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Equity Research

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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).

The most practical methods of valuation used in ER are:

1. Discounted Cash Flow (DCF) Valuation

DCF estimates the value of a company using the Present Value of expected future cash-flows of
the company.

To forecast the cash flows of a firm, you need to determine:


• What earnings to forecast? Is it Net Profit, Operating Profit or something else?
• What rate should these future cash flows is discounted at?
• How to forecast the earnings?

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.

There are 3 key steps to carry out relative valuation:

1. Identify a peer set


2. Identify the right multiple/ratio
3. Premium and discounts to multiple

Key terms in Valuation:

• 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.

• Depreciation & Amortization: ‘Depreciation’ is used for tangible assets, and


‘amortization’ for intangible assets. In other words, this indicates how the asset is
getting used up.

• 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.

• Market Value of Equity: Practically considered as the Market Capitalization of a firm –


that is, the estimated market value of shares issued.

• Enterprise Value: This measures the market's estimate of the value of Operating
assets/Company, including for its debt-holders.

• Enterprise Value/EBITDA: This is a commonly used multiple in relative valuation.


It enables comparison of firms that are reporting operating losses, and diverge widely
on depreciation methods used.

• Free Cash Flow (FCF): Free cash flow is the cash that flows through a company after
all cash expenses have been taken out.

Valuation - DCF Method

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).

Variants of DCF Method


There are two main variants of this method:

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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Calculating Equity Value from Firm Value

Equity Value = Firm Value - Value of long term debt - Value of short term debt - Value of other
non-equity claims in the firm

Free Cash Flow to Equity (FCFE)

(Revenues – Expenses – Interest) – Taxes = (EBITDA – Interest) - Taxes

Firm Valuation Method (Free Cash Flow to Firm - FCFF)


The value of the firm is obtained by discounting expected cash flows to the entire 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.

Weighted Average Cost of Capital (WACC)


WACC is the calculation of a firm's cost of capital. Each category of capital is proportionately
weighted.

When do we use Equity Valuation and Firm Valuation


• Use FCFE for firms which have stable capital structures – that is debt to equity ratios.
• Use FCFF for firms which have capital structures expected to change over time.

Calculating Cash Flows

FCFE = EBIT – Interest expenses - Taxes + Depreciation & Amortization - Capital Expenditures
- Working Capital Changes - Principal Repayments + Proceeds from New Debt Issues

FCFF = {EBIT x (1 - tax rate)} + Depreciation - Capex - Change in Working Capital

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:

• Constant growth model:


The value of equity, under the constant growth model, is a function of 3 elements:

 The expected FCFE in the future periods


 The stable growth rate and
 The required rate of return.

• 2 Stage FCFE model:

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Under this, the value of the firm is calculated in 2 stages:


1. We estimate the cash flows for a short period of three to five years (based on
company projections, your analysis) where you expect high growth.

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).

Normalizing Cash Flows

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.

Equity Research Report Writing

What is an Equity Research Report?

‘Research Report’ means any written (including electronic) communication that:


 includes an analysis of equity securities of individual companies or industries, and
 provides information reasonably sufficient, upon which to base an investment decision.

Main features of an Equity Research Report

 The report is prepared by an analyst.


 It focuses on an individual stock or industry.
 The report should provide sufficient amount of information.
 It has a specific and definitive outcome or suggestion

Equity Research Report (ERR): Types

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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5. Strategy/Economic Reports - These reports usually cover the general economic


trends, especially the macroeconomic variables.
6. Flash/News Report - These are short and precise reports, that give a quick overview
of how the company is doing.

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:

 The target price and recommendation comes first!


 Recommendation should come in very definitive words like ‘buy’, ‘sell’, ‘hold’ etc.
 The use of active voice is preferable.
 The first page should give a snapshot of the entire report.
 Timeliness are important.

Avoiding Blunders:

 Avoid overtly sensational, flamboyant, gambling language in your writing.


 Don’t include information based on unsubstantiated reports and rumors.
 Pre-announcements should not be made.
 Promissory wordings can be misleading and are not professional.
 The report must be coherent. Try reading this text.
 Avoid clichés like jack of all, lion’s share.

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