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Valuation
Introduction
Valuation of a company reflects the performance of the company – both its past performance as
well as expectations of its future performance.
Based on the facts and assumptions of these two broad time frames, one attempts to
understand what the company is worth.
Why valuation?
• You want to buy, hold or sell its common stock.
• You are evaluating a merger or an acquisition.
• You are evaluating a strategic or financial investment in the company (a private equity
fund perspective).
DCF estimates the value of a company using the Present Value of expected future cash-flows of
the company.
2. Relative Valuation
Relative valuation method estimates the value of a company by comparing it with the value of
similar companies (called ‘peers’), where key metrics and ratios are used to drive the
comparison.
• Beta: This is the measure of risk in a company that cannot be diversified away.
• Capital Expenditure: It is the capital spent on buying fixed assets for the company.
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• Cost of Capital or WACC: This is the weighted average of the cost of equity and after-
tax cost of debt, weighted by the market values of equity and debt.
• Cost of Debt: This is the effective rate of interest of the existing long term debt of the
company. This is used on an after tax basis, as interest on debt is tax deductible.
• Cost of Equity: Cost of equity is the rate of return that stockholders in a company
expect to make, when they buy its stock.
• EBITDA: This measures pre-tax cash flow from operations, and is the most important
number for Valuation.
• Effective Tax Rate: This measure the average tax rate paid across all the income
generated by a firm.
• Enterprise Value: This measures the market's estimate of the value of Operating
assets/Company, including for its debt-holders.
• Free Cash Flow (FCF): Free cash flow is the cash that flows through a company after
all cash expenses have been taken out.
In this method, all future cash flows of the company are estimated and discounted by an
appropriate discount rate (to cover riskiness or expectation); to give their present values (PVs).
1. The Equity Method - The equity version values just the equity stake in the business.
So, this applies to all equity shareholders in the company.
2. The Firm Method - The Firm variant values the entire business, which includes both
the shareholders and all the other claimholders of the firm – especially lenders to the
company.
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Equity Value = Firm Value - Value of long term debt - Value of short term debt - Value of other
non-equity claims in the firm
That is the cash flows after meeting all operating expenses and taxes, but prior to debt
payments.
This is discounted at the weighted average cost of capital (WACC) – Cost of Equity plus Cost of
Debt.
FCFE = EBIT – Interest expenses - Taxes + Depreciation & Amortization - Capital Expenditures
- Working Capital Changes - Principal Repayments + Proceeds from New Debt Issues
There are different models that can be followed under the FCFE method based on what you
expect the growth pattern of the business to be. These are:
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2. Beyond the high growth period, we assume a steady growth rate for the firm
(typically taken as the growth rate we expect for the economy over a long term).
Sometimes a firm may have had an exceptionally good or bad year, which reflects on its
general growth rate or stability.
If such a year is used as the year to estimate cash flows in a constant growth model or in a
terminal year, we would end up with a poor estimate of value.
In such cases, it is necessary to normalize the cash flows. We can normalize cash flows by
using average earnings over an extended historical time period for the firm. We could also use
industry comparables.
1. Initiating Coverage - This implies that a stock analyst has begun to cover, or follow, a
particular stock, and has issued an initial report and/or rating on it.
2. Results Update Report – Apart from financial statement and relative performance of
the company, the report includes, whether the view about the stock is maintained, in
light of the disclosures by the company.
3. IPO Report - It covers the analysis of a company raising money, through an IPO or
FPO.
4. Sector/Industry Report - These reports give an update on various sectors and
industries.
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Basic Template
Usually, there are templates available in research firms, and the analysts write reports using
those templates.
However, there are a few essential heads, which are more or less constant.
These include:
Highlights
Investment Rationale
Company Profile & Business Description
Industry Overview
Peer Competition
Financial Overview
Valuation
Risks & Concerns
Financials
Points to Remember:
Avoiding Blunders:
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