, and ultimate ROE may turnout low resulting in low growth and
ultimately low share price.
So we may conclude that high ROE creates value for shareholders only if it is attained through achieving
high ROIC, but high ROE may destroy value if attained by using too high a debt to equity ratio. Therefore
it is correct to say that the ultimate driver of value creation is ROIC, not ROE. It is operating performance
( buying, storing, manufacturing, and selling) that creates value for the owners of a business, not the
decisions to take more loans at high interest rates to expand the business and to have 4 factories instead
of one. Management, while doing planning for business expansion, must be watchful of the concept of
value destroying growth or growth without value creation. If a companys management attains high ROE
by employing very high financial risk, the market, instead of rewarding the shareholders of such a
company, may punishes them.
If you are looking for a concrete answer about wealth creation for owners of a business, as depicted by
share value in stock market, then the answer is high ROIC as measured by EBIT (1 T) / (NWC + FA).

The previous discussion about role of ROIC and attendant EBIT, NWC + FA, etc is unfortunately not
applicable to financial Institutions because assets of FIs are not easily classifiable as NWC + FA. Concept of
EBIT is also not applicable to financial institutions( FIs), and therefore it is not realistic to calculate ROIC
and WACC for FIs, though some analysts try to do that.

Yet the general wisdom derived from the

previous section is valid for FIs as well. That is, operating performance is the source of value creation, too
much financial leverage may hurt value.
In fact the fear of FIs using excessive financial leverage by employing too much debt financing is
recognized with such seriousness that the whole idea of Basel Accord and related capital adequacy
requirements, etc , are aimed at restricting the FIs from using too much borrowed funds (debt capital),
and forcing them to have appropriate levels of equity capital as well.